Lesson 4 Potential Output, the GDP Gap, and the Intelligence Gap

Lesson 2 GDP and US

National Growth, GDP, and the Geico Gecko



Gross domestic product is the term we use to describe all the final goods and services produced in a nation during a given period of time, usually a quarter or a year. To better understand GDP we define several specific terms that help us get to its definition.

Goods are tangible things that are produced – cars, computers, and umbrellas. Goods are often described as being durables (e.g. cars, washing machines) or non-durables (e.g. food, clothing).  They can also be referred to as follows:

                                          Types of Goods   

Final Consumer Raw Material Intermediate Final Capital
Intended for final use by a household member (example: breakfast cereals or dish washer) a business good that will be further transformed by a producer (example: crude oil) a business good that has been partially transformed but not finished (example: steering wheel) a good that will be used to produce other goods by a business

(example: printing machine)

A service is an intangible – meaning that unlike a good, you can’t really take it home with you. It is consumed as it is rendered. Sure, you look beautiful for days after your haircut – but we think of the act of giving the haircut as over when you leave the hair salon. Consumers enjoy lots of services like personal services, travel, banking, and many more. Businesses also buy services – for example from accountants, consultants, travel agents, and others.

Definition of GDP

This gets us back to GDP – or more formally – ta da – the market value of all final goods and services produced within the borders of a country during a given time period. Keep in mind that GDP is a SCHMOO – it is to macro what a steel rod is to micro. Just like we have supply and demand for steel, we can have AS and AD for GDP.

Below we show that it is very typical to use AD terms to measure GDP.

Measuring GDP

A traditional way of describing and measuring GDP is through the aggregate demand

approach which begins with following basic idea: Output is equal to two parts:


Part 1: Final Demand


      Part 2: Inventory Change

All the G&S demanded and produced within the borders of a country that went to a final household or capital user (Final demand for all goods and services) All the G&S produced that did not get to the final user – that is, these goods did not get finished or were finished but were not sold.  These unsold goods and services (it is hard to think of an unsold service since services are generally consumed as they are delivered – but you might think of a big consulting project that got only half done this year) would be additions to the nation’s inventories of either finished or unfinished goods.

The above points mean that we have a brief way to talk about GDP that emphasizes the AD side of macro is as follows:

GDP = final aggregate demand plus the change in business inventories

GDP = Final AD +  ΔINV

(For you econotechnies the above equation is not an equilibrium condition. It is one way of expressing the definition of GDP. The equilibrium condition for the goods and services market is AD = AS. More will be said about this equilibrium in Chapter 4.)

So now we know that GDP and final demand are closely related, though not exactly the same. Check the Wall Street Journal for that terminology. Now we need to dig into final demand a little more. It is very typical to discuss final demand in terms of its key components. All but one of these key final aggregate demand key components is listed directly below. In interpreting these components below do not forget that we are discussing a way to measure GDP – and remember that GDP is defined as production. So all these categories have to do with final demand for current production (and this means we are not thinking about demand for goods that are already in existence like houses that were built a year ago or used cars):

(Personal Consumption Expenditures)


(Residential Investment)


(Non-residential investment)


(Government purchases)



the G&S purchased by households (except for newly built houses) the purchases of newly built houses, apartments, condos, etc purchases by businesses of new plant and equipment and office buildings the purchases by local, state, and federal government of services, durables, non-durables, and capital goods these are goods and services that are sold to persons residing outside of the country.

But be careful now: The goods and services bought by households for final consumption include goods and services produced within the borders of other countries: Toys made in China, consulting services rendered by phone from India, etc.. Similarly, non-residential investment includes capital goods produced within the borders of other countries, such as printing machines made in Germany. While the US exports goods and services to other countries, it imports goods and services from other countries. To compute US GDP (the value of all goods and services produced within the borders of the US) correctly, we have to subtract imports, IM, from consumption, non-residential investment and government purchases. All legal imports to a country must go through some form of customs and in that way all imports can be calculated.

Note: the government gets import information from the port authorities.

Once you can remember the abbreviations we can rewrite this definition of GDP more simply as:

GDP = C + I-R + I-NR + G + X + ΔINV – IM

Let’s now define the term I or what is more formally called: Gross Private Domestic Investment:

I = I-R + I-NR + ΔINV

Therefore we can rewrite GDP as:

GDP = C + I + G + X – IM

A country’s net exports (NX) are the difference between the exports (X) and the imports (IM), so we can write the GDP expression one more time

GDP = C + I + G + NX

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