The The Circular Flow showed that the economy's spending and income go around a loop. To measure how much an economy produces, economists count the spending on its output in a careful way. The result is gross domestic product, or GDP.
Key idea
GDP is the market value of all final goods and services produced within a country in a given period, usually a quarter or a year.
Why it works
Each word in the definition keeps GDP from counting something twice or counting something that was not made. Market value means we add things up by their prices, so cars and haircuts can be combined in dollars. Final goods are sold to their last user; the flour inside a loaf of bread is already in the bread's price, so counting the flour too would double-count it. Produced in the period leaves out used goods, which were counted the year they were made. Within a country means location, not ownership: a Japanese-owned car plant in Kentucky adds to U.S. GDP.
- Counted: new goods and services sold to households, businesses, government and foreigners; new homes; goods produced this year but still unsold (they count as additions to inventories).
- Not counted: intermediate goods (already inside the final price), used goods, purchases of stocks and bonds (a change of ownership, not production), transfer payments such as Social Security checks (nothing is produced in return), and unpaid work at home.
A worked example
Worked example: Which purchases add to GDP?
This year a family buys a newly built house for \$300,000, buys \$5,000 of stock, and pays a real estate agent \$9,000 to help sell their old house. How much do these add to GDP?
- The new house is newly produced: \$300,000 counts (as residential investment).
- The stock is a financial asset changing hands: it does not count.
- The old house was counted when it was built, but the agent's service happened this year: the \$9,000 commission counts.
- Total: $300{,}000 + 9{,}000 = 309{,}000$ dollars.
Answer: \$309,000
Common mistake
Counting intermediate goods, used goods, stock purchases or transfer payments. These either count the same production twice or count things that were not produced this period. Quick check: ask "was something newly made, in this country, this period, and sold to its final user?" If not, leave it out (but do count any new service attached to it, like a commission).