Understanding the Components of GDP | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Welcome back as we dive deeper and examine the components of GDP. We first understand the flows of output, income, and expenditure in the economy, followed by the major components of GDP using the expenditure approach and the income approach. We shall also learn the fundamental relationship among the components.

Components of GDP and Economic Sectors

In our last lesson, our very simple economy consists of just two major sectors: households and businesses. Most modern economies will also have a government sector, which can be a major player in the economy, and the foreign sector, which comprises transactions with the rest of the world.

In such an economy, the activities center primarily around the goods and services market, the financial markets, and the factors of production market.

Flows in an Economy

Services of labor, land, and capital flow through the factor market to businesses. Income from businesses flow back to households in the form of profits and compensation.

Households spend part of their income on current consumption (C), where the expenditure flows through the goods and services market to the business sector. Households also save part of their income for future consumption (S), which flows into the financial markets where it provides funding for businesses that need to borrow or raise equity capital.

The amounts raised by businesses are invested (I) in inventory, property, plant, and equipment. As businesses are both buyers and producers of such goods, the investment money goes both ways in and out of the goods market.

Businesses also save part of their excess cash in financial markets for future needs.

The government sector collects taxes (T) from households and businesses. In turn, the government sector purchases goods and services from the goods and services market, which flow back to the businesses. For example, the government sector hires construction companies to build roads, schools, and public facilities. Government spending (G) also reflects spending on government services like the military and postal service. The government is also a major employer in the economy. To keep our illustration simple, government employment and the corresponding income are not explicitly shown here.

If government spending exceeds net taxes, then the government has a fiscal deficit and must borrow in the financial markets to fund its expenditures.

In our increasingly connected world, importing and exporting goods can form a huge portion of the economy. Likewise, the net exports proceeds (X – M) flow to businesses.

When an economy imports more than it exports, there is a trade deficit. A trade deficit must be funded by borrowing from the rest of the world through the financial markets. Conversely, if the imports are less than exports, there is a trade surplus. In this case, there is net foreign lending to the rest of the world.

Expenditure Approach and Income Approach to GDP

So from studying the flows in an economy, we can see that the total expenditures in the economy is the consumption spending by households (C), plus business investment (I), plus government spending (G), plus the net exports (X – M). This is the expenditure approach to determine the economy’s GDP. Market analysts generally prefer the expenditure approach because expenditure data are more timely and reliable than data for the income components.

Under the income approach, GDP is the sum of national income, capital consumption allowance, and statistical discrepancy.

National income is the sum of the income received by all factors of production that go into the creation of final output. This includes employee compensation, interest income, business owners’ incomes, rent, corporate and government enterprise profits before taxes, and indirect business taxes less subsidies, which include taxes like sales tax, import duties, and property taxes.

A capital consumption allowance (CCA) measures the wear and tear of physical capital from the production of goods and services over a period. Loosely speaking, CCA can be thought of as the profit to be reinvested to maintain the productivity of physical capital.

The statistical discrepancy is an adjustment for the difference between GDP measured under the income approach and the expenditure approach because they use different data.

Personal Income and Saving

Besides GDP, several governments also provide information on personal income and saving. Personal income is a measure of the pretax income received by households and is one determinant of consumer purchasing power and consumption. Of the components of national income, employee compensation, interest income, business owner income, and rent can be considered personal income.

Indirect business taxes are not considered personal income as they go to the government.

Part of corporate profits are paid as taxes to the government, and the remaining can be distributed to shareholders, or retained by the company. Only the portion distributed to shareholders can be considered personal income. Retained profits and corporate income taxes are not considered as the money does not flow to the households.

Governments also make transfer payments in the form of payouts like unemployment benefits, or indirectly through programs like universal health care. Such payments should be considered personal income. As mentioned in the last lesson, transfer payments are not included in government expenditures. Transfer payments are subtracted from taxes and reflected in net taxes.

So personal income is equal to transfer payments from the government, plus national income, minus undistributed corporate profits, minus corporate income taxes, minus indirect business taxes.

Take away personal income taxes, we get the personal disposable income (PDI) of the economy. PDI measures the amount that households have available to either save or spend on goods and services and is an important economic indicator of the ability of consumers to spend and save.

Fundamental Relationship among Savings, Investment, Fiscal Balance, and Trade Balance

And to wrap up this lesson, let us learn the fundamental relationship among savings and investment, the fiscal balance, and the trade balance.

We have learnt that:

GDP = consumption (C) + investments (I) + government spending (G) + net exports (X – M).

If we follow the flow of GDP, we can have an alternative expression. We can observe that GDP goes back to the households as income, and some of it ends up as business savings. Households pay income taxes, and the remaining is either spent on goods and services or end up as household savings.

The alternative way of expressing GDP is therefore:

GDP = net taxes (T) + consumption (C) + household and business savings (S)

If we equate these two expressions and rearrange the terms, we get the following fundamental relationship among domestic saving, investment, the fiscal balance, and the trade balance.

This equation shows that domestic private saving is used or absorbed in one of three ways: investment spending, financing government deficits, and building up financial claims against other countries. If there is a trade deficit, then domestic private saving is being supplemented by inflows of foreign saving and overseas economies are building up financial claims against the domestic economy.

Conclusion

In conclusion, understanding the components of GDP is crucial for anyone studying economics or finance. By examining the flows of output, income, and expenditure in the economy, we can gain a deeper understanding of how the economy works. Remember that the major components of GDP using the expenditure approach are consumption spending by households, business investment, government spending, and net exports. On the other hand, under the income approach, GDP is the sum of national income, capital consumption allowance, and statistical discrepancy. Moreover, personal income is an important determinant of consumer purchasing power and consumption, and personal disposable income (PDI) measures the amount that households have available to either save or spend on goods and services. Finally, the fundamental relationship among savings and investment, the fiscal balance, and the trade balance is important to understand as it explains the aggregate demand and supply curve.