Question

How does the income approach to measuring GDP differ from the expenditure approach? Explain the meaning of value added and its importance in the income approach. what are the leakages from and injections into the circular flow? How are leakages and injections related in the circulat flow?

Answer 1

The expenditure approach aims at calculating GDP by taking the sum of all the final goods and services in an economy. Its formula is

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

where C = Consumption, I = Investment, G = Government Spending, X = Exports, M = Imports

The income approach, on the other hand calculates GDP by factoring in the final income by various factors of production. Its formula is

Y = W + R + i + PR

where, W = Labor Income, R = Rental Income, i = Interest Income, PR = Profits

The basic difference between them is how it calculates GDP. Expenditure approach calculates by the amount of money spent whereas income approach calculates by money earned.

The circular flow on economy shows earnings and spendings between firms and houselholds in an economy. It states that

1) Households provide firms with land labour and capital and firms provide them with goods and services

2) Firms provide rent wages and profit to households in return for their land labou and capital whereas household give them money for the goods and service they provide.

However, not all money that are provided as rent, wages and profits are spent. Some are kept as savings, some are paid as taxes and some are spent on imported items or foreign goods. These are called leakages.

In a similar way, injections are capital provided by the firm itself, the governemt or by foreign nations.

They are related to circular flow as they hapen within the model. Government taxes leak out of the circular model whereas Government spending inject into the model. Savings leak out of the model whereas the the saved money is used as investment after bank loans it to firms. Imported goods leak out of the model whereas investment from foreign investment injects in the circular flow. Financial markets and system assists in the leakage and injections.