I’ve done an earlier version of this post, but have tried to simplify it even further in what follows.
Let’s go back and take a look at a concept that most of us are familiar with, but perhaps don’t know well enough (myself included!): GDP.
What is GDP?
That’s an easy question to answer, and one that every student of Econ101 more or less memorizes:
The final value of all goods and services produced in an economy in one accounting period.
Now, you can measure GDP in more than a couple of ways, but the version that most students of economics are definitely familiar with is the expenditure approach. It says that GDP is measured by tallying up the total expenditure used to buy final goods and services.
You might be familiar with this equation, for example:
GDP = Consumption + Investment + Government Spending + Exports – Imports
Or, to give this equation its abbreviated version:
GDP = C + I + G + X – M
Now, this is where things begin to get a little tricky.
This equation, and the way it is written out, leaves a lot of people under the impression that a country’s income will go up, if only we imported less as a country.
And it is an understandable position to take! If we imagine that M has a value of, say, 100, then GDP goes down by 100. If M were to be zero instead, GDP would be higher by hundred in this alternate scenario.
But this is wrong! I’m going to use two different ways to show you why this is wrong.
Here’s the first one: go back to the definition of GDP, at the top of this piece. Now that you’ve read it, answer this question: where are imports produced? Are they produced in our country, or are they produced in another country?
And if they’re produced in another country, should they be included in our GDP?
The reason the equation says minus M is because we shouldn’t be counting it in GDP in the first place. Once we remove imports, we’re left with the very definition of GDP: goods and services produced in an economy in a given time period.
Subtracting imports doesn’t make GDP higher. Adding it is completely wrong accounting.
All right, fine, you might grudgingly say. But then why is it in the equation at all in the first place?
If you are an American, living in America, and you buy a smartphone manufactured in China, that would count as an import (M).
But here’s the thing: it would also count as consumption ( C ).
Think about it: if you are using the expenditure approach to measure GDP, your purchase of a Chinese manufactured smartphone is consumption, and it is also an import.
If the American government were to import binoculars manufactured in Israel, it would be government expenditure (G). But it would also be imports (M). You could make similar arguments for investment (I) as well, but you get the idea now.
So, a longer, but more accurate and understandable way of writing out the expenditure method of GDP is as follows (hat-tip to Noah Smith for this version):
GDP = Domestically produced consumption + Imported consumption + Domestically produced investment + Imported investment + Government spending on domestically produced stuff + Government spending on imported stuff + Exports – Imports
Now, some simple crossing out of terms…
Gross Domestic Product = Domestically produced consumption +
Imported consumption + Domestically produced investment + Imported investment + Government spending on domestically produced stuff + Government spending on imported stuff + Exports – Imports
…leaves you with this:
Gross Domestic Product = Domestically produced consumption + domestically produced investment + Government spending on domestically produced stuff + Exports
That first version, with all the crossed out terms, is how we should really be writing it out all the time, because that is what economists really mean. But we don’t do that, unfortunately, leaving folks with the entirely understandable impression that reducing imports makes us richer.
But hey, now you know! GDP, by definition, has nothing to do with imports, and the reason we subtract imports out is because we’re adding them in while counting consumption, investment and government expenditure.