E = mc2 remains an equation upon which monumental advancements in man’s understanding of his world have been developed. Yet the fundamental representation of what produces Gross Domestic Product (GDP) and by extension income supporting employment continues to be a topic of inquiry among even the elite community of the world’s economist. From America to Europe and beyond, the disconcerting global economic recovery again has forwarded the contention, economists are not Einstein and economics is not physics.
If the readers of PolicyMic express an interest in this essay’s premise, I will attempt to explain why neither monetary or fiscal policy has achieved their respective stimulative objectives. But first we must take a moment to examine, How is GDP traditionally measured? There are three basic ways to determine a nation’s GDP.
1) The Expenditure Approach
This method of determining GDP adds up the market value of all domestic expenditures made on final goods and services in a single year, including consumption expenditures, investment expenditures, government expenditures, and net exports. Add all of the expenditures together and you determine GDP.
2) The Production Approach
This method also called the Net Product or Value added method requires three stages of analysis. First gross value of output from all sectors is estimated. Then, intermediate consumption such as cost of materials, supplies and services used in production final output is derived. Then gross output is reduced by intermediate consumption to develop net production.
3) The Income Approach
This method of determining GDP is to add up all the income earned by households and firms in the year. The total expenditures on all of the final goods and services are also income received as wages, profits, rents, and interest income. By adding together all of the wages, profits, rents, and interest income, you determine GDP:
The three methods of measuring GDP should result in the same number, with some possible difference caused by statistical and rounding differences. The credibility of data is always a significant concern in any form of research. An advantage of using the Expenditure Method is data integrity. The U.S. Bureau of Economic Analysis considers the source data for expenditure components to be more reliable than for either income or production components..
As such we will concentrate on the Expenditure Approach which is the most commonly discussed method of representing GNP particularly in non-academic examinations of economic activity.
GDP as examined using the Expenditure Approach is reported as the sum of four components. The formula for determining GDP is: C + I + G + (X - M) = GDP
C = Personal Consumption Expenditures
I = Gross Private Fixed Investment
G = Government Expenditures and Investment
X = Net Exports
M = Net Imports
Before moving forward in our discussion, it should be noted, the income approach is gathering a growing following. This is true particularly among economic blogs, investment publications and cable news business programs due to its concentration on the importance of wages. An alternative method of calculating GNP using the Income Approach is “RIPSAW.”
The mnemonic “RIPSAW” breaks down as follows: GDP = R + I + P + S + A + W
R = rents
I = interests
P = profits
SA = statistical adjustments (corporate income taxes, dividends, undistributed corporate profits
W = wages
At this point, we could spend the next thousand words describing alternate means of computing GNP. While that might be beneficial in its attempt to be exhaustive, for our purposes what you need to remember is, in economics, there is rarely only one way to develop and analyze data
Additionally, GDP is impacted by variables beyond economists’ control such as the economic health of our trade partners, monetary factors such as the value of the dollar, restrictions in state and local governments spending to the subjective views by consumers to business which influence their consumption/investment choices.
If all you remember from this essay is, jobs are created and lost based on the relative strength of the various components of GDP. Those components can and do fluctuate from internal and external factors beyond the control of any our economic sages. Then you realize why economists are not Einstein and economics isn’t physics.
Please consider joining us if you the readers of PolicyMic wish to see this series continue as we next explore C = personal consumption expenditures, perhaps the most factor necessary to stimulate our economic recovery.