What Is the Expenditure Method?
The expenditure method is a system for calculating gross domestic product (GDP) that combines consumption, investment, government spending, and net exports. It is the most common way to estimate GDP.
The method posits that everything that the private sector and the government spend within the borders of a particular country add up to the total value of all finished goods and services produced over a certain period of time. This method produces nominal GDP, which must then be adjusted for inflation to result in the real GDP.
The expenditure method may be contrasted with the income approach for calculating GDP, which focuses on total income earned.
Key Takeaways
- The expenditure method is the most common way of calculating a country's GDP.
- This method adds up consumer spending, investment, government expenditure, and net exports.
- It posits that aggregate demand is equivalent to the expenditure equation for GDP in the long-run.
- An alternative method to calculating GDP is through the income approach, which focuses on total income earned.
How the Expenditure Method Works
The expenditure method for calculating GDP is similar to the formula for calculating aggregate demand. That's because aggregate demand represents total spending for goods and services within an economy. As such, aggregate demand and expenditure-based GDP fall and rise largely in tandem.
However, this isn't always the case in the real world, especially when looking at GDP over the long run. Short-run aggregate demand only measures total output for a single nominal price level, or the average of current prices across the entire spectrum of goods and services produced in the economy. Aggregate demand only equals GDP in the long run after adjusting for price level.
The expenditure method is the most widely used approach for estimating GDP, a measure of the economy's output irrespective of who owns the means to production. The GDP under this method is calculated by summing up all of the expenditures made on final goods and services. There are four main aggregate expenditures that go into calculating GDP: consumption by households, investment by businesses, government spending on goods and services, and net exports, which are equal to exports minus imports of goods and services.
The formula for expenditure GDP is:
GDP=C+I+G+(X−M)where:C=ConsumerspendingongoodsandservicesI=InvestorspendingonbusinesscapitalgoodsG=GovernmentspendingonpublicgoodsandservicesX=ExportsM=Imports
Main Components of the Expenditure Method
In the United States, the most dominant component of GDP under the expenditure method is consumer spending. Consumption is typically broken down into purchases of durable goods (such as cars and computers), nondurable goods (such as clothing and food),and services.
The second component is government spending, which represents expenditures by state, local, and federal authorities on defense and nondefense goods and services, such as weaponry, health care, and education.
Business investment is one of the most volatile components that goes into calculating GDP. It includes capital expenditures by firms on assets with useful lives of more than one year each, such as real estate, equipment, production facilities, and plants.
The last component included in the expenditure approach is net exports, which represents the effect of foreign trade of goods and service on the economy.
Expenditure Method vs. Income Method
Theincome approachto measuringGDP is based on the accounting reality that all expenditures in an economy should equal the total income generated by the production of all economic goods and services. It also assumes that there are four majorfactors of productionin an economy and that all revenues must go to one of these four sources. Therefore, by adding all of the sources of income together, a quick estimate can be made of the total productive value of economic activity over a period. Adjustments must then be made for taxes,depreciation, and foreign factor payments.
The major distinction between each approach is its starting point. Theexpenditure approach begins withthe money spent on goods and services. Conversely, the income approach starts with the income earned—such as wages, rents, interest, and profits—from the production of goods and services.
Limitation of GDP Measurements
GDP is often used as an indicator of a country's standard of living and economic health. Critics, such as the Nobel Prize-winning economistJoseph Stiglitz, caution that the measure should not be taken as an all-encompassing indicator of a society's well-being, since it ignores important factors that make people happy.
For example, while GDP includes monetary spending by private and government sectors, it does not consider work-life balance or the quality of interpersonal relationships in a given country.
What Is Expenditure With an Example?
Expenditure is a broad term that encompasses any transaction in which a good or service is purchased. On an individual level, you may engage in various expenditures throughout a typical day, including buying a coffee, taking the bus, getting a hair cut, or renting an apartment. Business expenditures can include paying for both capital (such as a factory or warehouse) and labor (such as hiring workers).
What Is the Expenditure Method Formula?
The expenditure method formula for calculating GPD is straightforward. GDP is measured by adding the following: consumer expenditures, business expenditures, government expenditures, and net exports. Recall that net exports is total exports minus total imports.
What Is the Income Method Formula?
The income method formula for calculating GDP is similar to the expenditure method. GDP is measured by adding the following: total national income, sales tax, depreciation, and net foreign factor income. Total national income refers to income from all sources, including wages, rent, interest, and others. Sales tax includes all consumer taxes charged by governments on goods and services. Depreciation is the cost allocated to a tangible asset over its useful life. Lastly, net foreign factor income is the difference between income generated by a country's citizens in foreign countries and the income generated by foreign citizens domestically.
The Bottom Line
The expenditure method is one system of estimating GDP. It takes into account the total value of all spending on goods and services in an economy, including consumer spending, government spending, business spending, and net exports. The method is often contrasted with the income method of calculating GDP, which focuses on income earned from the production of goods and services.
