What is the Expenditure Method?
The expenditure method is a technique for measuring a country’s Gross Domestic Product (GDP) by incorporating imports, exports, investments, consumption, and government spending. The expenditure method can be regarded as the frequently used method to measure GDP.
According to the expenditure method, both private and public sector expenses incurred within a country’s borders will give the total production value of finished goods and services over a time period. It gives the nominal GDP, which is then adjusted for inflation to arrive at the actual GDP. The income approach is another way to calculate GDP.
- The expenditure method is a frequently used method for measuring the Gross Domestic Product (GDP) of a country.
- The expenditure method adds up consumer consumption, net exports, investments, and government spending to arrive at GDP.
- The expenditure method produces nominal GDP, which, when accounted for inflation, gives the actual GDP.
Calculation of GDP Using the Expenditure Method
The formula for calculating the GDP using the expenditure method is:
- C is the consumer spending on various goods and services
- I signifies the investments by businesses
- G represents the government spending on goods and services
- X is the gross exports
- M represents gross imports
The following are the four different kinds of aggregated expenses used to measure GDP:
1. Consumer consumption
About two-thirds of the GDP of the United States constitutes consumer spending. It includes all the costs incurred by the citizens of a country within the country borders or outside. For example, the costs incurred for foreign travel are included in consumer spending. However, it does not include the expenses that foreign visitors incur. Consumer spending can be categorized into the following:
- Purchasing perishable and non-perishable goods
- Procuring services
2. Private investments
Investments by businesses include capital expenditures on various assets. They can be categorized into the following:
Gross fixed capital
It comprises of the costs incurred for the purchase of different fixed assets. Gross fixed capital can be divided further into two categories – gross business fixed investments, which include expenses incurred towards long-term assets, and gross residential construction investments, which include the expenses that businesses incur for constructing or purchasing residential units.
The costs incurred by businesses for procuring raw materials and finished or unfinished goods are included as inventory investment. The category is performed on items that cannot be currently used for consumption. The opening and closing stock balances at each year-end are calculated to determine the inventory investment.
3. Government spending
Both state and federal governments of a country incur expenses for providing essential commodities, healthcare, infrastructure, education, and other necessities to its citizens.
4. Net exports
The difference in the value of a country’s total export and total import in one fiscal year is termed net exports. Exports are regarded as an economy’s output, while imports are regarded as expenses since they are produced outside the national boundaries of a country. A country’s total trade is measured by net exports and is also known as a balance of trade.
Precautions Taken While Applying the Expenditure Method
- Since the production value of final goods is included, the expenses for any intermediate good is not considered. Otherwise, a single expense will be counted twice, causing the national income to inflate inaccurately.
- The transfer payments do not add value to the economy of a nation; hence, they should not be included.
- The purchase of second-hand goods is not included since they do not affect the total value of produced goods and services. However, if the purchase of second-hand goods involves brokerage, the brokerage paid is included in the expense calculation.
- When assets such as bonds and shares are procured, it signifies a change in ownership and does not affect the value of goods and services; hence, the transactions are not involved in expense calculation. However, the brokerage paid for the transfer of shares is considered while using the expenditure method.
- Services provided by the government and non-profit organizations and the expenses incurred for the production of any good that is used for self-consumption are considered in the national income calculation.
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