COMPONENTS OF GDP (THE EXPENDITURE APPROACH)

The expenditure approach of computing Gross Domestic Product (GDP) measures the aggregate expenditure of household, business, government, and foreign sectors on final goods and services during a given period.

Stated differently, the expenditure approach asserts that GDP is the sum of households spending (consumption), Businesses spending (investment), Government spending, and foreign sector spending (Net exports)

These four components together give us the most important formula in national income accounting:

$Y=C+I+G+(X-M)$

 where $Y$ is GDP

             $C$ is Households consumption

              $I$ is investments

              $G$ is government expenditures

              $(X-M) is net exports

The evaluation of each component of GDP follows.

CONSUMPTION

This is the total expenditures by the household on the acquisition of final goods and services by households in s given period.

It is total money spent by the household on final goods (not capital goods, or investment assets). This distinction is necessary for two reasons.

First, household expenditure on housing is not counted as consumption. Rather, they are counted as investments.

The reason for this is that a house is a capital good to households since it provides service ( roof over your head) over an extended period.

Secondly, Household expenditures on investment assets ( stocks, shares) and interest payments are not included in consumption expenditure because such expenditures are not related to the production of goods.

There are three major categories of consumption expenditures.

1. Durable goods: These are goods that last for a relatively long period. Examples are automobiles and furniture.

2. Non-durable goods: This is the direct opposite of durable goods. That is, they do not last long as they are used quickly. Food, cloth are some of the best-known examples of durable goods

3. Services: These are intangibles that we buy. They do not involve any creation of physical things. Examples are education and medical services.

INVESTMENT

In economics, Investment expenditure refers to the purchase of new capital— housing, plants, equipment, and inventory primarily by businesses that will be used to produce goods and services in the future.

More appropriately, Investment is the total spending by firms on capital goods in an economy. They include the purchase of capital equipment, inventories, and structures.

Household (not government) spending on housing is also included in investment expenditure because housing is considered capital goods for national income accounting purposes.

Contrary to its colloquial use, Investment does not include buying financial assets like stocks. Buying such assets are classified as savings. By the way, buying and selling of assets aren't included in GDP.

Like household expenditure, investment expenditure is also divided into three parts:

1. Business fixed investment: This is total spending by businesses on equipment (machines, computers, and trucks) and structures (factories, stores, and warehouses).

2. Inventory investment: This comprises the change in inventories held by firms. If inventory increases, inventory investment will be positive. 

Conversely, inventory investment will be negative if inventory decreases.

3. Residential investment: This is the total purchases of new houses and apartments by household. 

Take note of the word "new houses", national income accountants do not include purchases of used houses in GDP.

Houses and apartments are counted in investment (not consumption) because they produce a service (a roof over your head) over an extended period. Hence, houses and apartments are capital goods to households.

GOVERNMENT EXPENDITURE

Government expenditure is the total spending on goods and services by local, state, and federal governments. They include government spending on education, healthcare, and infrastructure. 

Government spending on short-lived goods and services (like healthcare, army) represents government consumption.

Government spending on capital goods like buildings is referred to as government investment.

For national income accounting purposes, Two items of government expenditure are excluded from GDP. 

The first is transfer payments made by the government and the second is interest paid by the government on debt.

Transfer payments are payments of money from the government to the individuals, for which there is no exchange of goods and services in return. They include unemployment benefits and subsidies.

Transfer payments do not involve the production of goods and services. They are, therefore not counted in Gross Domestic Product (GDP). Remember that GDP is the market value of all goods and services produced in a country.

Government interest payments on debt are also not entered in GDP because these payments are not connected to the production of goods and services.

NET EXPORT

Net exports equal the purchases of domestically produced goods by foreigners (exports) minus the purchases of foreign goods by nationals (Import). Put in another way, Net export is the difference between the monetary value of a nation's export and import for a given period. 

Net export is also called the balance of trade. If a country's exports are greater than its imports, net export is positive and the country is enjoying a trade surplus

Conversely, If a country's imports are greater than its exports, Net export is negative. and the country is suffering a trade deficit.

Having looked at the various surplus of GDP, our next task is to practice some examples.

Example 1

Calculate the GDP if a country reports 17 trillion in household consumption, 8 trillion in investments, 10 trillion in government spending, and 2 trillion in net exports.

Solution:

$GDP=17+8+10+2$

$GDP=37$

Therefore, the country's GDP is 37 trillion.

Example 2

An economy produced 500,000 books valued at €15,000 each. Of these, 350,000 were sold to consumers, 100,000 are sold to businesses, 25,000 were sold to the government, and 12,500 were sold abroad. No books were imported. The books left unsold at the end of the year are held in inventory by the book produce. Calculate the GDP using the expenditures approach.

Solution:

According to the expenditure approach

$Y=C+I+G+(X-M)$

Consumption expenditure is 350,000 books times €15,000, which works out to €5.250 billion.

Government expenditure is 25,000 books times $15,000, or €0.375 billion. 

Net exports are the difference between exports and imports. Since imports are zero, net exports are 12,500 books times €15,000 which works out to 0.1875 billion.

The 100,000 books sold to businesses, worth 1.5 billion is an investment. However, this is not the total investment. Notice that the book manufacturer produces 500,000 books but sold only 487,500 (350,000+100,000+50,000+25,000). This means 12,500 books were unsold and was, therefore, added to the book producers' inventories. This addition to the inventory book producer inventory (12,500 books times €15,000, or 0.1875 billion) will count as inventory investment, which is part of total investment.

Therefore, total investment expenditure will equal 1.5 billion worth of books sold to the business plus the 0.1875 billion worth of books in inventory investment. That is, the Total investment will be 1.5+0.1875=1.6875 billion.

Therefore, GDP is:

$Y=5.250+1.6875+0.375+0.1875$

$Y=7.5 billions.

RELATED POSTS

To assess your understanding of this topic, Let try a simpler example.

In each of the following, identify which components of GDP is it included to:

1. Household spending on housing

2. Social security payment by the government

3. Consumer spending on goods

4. Purchases of domestic produce goods by foreigners.

5. Teaching services offer to households.

Answers

1. Household spending on housing is not included in consumer spending. Rather, it is included in investment.

2. Social security payments by the government is a transfer payment. Hence, it is not included in GDP at all. If you don't understand this, read this post on what is excluded in GDP calculations.

3. Consumers' spending is added to consumption.

4. Purchase of domestic goods by foreigners is export. So, it is an element of net exports

5. Consumption does not just include only tangible goods. Intangibles like services are also included in consumption. Therefore, services are added to household consumption.

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