GDP describes the monetary value of all final goods and services produced within an economy over a specific period (usually one year). There are two main methods to calculate GDP: the expenditure approach, and the income approach (see also Gross Domestic Product). According to the expenditure approach, GDP can be computed as the sum of consumer spending (C), investment (I), government spending (G), and net exports (NX, or X – M).
GDP = C + I + G + (X – M)
In the following paragraphs, we will take a closer look at each of those components and learn how to calculate GDP using the expenditure approach step-by-step. Let’s get started.
1) Find Consumer Spending (C)
First, we have to find consumer spending (C). Consumer spending describes all expenditures consumers make to buy goods and services for personal consumption. This includes non-durable goods (e.g., food, drinks), durable goods (e.g., clothing, furniture), and services (e.g., transport, education). Please note that by convention, consumer spending does not include the purchase of new housing (see below).
For example, think of an imaginary country, called Smolland. As the name suggests, Smolland is really small and only has 100 inhabitants. In total, they spend USD 200,000 per year on food, USD 200,000 on clothing, and USD 100,000 on public and private transport. For now, we’ll assume that’s all the money they spend (i.e., they have no other expenditures). In that case, Smolland’s consumer spending adds up to USD 500,000.
2) Add Investment (I)
Next, we have to add investment (I). Investment (or investment spending) describes all expenditures of firms on goods and services that will be used to produce more goods and services in the future . This includes all expenses on capital equipment, inventory, and buildings. There are two important things to point out here. First, the accumulation of inventory is considered an investment. That means an increase in inventory is treated as if the company had bought its own products for resale. And second, the purchase of new housing is always considered an investment, even if the buyer is a private household.
Going back to our example, let’s say that there are two companies located in Smolland. The first one is a factory that just bought USD 2,000,000 worth of new machinery. Meanwhile, the second company is a large retailer. This retailer has increased its inventory by USD 200,000 as compared to the previous year. In addition to that, a Smolland resident buys a new house worth USD 300,000. As a result, total investor spending in Smolland adds up to USD 2,500,000.
If we add this to the consumer spending we calculated above the interim result is USD 3,000,000.
3) Add Government Spending (G)
Now that we know consumer spending and investment, we have to add government spending (G) to the equation. Government spending describes all expenditures on goods and services by local, state, and national government institutions. This includes funding for public schools, roadwork, salaries of government employees, and many more. However, please note that government spending does not include transfer payments, because they don’t involve the exchange of a good or service.
Of course, the government of Smolland knows how important education is. Therefore, it spends USD 1,000,000 a year to run a public school and pay all the teachers who work there. In addition to that, the government contributes USD 500,000 to fix broken roads and highways throughout the year. As a result, government spending in Smolland is USD 1,500,000.
If we add this to the sum of consumer spending and investment calculated above, the new interim result is USD 4,500,000.
4) Add Net Exports (NX, or X – M)
Last but not least, we must consider net exports (NX, or X – M). Net exports are defined as the sum of all purchases of domestically produced goods and services (i.e., exports, X) minus the sum of all domestic purchases of foreign goods and services (i.e., imports, M). We have to use net exports (i.e., exports – imports) at this point because imports of goods and services are already included in different components of GDP (e.g., consumer spending).
To illustrate this, let’s assume that Smolland exports goods and services worth USD 1,500,000 this year. In the meantime, the country also imports products worth USD 1,000,000 from foreign countries. As a result, Smolland’s net exports add up to USD 500,000. Please note that whenever imports exceed exports, net exports are negative, which means they reduce total GDP.
Finally, by adding net exports to the sum of consumer spending, investment, and government spending we can calculate GDP according to the expenditure approach. That means, in the case of Smolland GDP results in USD 5,000,000 (i.e. 500,000 + 2,500,000 + 1,500,000 + 500,000).
In a Nutshell
GDP describes the monetary value of all final goods and services produced within an economy over a specific period. According to the expenditure approach, GDP can be calculated as the sum of consumer spending (C), investment (I), government spending (G), and net exports (NX, or X – M). Consumer spending describes all purchases consumers make to buy goods and services for personal consumption. Investment includes all expenditures of firms on goods and services that will be used to produce more goods and services in the future. Government purchases describe all spending on goods and services by government institutions. And finally, net exports are defined as the sum of all purchases of domestically produced goods and services minus the sum of all domestic purchases of foreign products.