Detailed Explanation of GDP Components - Online Tutor, Practice Problems & Exam Prep

Gross Domestic Product (GDP) comprises four components: consumption, investment, government purchases, and net exports. Consumption includes household spending on goods (durable and nondurable) and services. Investment refers to business spending on capital goods, residential construction, and inventory changes. Government purchases involve spending by local, state, and federal governments, excluding transfer payments. Net exports are calculated as exports minus imports, indicating trade balance. The GDP formula is: $\mathrm{GDP}=C+I+G+\mathrm{NX}$, where C is consumption, I is investment, G is government purchases, and NX is net exports.

Consumption

Alright. Now let's go into a little more detail for each of the 4 components of GDP: consumption, investment, government purchases, and net exports. Let's start here with consumption. Remember that consumption is spending by households on goods and services. We're going to break out what this consumption is into three categories. First, there are the services that get purchased, and then we break up goods into nondurable and durable goods. Services are basically intangible acts that are being used up by the consumer, right? So you're going to buy something that's not tangible. You can't hold it in your hand like this pen or a computer; these aren't goods. They're services that someone’s doing something for you.

Compare that with goods. We break goods into two categories where there is something tangible. Non-durable goods are products where we say they have less than three years of expected life, and durable goods are products with more than three years of expected life. Let’s go through some simple examples here of a service. What would be a service? A service would be maybe getting a haircut; there's nothing tangible you can hold about a haircut, but it's a service that's being provided to you. How about hiring a lawyer or an accountant? They're providing a service for you by helping you with a legal case or finances. What about a tutor? A tutoring service is also considered a service here because there's no tangible good; you're just getting smarter.

How about some non-durable goods? What are some things that don't last a long time? Well, a very good example here would be food, maybe shoes. I know I can wear my shoes for more than three years, but sometimes my big toe starts to come out the front; but for the most part, shoes are going to be called a non-durable good here. And a very good example of a durable good that gets purchased by households maybe a car, a washing machine, things like that. Things that are going to last for quite a long time, right? A computer maybe. Things like that.

Non-durable goods, durable goods, and services. So the big thing to remember there is the three-year threshold for non-durable and durable. But for the most part, you can probably make a logical guess as to what's going to be non-durable compared to a durable good. Let's go ahead and pause here and then we'll move on to investment in the next.

Investment

Alright. Let's move on to investment now. So investment, remember, this isn't like financial investments in stocks and bonds. This is big investments in capital equipment, inventory, structures, things that are going to last quite a few years here, right? Big things here. Now, we break this up into 3 categories here. So the business spending is going to be the business fixed investment, then we've got that residential investment and remember how we talked about households buying new houses? Well, that was included investment and then we've got changes in inventory. Let's go through these 1 by 1 here.

So business fixed investment. Well, this is spending on how we said like new factories, buildings, equipment to produce goods. So this is increasing future production by buying these things today, right? We're building new factories. We're buying buildings. These are things that are going to increase our productivity in the future. The next is those residential investments. Remember, spending by household and firms on new homes. So it's, it's, you gotta be clear that we're purchasing new homes here, new construction, not purchasing homes that were built in other years and now being resold as a secondhand sale. Okay. So this includes both single-family or multi-unit homes. This is the key here is that they're new construction this year. So just like I said, resale of previously constructed are not included. Cool?

Finally, we have changes in inventory. So this is the last part of the investments here and changes in inventory. Remember when a business holds inventory, so they have goods that they haven't sold yet, well, remember those goods that are sitting in inventory, they were produced in another year. So if the inventory decreases during the year, well that means we're selling other year's production, right? We're getting rid of inventory. We're getting rid of things that we produced in other years. That should decrease our investment here. Where if we increase our inventory, if we're building more and more of something and increasing our inventory, well, we increased what was produced during this year, so it should increase our investment. So let's look through this example right here. Notice that it can be positive or negative.

Sony had 100,000,000 of unsold televisions at the beginning the beginning of the year in this example. So let's start in the left-hand box and then by the end of the year, they had only 20,000,000 of unsold televisions. So what happened to their inventory? Did it increase or decrease during the, excuse me, during the year? They started at a 100,000,000 and they ended at 20,000,000. So they had an 80,000,000 change, and was it an increase or a decrease? Well, the inventory decreased throughout the year. Right? Decrease in inventory. So what would happen to investment? The decrease in inventory, would that lead to an increase or a decrease in investment? This is a decrease in investment. Right? Because we're selling stuff that we produced in other years. If we're decreasing our inventory, remember, we had a 100,000,000 of televisions at the beginning of the year. Well, we had produced those in other years and now there's only 20,000,000 of it left. Those 80,000,000 that we sold, well, it would have been counted as consumption, right? Things that got sold during the year. However, we didn't produce them this year. So, we need to get rid of that out of our GDP calculation. So it would decrease investment.

Okay. A decrease in inventory decreases investment. Now look on the other side of the coin. Let me scroll up a little bit. Is an increase. Right? So at the beginning 100,000,000, but by the end of the year, there was a 160,000,000 of unsold televisions. So clearly, there was an increase in inventory. Right? There's the 100,000,000 minus the 160 that leaves us with 60, and I just did beginning minus ending kinda silly, but you can clearly see that this is a 60,000,000 increase to inventory, right? They started with a 100. They got to a 160. So that's a 60,000,000 increase in the inventory and what do we see in this case? The increase in inventory would increase investment by the same logic, right? We produce these things this year, so they should be included in the GDP of this year even if they haven't been sold yet. Cool?

So the last but not least, we've talked about this before, but remember that the financial transactions like stocks and bonds are not included in investment. They are not part of investment even though in your head, you might be thinking investments in our stocks, bonds, mutual funds, those types of things. Those are financial investments. Here, we're talking about economic investments. We're taking an economics class. We're focused on economic investment. Cool? So that's about it for investment. Let's go ahead and in the next video, we're just gonna review some stuff about government purchases, net exports, and we'll wrap this.

Government Purchases and Net Exports

Alright. So there's not much more details we need to go on here, but let's go ahead and review this just so we have it all in one place. Government purchases spending on goods and services by who? By the government. Right? Local, state, and federal government. They're the ones who make the government purchases. Pretty straightforward. And remember, just to reiterate that this does not include transfer payments. So when the government transfers money to other citizens, so through, let's say, a welfare check or an unemployment check, that does not get included in GDP. It gets included when that gets spent on consumption, right? So the money when it gets received by the households, they're going to spend it on goods and services and then it'll be included in the consumption category, not in the government purchases category. The welfare check itself does not result in production. Only when it gets spent on the final goods and services does it result in production. So again, net exports, exports minus imports. Right? Exports minus imports. And remember that this could be it could be positive or negative. If the imports are greater than exports, well, we're gonna have a negative number there, right? If we've got a trade deficit in that case, if the imports are greater than exports. So exports remind me again, goods produced where? Are they produced here or abroad? Exports are goods that are produced here but sold abroad, right? They're sold in other countries. And what about imports? Those are goods sold abroad Goods that are produced abroad in other countries but sold here, right? Those are imports. Cool? So remember, those are the four sections of our GDP. Again, GDP equals consumption plus investment plus government purchases plus net exports, okay? There we go. There we have it. A little more detail on the different sections of GDP. The main thing I want you to remember here is, this formula for GDP:

GDP = Consumption + Investment + Government P Purchases + Net Exports

What is included through the expenditure approach?

Let's pause here and move on to the next topic.

Here’s what students ask on this topic:

What are the four components of GDP and how are they defined?

The four components of GDP are consumption, investment, government purchases, and net exports. Consumption includes household spending on goods (durable and nondurable) and services. Investment refers to business spending on capital goods, residential construction, and inventory changes. Government purchases involve spending by local, state, and federal governments, excluding transfer payments. Net exports are calculated as exports minus imports, indicating the trade balance. The GDP formula is: $\mathrm{GDP}=C+I+G+\mathrm{NX}$, where C is consumption, I is investment, G is government purchases, and NX is net exports.

How is consumption categorized in GDP?

Consumption in GDP is categorized into three main types: services, nondurable goods, and durable goods. Services are intangible acts consumed by households, such as haircuts, legal advice, or tutoring. Nondurable goods are tangible products with a life expectancy of less than three years, like food and shoes. Durable goods are tangible products expected to last more than three years, such as cars, washing machines, and computers. Understanding these categories helps in analyzing household spending patterns and their impact on GDP.

What is the difference between durable and nondurable goods in GDP?

Durable goods are tangible products with a life expectancy of more than three years, such as cars, washing machines, and computers. These goods are typically used over a long period. Nondurable goods, on the other hand, are tangible products with a life expectancy of less than three years, like food, beverages, and clothing. These goods are consumed quickly and need to be purchased more frequently. The distinction between durable and nondurable goods helps in understanding different consumption patterns and their impact on GDP.

How do changes in inventory affect GDP?

Changes in inventory affect GDP through the investment component. If a business increases its inventory, it means more goods were produced than sold, leading to an increase in investment and thus GDP. Conversely, if inventory decreases, it indicates that goods produced in previous years are being sold, leading to a decrease in investment and GDP. For example, if Sony starts the year with $100 million in unsold televisions and ends with $20 million, the $80 million decrease in inventory would reduce investment and GDP.

Why are government transfer payments not included in GDP?

Government transfer payments, such as welfare checks and unemployment benefits, are not included in GDP because they do not represent production of goods or services. These payments are simply transfers of money from the government to individuals. GDP only includes spending that results in the production of goods and services. When recipients of transfer payments spend the money on consumption, it is then included in GDP under the consumption category, not as government purchases.