Components of GDP

Identity of the GDP Components

The following is an equation representing the components of GDP, meaning it must be true given the definitions of the variables in the identity:

Consumption

In GDP, consumption expenditure includes all individual spending on goods and services except for the purchase of housing. This can be all types of durable goods like automobiles or appliances, non-durable goods such as food, or intangible services such as home delivery or hairdressing services. By convention, education expenditure is also included in consumption, although it could be argued that it fits better as investment spending.

Investment

In GDP, investment expenditure includes the purchase of business capital, residential capital, and inventories. Investment refers to the purchase of goods and services intended to be used later to produce more goods and services. Business capital includes items such as factories or offices, machinery or equipment, and intellectual property. Residential capital includes homes purchased for rental purposes and personal use. By convention, the purchase of housing is the only type of household expenditure classified as investment rather than consumption.

Inventories receive special treatment. When a company produces a new good and adds it to its inventory, it is counted as if the company had purchased it and is thus added as investment expenditure. Later, when the product is sold and removed from inventory, it is subtracted from inventory investment to offset the positive expenditure of the buyer. Inventories are treated this way because the goal of GDP is to measure the value of production within a specific period, and goods produced and added to inventory are part of that period, not the next when the sale occurs.

Government Spending

In GDP, government spending or public expenditure includes local, state, and national or federal government spending on goods and services. When the government purchases a good or hires a service, such as the salaries of public school teachers, equipment for state offices, salaries of the public force, or utility bills for state buildings, these are included in GDP because the government is buying a good or service in the market and consuming it for its functioning. However, government transfers like unemployment benefits, transfers to the elderly, or early childhood support are not included in GDP because the government is not purchasing anything; it is providing a subsidy that, from an economic standpoint, is a negative tax. Transfers alter household income but do not reflect production in the economy. Therefore, since GDP aims to measure expenditure on goods and services, transfer payments are not counted as government spending.

Net Exports

In GDP, net exports are calculated as exports minus imports. Imports are subtracted from exports because, by definition, imports are always included in one of the other three components. When a household, business, or government buys an imported good, it is always counted as consumption expenditure, investment expenditure, or government spending, and subtracted as an import. This way, spending on goods produced abroad does not affect the measurement of the economy's aggregate production.

Thus, when spending on an imported good occurs, the purchase does not affect GDP because it reduces net exports by the same amount it increases consumption, investment, or government spending.

Aggregate Expenditure vs. Aggregate Income

These are the components of GDP from the expenditure perspective. Since every monetary unit spent in the economy enters GDP through one of these four components, their sum must equal GDP. From the income perspective, the GDP level is the same because every dollar, euro, or peso spent in an economy is an income for its counterpart. Therefore, aggregate expenditure and aggregate income are always equal, though they may differ slightly in practice due to measurement difficulties. Consequently, it is essential that the data be as precise and consistent as possible.