Splitting GDP

GDP. It's a big number, and it encompasses a lot of activity, from consumers buying bread, to a business buying computers, to the government buying a tank. So, when analyzing an economy, it's often useful to split GDP into different subcategories. I'm going to cover the two most common ways of splitting GDP: the National Spending Approach and the Factor Income Approach.

First up, the National Spending Approach. This takes all the goods and services that go into GDP and splits them into consumption -- goods and services like cakes and massages bought by consumers; investment -- goods and services like computers or tractors usually bought by businesses; and government purchases, which includes consumption goods like paper and pens, and also investment goods like tanks and computers, which are bought by governments. We then need to make one correction. People in other countries might also have bought some of our goods, so we add exports. On the other hand, some of what we've counted already, some of what was bought by U.S. consumers, businesses or governments, was purchased from abroad -- imports. Imports don't add to our GDP, so we want to subtract imports. Exports minus imports is sometimes also called net exports.

Now, how big are each of these categories? Consumption is the biggest at around 63% of GDP. Investment and government purchases make up the rest, with government purchases usually a bit bigger than investment. In the United States, net exports is usually quite small. It's important to remember that government purchases are different from government spending. When the government spends some tax revenue by sending out, let's say, a social security check, that's just a transfer. It doesn't add to GDP. Why not? Well, when the social security recipient gets the check and spends it on goods and services, that does add to GDP. So, we don't want to double count. So, remember, government purchases are just the money spent directly by government on goods and services.

So why are we doing all this? Economists find it useful to split GDP in this way because the forces that determine consumption, investment, and government purchases, they're very different. And if GDP falls, we may be interested in knowing, was that caused by a fall in consumption, or was it a fall in investment or government purchases? If we want to combat a recession, we also have different tools for increasing consumption, investment, or government purchases. We'll be looking more about those tools in future videos.

The second way of measuring GDP is called the Factor Income Approach. And it measures GDP by adding up employee compensation, rent, interest, and profit. Now, this may seem a little bit odd. Didn't we define GDP as the market value of goods and services? How can we measure it by looking at incomes? The reason is that when a consumer spends money on final goods and services, that money ultimately is received by someone, namely, by workers, landlords, lenders, and entrepreneurs. So, we can measure GDP by looking at the spending, or the other side of the ledger, by looking at the receiving.

Now, in practice, there are some tricky accounting issues, such as what to do about sales taxes, but we're going to leave that to the accountants. The basic idea here is that we can compute GDP by looking at the spending or the receiving. And in fact, we do both. When we calculate GDP by adding up employee compensation, rent, interest, and profit, we call it Gross Domestic Income or GDI. Why the different name? In theory, GDP and GDI are exactly equal. But since they're calculated in very different ways, they usually give slightly different results, hence the different names.

Let's take a look at the FRED database. Here, we graph GDP and GDI. Hard to see a difference, right? But zoom in a little bit, however. We can now see that they're not perfectly identical. And in a recession, economists often look at both figures since one of them might sometimes give us an earlier or more accurate picture of the economic situation. Keep in mind, however, the key idea. We can split or measure GDP in many different ways, depending on the questions that we're interested in asking. The GDP is always the market value of all finished goods and services produced within a country in a year.