The national income identity states that
production = consumption + investment + government purchases + net exports.
Toolkit: Section 16.16 "The Circular Flow of Income" The toolkit describes the circular flow of income in more detail.
Consumption refers to total consumption spending by households on final goods and services. Consumption is divided into three categories.
- Services. These are items such as haircuts, restaurant meals, hotel nights, legal services, and movies. There is often no tangible product; the consumer purchases the time and skills of individuals (such as barbers, chefs, and lawyers). Production and consumption of services usually occur together.
- Nondurable goods. Examples include groceries, clothing, and DVDs—tangible products that (usually) have a fairly limited lifespan (typically less than three years).
- Durable goods. These are items such as automobiles, “white goods” (washing machines, refrigerators, and other appliances), and computers. They are tangible products that usually have a lifespan of several years.
The distinctions among these categories are not always as clear-cut as the definitions suggest. A good pair of blue jeans might outlast a shoddy dishwasher, even though the jeans are classified as a nondurable good and the dishwasher as a durable good. Investment is the purchase of new goods that increase the capital stock, allowing us to produce more output in the future. Investment is divided into three categories.
- Business fixed investment. Purchases of physical capital (plants, machines) for the production of goods and services
- New residential construction. The building of new homes
- Inventory investment. Change in inventories of final goods
The economist’s definition of investment is precise and differs from the way we often use the word in everyday speech. Specifically, economists do not use the term to mean the purchase of financial assets, such as stocks and bonds. Most of the time when we talk about investment in this book, we are referring to business fixed investment—the production of new physical capital goods. Inventory investment is a special category of investment that we explain in Section 7.3.2 "Inventory Investment".
As a rough rule of thumb, consumption spending is carried out by households, and investment spending is carried out by firms. But there is one important exception: new residential construction is included in investment. A new house purchased by a household is treated as investment, not consumption.
Government purchases include all purchases of goods and services by the government. We include in our definition of “government” local as well as national government activity. In the United States, this means that we collapse together federal, state, and local governments for the purpose of our analysis.
This component of spending refers only to purchases of goods and services, not to transfers. So, if the federal government buys aircraft from Boeing or the local police department buys a fleet of Volvos, these are included in government purchases. However, a transfer you receive from the government—say, because you are unemployed and are being paid unemployment insurance—is not counted in GDP. (Of course, if you then use this income to purchase goods and services, that consumption is part of GDP.)
Net exports simply equal exports minus imports. They are included because we must correct for the expenditure flows associated with the rest of the world. Some spending in the economy goes to imported goods, which is not associated with domestic production. We must subtract these imports from total expenditures. Against that, some demand for domestically produced goods comes from other countries. We add these exports to total expenditure.
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