Expenditure Approach

Expenditure Approach Definition

What is the definition of the expenditure approach? Let's start from the beginning!

Economists use different methods to measure a country's Gross Domestic Product (GDP). The expenditure approach is one of the methodologies used to measure a nation's GDP. This method takes into account a country's imports, exports, investments, consumption, and government expenditures.

The entire production value of completed goods and services during a specific time period may be calculated using the expenditure approach, which considers expenditures from both the private and public sectors that are spent inside a nation's boundaries.

The result is the GDP on a nominal basis, which must afterward be revised to account for inflation in order to get the real GDP, which is the actual number of goods and services produced in a country.

The expenditure approach, as the name suggests, is focused on the total spending in the economy. The total spending in the economy is also represented by aggregate demand. Therefore, the expenditure approach's components are the same as those of aggregate demand.

The expenditure approach uses four critical types of spending: consumption, investment, net exports of goods and services, and government purchases of goods and services to calculate gross domestic product (GDP). It does so by adding them all up and receiving a final value.

In addition to the expenditure approach, there is also the income approach, yet another method that may be used to compute GDP.

Components of Expenditure Approach

The main components of the expenditure approach, as seen in Figure 1 below, include Personal consumption expenditure (C), gross private domestic investment (I_g), government purchases (G), and net exports (X_n).

Personal consumption expenditure (C)

Personal consumption expenditure is one of the most significant components of the expenditure approach.

Personal consumption expenditure includes durable goods, non-durable goods, and services.

1. Durable goods. Long-lasting consumer goods like automobiles, televisions, furniture, and large appliances (though not homes, as those are included under investment). These products have expected lives of more than three years.
2. Non-durable goods. Non-durable goods include short-lived consumer items, such as food, gas, or clothing.
3. Services. Under services, things like education or transportation are included.

Gross private domestic investment (I_g)

Investment involves the purchase of new capital goods (also known as a fixed investment) and the expansion of a company's inventory (also known as inventory investment).

Categories that fall under this component include:

• Final purchases of machinery, equipment, and tools
• Construction
• Research and development (R&D)
• Inventory changes.

Investing also involves buying foreign-made items that fall under any of the above-mentioned categories.

Government Purchases (G)

The government's purchase of goods and services is the third most significant component of spending. This category includes any expenditure made by the government for a currently produced item or service, regardless of whether it was created domestically or internationally.

There are three parts that constitute government purchases:

1. Spending on goods and services that the government needs to provide public services.
2. Spending on long-lasting public assets like schools and highways.
3. Expenditure on research and development and other activities that add to the economy's stock of knowledge.

Government transfer payments are not included when measuring GDP using an expenditure approach. That's because government transfer payments do not generate production in the economy.

Net exports (N_x)

Net exports are exports minus imports.

If exports are higher than imports, then net exports are positive; if imports are higher than exports, then net exports are negative.

When calculating total expenditure, exports are included because they reflect money spent (by customers outside of a country) on finished products and services created in that nation.

Because consumption, investment, and government purchases are all considered to contain imported goods and services, imports are deducted from the overall amount spent on goods and services.

Expenditure Approach Formula

The expenditure approach formula is:

\(GDP=C+I_g+G+X_n\)

Where,

C is consumption

I_g is investment

G is government purchases

X_n is net exports

The expenditure approach formula is also known as income-expenditure identity. That is because it states that income equals expenditure in an economy.

Expenditure Approach Example

As an expenditure approach example, let's calculate US's GDP using this approach for the year 2021.

Using the data in Table 1 and the expenditure approach formula, we can calculate the GDP.

\(GDP=C+I_g+G+X_n\)

\(GDP= 15,741.6 + 4,119.9 + 7,021.4 - 918.2 = \$25,964.7 \)

Fig 2. Main contributors to the US GDP in 2021. Source: FRED Economic data^1-4

Using the same data as in Table 1, we've created this pie chart to help you understand which components of the expenditure approach were the most significant contributors to the US GDP in 2021. It turns out that personal consumption expenditure made up more than half (58.6%) of the US GDP in 2021.

Expenditure Approach vs. Income Approach

Two different methods are used to calculate the gross domestic product (GDP), the income approach and the expenditure approach. While both approaches, in theory, reach the same value of GDP, there are differences between the expenditure approach vs. the income approach in terms of the methodology they use.

• According to the income approach, GDP is measured by the sum of the total income generated by all households, businesses, and the government that circulates within an economy for a certain amount of time.

• Under the expenditure (or output) approach, GDP is measured as the total market value of an economy's final products and services produced over a certain amount of time.

The income approach is a method for calculating GDP that is derived from the accounting principle that the entire income created by the production of all of an economy's products and services should be equal to the total expenditures of that economy.

Based on this, the income approach may estimate the overall production value of economic activity by simply adding up all of the different revenue sources throughout a specific period.

There are eight types of income included in the income approach:

1. Compensation of employees
2. Rents
3. Proprietor's income
4. Corporate profit
5. Net interest
6. Taxes on production and imports
7. Business net transfer payments
8. The current surplus of government enterprises

Let's take a look at an example calculating GDP using the income approach.