GDP and Pizza Video Explainers

GDP is the best-known three-letter acronym in economics. But what exactly is GDP?

GDP, or Gross domestic product, is the total market value of all final goods and services produced in an economy in a given year.

It measures the production of goods like pizza, new houses, cell phones, and services like your favorite streaming channels.

The calculations are simple accounting – multiplying the prices of the goods and services by the quantities sold and adding it all up… for the entire economy.

It’s important to note that all these goods are measured in the price at which they are sold to the end consumer, in U.S. Dollars.

Because one person’s spending is another person’s income, GDP can be tracked by either adding up income earned from selling goods and services, or by tracking spending on goods and services. As we’ll find out later, the spending, or “expenditure” approach, is a useful way to learn about the economy.

GDP is measured on a quarterly basis – that is -- the U.S. Department of Commerce releases GDP data four times per year. Economists analyze the numbers to see if the economy is growing – producing more goods and services, or contracting – producing fewer goods and services. A growing economy is associated with more jobs and rising standards of living. A contracting economy indicates the economy is likely in recession and will experience rising unemployment.

In other words, GDP is a very useful indicator of the economy’s health.

The typical treatment of GDP is the expenditure approach, where spending is categorized into the following buckets: personal consumption expenditures (C); gross private investment (I); government purchases (G); and net exports (X – M), composed of exports (X) and imports (M). Textbooks often capture this in one relatively simple equation:

GDP = C + I + G + (X – M)

C is personal consumption expenditures; it measures spending by households on consumer goods and services

Personal consumption expenditures includes spending on goods such as televisions and cell phones, and services such as the internet, streaming services, and wireless plans that make your television, and cell phone useful.

It’s important to note that these are new goods – those thrift store fashions you enjoy don’t count toward GDP because they were counted when they were sold as a new product.

And they are counted when they are sold to the end user – the consumer -- not at each of the various stages of production.

I is gross private investment; this measures spending by businesses on capital goods, these are goods such as machinery, tools, and buildings. Investment also includes household purchases of new homes, and business additions to inventory.

Notice, this is new housing – when the house is resold, it is not counted as a new addition to GDP. That is true for other goods too. GDP is a about measuring production of new goods and services.

G is government purchases; it measures spending by all levels of government on goods, services, and physical capital – including things like bridges, buildings, and highways.

The final category is net exports, which is composed of exports and imports.

X is exports; it includes goods and services produced domestically but sold abroad.

M is imports; it includes goods and services produced abroad but sold here.

You’ll notice in our equation, that all the numbers are added to form GDP, except M, imports. We’ll get to that a little later…

For now, it’s important to know that GDP is calculated as total spending on personal consumption, gross private investment, government purchases, and net exports.

Remember that exports are goods and services produced domestically but sold abroad

And, imports are goods and services produced abroad but sold here.

Because imports are produced elsewhere, those goods are counted in that country’s GDP. So, a cell phone produced in China is counted in China’s GDP. They can’t be counted twice; that is, they can’t be counted in our GDP.

Let’s go back to our equation,

GDP = C + I + G + (X – M).

Now, let’s focus on the last part of the equation, the “X-M” part – that part is known as net exports, because it is the result of subtracting imports from exports.

You’ll notice in our equation, that all the numbers are added to form GDP, except M, imports. The M variable is subtracted from GDP because GDP measures domestic production – in fact “domestic” -- which means it was produced inside a particular country -- is in the name. Imports aren’t produced domestically, so subtracting them is necessary.

But, does buying an import, actually subtract from domestic production?

Actually no.

It’s important to realize that the “M” variable – imports – is there for accounting purposes. The imports part of the equation is there to subtract out goods that were originally counted as consumption, investment, or government spending, but were imported. We subtract them to make sure we aren’t including the value of imported goods in the GDP number.

Here’s an example, let’s say you buy a car produced outside the U.S., and that car cost $30,000. When you bought the car, it was added to GDP as “C” or consumption spending. Then, because it was imported, the $30,000 dollars is subtracted, so they cancel each other out. So, the net effect of buying an import is no change in U.S. GDP.

In other words, the M variable is there to make sure we’re only counting goods produced domestically. But make sure you notice that buying an import does not subtract from GDP.

Knowing this can be useful because many goods are not purely domestic. For example, let’s say you bought a $30,000 car that was assembled in the U.S. but used $5,000 in imported parts. In this case, the net effect on GDP is $25,000.

The net imports part of the equation is also helpful for discussing the balance of trade – comparing the value of the goods we export, to the value of goods we import.

If we export more than we import, the balance of trade is positive. If we import more than export, the balance of trade is negative. But don’t automatically assume that a negative trade balance is bad for the economy – there’s a larger story here that we don’t have time to discuss in this video.

GDP is the total market value, expressed in dollars, of all final goods and services produced in an economy in a given year, but GDP can also be viewed as “national income.” Because a nation is made up of people, national income can be divided by the population of the country to indicate average economic well-being of the people within a country. So, dividing a particular country's GDP by its population is an estimate of how much income, on average, the economy produces per person (per capita) per year. In other words, GDP per capita is an estimate of a nation's average standard of living.

Think about a pizza. If the pizza represents the value of the economy’s output, or the national income, dividing it into four slices leaves everyone with a very large slice. Taking another identical pizza and dividing it among 8 people, leaves everyone with a much smaller piece.

Speaking economically, if the pizza represents GPD, or national income, the people dividing pizza 1 have a higher standard of living than pizza 2.

But, in both cases, if we could grow the size of the pizzas, everyone’s slice can be a little larger. This reveals a key idea in economics – the key to a rising standard of living is a growing economy.

Because GDP is a measure of the size of the economy, it can be useful for discussing how the economy is performing over time. If the economy at one point in time is $20 Trillion, and $22 Trillion at a later point in time, a simple calculation tells you that GDP, also known as nominal GDP, increased by 10 percent. With this information, you might assume that the economy grew by 10 percent – meaning you might assume production of goods and services increased by 10 percent.

However, there’s a pretty good chance that prices changed over that time span. So, some of that 10 percent growth, might be a change the prices of goods and services; meaning not all of the 10 percent increase in GDP represents an increase in the production  of goods and services.

Let’s use pizzas as an example again. Imagine these data reflected the income generated from your pizza parlor.

Year 1 you sold $500,000 worth of pizza.

Year 2 you sold $900,000 worth of pizza.

That’s a 80% increase – but does that really mean that the pizzeria produced 80 percent more pizzas this year than last year? Not necessarily. Here’s why – it is likely that both the prices and quantities increased from year 1 to year 2.

Let’s assume in year one the pizzeria produced 50,000 pizzas and charged $10 per pizza.

50,000 x $10 = $500,000

Then in year 2, it sold

60,000 x $15 = $900,000

Notice that income is calculated by multiplying the price of the goods by the quantity produced. In this case, the increase in income is the result of both an increase in price, and an increase in output.

In other words, because part of the increase in income from year 1 to year 2 was due to rising prices, you need to account for changing prices to discover how much of the increase in GDP was due to higher output.

If we want to know about the change in output, we must hold the price constant.

In this case, let’s hold price constant at $10—the price of pizza in Year 1.  So, let’s multiply the year 2 quantity by the year 1 price.

Year 1

50,000 x $10 = $500,000

Year 2

60,000 x $10 = $600,000

Once we hold prices constant, we can see that in real terms, output increased by 20%, not 80%.

So, in economics “real” means that we have adjusted for inflation and measured in constant prices—that is, in prices of a given or base period.

This is true for pizzerias, but also true for the economy at large. When examining GPD over time it’s important to use Real GDP, which is GDP that has been adjusted for inflation.

GDP is often expressed in dollars, or “levels” but it is often more useful to discuss changes in GDP in percentages. For example, let’s say GDP is $20 Trillion, meaning that the total market value, expressed in dollars, of all final goods and services produced in an economy in a given year is $20 Trillion. Now, let’s say the economy increased in size by $10 billion – that seems like a large increase, right? Well, it is large in dollar terms, but in percentage terms it is 0.05 percent, or 5 one-hundredths of one percent, that’s very small.

As such, economists generally find it helpful to talk about changes in GDP in terms of percentages.

While it might be tempting to think that the economy should grow at a very high rate all the time, the economy has limits to how fast it can grow – in other words, because economic resources are scarce, the economy has a potential growth rate.

Potential output is an estimate of what an economy could feasibly produce when it fully employs its available economic resources. The Congressional Budget Office (CBO) estimates potential output by estimating potential GDP, which it describes as "the economy's maximum sustainable output." Economists sometimes refer the economy’s potential growth rate as trend growth.

Of course, at any given time, there might be a difference between actual output and potential output. Although rare, it's possible for actual output to be higher than potential output – or above trend. It is far more common, though, for actual output to be lower than potential output – or below trend. The difference between actual output and potential output is called the output gap. The short-run fluctuations of actual output around potential output determine the business cycle—a term used to describe the fluctuating levels of economic activity in an economy over a period of time measured from the beginning of one recession to the beginning of the next.

Knowing the economy’s potential growth rate, or trend growth, is important because policymakers consider the output gap when determining whether the economy needs more or less stimulus. For example, when the economy is experiencing a negative output gap, meaning growth is below its trend the Federal Open Market Committee (FOMC) is likely to lower its target range for the federal funds rate to lower interest rates and ease financial conditions for consumers and businesses.

The goal is to keep the economy growing as close to trend as possible.

As the economy moves along the business cycle, experiencing periods of economic growth or recession, and changing unemployment and inflation, it impacts people’s lives. Ideally, the economy would experience a steady, stable, growth near its long run trend growth rate.

Automatic stabilizers help. Automatic stabilizers are a standing policy that activates automatically without intervention, usually during a recession.

An example is unemployment insurance.

Unemployment insurance is a program providing cash benefits for a specified period of time to workers who lose a job through no fault of their own.

When the economy is in recession, there are normally more people who are unemployed, which means more people qualify for unemployment insurance. The income provided by unemployment insurance supports people while they are out of work, and the extra spending supports the economy. So, unemployment insurance is an “automatic” stabilizer because government spending automatically increases during recessions.

As the economy recovers, and people find jobs, they move from receiving unemployment insurance to earning income, and government spending on this program automatically adjusts.

So in this way, automatic stabilizers are a little like the cruise control on your car – when you are going uphill, the cruise control will adjust the engine to work harder to keep the car near a constant speed; and as you reach the crest of the hill and go down the other side, the cruise control will adjust the engine so it keeps that same speed going downhill.

In a similar way, automatic stabilizers can moderate, or smooth the business cycle, but can’t entirely eliminate the highs and lows.