uploads/2014/05/GDP-formula.jpg

A must-know update for beginner investors: Calculating the GDP

By

Updated

Calculating the GDP

There are three approaches to calculating a country’s GDP:

  1. The production approach sums the “value-added” at each stage of production, where value-added is defined as total sales less the value of intermediate inputs into the production process. For example, flour would be an intermediate input and bread the final product; or an architect’s services would be an intermediate input and the building the final product.
  2. The expenditure approach adds up the value of purchases made by final users—for example, the consumption of food, televisions, and medical services by households; the investments in machinery by companies; and the purchases of goods and services by the government and foreigners.
  3. The income approach sums the incomes generated by production—for example, the compensation employees receive and the operating surplus of companies (roughly sales less costs).

In practice, however, the simplest and more popular way used to calculate GDP is:

GDP = consumption + investment + government spending + net exports (that is, exports – imports), which translates to the formula GDP = C + I + G + (X – M), where, C= spending by consumers, I= investment by businesses, G= government spending, and (X – M) = net exports, that is, the value of exports minus imports. Net exports can be negative, which means imports are more than exports.

Accordingly, the four major components that go into the calculation of the U.S. GDP, as used by the Bureau of Economic Analysis, U.S. Department of Commerce, are:

  • Personal consumption expenditures
  • Investment
  • Net exports
  • Government expenditure
Article continues below advertisement

By knowing an economy’s GDP numbers, one can better assess the direction of growth. Also, the performances of popular exchange-traded funds (or ETFs) like the SPDR S&P 500 ETF (SPY), the iShares Core S&P 500 ETF (IVV), and the iShares S&P 100 ETF (OEF), which track large-cap equities of companies like Apple Inc. (AAPL) and Exxon Mobil (XOM), serve as good indicators of the course that the U.S. economy is taking.

The next part of this series gives a quick view on each of the four main components that go into the calculation of GDP in the U.S.

Advertisement

More From Market Realist