What are the differences between the income approach and expenditure approach to GDP?

The basic difference between the two is in terms of the components included in the measurement of GDP.

The EXPENDITURE APPROACH includes the expenditures incurred by various economic agents involved in production and consumption.

Recalling the fundamental national income identity :

Y = C + I + G which is a formulation of the expenditure approach.

Thus, C includes the CONSUMPTION Expenditures by household units in the economy. These are also called private final consumption expenditures (PFCE). The money that you spend on, say, buying a jacket or a cell phone or grains will fall under PFCE.

I includes the INVESTMENT Expenditure by all production units in the economy. When a firm buys new capital equipment or a machine for its production, it becomes an Investment expenditure since the firm augments its productive capacity base. At the same time, it is worth noting that any expenditure made towards maintenance of capital assets, usually called depreciation, is to be DEDUCTED from GDP calculations. In other words, Investment expenditures have to be NET of depreciation expenditures.

G includes all expenditures made by the government or public institutions towards provisioning of various services in the economy. Spending on defense, public administration, social security, education, health etc. are all forms of government expenditures.

The INCOME APPROACH calculates GDP on the basis of the sum total of all payments (income) received by various economic agents engaged in different production activities. Thus, firstly, it includes the wages and salaries (W) of individuals engaged in gainful employment in public or private institutions including social benefits as also those that are self-employed.

Secondly, it includes the interest income (I) received by lenders of capital particularly financial capital. Any interest that you pay on your bank loan forms a part of interest income for the bank. As a corollary, any interest that you receive on your bank deposits also forms a part of interest income since you are the lender of financial capital to the bank.

The third component is the rent (R) earned by owners of land, usually called unearned income since it is not through any gainful employment.

Finally, the profits or losses (P/L) that accrue to the producers/entrepreneurs forms the last component. It should be noted that while profits add to the GDP (+), losses similarly DEDUCT from the GDP (-).

Thus, Y = W + I + R +/- P/L

Easy to understand, with video are on this site: http://www.econclassroom.com/?p=2632







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