There are three ways that economists use to calculate GDP. One is to look at the total income of all people in a country (or other area that is being looked at, being a state, region of a country, or an international collection of countries). The other way is to look at the total value of all the goods and services produced. The third and final way is to measure all the spending that flows into firms from the final users of the goods and services (Krugman & Wells, 2013, p. 192).
The focus on the final user is important because it does not inflate the final value of the GDP. If economists were to measure the price all firms added to the goods and services that are measured for GDP calculations, every layer of sales would add in more value. Therefore, the value of the Ritz cracker, for example, which is paid by the consumer, is what is calculated as being a component of the GDP. This avoids counting as sales what the company paid to the farmer in Kansas for the wheat and the farmer in Wisconsin for the butter.
Ultimately, there are four separate inputs that are counted as part of GDP and is shown commonly as the equation GDP= C + I + G + (X-M). The “C” stands for all the consumer purchases. The “I” stands for the investments businesses make to facilitate the creation of the goods and services. For example, the farmer who is growing wheat will pass on the cost of the seed to the end-user, but that same farmer might purchase a combine to help harvest the grain faster and more efficiently. All comparable purchases are included in the “I” component of the GDP calculation. The “G” part is the amount that the government spends on the goods and services it purchases, from the most cutting-edge fighter jets to the red pens at the IRS. The final part is shown as two letters, both “X” and “M,” but it is one term. “X-M” is the net balance of exports minus imports. Currently the United States is a world leader in both exports and imports, but the final value of the imports is greater than the final value of the exports, so this part has the effect to be an overall decrease in the GDP for the US (Krugman & Wells, 2013, p. 194).
Overall, the largest input in this GDP calculation comes from the consumers. With over seventy percent of the current calculation (Krugman & Wells, 2013, p. 195), a shift in the amount consumers are willing (or not willing) to spend has a huge effect on the economy. If businesses see consumers willing to spend, they will be able to make the investments for the future and the government will be able to reap more tax revenues. Perhaps the government would also prefer pay off debt or reduce tax rates. Conversely, if consumers pull back their spending, businesses will delay their investments and the federal government will have to fill the hole in spending or risk widespread penury and face political discontent. As illustrated, the governments have more options politically when the consumers are spending, so they are not just the larger part of the equation, but consumer response can drive many political responses.
Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers