GDP – Trade Deficit Component
So far we have added consumption expenditure, investment spending and government spending to calculate the gross domestic product in an economy. We have reached the final component of GDP namely exports minus imports or the trade deficit with the rest of the world.
Lets include the last economic entity, the rest of the world, to make the hypothetical economy resemble our real world. Domestic firms buy imports from the rest of the world in exchange for money and sell exports in exchange for money to the rest of the world.
Also, exports minus imports is called net exports.
Now when we look at outflows from firms we see that firms pay incomes (Y) to households plus pay for imports (IM). The outflows are now Y + IM.Â With exports introduced in our new economy inflows to firms are now
consumption (C) + government expenditure (G) + investments (I) + exports (EX).
Y+IM = C+G+I+EX or
Y = C + G + I + (EX-IM) and since Y = E
E = C + G + I + (EX-IM)
The right hand side of this equation is the total expenditure on domestic output or the Gross Domestic Product.
Figure: Hypothetical Economy with Households, Firms, the Government and the Rest of the World
We can also see that for households, inflows are incomes (Y) and outflows are C + S + T, and therefore,
Y = C + S + T
We also saw that for firms inflows are now C + I + G + EX, and outflows are Y + IM. Therefore
Y + IM = C + I + G + EX
substituting for Y from above
C + S + T + IM = C + I + G + EX or
S + T + IM = I + G + EX
We can rehash this equation to
(S â€“ I) + (T â€“ G) + (IM â€“ EX) = 0
This equation also has very interesting implications.
S â€“ I is the financial surplus of the private sector (households and firms).
T â€“ G is the government’s budget surplus or deficit.
IM â€“ EX is the trade deficit or surplus of a country with the rest of the world.
The sum of the three sectors is always zero in the equation. Therefore, if the government is in a deficit it must borrow from the private sector, and in order to borrow, savings must be greater than investments (S>I).
However, if savings are not greater than investments, for the equation to hold true imports must be greater than exports.Â If the country’s government sector and the countryâ€™s balance of trade with the rest of the world is in deficit, then the country is said to have a twin deficit.
The aggregate expenditure in a country’s economy is equal to C + G + I + (EX – IM) where EX – IM is net exports. This aggregate expenditure is basically what we know as Gross Domestic Product and is the measure of aggregate economic activity for that year.
It is called â€œGrossâ€ because depreciation of existing inventory is not deducted from investments. It is also called domestic since it is a measure of aggregate products produced domestically as opposed to Gross National Product (GNP) which measures aggregate goods and services produced by the country’s nationals wherever they reside in the world.
If the goods and services are measured in the current year’s prices it is called nominal GDP, but if the prices are adjusted for inflation then it is called real GDP because goods and services are valued at the base yearâ€™s prices. We will discuss real vs nominal GDP in later chapters.
We have seen in the hypothetical country example that income = products = expenditure and therefore in the real world GDP can be measured by any of the three methods.
In the expenditure approach, GDP is measured by aggregating Consumer Expenditure, Investments , Government spending, and Net Exports.
In the income approach statisticians add the incomes generated from the factors of productionâ€”salaries, interest, rent, and profits. Since profits are net of depreciation and by definition Gross Domestic Product does not account for depreciation, depreciation is added back.
In the products approach the aggregate is computed by measuring the value of output of each industry and then aggregating.
We now understand how GDP is computed and by modelling the real world with our hypothetical world we understand its componentsâ€”consumer spending, government spending, investments, exports and imports. This is the foundation of our economic map which we will keep referring to in order for us to make the connections between the macroeconomic indicator releases, the economic entities, and financial markets.
Economic Growth â€“ A Historical Context
Before we begin exploring economic indicators, we need to understand the historic context of economic growth in a country in order to classify what high growth, sustainable growth and recession are. We need to know the historical context of growth, inflation, and interest rates because when any economic data is released we can look back to see how the central bank, economic policy makers, market participants and analysts reacted in the past when confronted with a similar release of information.Â
For example, if the sustainable growth rate had been 3% in a specific interest rate regime, and if the growth rate moved from 3% towards 4%, knowing that the central bank reacted by raising interest rates in the past gives us some confidence in predicting how they will react in the current economic scenario, such as whether the central bank aggressively raised interest rates in the past to curb inflation or raised it gradually. What were the markets expecting at the time? Was the monetary policy effective, and what were the levels of inflation? All these are very important questions to ask in order to gain an understanding of how the country’s central bank’s monetary policy affects economic growth.