Understanding GDP and Economic Policy

While most are aware that gross domestic product, or GDP, is the primary measure of macroeconomic activity that economists and policymakers study worldwide, for many, this statistic remains somewhat mysterious. GDP’s mysterious nature suggests that there is at least some wiggle room to modify its definition to better reflect an individual or a policymaker’s particular view of the economy. Now, let’s peek under the hood to try to demystify the concept of GDP. My goal is to highlight why there is no ambiguity, no wiggle room so to speak, about how to measure economic activity and then to discuss how to use these measures to have a productive dialogue about the role government plays in our economy.

The Circular Flow Model: The Interconnected Economy

Formally, GDP is a measure of the value of all final goods and services newly produced in a given year in a given country. In plain English, GDP is a measure of how much stuff we produce each year. If you like, imagine a statistician approaching every business in our economy and asking how much new product they sold this year.¹

Now, when firms produce new goods and services, two additional economic outcomes typically occur. First, firms usually sell these items to consumers, to other businesses, to the rest of the world, and, yes, to the government. This means that if we can accurately measure all expenditures or purchases of goods and services, we should arrive at the same estimate of GDP as we did when we measured all production. Second, selling products generates revenue and income for the firm, and this income is paid out to workers and those who own or otherwise hold claims to the business. This means that if we can accurately measure all income generated in our economy, we should also arrive at the same estimate of GDP as we did when we measured all new production.

The fact that we can measure GDP in three ways arises from the interconnected nature of households, businesses, and the government in a macroeconomy, often referred to by economists as the circular flow model.

Why Government Spending Is Included in GDP

This circular flow view of the economy highlights why we cannot simply “remove” government spending from a measure of GDP. If we did, our numbers would simply stop adding up. Imagine a pen producer who produces and sells $1 billion in pens to the public this year. We would agree that this producer created $1 billion in value. Suppose a second producer also sells $1 billion in pens, but it happens to sell $200 million of those pens to the government. Would we say this second pen producer added less value just because it happened to sell some of its product to the government? No. Two private businesses produced the exact same output, therefore, we would say they contribute to GDP equally.

This may seem clear for tangible products like pens, but the same exact argument holds for less tangible products, such as services like consulting. Again, if a consulting firm generates $1 billion in sales, why should it matter how we measure the firm’s contribution to production, whether it happens to consult for other private businesses or the government? One can debate the effectiveness of these government purchases—do such services enhance government efficiency or not—but the purchases belong in our measure of production.

If we are to arrive at a measure of aggregate expenditures that is consistent with our measure of production, it is imperative to also measure purchases made by the government. There is no ambiguity here.

Impact and Considerations

The fact that GDP, in part, reflects the economic activities of the government means that changes in government spending are likely to imply changes in GDP. The exact size of these changes depends on the response of the other sectors of the economy (households, private businesses, the rest of the world, etc)—this is the logic of the circular flow model again. But it is important to remember that while high levels of GDP per person are typically associated with good economic outcomes (such as high levels of consumption, low poverty, and low child mortality rates), GDP is not by itself a measure of well-being. As a result, it is not the objective of sound economic policy to raise GDP at all costs.

We can have a useful and important discussion about the appropriate level of spending (and implicitly taxation and inflation) in our economy despite the fact that reductions in government spending may cause at least temporary declines in GDP. These discussions should focus on how government activities enhance our economy’s productivity, which has long been recognized by economists as the engine of growth in the standard of living, and at what cost. Evaluating the tradeoffs of changes in our policy environment relies on sound, principled economic measurement rather than attempts to obscure the costs by manipulating our nation’s economic statistics.

1. If we actually did this, we would end up double-counting the value of some goods, which is why the definition of GDP focuses on final goods (as opposed to intermediate goods that are used up in the production of other goods). For example, when a car manufacturer sells a car, part of its value reflects the value of the tires in the car, which our statistician would have already measured when they visited the tire producer.