Components of GDP

There are many approaches to estimating GDP (such as the value-added approach, income approach, etc), but the one that normally receives the most attention is the expenditure approach.  Whatever is produced is going to be purchased, so the expenditure approach identifies four components of total spending (click here for a video from the Atlanta Fed about the components of GDP).  Why does this receive the most attention?  It helps people to understand the behavior of different segments of the economy - households, businesses, government, and the rest of the world).

Consumption

This involves the purchases of goods (including durables and nondurables) and services by households.  Durables are goods that tend to last 3 or more years, such as motor vehicles and appliances.  Since these items last awhile and tend to be expensive, they are quite sensitive to the business cycle.  As such, spending on durable goods tends to be much more volatile than other forms of consumption.  Nondurable goods include items that don't last as long, such as food and clothing.  Since these items typically do not last as long, spending tends to be less volatile than the overall economy.  Services involves tasks performed by others, such as medical, legal, entertainment, etc.  This tends to be the most stable component of consumption.  In the US, consumption is about 70% of GDP; it is also the largest component of GDP in most countries.  Normally, if consumption isn't growing quickly, it's unlikely that the economy will grow quickly in the short run.

Factors Affecting Consumption

• income: The primary factor affecting consumption is people's income, which primarily comes from their job.  Clearly, increasing income results in more consumption.
• wealth: Wealth is the net worth of an individual - the difference between the value of assets that a person owns minus liabilities.  For most people, their primary asset is their home.  Many people also hold significant amounts of wealth in stocks, mutual funds, bank accounts, etc.  Estimates indicate that consumers normally spend about 3-5% of their wealth in a given year.
• interest rates and credit availability: When purchasing durable goods, people typically take out loans.  The availability and cost of credit has a significant effect on the purchase of consumer durables.
• outlook for personal financial situation: If people feel more secure about their job and/or their wealth, they are more likely to increase their consumption.  This shouldn't be confused with general measures of consumer confidence.  Many times, consumers are pessimistic about the overall state of the economy, but optimistic about their own situation.

STOP AND THINK: What are the primary drivers of consumption?  Why has the growth of consumption been subdued in the recovery following the Great Recession?

Investment

Though people many times think of investment in terms of stocks, bonds and other financial assets, economists think of those items as savings.  Investment involves the purchase of physical assets, as opposed to financial assets.  When people save, whether in bank accounts, stocks or bonds, they are not spending funds but instead making funds available to others who will use those funds to buy physical assets.  There are three forms of investment: business fixed investment (sometimes referred to as nonresidential investment), residential investment and inventory investment.

Business Investment

Business investment involves the business purchases of new structures and equipment.  This includes such things as computers, machinery, office buildings and factories.  Beginning in July 2013, business investment better captures investment in intellectual property (research & development, etc.; click here for details).  Notice the extreme volatility of investment over the business cycle.

Factors Affecting Business Investment

• expected profitability: If an investment is expected to be profitable, firms are likely to undertake the investment.  This is more likely to occur when the economy is expected to grow and remain strong.  Thus, an optimistic economic outlook has a positive effect on business investment.
• interest rates and credit availability: Many firms borrow funds in order to invest.  If credit is available and inexpensive, they are more likely to increase investment.
• technological change: As technology improves, firms will seek to obtain the new technology by investing in new equipment or structures.
• capacity utilization: If there's a lot of structures not being used (for example, empty office buildings), business investment in structures is likely to be quite weak.  Similar reasoning applies to business equipment.

STOP AND THINK: Given the factors that affect business investment, why is business investment so volatile?

Residential Investment

Residential investment includes purchases of new houses and apartment complexes.  As everyone knows by now, there was a bubble in residential investment in the 2000s.  The amount of residential investment reached record levels before experiencing a rapid decline beginning in 2006.  Note that residential investment has surged in the early stages of every recovery since 1970.  What if residential investment doesn't surge early in a recovery?  How does that affect the strength of the recovery?

The following graph is the level of residential investment for each year, not the percent change (enables one to better see the formation of the housing bubble in the 2000s).

The following chart compares the ratio of residential investment to GDP.  As can be seen, it rose from a low in 1991 through the end of the decade.  Rather than decline as in previous recessions, it paused before surging in the 2000s.  Though it rebounded recently, it's still near the lowest since records started being kept in 1947.

Factors Affecting Residential Investment

• demographic trends: Demographic trends, such as the formation of new households, play a major role in residential investment over time.  As new households are formed, home sales tend to grow.  However, the relative preference for apartments vs. houses vs. condos has an impact as well.  If people become more hesitant to buy houses due to the bursting of the housing bubble or desire for increased mobility, home sales may decline.
• interest rates and credit availability: Most people finance their houses by taking out mortgages.  Thus, the availability and cost of credit has a significant effect on residential investment.  Lower interest rates and/or credit becoming increasingly available tends to lead to more residential investment.
• existing inventory of houses for sale: Since residential investment involves new homes, if there's a huge supply of existing homes, there will be less residential investment (people can purchase the existing homes and are less likely to build new homes).
• outlook for personal financial situation: As with consumption, if people feel more secure about their job and/or their wealth, they are more likely to buy a new house.
• beginning in the late 1990s, expected price appreciation became a factor affecting residential investment.  In other words, speculators and even some traditional homeowners bought new houses because they expected them to increase in value (instead of just to be used as a residence).

STOP AND THINK: Given the factors affecting residential investment, which ones do you think contributed to the housing bubble in the 2000s?

Inventory Investment

• The third form of investment, inventory investment, is unique in that it doesn't include purchases but instead is the change in the level of inventories.  There are two major types of inventories - finished goods not yet sold and intermediate products (such as components). 

• When considering finished goods not yet sold, companies seek to maintain enough inventory to meet the demand of their customers. If they anticipate higher demand, they will hold a higher level of inventories (and hold less inventories if they anticipate a decline in sales).  In terms of components, firms seek to maintain the amount needed for the planned production of goods.  Businesses don't want to hold too many inventories since it's costly to maintain inventories (think of the cost to a car dealership of keeping cars on its lot).  As before, if firms expect higher sales or the need to produce goods to increase, they'll increase the amount of components and thus increase the inventories that they hold (or decrease the amount of inventories if they anticipate weaker sales).
• Inventory investment can provide clues about the turning points in the economy.  If inventories rise unexpectedly, firms conclude that sales were less than expected.  As a result, they  respond by either reducing production (and thus economic growth), reducing prices (lower inflation) or some combination of the two.  Similarly, an unexpected decline in inventories can be a sign of sales exceeding expectations, leading to future increases in production and thus stronger economic growth or an increase in prices and thus more inflation.
• The chart below shows the steady decline in the inventory-sales ratio over time as companies implemented just-in-time inventory management (having components arrive just in time to be used in production).  The sudden collapse in demand that took place in late 2008 led to a spike in the ratio, followed by the largest inventory liquidation ever recorded as firms sought to reduce inventories to get them back in line with sales.

• Many times, GDP rebounds strongly immediately following the end of recessions.  A significant portion of this growth is typically due to smaller declines in inventories or increases in inventories as companies anticipate stabilization or higher sales.  How can a smaller decline in inventories add to economic growth?  As mentioned above, inventory investment is the change in the level of inventories.  If this change becomes smaller, inventory investment increases.  For example, in the third quarter of 2009, inventory investment was -$181.5b while in the fourth quarter of 2009, it was -$38.8b, an increase of more than $142b.  This added 4.5% to economic growth in the fourth quarter of 2009 (see the chart below which shows economic rebounds from recessions since 1950).  When one subtracts inventory investment from GDP, what's left is final demand for domestically produced goods and services (i.e., GDP is what's produced; subtract what's not purchased and you're left with demand or what was purchased).  During the first year of the recovery from the 2007-2009 recession, the fastest quarter of economic growth took place in the fourth quarter of 2009, when the economy grew by 4%.  However, after removing the effects of inventories, final demand actually declined.

STOP AND THINK: How can changes in inventory investment provide signals about upcoming economic activity?

Government Purchases

• This involves the purchases of goods and services by all levels of government, not all government spending.  Many times, the government spends money but does not purchase goods or services.  In most cases, this is referred to as transfer payments.  For example, social security recipients receive funds from the government, but no purchase is involved in the transaction (other examples include Medicare, Medicaid, welfare and unemployment benefits).  The funds are transferred to households who then purchase goods or services, so transfer payments lead to increased consumption.  A majority of spending by the US federal  government involves transfer payments.  What does the federal government purchase?  Most military spending involves purchases as do salaries of anyone who works for the government.  Most state and local spending is on purchases of services, including education and safety (police, fire, etc).
• Since this category does not includes transfer payments, it doesn't show the full impact of government spending.  For example, some commentators looked at the government purchase contribution to economic growth during the recovery following the Great Recession and concluded that the fiscal stimulus had no impact on economic growth.  During the second half of 2009, federal government nondefense purchases added about 0.2% to economic growth followed by just over .3% in the first quarter of 2010.  Does that mean the $800 billion stimulus had little effect?  Nearly one-third of the stimulus involved tax cuts and a large portion of the rest of it involved transfer payments or aid to states, none of which show up in this category (which category(ies) would be affected?).  One can debate whether the stimulus was effective, but the only portion that would show up as purchases by the federal government would be infrastructure spent during those quarters.  As the chart below illustrates, federal government purchases as a percent of GDP has trended downward over time, mainly because of declines in defense spending (as a portion of GDP).

Net Exports

• Net exports is the difference between exports and imports.  Exports are goods and services produced in a country but sold elsewhere while imports are produced elsewhere but purchased in the country.  Both exports and imports include intermediate goods as well as final goods.  For example, suppose oil is imported to the US from Saudi Arabia and then is refined to make gasoline. Oil is an import but the refining that takes place in the US is domestic production and adds to US GDP.  The following chart shows the behavior of exports (red line) and imports (blue line) as a percent of GDP since the 1940s.  As can be seen, trade has become an increasingly important part of the US economy in recent decades