🎧 I Spent 3 Months Breaking Down GDP — Here's What Most People Miss
Breaking down GDP by component and putting it back together with an example from the pandemic
Over the last three months, we’ve been constructing Gross Domestic Product (GDP) from the ground up. On the domestic side, we talked about the consumer’s role in the economy, and about what businesses and the government spend on goods and services to help provide you with final goods and services.
The last two posts showed us the international side of GDP.
Putting the components of GDP together
In the process, we’ve also constructed what’s called the expenditures side of GDP:
GDP is the value of all the finished (or final) goods and services domestically produced during a given year. GDP gives a broad picture of the economy’s health.
We can put all we’ve learned together to get the GDP equation:
GDP = Consumption + Investment + Government Spending and Investment +
Exports – ImportsFor all but one component (Imports), as they rise, GDP rises. If they fall, GDP falls.
We subtract Imports because those aren’t produced domestically. If imports rise, and the other components stay the same, then GDP falls. And if imports fall, and the other components stay the same, then GDP rises.
Here’s a simple numeric example.
Suppose domestic production (Consumption + Investment + Government Spending and Investment + Exports) = 600 and Imports = 100.
Then GDP = 600 – 100 =500.
Suppose Imports fall to 50, while the other components stay the same.
Now GDP = 600 – 50 = 550.
This leads us to a version of supply and demand for all goods and services, called Aggregate (or Total) Demand and Aggregate Supply.
Aggregating demand and supply
Aggregate or Total Demand is the GDP equation. The behavior of that demand curve depends on the determinants we talked about in earlier posts. Employment and population growth positively affect Consumption, Investment, and Imports, for example.
If employment grows or the population rises, our demand for goods and services both domestic and imported rises. The opposite is also true.
On the other hand, higher interest rates and rising costs negatively affect Consumption and Investment. If interest rates or costs rise, the demand for all goods and services will fall, all else being equal.
I’ve prepared a cheat sheet for you as a pdf file that shows each component or part of GDP and its determinants. You’ve seen it before in each of the stories in the GDP series.
As with ordinary demand, we need someone to make these goods. Aggregate Supply (AD) is that piece of the puzzle. One of the determinants of supply is the cost and availability of resources.
Resources include the skills, knowledge, and availability of your workers, as well as the availability of materials. Other factors affecting aggregate supply are changes in productivity and changes in technology. Most of these supply shocks are positive. Some are not. Let’s use the pandemic as an example.
The pandemic was an unforeseen event
The pandemic was an external, unforeseen, and unusual event. To protect ourselves, the country went into lockdown. Government spending on social programs and business protection increased. Taxes fell too. Those temporarily or permanently out of work had some income protection. Businesses had extra money to protect their payroll.
As the amount taken out of our paychecks for withholding falls, we have higher take-home pay. So, when taxes fall, Consumption rises.
All of this causes GDP to rise.
Port, factory, and service businesses’ closures led to a lower supply of goods and services. Businesses ran out of inventories and couldn’t replace them. In some cases, factories destroyed inventories, especially unpackaged meat.
At the beginning of the pandemic recovery, workers were sick with COVID, needed at home by their children, or scared to return as reported deaths climbed every day. Since 2022, when the US reopened the border for immigration, many employers found some of the workers they needed to replace those lost to COVID or those who decided to pursue a different career path.
The initial fall in the supply of labor led to fewer employees and an increase in wages. Those who had trouble finding work could find it. Those sidelined before and during the pandemic returned to the labor market because wages rose.
Consumers demanded more goods and services to make up for the times they couldn’t get anything.
As a result, prices rose—a lot. As inventories began to rise and businesses got back to work making things, the spike in inflation leveled out. Productivity increased as well, causing Aggregate Supply to rise.
Using GDP to measure the economy has problems
When we measure GDP, we have a problem as it does not include unpaid work in the home, illegal and under-the-table work, and production by undocumented workers. Putting a price on the value of housework and unpaid labor is difficult since we don’t know the impact on demand.
In addition, some people want payment under the table work to avoid taxes. Some of the work may not meet codes or regulations or is harmful. The production of illegal work is also harmful to the legal participants in the economy. Think drugs and theft.
Undocumented workers, on the other hand, add to the economy by working off the books. They add to production as housekeepers, nannies, and farm help. In 2002, I did taxes for a few undocumented workers. They got taxpayer ID numbers and paid their taxes, so that the government would consider them for the next general pardon.
That never happened. The bill stalled under George W. Bush in 2007 because the Senate didn’t support it.
We’ve now completed our GDP Series. Give yourself a pat on the back if you got through them all! Your bonus pdf will be in your inbox soon.
We’ve learned about the components of GDP and what determines each of them. When external forces change a determinant, then one or more components change.
Thank you for reading,
Nikki