Gross Domestic Product (GDP) is generally thought of as a measure of an economy's aggregate output or income, but, as it turns out, GDP also represents aggregate expenditure on an economy's goods and services. Economists divide the spending on an economy's goods and services into four components: Consumption, Investment, Government Purchases, and Net Exports.
Consumption, represented by the letter C, is the amount that households (i.e. not businesses or the government) spend on new goods and services. The one exception to this rule is housing since expenditure on new housing is placed in the investment category. This category counts all consumption spending regardless of whether the spending is on domestic or foreign goods and services, and the consumption of foreign goods is corrected for in the net exports category.
Investment, represented by the letter I, is the amount that households and businesses spend on items that are used to make more goods and services. The most common form of investment is in capital equipment for businesses, but it's important to remember that households' purchases of new housing also counts as investment for GDP purposes. Like consumption, investment expenditure can be used to purchase capital and other items from either domestic or foreign producer, and this is corrected for in the net exports category.
Inventory is another common investment category for businesses since items that are produced but not sold in a given time period are considered as having been purchased by the company that made them. Therefore, the accumulation of inventory is considered positive investment, and the liquidation of existing inventory is counted as negative investment.
Government Purchases (G)
In addition to households and businesses, the government can also consume goods and services and invest in capital and other items. These government purchases are represented by the letter G in the expenditure calculation. It's important to keep in mind that only government spending that goes towards producing goods and services is counted in this category, and "transfer payments" such as welfare and social security are not counted as government purchases for the purposes of GDP, mainly because transfer payments do not directly correspond to any type of production.
Net Exports (NX)
Net Exports, represented by NX, is simply equal to the amount of exports in an economy (X) minus the number of imports in that economy (IM), where exports are goods and services produced domestically but sold to foreigners and imports are goods and services produced by foreigners but purchased domestically. In other words, NX = X - IM.
Net exports is an important component of GDP for two reasons. First, items that are produced domestically and sold to foreigners should be counted in GDP, since these exports represent domestic production. Second, imports should be subtracted out from GDP since they represent foreign rather than domestic production but were allowed to sneak into the consumption, investment and government purchases categories.
Putting the expenditure components together yields one of the most well-known macroeconomic identities:
- Y = C + I + G + NX
In this equation, Y represents real GDP (i.e. domestic output, income, or expenditure on domestic goods and services) and the items on the right-hand side of the equation represent the components of expenditure listed above. In the US, consumption tends to be the largest component of GDP by far, followed by government purchases and then investment. Net exports tend to be negative because the US typically imports more than it exports.