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The typical textbook 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).

Notice that, here, imports (M) are subtracted. On the surface, this implies that an extra dollar of spending on imports (M) will decrease GDP by one dollar. For example, let's assume you spend $30,000 on an imported car; because imports are subtracted (e.g., "- M"), the equation seems to imply that $30,000 should be subtracted from GDP. However, this cannot be correct because GDP measures domestic production, so imports (foreign production) should have no impact on GDP.

When the Bureau of Economic Analysis (BEA; see its primer on this topic) measures economic output, it categorizes spending with the National Income and Product Accounts (NIPA). Some of this spending (which is counted as C, I, and G) is spent on imported goods. As such, the value of imports must be subtracted to ensure that only spending on domestic goods is measured in GDP. For example, $30,000 spent on an imported car is counted as a personal consumption expenditure (C), but then the $30,000 is subtracted as an import (M) to ensure that only the value of domestic production is counted. As such, the imports variable (M) functions as an accounting variable rather than an expenditure variable. To be clear, the purchase of domestic goods and services increases GDP because it increases domestic production, but the purchase of imported goods and services has no direct impact on GDP.

The misconception that imports reduce GDP also seems to be implied when the GDP components are stacked using the FRED release view. Notice that the green "net exports" area is negative. This occurs because the dollar value of imported goods and services exceeds the value of exported goods and services. While this aspect of net exports (X - M) is useful for evaluating how international trade affects economic activity, it can be misleading. Like the misleading aspects of the expenditure equation, it suggests (visually) that imports reduce overall GDP. While the graph is not incorrect, it is important to keep in mind that, when calculating GDP, the value of imports is actually subtracted from the other components of GDP (personal consumption expenditures, gross private domestic investment, government consumption expenditures, and gross investment), not exports. Again, it's important to emphasize that the imports variable (M) is an accounting variable rather than an expenditure variable.

To learn how to create your own GDP stacking graph, see this FRED blog post. For a more complete description of GDP and the expenditures equation, read the September 2018 issue of Page One Economics.

Suggested by Scott Wolla.

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Do imports subtract from GDP? | FRED Blog

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The typical textbook 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).

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Define (using the circular flow diagram as appropriate) how GDP is measured and its components.

Calculate nominal GDP.

Define the limitations of GDP.

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An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

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GDP is a measure of final output of the economy.

GDP as a total flow of income and expenditure can be represented by the circular flow diagram.

There are three ways of measuring GDP: the expenditures approach, the income approach, and the value-added approach.

GDP is a useful indicator of a nation’s economic performance, but it has some limitations, such as failing to account for non-market transactions.

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APMac Unit 2 Lesson 1 - Circular Flow, GDP, and Limitations of GDP

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Start studying APMac Unit 2 Lesson 1 - Circular Flow, GDP, and Limitations of GDP. Learn vocabulary, terms, and more with flashcards, games, and other study tools.

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What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country's economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal quarter and also for the calendar year. The individual data sets included in this report are given in real terms, so the data is adjusted for price changes and is, therefore, net of inflation.

Understanding Gross Domestic Product (GDP)

The calculation of a country's GDP encompasses all private and public consumption, government outlays, investments, additions to private inventories, paid-in construction costs, and the foreign balance of trade. (Exports are added to the value and imports are subtracted).

Of all the components that make up a country's GDP, the foreign balance of trade is especially important. The GDP of a country tends to increase when the total value of goods and services that domestic producers sell to foreign countries exceeds the total value of foreign goods and services that domestic consumers buy. When this situation occurs, a country is said to have a trade surplus.

If the opposite situation occurs-if the amount that domestic consumers spend on foreign products is greater than the total sum of what domestic producers are able to sell to foreign consumers-it is called a trade deficit. In this situation, the GDP of a country tends to decrease.

GDP can be computed on a nominal basis or a real basis, the latter accounting for inflation. Overall, real GDP is a better method for expressing long-term national economic performance since it uses constant dollars.

Let's say one country had a nominal GDP of $100 billion in 2012. By 2022, its nominal GDP grew to $150 billion. Prices also rose by 100% over the same period. In this example, if you looked solely at its nominal GDP, the country's economy appears to be performing well. However, the real GDP (expressed in 2012 dollars) would only be $75 billion, revealing that an overall decline in real economic performance actually occurred during this time.

Types of Gross Domestic Product

GDP can be reported in several ways, each of which provides slightly different information.

Nominal GDP

Nominal GDP is an assessment of economic production in an economy that includes current prices in its calculation. In other words, it doesn't strip out inflation or the pace of rising prices, which can inflate the growth figure.

All goods and services counted in nominal GDP are valued at the prices that those goods and services are actually sold for in that year. Nominal GDP is evaluated in either the local currency or U.S. dollars at currency market exchange rates to compare countries' GDPs in purely financial terms.

Nominal GDP is used when comparing different quarters of output within the same year. When comparing the GDP of two or more years, real GDP is used. This is because, in effect, the removal of the influence of inflation allows the comparison of the different years to focus solely on volume.

Real GDP is an inflation-adjusted measure that reflects the number of goods and services produced by an economy in a given year, with prices held constant from year to year to separate out the impact of inflation or deflation from the trend in output over time. Since GDP is based on the monetary value of goods and services, it is subject to inflation.

Rising prices tend to increase a country's GDP, but this does not necessarily reflect any change in the quantity or quality of goods and services produced. Thus, by looking just at an economy's nominal GDP, it can be difficult to tell whether the figure has risen because of a real expansion in production or simply because prices rose.

Economists use a process that adjusts for inflation to arrive at an economy's real GDP. By adjusting the output in any given year for the price levels that prevailed in a reference year, called the base year, economists can adjust for inflation's impact. This way, it is possible to compare a country's GDP from one year to another and see if there is any real growth.

Real GDP is calculated using a GDP price deflator, which is the difference in prices between the current year and the base year. For example, if prices rose by 5% since the base year, then the deflator would be 1.05. Nominal GDP is divided by this deflator, yielding real GDP. Nominal GDP is usually higher than real GDP because inflation is typically a positive number.

Real GDP accounts for changes in market value and thus narrows the difference between output figures from year to year. If there is a large discrepancy between a nation's real GDP and nominal GDP, this may be an indicator of significant inflation or deflation in its economy.

GDP Per Capita

GDP per capita is a measurement of the GDP per person in a country's population. It indicates that the amount of output or income per person in an economy can indicate average productivity or average living standards. GDP per capita can be stated in nominal, real (inflation-adjusted), or PPP (purchasing power parity) terms.

At a basic interpretation, per-capita GDP shows how much economic production value can be attributed to each individual citizen. This also translates to a measure of overall national wealth since GDP market value per person also readily serves as a prosperity measure.

Per-capita GDP is often analyzed alongside more traditional measures of GDP. Economists use this metric for insight into their own country's domestic productivity and the productivity of other countries. Per-capita GDP considers both a country's GDP and its population. Therefore, it can be important to understand how each factor contributes to the overall result and is affecting per-capita GDP growth.

If a country's per-capita GDP is growing with a stable population level, for example, it could be the result of technological progressions that are producing more with the same population level. Some countries may have a high per-capita GDP but a small population, which usually means they have built up a self-sufficient economy based on an abundance of special resources.

GDP Growth Rate

The GDP growth rate compares the year-over-year (or quarterly) change in a country's economic output to measure how fast an economy is growing. Usually expressed as a percentage rate, this measure is popular for economic policymakers because GDP growth is thought to be closely connected to key policy targets such as inflation and unemployment rates.

If GDP growth rates accelerate, it may be a signal that the economy is overheating and the central bank may seek to raise interest rates. Conversely, central banks see a shrinking (or negative) GDP growth rate (i.e., a recession) as a signal that rates should be lowered and that stimulus may be necessary.

GDP Purchasing Power Parity (PPP)

While not directly a measure of GDP, economists look at purchasing power parity (PPP) to see how one country's GDP measures up in international dollars using a method that adjusts for differences in local prices and costs of living to make cross-country comparisons of real output, real income, and living standards.

GDP Formula

GDP can be determined via three primary methods. All three methods should yield the same figure when correctly calculated. These three approaches are often termed the expenditure approach, the output (or production) approach, and the income approach.

The Expenditure Approach

The expenditure approach, also known as the spending approach, calculates spending by the different groups that participate in the economy. The U.S. GDP is primarily measured based on the expenditure approach. This approach can be calculated using the following formula:

GDP = C + G + I + NX

where

C = consumption;

G = government spending;

I = investment; and

NX = net exports

All of these activities contribute to the GDP of a country. Consumption refers to private consumption expenditures or consumer spending. Consumers spend money to acquire goods and services, such as groceries and haircuts. Consumer spending is the biggest component of GDP, accounting for more than two-thirds of the U.S. GDP.

Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.

Government spending represents government consumption expenditure and gross investment. Governments spend money on equipment, infrastructure, and payroll. Government spending may become more important relative to other components of a country's GDP when consumer spending and business investment both decline sharply. (This may occur in the wake of a recession, for example.)

Investment refers to private domestic investment or capital expenditures. Businesses spend money to invest in their business activities. For example, a business may buy machinery. Business investment is a critical component of GDP since it increases the productive capacity of an economy and boosts employment levels.

The net exports formula subtracts total exports from total imports (NX = Exports - Imports). The goods and services that an economy makes that are exported to other countries, less the imports that are purchased by domestic consumers, represent a country's net exports. All expenditures by companies located in a given country, even if they are foreign companies, are included in this calculation.

The Production (Output) Approach

The production approach is essentially the reverse of the expenditure approach. Instead of measuring the input costs that contribute to economic activity, the production approach estimates the total value of economic output and deducts the cost of intermediate goods that are consumed in the process (like those of materials and services). Whereas the expenditure approach projects forward from costs, the production approach looks backward from the vantage point of a state of completed economic activity.

The Income Approach

The income approach represents a kind of middle ground between the two other approaches to calculating GDP. The income approach calculates the income earned by all the factors of production in an economy, including the wages paid to labor, the rent earned by land, the return on capital in the form of interest, and corporate profits.

The income approach factors in some adjustments for those items that are not considered payments made to factors of production. For one, there are some taxes-such as sales taxes and property taxes-that are classified as indirect business taxes. In addition, depreciation -a reserve that businesses set aside to account for the replacement of equipment that tends to wear down with use-is also added to the national income. All of this together constitutes a nation's income.

GDP vs. GNP vs. GNI

Although GDP is a widely used metric, there are other ways of measuring the economic growth of a country. While GDP measures the economic activity within the physical borders of a country (whether the producers are native to that country or foreign-owned entities), gross national product (GNP) is a measurement of the overall production of people or corporations native to a country, including those based abroad. GNP excludes domestic production by foreigners.

Gross national income (GNI) is another measure of economic growth. It is the sum of all incomeearned by citizens or nationals of a country (regardless of whether the underlying economic activity takes place domestically or abroad). The relationship between GNP and GNI is similar to the relationship between the production (output) approach and the income approach used to calculate GDP.

GNP uses the production approach, while GNI uses the income approach. With GNI, the income of a country is calculated as its domestic income, plus its indirect business taxes and depreciation (as well as its net foreign factor income). The figure for net foreign factor income is calculated by subtracting all payments made to foreign companies and individuals from all payments made to domestic businesses.

In an increasingly global economy, GNI has been put forward as a potentially better metric for overall economic health than GDP. Because certain countries have most of their income withdrawn abroad by foreign corporations and individuals, their GDP figure is much higher than the figure that represents their GNI.

For example, in 2019, Luxembourg had a significant difference between its GDP and GNI, mainly due to large payments made to the rest of the world via foreign corporations that did business in Luxembourg, attracted by the tiny nation's favorable tax laws. On the contrary, in the U.S., GNI and GDP do not differ substantially. U.S. GDP was $24.9 trillion as of Q2-2022 while its GNI was $23.4 trillion at the end of 2021.

Adjustments to GDP

A number of adjustments can be made to a country's GDP to improve the usefulness of this figure. For economists, a country's GDP reveals the size of the economy but provides little information about the standard of living in that country. Part of the reason for this is that population size and cost of living are not consistent around the world.

For example, comparing the nominal GDP of China to the nominal GDP of Ireland would not provide much meaningful information about the realities of living in those countries because China has approximately 300 times the population of Ireland.

To help solve this problem, statisticians sometimes compare GDP per capita between countries. GDP per capita is calculated by dividing a country's total GDP by its population, and this figure is frequently cited to assess the nation's standard of living. Even so, the measure is still imperfect.

Suppose China has a GDP per capita of $1,500, while Ireland has a GDP per capita of $15,000. This doesn't necessarily mean that the average Irish person is 10 times better off than the average Chinese person. GDP per capita doesn't account for how expensive it is to live in a country.

PPP attempts to solve this problem by comparing how many goods and services an exchange-rate-adjusted unit of money can purchase in different countries-comparing the price of an item, or basket of items, in two countries after adjusting for the exchange rate between the two, in effect.

Real per-capita GDP, adjusted for purchasing power parity, is a heavily refined statistic to measure true income, which is an important element of well-being. An individual in Ireland might make $100,000 a year, while an individual in China might make $50,000 a year. In nominal terms, the worker in Ireland is better off. But if a year's worth of food, clothing, and other items costs three times as much in Ireland as in China, however, then the worker in China has a higher real income.

How to Use GDP Data

Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.

GDP's market impact is generally limited, since it is backward-looking, and a substantial amount of time has already elapsed between the quarter-end and GDP data release. However, GDP data can have an impact on markets if the actual numbers differ considerably from expectations.

Because GDP provides a direct indication of the health and growth of the economy, businesses can use GDP as a guide to their business strategy. Government entities, such as the Fed in the U.S., use the growth rate and other GDP stats as part of their decision process in determining what type of monetary policies to implement.

If the growth rate is slowing, they might implement an expansionary monetary policy to try to boost the economy. If the growth rate is robust, they might use monetary policy to slow things down to try to ward off inflation.

Real GDP is the indicator that says the most about the health of the economy. It is widely followed and discussed by economists, analysts, investors, and policymakers. The advance release of the latest data will almost always move markets, although that impact can be limited, as noted above.

GDP and Investing

Investors watch GDP since it provides a framework for decision-making. The corporate profits and inventory data in the GDP report are a great resource for equity investors, as both categories show total growth during the period; corporate profits data also displays pre-tax profits, operating cash flows, and breakdowns for all major sectors of the economy.

Comparing the GDP growth rates of different countries can play a part in asset allocation, aiding decisions about whether to invest in fast-growing economies abroad-and if so, which ones.

One interesting metric that investors can use to get some sense of the valuation of an equity market is the ratio of total market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is a company's market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio.

Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at market-cap-to-GDP ratios that are literally all over the map. For example, according to the World Bank, the U.S. had a market-cap-to-GDP ratio of 195% for 2020, while China had a ratio of just over 83% and Hong Kong had a ratio of 1,769%.

However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a market-cap-to-GDP ratio of 142% at the end of 2006, which dropped to 79% by the end of 2008. In retrospect, these represented zones of substantial overvaluation and undervaluation, respectively, for U.S. equities.

The biggest downside of this data is its lack of timeliness; investors only get one update per quarter, and revisions can be large enough to significantly alter the percentage change in GDP.

History of GDP

The concept of GDP was first proposed in 1937 in a report to the U.S. Congress in response to the Great Depression, conceived of and presented by an economist at the National Bureau of Economic Research (NBER), Simon Kuznets.

At the time, the preeminent system of measurement was GNP. After the Bretton Woods conference in 1944, GDP was widely adopted as the standard means for measuring national economies; however, the U.S. continued to use GNP as its official measure of economic welfare until 1991, after which it switched to GDP.

Beginning in the 1950s, however, some economists and policymakers began to question GDP. Some observed, for example, a tendency to accept GDP as an absolute indicator of a nation's failure or success, despite its failure to account for health, happiness, (in)equality, and other constituent factors of public welfare. In other words, these critics drew attention to a distinction between economic progress and social progress.

However, most authorities, like Arthur Okun, an economist for President John F. Kennedy's Council of Economic Advisers, held firm to the belief that GDP is an absolute indicator of economic success, claiming that for every increase in GDP, there would be a corresponding drop in unemployment.

Criticisms of GDP

There are, of course, drawbacks to using GDP as an indicator. In addition to the lack of timeliness, some criticisms of GDP as a measure are:

It ignores the value of informal or unrecorded economic activity. GDP relies on recorded transactions and official data, so it does not take into account the extent of informal economic activity. GDP fails to account for the value of under-the-table employment, underground market activity, or unremunerated volunteer work, which can all be significant in some nations and cannot account for the value of leisure time or household production, which are ubiquitous conditions of human life in all societies.

It is geographically limited in a globally open economy. GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had a GDP of $426 billion and GNI of $324 billion in 2020, the difference of approximately $100 billion (or over 20% of GDP) largely being due to profit repatriation by foreign companies based in Ireland.

It emphasizes material output without considering overall well-being. GDP growth alone cannot measure a nation's development or its citizens' well-being, as noted above. For instance, a nation may be experiencing rapid GDP growth, but this may impose a significant cost to society in terms of environmental impact and an increase in income disparity.

It ignores business-to-business activity. GDP considers only final goods production and new capital investment and deliberately nets out intermediate spending and transactions between businesses. By doing so, GDP overstates the importance of consumption relative to production in the economy and is less sensitive as an indicator of economic fluctuations compared to metrics that include business-to-business activity.

It counts costs and waste as economic benefits. GDP counts all final private and government spending as additions to income and output for society, regardless of whether they are actually productive or profitable. This means that obviously unproductive or even destructive activities are routinely counted as economic output and contribute to growth in GDP. For example, this includes spending directed toward extracting or transferring wealth between members of society rather than producing wealth (such as the administrative costs of taxation or money spent on lobbying and rent-seeking); spending on investment projects for which the necessary complementary goods and labor are not available or for which actual consumer demand does not exist (such as the construction of empty ghost cities or bridges to nowhere, unconnected to any road network); and spending on goods and services that are either themselves destructive or only necessary to offset other destructive activities, rather than to create new wealth (such as the production of weapons of war or spending on policing and anti-crime measures).

Global Sources for Country GDP Data

The World Bank hosts one of the most reliable web-based databases. It has one of the best and most comprehensive lists of countries for which it tracks GDP data. The International Money Fund (IMF) also provides GDP data through its multiple databases, such as World Economic Outlook and International Financial Statistics.

Another highly reliable source of GDP data is the Organization for Economic Cooperation and Development (OECD). The OECD not only provides historical data but also forecasts GDP growth. The disadvantage of using the OECD database is that it tracks only OECD member countries and a few nonmember countries.

In the U.S., the Fed collects data from multiple sources, including a country's statistical agencies and The World Bank. The only drawback to using a Fed database is a lack of updating in GDP data and an absence of data for certain countries.

The BEA is a division of the U.S. Department of Commerce. It issues its own analysis document with each GDP release, which is a great investor tool for analyzing figures and trends and reading highlights of the very lengthy full release.

What Is a Simple Definition of GDP?

Which Country Has the Highest GDP?

Is a High GDP Good?

The Bottom Line

In their seminal textbook Economics, Paul Samuelson and William Nordhaus neatly sum up the importance of the national accounts and GDP. They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent.

GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon. Like any measure, GDP has its imperfections. In recent decades, governments have created various nuanced modifications in attempts to increase GDP accuracy and specificity. Means of calculating GDP have also evolved continually since its conception to keep up with evolving measurements of industry activity and the generation and consumption of new, emerging forms of intangible assets.

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Gross Domestic Product (GDP): Formula and How to Use It

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Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country's economic health.

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New Zealand's focus on wellbeing, rather than GDP, may have the best of intentions. But if GDP does not increase, the government will have less money for its grand schemes. And compared to what it could have had, the country will have less overall wellbeing, worse environmental performance, and weaker human capital.

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Why GDP Still Matters | by Bjørn Lomborg

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New Zealand's focus on wellbeing, rather than GDP, may have the best of intentions. But if GDP does not increase, the government will have less money for its grand schemes. And compared to what it could have had, the country will have less overall wellbeing, worse environmental performance, and weaker human capital.

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Andrew McAfee argues that the Earth Day environmentalists correctly diagnosed the problem, a worsening environment, but were wrong about the solution, degrowth. In fact, the drive to reduce costs by making better use of resources has led to a dramatic decrease in resource use even as production has increased, a dematerialization. Poverty not prosperity is the enemy of the environment.

I love this talk for many reasons not the least of which is that Andrew has put all his data online.

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Dematerialization: Humanity's Biggest Surprise - Marginal REVOLUTION

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Andrew McAfee argues that the Earth Day environmentalists correctly diagnosed the problem, a worsening environment, but were wrong about the solution, degrowth. In fact, the drive to reduce costs by making better use of resources has led to a dramatic decrease in resource use even as production has increased, a dematerialization.

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We know that there are rich countries, poor countries, and countries somewhere in between. Economically speaking, Japan isn't Denmark. Denmark isn't Madagascar, and Madagascar isn't Argentina. These countries are all different.

But how different are they?

That question is answered through real GDP per capita -a country's gross domestic product, divided by its population.

In previous videos, we used real GDP per capita as a quick measure for a country's standard of living. But real GDP per capita also measures an average citizen's command over goods and services. It can be a handy benchmark for how much an average person can buy in a year -- that is, his or her purchasing power. And across different countries, purchasing power isn't the same.

Here comes that word again: it's different.

How different? That's another question this video will answer.

In this section of Marginal Revolution University's course on Principles of Macroeconomics, you'll find out just how staggering the economic differences are for three countries-the Central African Republic, Mexico, and the United States.

You'll see why variations in real GDP per capita can be 10 times, 50 times, or sometimes a hundred times as different between one country and another. You'll also learn why the countries we traditionally lump together as rich, or poor, might sometimes be in leagues all their own.

The whole point of this? We can learn a lot about a country's wealth and standard of living by looking at real GDP per capita.

But before we give too much away, check out this video -- the first in our section on The Wealth of Nations and Economic Growth.

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Basic Facts of Wealth | Marginal Revolution University

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We know that there are rich countries, poor countries, and countries somewhere in between. Economically speaking, Japan isn't Denmark. Denmark isn't Madagascar, and Madagascar isn't Argentina. These countries are all different. But how different are they? That question is answered through real GDP per capita -a country's gross domestic product, divided by its population.

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In the first video in this section on The Wealth of Nations and Economic Growth, you learned a basic fact of economic wealth-that countries can vary widely in standard of living. Specifically, you learned how variations in real GDP per capita can set countries leagues apart from one another.

Today, we'll continue on that road of differences, and ask yet another question.

How can we explain wealth disparities between countries?

The answer? Growth rates.

And in this video, you'll learn all about the ins-and-outs of measuring growth rates.

For one, you'll learn how to visualize growth properly-examining growth in real GDP per capita on a ratio scale.

Then, here comes the fun part: you'll also take a dive into the growth of the US economy over time. It's a little bit like time travel. You'll transport yourself to different periods in the country's economic history: 1845, 1880, the Roaring Twenties, and much more.

As you transport yourself to those times, you'll also see how the economies of other countries stack up in comparison. You'll see why the Indian economy now is like a trip back to the US of 1880. You'll see why China today is like the America of the Jazz Age. (You'll even see why living in Italy today is related to a time when Atari was popular in the US!)

In keeping with our theme, though, we won't just offer you a trip through ages past.

Because by the end of this video, you'll also have the answer to one vital question: if the US had grown at an even higher rate, where would we be by now?

The magnitude of the answer will surprise you, we're sure.

But then, that surprise is in the video. So, go on and watch, and we'll see you on the other side.

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Growth Rates are Crucial | Marginal Revolution University

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In the first video in this section on The Wealth of Nations and Economic Growth, you learned a basic fact of economic wealth-that countries can vary widely in standard of living. Specifically, you learned how variations in real GDP per capita can set countries leagues apart from one another.

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Surprized you did not mention Adam Smith and division of labour, in view of your earlier reference: or examine the evidence for either theory. Do you have some limks for students to explore this aspect? Is take-off still a concept that theorists still use or has it become uninteresting? Did the US 'take-off' more than once: pirating English arms with industrial manufacturing systems, then English literature (encouraging a literate community: i.e. Americans were not just ignorant pioneers), then building a nation built on managing big distances (which Russia never managed) -- e.g. the wagon train, railroad, pony express, department house (adopted from France), telegraph, telephone, cattle drive, creating the mass market and the workers to serve it (New York, Chicago): is innovationism an adequate concept for dealing conceptually with such developments? And is it true that innovationism didn't exist before (16th and 17th century, not to speak of the 18th -- French and American revolutions)? What is your take on this?

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An Orgy of Innovation | Marginal Revolution University

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Surprized you did not mention Adam Smith and division of labour, in view of your earlier reference: or examine the evidence for either theory. Do you have some limks for students to explore this aspect? Is take-off still a concept that theorists still use or has it become uninteresting?

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In previous videos, you learned two things.

First, that there can be large disparities in economic wealth among different countries. And second, you learned that one key factor drives that disparity: growth rate. As we said, it changes everything. But just how transformative is a country's growth rate?

Take Argentina, for example.

In 1950, the Argentine standard of living was similar to that of many Western European countries. Up until 1965, Argentina's per capita income was ahead of many of its neighbors.

On the other hand, Japan in 1950 was on the other end of the spectrum. Japan had been ravaged by war and was only just beginning to find its economic footing again. At that time, Japan's standard of living was roughly the same as that of Mexico.

It was quite poor, compared to the Argentina of the same era.

But look at what's happened in the past 65 years.

Japan today is one of the world's most prosperous countries. Since 1950, it has managed to double its living standards about every eight years. Argentina, on the other hand, has stagnated. Once, Argentina had double the standard of living of Japan. But Japan now doubles them today, with a standard of living 10 times higher than the one it had in 1950.

In economic terms, Japan is what we would call a growth miracle. It's in the same class as other growth success stories, like South Korea and China which have experienced the " hockey stick " of prosperity. (India seems like it may have started on this path as well.)

These countries are proof of one thing: with the right factors, a poor country can not only grow, but it can do so quickly. It can catch up with developed countries at an astonishing rate.

What took the United States two centuries of steady growth can now be achieved by other countries in about one-fifth the time. Catch-up can happen in 40 years-about the span of a generation or two.

That's the good news.

The bad news is, while growth can skyrocket in some countries, growth isn't guaranteed at all.

Argentina is an example of this. It grew well for a time, and then it stalled. Even worse than Argentina, are countries like Niger, and Chad, which are the very worst of growth disasters. Not only are these countries in extreme poverty, but they also have little to no growth. More than that, these countries have never experienced substantial growth in the past.

But why does that all matter?

It matters because growth isn't just about numbers. It's not just about more goods and services. When a country grows, its citizens often end up with longer, healthier, and happier lives. Conversely, the countries that are growth disasters have citizens in poverty, with shorter and less happier lives.

As bleak as this seems, it's the plain truth: while growth miracles are possible, growth disasters are, too.

Which leaves us with another question: what causes either state?

What leads to growth, prosperity, health, and happiness? And then, what leads to the opposite situation?

We're excited to share the answer, but that's a topic for future videos.

For now, check out this video to get up to speed on growth miracles and growth disasters.

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Growth Miracles and Growth Disasters | Marginal Revolution University

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In previous videos, you learned two things. First, that there can be large disparities in economic wealth among different countries. And second, you learned that one key factor drives that disparity: growth rate. As we said, it changes everything. But just how transformative is a country's growth rate? Take Argentina, for example.

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In today's video, we discuss a topic critical to understanding economic growth: the power of institutions.

To better shed light on this, we're going to look at an example that's both tragic and extreme.

In 1945, North and South Korea were divided, ending 35 years of Japanese colonial rule over the Korean peninsula. From that point, the two Koreas took dramatically different paths. North Korea went the way of communism, and South Korea chose a relatively capitalistic, free market economy.

Now-what were the results of those choices?

In the ensuing decades after 1945, South Korea became a major car producer and exporter. The country also became a hub for music (any K-pop fans out there?), film, and consumer products. In stark contrast, North Korea's totalitarian path resulted in episodes of famine and starvation for its people.

In the end, South Korea became a thriving market economy, with the living standards of a developed country. North Korea on the other hand, essentially became a militarized state, where people lived in fear.

Why such an extreme divergence?

It all comes down to institutions.

When economists talk about institutions, they mean things like laws and regulations, such as property rights, dependable courts and political stability. Institutions also include cultural norms, such as the ones surrounding honesty, trust, and cooperation.

To put it another way, institutions guide a country's choices -- which paths to follow, which actions to take, which signals to listen to, and which ones to ignore.

More importantly, institutions define the incentives that affect all of our lives.

Going back to our example, in the years after 1945, North and South Korea took dramatically different institutional paths.

In South Korea, the institutions of capitalism and democracy, promoted cooperation and honest commercial dealing. People were incentivized to produce goods and services to meet market demand. Businesses that did not meet demand were allowed to go bankrupt, allowing the re-allocation of capital towards more valuable uses.

Against that grain, North Korea's institutions produced starkly different incentives. The totalitarian regime meant that the economy was centrally planned and directed. Most entrepreneurs didn't have the freedom to keep their own profits, resulting in few incentives to do business. Farmers also didn't have enough incentive to grow sufficient food to feed the population. This was due in part to price controls, and a lack of property rights.

As for capital, it was allocated by the state, mostly towards political and military uses. Instead of going towards science, or education, or industrial advancement, North Korea's capital went mostly towards outfitting its army, and making sure that the ruling party remained unopposed.

And now, look at how different the two countries are as a result of those differing institutions. When it comes to economic growth, institutions are critically important. A country's institutions can have huge effects on long-term growth and prosperity. Good institutions can help turn a country into a growth miracle. Bad institutions can doom a country to economic disaster.

The key point remains: institutions are important.

They represent the choices that a country makes, and as the Korean peninsula shows you, choices on this scale can have staggering effects on a nation's present, and future.

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The Importance of Institutions | Marginal Revolution University

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In today's video, we discuss a topic critical to understanding economic growth: the power of institutions. To better shed light on this, we're going to look at an example that's both tragic and extreme. In 1945, North and South Korea were divided, ending 35 years of Japanese colonial rule over the Korean peninsula.

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If you look at the African continent, perhaps the first word to come to mind is "enormous." And that's true. You could fit most of the United States, China, India, and a lot of Europe, into Africa. But if you compare Africa to Europe, Europe has two to three times the length of coastline that Africa has.

But what does coastline length have to do with anything?

Well, coasts mean access to water.

As benign as water might seem, it's a major driver of economic growth. Adam Smith, the father of modern economics, argued that access to water reduced the cost of trade, and gave merchants access to larger markets. These larger markets incentivized specialization and innovation.

These twin processes ultimately spurred trade activity, and consequently, economic growth.

As an end result, civilization tended to grow wherever trade was easiest.

If you want proof of this, think of a few major cities.

Look at Istanbul, New York, Venice, Hong Kong, London, and similar areas. What do they all have in common? They all sit near a major coast or a major river. In contrast, look at some of the poorest areas in the world-places like Kampala, or Pointe-Noire. These places are all landlocked. Since goods are easier to transport over water than over land, trade in landlocked areas is more expensive.

And what happens when trade is more expensive?

It becomes harder to spark economic growth.

What this all means is economic growth is not only affected by a country's rules and institutions, but by a country's natural blessings, or natural hindrances, too. The effects of geography on growth cannot be discounted.

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Geography and Economic Growth | Marginal Revolution University

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If you look at the African continent, perhaps the first word to come to mind is "enormous." And that's true. You could fit most of the United States, China, India, and a lot of Europe, into Africa. But if you compare Africa to Europe, Europe has two to three times the length of coastline that Africa has.

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Throughout this section of the course, we've been trying to solve a complicated economic puzzle-why are some countries rich and others poor?

There are various factors at play, interacting in a dynamic, and changing environment. And the final answer to the puzzle differs depending on the perspective you're looking from. In this video, you'll examine different pieces of the wealth puzzle, and learn about how they fit.

The first piece of the puzzle, is about productivity.

You'll learn how physical capital, human capital, technological knowledge, and entrepreneurs all fit together to spur higher productivity in a population. From this perspective, you'll see economic growth as a function of a country's factors of production. You'll also learn what investments can be made to improve and increase these production factors.

Still, even that is too simplistic to explain everything.

So we'll also introduce you to another piece of the puzzle: incentives.

In previous videos, you learned about the incentives presented by different economic, cultural, and political models. In this video, we'll stay on that track, showing how different incentives produce different results.

As an example, you'll learn why something as simple as agriculture isn't nearly so simple at all. We'll put you in the shoes of a hypothetical farmer, for a bit. In those shoes, you'll see how incentives can mean the difference between getting to keep a whole bag of potatoes from your farm, or just a hundredth of a bag from a collective farm.

(Trust us, the potatoes explain a lot.)

Potatoes aside, you're also going to see how different incentives shaped China's economic landscape during the "Great Leap Forward" of the 1950s and 60s. With incentives as a lens, you'll see why China's supposed leap forward ended in starvation for tens of millions.

Hold on-incentives still aren't the end of it. After all, incentives have to come from somewhere.

That "somewhere" is institutions.

As we showed you before, institutions dictate incentives. Things like property rights, cultural norms, honest governments, dependable laws, and political stability, all create incentives of different kinds. Remember our hypothetical farmer? Through that farmer, you'll learn how different institutions affect all of us. You'll see how institutions help dictate how hard a person works, and how likely he or she is to invest in the economy, beyond that work.

Then, once you understand the full effect of institutions, you'll go beyond that, to the final piece of the wealth puzzle. And it's the most mysterious piece, too.

Why?

Because the final piece of the puzzle is the amorphous combination of a country's history, ideas, culture, geography, and even a little luck. These things aren't as direct as the previous pieces, but they matter all the same.

You'll see why the US constitution is the way it is, and you'll learn about people like Adam Smith and John Locke, whose ideas helped inform it.

And if all this talk of pieces makes you think that the wealth puzzle is a complex one, you'd be right.

Because the truth is, the question of " what creates wealth?" really is complex. Even the puzzle pieces you'll learn about don't constitute every variable at play. And as we mentioned earlier, not only are the factors complex, but they're also constantly changing as they bump against each other.

Luckily, while the quest to finish the wealth puzzle isn't over, at least we have some of the pieces in hand.

So take the time to dive in and listen to this video and let us know if you have questions along the way. After that, we'll soon head into a new section of the course: we'll tackle the factors of production so we can further explore what leads to economic growth.

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The Puzzle of Growth | Marginal Revolution University

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Throughout this section of the course, we've been trying to solve a complicated economic puzzle-why are some countries rich and others poor? There are various factors at play, interacting in a dynamic, and changing environment. And the final answer to the puzzle differs depending on the perspective you're looking from.

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The Commerce Department released third-quarter gross domestic product numbers today, showing that the economy grew almost twice as fast over the summer ...

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Picture the economy as a giant supermarket, with billions of goods and services inside. At the checkout line, you watch as the cashier rings up the price for each finished good or service sold. What have you just observed?

The cashier is computing a very important number: gross domestic product, or GDP.

GDP is the market value of all finished goods and services, produced within a country in a year.

But, what does "market value" mean? And what defines a "finished good"?

These, and more questions, percolate inside your head. Meanwhile, the cashier starts ringing up the total, and you're left confused. An array of things pass by you - A bottle of wine. A carton of eggs. A cake from the local bakers. A tractor, of all things. A bunch of ballpens. A bag of flour.

In this video, join us as we show you how to make sense of this important economic indicator. You'll learn how GDP is computed, and you'll get answers to some pretty interesting questions along the way.

Questions like, "Why are the eggs in my homemade omelet part of the GDP, but the eggs my baker uses are not? Why does my bottle of French wine contribute to France's GDP, even if I bought it in the United States?"

Most importantly, you'll also learn why polar bears aren't part of the GDP computation, even if they're incredibly cute.

So, buckle in for a bit-in the following videos we'll dive into specifics on GDP.

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What Is Gross Domestic Product (GDP)? | Marginal Revolution University

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Picture the economy as a giant supermarket, with billions of goods and services inside. At the checkout line, you watch as the cashier rings up the price for each finished good or service sold. What have you just observed? The cashier is computing a very important number: gross domestic product, or GDP.

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"Are you better off today than you were 4 years ago? What about 40 years ago?"

These sorts of questions invite a different kind of query: what exactly do we mean, when we say "better off?" And more importantly, how do we know if we're better off or not?

To those questions, there's one figure that can shed at least a partial light: real GDP.

In the previous video, you learned how to calculate GDP. But that was a very particular kind of GDP: nominal GDP, which isn't adjusted for inflation, and doesn't account for increases in the population.

A lack of these controls produces a kind of mirage.

For example, compare the US nominal GDP in 1950. It was roughly $320 billion. Pretty good, right? Now compare that with 2015's nominal GDP: over $17 trillion.

That's 55 times bigger than in 1950!

But wait. Prices have also increased since 1950. A loaf of bread, which used to cost a dime, now costs a couple dollars. Think back to how GDP is computed. Do you see how price increases impact GDP?

When prices go up, nominal GDP might go up, even if there hasn't been any real growth in the production of goods and services. Not to mention, the US population has also increased since 1950.

As we said before: without proper controls in place, even if you know how to compute for nominal GDP, all you get is a mirage.

So, how do you calculate real GDP? That's what you'll learn today.

In this video, we'll walk you through the factors that go into the computation of real GDP.

We'll show you how to distinguish between nominal GDP, which can balloon via rising prices, and real GDP-a figure built on the production of either more goods and services, or more valuable kinds of them. This way, you'll learn to distinguish between inflation-driven GDP, and improvement-driven GDP.

Oh, and we'll also show you a handy little tool named FRED - the Federal Reserve Economic Data website.

FRED will help you study how real GDP has changed over the years. It'll show you what it looks like during healthy times, and during recessions. FRED will help you answer the question, "If prices hadn't changed, how much would GDP truly have increased?"

FRED will also show you how to account for population, by helping you compute a key figure: real GDP per capita. Once you learn all this, not only will you see past the the nominal GDP-mirage, but you'll also get an idea of how to answer our central question:

"Are we better off than we were all those years ago?"

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Nominal vs. Real GDP | Marginal Revolution University

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"Are you better off today than you were 4 years ago? What about 40 years ago?" These sorts of questions invite a different kind of query: what exactly do we mean, when we say "better off?" And more importantly, how do we know if we're better off or not?

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They say what matters most in life are the things money can't buy.

So far, we've been paying attention to a figure that's intimately linked to the things money can buy. That figure is GDP, both nominal, and real. But before you write off GDP as strictly a measure of wealth, here's something to think about.

Increases in real GDP per capita also correlate to improvements in those things money can't buy.

Health. Happiness. Education.

What this means is, as real GDP per capita rises, a country may also see related benefits.

As the figure increases, people's longevity tends to march upward along with it. Citizens tend to be better educated. Over time, growth in real GDP per capita also correlates to an increase in income for the country's poorest citizens.

But before you think of GDP per capita as a panacea for measuring human progress, here's a caveat.

GDP per capita, while useful, is not a perfect measure.

For example: GDP per capita is roughly the same in Nigeria, Pakistan, and Honduras. As such, you might think the three countries have about the same standard of living.

But, a much larger portion of Nigeria's population lives on less than $2/day than the other two countries.

This isn't a question of income, but of income distribution-a matter GDP per capita can't fully address. In a way, real GDP per capita is like a thermometer reading-it gives a quick look at temperature, but it doesn't tell us everything.

It's far from the end-all, be-all of measuring our state of well-being. Still, it's worth understanding how GDP per capita correlates to many of the other things we care about: our health, our happiness, and our education.

So join us in this video, as we work to understand how GDP per capita helps us measure a country's standard of living. As we said: it's not a perfect measure, but it is a useful one.

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Real GDP Per Capita and the Standard of Living | Marginal Revolution University

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They say what matters most in life are the things money can't buy. So far, we've been paying attention to a figure that's intimately linked to the things money can buy. That figure is GDP, both nominal, and real. But before you write off GDP as strictly a measure of wealth, here's something to think about.

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In the last three videos, you learned the basics of GDP: how to compute it, and how to account for inflation and population increases. You also learned how real GDP per capita is useful as a quick measure for standard of living.

This time round, we'll get into specifics on how GDP is analyzed and used to study a country's economy. You'll learn two approaches for analysis: national spending and factor income.

You'll see GDP from both sides of the ledger: the spending and the receiving side.

With the national spending approach, you'll see how gross domestic product is split into three categories: consumption goods bought by the public, investment goods bought by the public, and government purchases.

You'll also learn how to avoid double counting in GDP calculation, by understanding how government purchases differ from government spending, in terms of GDP.

After that, you'll learn the other approach for GDP splitting: factor income.

Here, you'll view GDP as the total sum of employee compensation, rents, interest, and profit. You'll understand how GDP looks from the other side-from the receiving end of the ledger, instead of the spending end.

Finally, you'll pay a visit to FRED (the Federal Reserve Economic Data website) again.

FRED will help you understand how GDP and GDI (the name for GDP when you use the factor income approach) are used by economists in times of economic downturn.

So, buckle in again. It's time to hit the last stop on our GDP journey.

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Splitting GDP | Marginal Revolution University

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In the last three videos, you learned the basics of GDP: how to compute it, and how to account for inflation and population increases. You also learned how real GDP per capita is useful as a quick measure for standard of living.

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1. What is gross domestic product?

2. What are the three methods that can be used to measure GDP?

3. How does the expenditure method work?

4. Explain C + I + G + (X-M).

5. How are year-end inventories and houses treated?

6. How do we measure per capita GDP?

7. What are strengths and weaknesses of GDP as a measure of standard of living?

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Consumption is financed primarily out of our income. Therefore real wages will be an important determinant, but consumer spending is also influenced by other factors, such as interest rates, inflation, confidence, saving rates and availability of finance.

Interest Rates - Interest Rates influence the cost of borrowing and mortgage interest payments. - Higher interest rates increase the cost of mortgage payments. Therefore higher rates will lead to lower spending as consumers have lower disposable income. It is also important to note real interest rates - interest rates - inflation.
However, higher interest rates will also increase the income from savings, so some groups of people may feel they have more income.

Wage growth. Higher wages are the most significant factor in encouraging consumer spending.

Inflation. Inflation can be influential in determining spending. If inflation is greater than nominal wage growth, then consumers will see a fall in disposable income.

This graph shows nominal wages and inflation. Between 2008 and 2014, inflation was higher than nominal wages - causing weak consumer spending.

Deflation - periods of deflation (falling prices) can also have a negative impact on consumer spending. If prices are falling, consumers may feel that prices will be cheaper in the future and therefore, they delay purchasing goods - hoping they will be cheaper. Deflation can also cause a rise in the real value of debt, squeezing incomes.

House prices - Housing is the biggest form of wealth. When house prices are rising people are more confident to spend and they can also remortgage their houses. Rising house prices cause a wealth effect - with higher prices encouraging spending.

In the late 1980s, the UK experienced rapid house price inflation, this was a factor in causing the "Lawson Boom' - a period of rising consumer spending.
However, very expensive house prices and rent can reduce consumer spending amongst the younger population who spend a high percentage of income on rent and try to save for a deposit.

Consumer confidence. Higher confidence will encourage people to spend more. With higher confidence about future incomes, consumers will be more willing to borrow and spend.

Difficulty/ease of borrowing money. If finance is easily available, it will encourage people to take out personal loans and credit on credit cards. e.g. after the credit crunch, it was more difficult to borrow from banks leading to lower consumer spending.

Tax rates - A cut in income tax would give consumers more disposable income

Propensity to save. The opposite of consumption is saving. If consumers become more pessimistic and increase savings, then consumption will tend to fall.

Demographic factors. Another factor that influences consumer spending is demographic factors. If a population has an ageing population, the ratio of saving may rise and consumer spending may fall.

The sharp rise in saving ratio in 2008/09 - corresponded with the recession of 2008/09 and sharp fall in consumer spending.

Autonomous and Induced Consumption

In Keynesian models of consumption, it is argued that even with zero income, people will still consume a certain amount (to buy food to live). This consumption may be financed by borrowing or running down savings. This consumption is known as autonomous consumption

See: Keynesian Consumption Function
Related
see also: Causes of economic growth

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Consumption is financed primarily out of our income. Therefore real wages will be an important determinant, but consumer spending is also influenced by other factors, such as interest rates, inflation, confidence, saving rates and availability of finance. Interest Rates - Interest Rates influence the cost of borrowing and mortgage interest payments.

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In Economics, Purchasing Power Parity (PPP) is a theory that says that in the long run (over several decades), the exchange rates between countries should even out so that goods essentially cost the same in both countries. The Purchasing Power Parity theory explains that there should be no arbitrage opportunities (where price differences in countries can result in profit). PPP is based on The Law of One Price which implies that all identical goods should have the same price. It is usually calculated using a similar basket of goods in two countries and is also used to evaluate under/over valued currencies.

The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by GDP. The final product list covers around 3,000 consumer goods and services, 30 occupations in government, 200 types of equipment goods and about 15 construction projects. The large number of products is to enable countries to identify goods and services which are representative of their domestic expenditures.

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Purchasing Power Parity | Intelligent Economist

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In Economics, Purchasing Power Parity (PPP) is a theory that says that in the long run (over several decades), the exchange rates between countries should even out so that goods essentially cost the same in both countries. The Purchasing Power Parity theory explains that there should be no arbitrage opportunities (where price differences in countries can result in profit).