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Expenditure Method Definition in Economics

Expenditure Method in Economics

Expenditure Method

In order to calculate national income by expenditure method, the economy is divided into four major sectors: household, government, business, and foreign. These are the major markets for the output of an economy. In one year, the total expenditures of these sectors on final output constitute the nation's GDP at MP. GDP at MP is, therefore, the sum of total final expenditures made by households, government, business, and foreign sectors.

The expenditure method measures national income as the total of all final expenditure on the gross domestic product in an economy during a year. Final expenditure means expenditure on the final product. The total income generated in the economy is spent either on consumer goods or capital goods. According to the expenditure method, the sum of private consumption expenditure, private investment expenditure, government expenditure, and net export gives the GDP account at market price.

Net export equals total exports n•minus total imports. These both are part of the GDP. Gross exports are the currently produced goods and services that are sold to foreign buyers. Imports are purchases by domestic buyers of goods and services produced abroad and should be deducted from GDP. The expenditure on imported goods and services is included in the consumption, investment, and government expenditure. Therefore, we need to subtract the value of imports to obtain the value of domestically produced goods and services. Thus, we add up the above four types of expenditures to get the final expenditures on the gross domestic product at market prices. When net factor income from abroad is summed up to GDP at MP, GNP at MP is obtained. GNP at MP is converted to NNP at MP by deducting depreciation. At the last, NNP at MP is converted to NNP at factor cost by deducting net indirect taxes. NNP at factor cost is the national income.

The components of national income by this method are as follows:

1. Personal consumption expenditures:- 
It is frequently referred to as consumption expenditures or simply consumption. This component consists of expenditures on consumer goods and services. Some examples are personal consumption expenditures are food, clothing, appliances, automobiles, medical care, recreation, etc.

2. Government expenditure:-
The items in this component are purchased by all levels of government. They include government expenditures on security, administration, infrastructure development, etc. However, the transfer payments which are a significant part of government expenditures are omitted because they do not represent part of the current output of goods and services.

3. Gross private domestic investment:-
This component includes total investment spending by business firms. Investment has a special meaning in economics. In everyday language, a person makes an investment when buying stocks, bonds, or other assets with the intention of receiving an income or making a profit. In economics, investment means additions to or replacement of physical productive assets. Thus, the investment represents spending on business goods. Because such expenditures contribute significantly to GDP, they are of major concern in economics.

Gross private domestic investment (I) = Net fixed capital formation Depreciation + Change in the stock

Change in stock (Change in Inventories) = Closing stock — Opening stock

4. Net exports of goods and services: 
Some domestic expenditure is made to purchase foreign goods and services which is known as imports. On the other hand, some foreign expenditure is made to purchase domestic goods and services which is known as the export. To measure GDP at MP in terms of total expenditures, we must include the value of exported goods and services (because the value of exported represents the amount that foreign buyers spend on purchasing some of our total output). Then, we subtract the value of imported goods and services from our total expenditures (because the part of our consumption was for imported goods, and we are interested only in measuring the value of domestic output). Hence, net exports are equal to total exports and less total imports.

Net export = Export — Import

5. Net indirect taxes:-
Net indirect tax is equal to indirect taxes and fewer subsidies. The indirect tax consists primarily of sales or value-added tax (VAT), excise, and real property taxes incurred by businesses. It is considered a business expense — the same as wages and other costs. Though the final burden of such taxes is borne by the final consumer in the form of higher prices, it is included in GDP. This is because the indirect taxes cause the expenditure side of GDP to be greater than the income side. On the other hand, subsidies cause the expenditure side to be lower- than the income side. Therefore, indirect taxes are deducted and subsidies are added to get GDP at factor cost.

Net indirect taxes = Indirect taxes — Subsidies

6. Net factor income from abroad: 
The net factor income from abroad is included in the national income. Net income from abroad is equal to income received by citizens of a country from abroad less income paid to the foreigners. It is added to GDP to get GNP.

7. Depreciation: 
The depreciation amount is deducted from the gross national product (GNP) to get the net national product (NNP). Depreciation is the wear and tear of fixed assets and machinery. It is also known as capital consumption.

The calculation of national income by expenditure method involves the following steps:

GDP at MP (GDPMP) = C + 1 + G + (X - M)

GNP at MP (GNPMR) = GDP at MP + Net factor income from abroad

NNP at MP (NNPMF) = GNP at MP - Depreciation

NNP at FC (NNPFc) = NNP at MP - Net indirect taxes

= NNP at FC


C = Private consumption expenditure,    
X = Export
I = Private investment expenditure, 
M = Import,
G = Government expenditure 
X — M = Net export

The use of the expenditure approach to measuring NI requires careful specification of what is to be included under the heading of expenditures. There are certain exclusions from expenditures:

  • It must include only expenditures on the purchase of goods and services produced during a specified time period. It must exclude expenditures on previously produced goods. All expenditures of this kind merely reflect changes in the ownership of preexisting output such as they are not part of the total expenditures that measure the value of current output.
  • It must also exclude all expenditures for the purchase of used assets. They merely exchange money assets for physical assets; they are not the part of current year's production.
  • It must exclude the purchase of financial assets such as stock and bonds there is no production of goods or services corresponding to expenditures for mere pieces of paper.
  • It must also exclude transfer payment i.e., expenditures by the government for which the government does not receive a good or service in exchange. Such expenditure does not reflect the output of goods and services.
  • Expenditures on intermediate goods, such as fertilizers and seeds by farmers, should be excluded. This is because we have to avoid double counting. Hence, for estimating GDP, we must include only the expenditures on final goods and services.

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