How is GDP measured?
The three primary methods of measuring GDP are the expenditure approach, the income approach, and the production approach.
The method used varies by the country or institution making the measurement. In theory, they should all produce the same result.
(1) Expenditure approach
The expenditure approach of measuring GDP adds up all the spending, or expenditure, on goods and services in a country in a year.
The formula for this method is:
GDP = C + I + G + (X - M)
- C = Consumption, meaning spending by private households on goods and services, such as food, electronics, healthcare, entertainment, etc. This does not include buying houses, which is included in I
- I = Investment, meaning spending by businesses on goods and services, including equipment like trucks, construction such as office buildings, software, and machinery
- G = Government expenditure, including defense, education, healthcare, building roads and power lines, and salaries for government employees. It does not include transfer payments such as unemployment benefits
- X = Exports, which are goods produced by the country, but sold to other countries for consumption there
- M = Imports, which are goods produced in other countries by consumed locally. Spending on these imports is counted within C, I, or G
- (X - M) is referred to as net exports
(2) Income approach
The income approach of measuring GDP adds up the incomes that firms pay to the factors of production they hire.
In effect this is calculating how firms spend the money they earn.
The formula for this method is:
GDP = Wages + Rents + Interests + Profits + Business Cash Flow + Net Foreign Income
- Wages = wages or salaries paid to employees, as well as benefits such as health insurance, and taxes paid to the government for unemployment benefits
- Rents = incomes received from property, including rents for houses, royalties from patents, etc.
- Interest = interest earned on capital such as money lent
- Profits = the amount firms earn after paying wages, rent, and interest
- Business Cash Flow consists of two components:
- Indirect Business Taxes, e.g. Sales taxes or excise taxes, which are paid by consumers to businesses, but then passed on to the government
- Depreciation, or spending by businesses to replace their worn-out equipment, and
- Net foreign income is the income earned by citizens abroad, minus the income earned by foreigners in the country.
This is the only component that isn't related to how firms spend their money.
(3) Production approach
The production approach is also known as the value added approach.
The formula for this approach is:
GDP at factor cost = gross value of output - intermediate consumption
GDP at producer prices = GDP at factor cost + (indirect taxes - subsidies on products)
- the gross value of output is estimated across all sectors and types of economic activity, e.g. by adding together the gross sales of all sectors
- intermediate consumption is the cost of materials and services used to produce that gross value of output
- indirect taxes, e.g. sales taxes and excise taxes, are paid by consumers to businesses, but are then transferred to the government
- subsidies are transferred from the government to businesses to produce goods and services
In essence, the GDP at producer prices reflects the prices consumers pay to producers for goods and services, while the GDP at factor cost reflects the revenues earned by businesses for their production.