What the textbooks get wrong when they explain GDP

Most economics textbooks don’t devote a lot of space to explaining economic statistics, but they usually provide a short discussion of gross domestic product, or GDP. In limited space, they typically are able to explain some of the important features of GDP—that it’s a comprehensive measure of income and expenditure, that it measures transactions at market prices, that it excludes non-market production, and that it isn’t a measure of well-being. But I’ve also observed that the typical American textbook definition of GDP misses one of its most important features and often leads to misinterpretation.

GDP is fundamentally a measure of value added in production

Let’s consider a simple example of production. Let’s say Henry has a food truck and sells Korean tacos. His produces and sells his output (Korean tacos), using purchased inputs of various food items, as well as other materials such as food containers and napkins. He also pays for fuel to operate the truck, and if he leases the truck, he makes lease payments. His contribution to GDP, or value added, is the value of his output (that is, the food he sells) during a given period of time, less the value of the goods and services that are used up in producing that output. GDP is equal to the sum of value added of all producers that are residents of the country or other economic area that is being measured, valued at the prices paid by purchasers.

GDP is part of the national economic economic accounts and is based on that accounting system. The national accounts include a number of identities, so there are other, equivalent definitions of GDP. In fact, there are three common approaches for measuring GDP—the production approach (sum of value added), the expenditure approach (sum of final expenditures), and the income approach (sum of income from current production). But most manuals focusing on national accounts start with the production approach. For example, the System of National Accounts 2008 (SNA), which is the international standard for national accounts, says, “The underlying rationale behind the concept of gross domestic product… is that it should measure the total gross value added from all institutional units resident in the economy.”

But that’s not the definition of GDP taught in most textbooks

Most economics textbooks, on the other hand, define GDP using the expenditure approach. For example, the fifth edition of Greg Mankiw’s Principles of Macroeconomics provides the following definition of GDP: “Gross domestic product is the market value of all final goods and services produced within a country in a given period of time.” The online macroeconomics course from Tyler Cowen and Alex Tabarrok’s MRUniversity uses a similar definition, though they substitute “finished” for “final” goods and services. Both sources also explain that the expenditure and income approaches are conceptually identical and that there may be a statistical discrepancy between them. However, the production approach is typically given short shrift.

Why is that a problem?

While what the textbooks are teaching isn’t technically incorrect—these are, after all, conceptually equivalent ways of measuring GDP—I do think that focusing on the expenditure approach instead of the production approach leads economics students to certain misinterpretations of GDP.

For example, I’ve often heard people say that the production of intermediate goods and services “isn’t counted” in GDP. But if we treat the production approach as the principal definition of GDP, we understand that producers of intermediate goods and services are generating value added—their output is almost always worth more than the value of the intermediate goods and services that went into its production—so the production (value added) of intermediate products is part of GDP.

Another very common confusion comes about because imports are a subtraction in the calculation of GDP using the expenditure approach. The familiar expenditure formula says that GDP is the sum of household final consumption expenditure, government final consumption expenditure, gross capital formation (or “investment”), and exports, less imports. This identity sometimes leads even credentialed economists to the fallacy that GDP can be boosted simply by cutting imports. Indeed, during the campaign Trump’s trade policy advisers Wilbur Ross and Peter Navarro (now Secretary of Commerce and Director of the National Trade Council) wrote a white paper on trade policy that made exactly that mistake. They argued that the effects of policies to eliminate the trade deficit could be measured directly, without using “any complex computer model,” as simply an addition to GDP in the amount of the reduction in the trade deficit. This analysis implausibly argues that all of the other components of the GDP expenditure formula can be held constant while eliminating the trade deficit.

The production approach, on the other hand, makes clear that imports are neither a subtraction nor an addition to GDP. They simply aren’t part of value added, so they aren’t included. Imports certainly may be correlated with GDP (value added). In some rare cases, a reduction in imports could, in fact, lead to a temporary shift to domestic suppliers, which could produce a temporary boost to GDP. But the more common relationship is that imported goods or services are used by domestic producers as intermediate inputs, which leads imports to move procyclically—increasing (along with GDP) during expansions, and decreasing (again, along with GDP) during recessions. The relationships between imports and GDP can’t be read directly from the GDP final expenditure formula.

Another quibble with the textbook definition is the term “final” (or “finished”) goods and services. The SNA never uses these terms because “final expenditures” (or “final uses”) is not necessarily a characteristic of a good or a service. For example, if a household buys an airline ticket for vacation travel, that’s counted as part of “final consumption expenditure,” even though the ticket for the business traveler sitting next to them will be counted as intermediate consumption. The service of airline travel is neither fundamentally “final” or “intermediate”—it all depends on who’s buying it.

Finally, when we get into certain technicalities about explaining the expenditure and income approaches, I think we ultimately have to go back to the production approach to explain why the measures take the form that they do. For example, why are imports subtracted in the expenditure approach? For imports of consumption or investment goods or services, the textbooks typically say that they need to be subtracted because they are counted in consumer spending or investment spending even though they are not produced domestically. But many imports are not targeted for final consumption or investment, but are intended for use as intermediate inputs (think crude petroleum or memory chips). To explain why these imports also need to be subtracted, we more or less have to go back to the explanation of GDP as a concept of value added—if imported intermediate goods weren’t subtracted, the expenditure approach would overstate the nation’s total value added. Similarly, under the income approach, national accountants remove capital gains from their measures of income. Again, the reason for doing that goes back to the concept of value added—capital gains are income derived from changes in prices of existing assets, rather than from the output of goods and services.

So while the textbook definitions of GDP aren’t awful, I do think they would be better if they: (a) discussed the production approach along with the expenditure and income approaches, and (b) explained that GDP is principally designed to be a measure of production or economic activity, and that using the production approach is perhaps the clearest way to present that concept.