Question

1. Discuss the differences calculating GDP using the expenditure approach and income approach. Be specific, do not just write the formula.

Answer 1

GDP refers to the money value of all goods and services that are produced within the country during specified period of time. GDP is calculated on annual basis as well as on quarterly basis. Higher GDP reflects increase in national output, higher economic growth, more employment and better standard of living. GDP act as a tool for Investors, Businesses, government for investment and strategic decision making.

Methods of GDP calculation are  -

A. Expenditure method - The most widely used method to calculate GDP is expenditure method. This method aims to collect data on expenditure side by adding household spending, government spending, business investment and Net exports. Here we do not include expenditure on sale and purchase of second hand goods, as these transactions are not included in GDP.

GDP by Expenditure Method = Household consumption + Gross Business Investment + Government Spending + Net Exports (Export - Import)

Components -

1 Household Consumption - The household consumption is the largest component in GDP contribution. Household consumption mainly accounts higher than 50 % in overall GDP. Household consumption falls under following categories: durable goods, non-durable goods, and services.

2 Investment - It includes investment in the economy which result in asset creation. Machinery, equipment, Buildings, land and household purchase of Houses are all included in Investment component. Financial and capital market transactions are not part of investments.

3 Government Spending - Government spending refers to the expenditure of government on goods and services. It includes salary and wages of government employees, public and defence spending, infrastructure spending all comes under Government spending. Here Transfer payments are not included in Government spending, they are included in Consumption when these payments are spend in the economy.

4 Net exports - Net exports refer to the difference between country Exports less imports. The Exports are added to the GDP and imports are deducted from GDP.

B. Income method – whatever the firms produces, when sold, becomes revenues to the firm. Businesses use revenues to pay their bills: Wages and salaries for labour, interest and dividends for capital, rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year (Businesses, household) provides a second way of measuring GDP.

In income method, we add all income that is generated by production of goods and services and by Businesses ie(land, labour, capital & profit)

GDP by income method = Compensation to Employees (wages & salaries) + Business profits + Royalty fees + rental & interest income

Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach. We exclude:

Transfer payments e.g. the state pension; income support for families on low incomes; the Jobseekers’ Allowance for the unemployed and other welfare assistance such housing benefit and incapacity benefits

Private transfers of money from one individual to another

Income not registered with the tax authorities every year, billions of pounds worth of activity is not declared to the tax authorities. This is known as the shadow economy.

Published figures for GDP by factor incomes will be inaccurate because much activity is not officially recorded – including subsistence farming and barter transactions