Components of GDP - Coursework Example

Components of GDP Affiliation Components of GDP Part I A person’s standard of living (economic status) is measured by how much he orshe earns and spends at the same time. Similarly, the economic status of a country in a given period of time is determined by its GDP per capita. According to Mankiw (2011), gross domestic product (GDP) of a country refers to the market value of all final goods and services within that country in a specified period of time. GDP measures the total income of all people in an economy and the total expenditure in that economy, and thus gives the economic status of a country. The Components of GDP The main components of GDP are consumption, net export, government spending and investment. These four components of GDP together with other types of spending help economists in understanding how a country uses its scarce resources (Edgmand, Moowaw and Olson, 1996). The four components are related and their relationship can be expressed using an equation: Y=C+I+G+NX where; Y=GDP C=Consumption I=Investment G= Government spending, and NX=Net export This equation is an identity equation, that is, the total sum of the four components equal GDP. Here is an explanation of each component: Consumption It is the largest component of GDP in an economy. It refers to the private spending (personal expenditures) by households on goods and services. The personal expenditures consist of three categories, that is, purchase of durable goods such as automobiles and furniture but not the purchase of new housing, purchase of non-durable goods such as clothing and food, and purchase of services such as health care and education (Edgmand, Moowaw and Olson, 1996). In most economies, consumption is the fastest growing component of GDP. This is because consumption depends on population thus as population increases the rate of consumption also increases hence causing a sharp change in the GDP. Investment This is the purchase of goods and services for future use. It is the third largest component of GDP and includes the purchase of equipment, inventories and newly produced structures. Therefore, the purchase of new housing is an example of investment in structures. In GDP, investment implies to the purchase of goods such as equipment and inventories but not purchase of financial products such as bonds and stocks. The purchase of financial products is classified as saving but not investment (Mankiw, 2011). Government Spending This is the second largest component of GDP. It is total expenditure of the government on goods and services such as purchase of military weapons, payment of public servant salaries, and any investment expenditure. However, it does not include expenditure on transfer payments such as social security. Transfer payments are not counted as government spending in GDP because they affect household income but do not reflect the production of an economy (Edgmand, Moowaw and Olson, 1996). Net Export In most economies, net export is often the smallest component of GDP. It is the difference between exports (foreign purchase of domestically produced goods and services) and imports (domestic purchase of foreign goods and services), that is, Net Export= Exports – Imports. Investment-Savings Identity This is a concept in economics which states that the amount saved in an economy will always be equal to the amount invested (Edgmand, Moowaw and Olson, 1996). Expressed as S=I where S is the amount saved and I is the amount invested. Therefore, for classical economists, the market is always in equilibrium since S=I. The concept of investment-saving identity is however, used by modern economists to emphasize the behavior of the economy as a whole. Importance of GDP Equation in Macroeconomics Macroeconomics is a branch of economics that deals with the study of economy as a whole. It seeks to explain the economic changes that affect many households, firms and markets at the same time in a given country (Mankiw, 2011). Therefore, since GDP is measure of the total income and total expenditure of an economy, it plays an important role in the study of economy. The GDP equation helps macroeconomists to monitor the overall performance of a country’s economy and explain the economic changes that affect it. Nominal versus Real GDP Nominal GDP measures the value of output of a country during a given period of time using the prevailing prices during that period. On the other hand, real GDP measures the value of output of a country expressed in the prices of some base year (Mankiw, 2011). Therefore, the main difference between the two is that real GDP values are adjusted for inflation whereas those of nominal are not. Real GDP is often used in calculating GDP growth because it gives a more accurate view of the economy. Although the two differ, they often related as follows: Real GDP= Nominal GDP/GDP Deflator×100. Where; The deflator is the price index used. Part II The GDP of Country A From the information given about country A we find out that: Population=500,000 Cars produced per year=100,000 Cars purchased by people in the country (consumption) =90,000 Investment=10,000 Government spending= 25,000+10,000=35,000 Net Export= Exported cars-Imported cars =65,000-50,000 =15,000 Therefore, since GDP(Y) =C+I+G+NX, it implies that the GDP of country A is given by: GDP of country A=90,000+10,000+35,000+15,000 =150,000 The Composition by Percentage Consumption=90,000/150,000×100 =60% Investment=10,000/150000×100 =6.67% Government spending=35,000/150,000×100 =23.33% Net Export=15,000/150,000×100 =10% The GDP per capita This is the approximate value of goods produced by each person in a country, usually given by dividing the GDP of a country by the total number of people in that country i.e. GDP per capita=GDP/total population Therefore, The GDP per capita of country A=150,000/500,000 =0.3 Effect of Government Spending On the GDP If the government purchases of country A go up, its GDP will also go up, that is to say, if the government spending goes up by 10,000 then the GDP also goes up with the same amount. Graphically, it can be represented as follows: Effect of Consumption and Government Spending On GDP An increase in both consumption and government purchases would increase the GDP of country A because the components in the GDP equation are directly proportional, that is, any increase in one component would increase the GDP (Edgmand, Moowaw and Olson, 1996). Since we had represented the effect of government spending on GDP in the above diagram, the following graphical representation shows the how a change in consumption would affect GDP. Although the graph only gives an explanation of what would happen if consumption is changed, it is important to note that if both consumption and government spending are changed concurrently then the GDP will also change with the equivalent amounts. Part III Real GDP Today According to the Bureau of Economic Analysis US Department of Commerce (2011), the real annual GDP of United States of America in 2010 was 14,526.5 billion dollars. However, as at 26th August 2011 when the bureau released the second quarter estimates of the year 2011, the GDP was 15,003.8 billion dollars. This estimate was equal to annual increase rate of 1.3 percent. Components Involved In the Change According to the report released by the bureau in the second quarter, the increase in real GDP was as a result of positive contributions from: Nonresidential fixed investments Exports Private inventory investments and Federal government spending Imports which are usually subtracted from the GDP increased. Price index The United States GDP price index was 4.0 in the first quarter of 2011. However, in the second quarter (August 2011) the GDP price index was 3.2. Generally, the change in the price index was due to the increase in personal consumption expenditure, government spending, and investment. Particularly, the change was due to decrease in the price of energy and increase of food prices. Further, the pay rise for federal military personnel also contributed to the change (Bureau of Economic Analysis, 2011). Difference between GDP Price Index and CPI Although most people often confuse GDP price index to CPI, the two are different. GDP price index gives the prices of all final goods and services produced in a country within a given period of time. On the other hand, CPI gives the value of a representative basket of goods and services bought by the consumers over a given period of time (Mankiw, 2011). CPI, GDP and PPI Price Indices Although not commonly used, Producer price index (PPI) is still regarded as one of the good indicators of inflation in an economy. It measures the average changes in the trading prices of products (Mankiw, 2011).. However, of the three price indices, CPI is the most effective indicator because it reveals the current state of inflation in an economy. The other two compare prices of goods relative to the price of those in the base year thus do not monitor the current inflation of an economy. References Bureau of Economic Analysis: US Department of Commerce (2011). GDP and the Economy: Advance Estimates for the Second Quarter of 2011.Retrieved on 25 august 2011 from http://www.bea.gov/ Edgmand Michael, Moowaw Ronald and Olson Kent (1996). Economics and Contemporary Issues (3rd edit). Dryden Press Mankiw N. Gregory (2011). Principles of Economics (edit.6). Cengage Learning Read More