Understanding Public Spending, GDP, and Price Indices
Public spending includes all expenditures of the public sector intended to pay the payroll of its employees plus the costs of goods and services purchased by the sector. This should not be confused with the private sector.
National accounts measure public expenditure in the Government’s budget. Net exports are also important. To obtain an accurate measurement of GDP, we must add that part of Spanish production acquired by foreigners (total exports) and subtract the purchase of Spanish goods produced outside Spain (total imports). Thus, net exports are obtained.
The sum of all expenditure on goods and services carried out by different operators (consumers, businesses, the public sector, and the external sector) is the GDP at market prices. This quantity is also known as aggregate demand and represents the total expenditure carried out by different operators.
GDP Measurement Methods
GDP can be measured by the cost method, using the factor cost method:
- Adding all factor costs paid by all firms in the economy.
- Summing all income or revenue (wages, salaries, rents, interest, and profits) obtained by all the families of the economy.
Cost or Income Approach
Wages, salaries, and other labor income + interest, rents, and other property income + indirect taxes + depreciation or amortization + profits. This method demonstrates a major macroeconomic reality: that GDP (the total output of an economy) equals the income generated from that production. In economic terms, production and income are synonymous. If production increases, income increases by the same amount; if production falls, income falls by the same amount.
Equivalence of Approaches
GDP calculated as the flow of final goods and services or costs is exactly the same. The limited nature of the benefits (operating surplus) allows the flow approach or product costs and the flow of revenue to be exactly the same total costs. The GDP is the residual benefit that adjusts automatically to match revenues with costs or the value of assets.
The relationship between GDP at market prices and GDP at factor cost: to pass from GDP at market prices to GDP at factor cost, add indirect taxes and deduct operating subsidies.
Real vs. Nominal GDP, Price Indices, and Inflation
Nominal GDP is measured with the existing prices when it is in production, while Real GDP is measured or priced existing in a specific base year and thus eliminates the effect of inflation. This is done through price indices. Price indices are used to eliminate the effect of the variation of prices. To find the Real GDP, divide nominal GDP by the price index.
Consumer Price Index (CPI)
The consumer price index (CPI) is estimated as a weighted average of consumer goods. The average household expenditure in each of the assets constitutes the weighted average used. Considering that a price index cannot cover all existing assets in an economy, a set that is considered representative of the total must be chosen.
CPI and Inflation
The CPI represents the cost of a basket of goods and services representative consumed by a domestic economy. Rate of inflation: is the variation in the price level, ie growth rate or lowering the standard of living from one year to another. The inflation rate between 2 years is the percentage change in CPI experienced in that period. The CPI is suitable for learning the evolution of prices of goods and services purchased by consumers. It properly reflects how life has become more expensive.
GDP Deflator
The differences observed between nominal GDP and real GDP are due to variations in prices between the base year and the current year. The ratio of these 2 quantities is a measure of the general price level and is known as the GDP deflator (an index of prices). The GDP deflator is defined as the price of GDP. Real GDP eliminates price changes in nominal GDP and GDP estimated at constant prices. The price deflator is used to separate the effect of prices and obtain a set of values that will see the evolution of the national product. We will obtain the national product in real terms or in constant euros.
The deflator and the CPI differ in that the deflator includes all goods produced, while the CPI measures the cost of goods consumed, those included in the basket of the representative domestic economy.