3.2 Income approach vs. expenditure approach
3 min read•july 30, 2024
National income can be measured using two approaches: income and expenditure. These methods sum up different economic activities but should theoretically yield the same result, reflecting the of money in an economy.
The adds up , , and , while the totals consumption, investment, and . Understanding both methods helps grasp how money flows through the economy and how national income is calculated.
Income vs Expenditure Approaches
Measuring National Income
Top images from around the web for Measuring National Income
Calculating GDP | Macroeconomics with Prof. Dolar View original
Is this image relevant?
Equilibrium in the Income-Expenditure Model | Macroeconomics View original
Is this image relevant?
Calculating GDP | Macroeconomics View original
Is this image relevant?
Calculating GDP | Macroeconomics with Prof. Dolar View original
Is this image relevant?
Equilibrium in the Income-Expenditure Model | Macroeconomics View original
Is this image relevant?
1 of 3
Top images from around the web for Measuring National Income
Calculating GDP | Macroeconomics with Prof. Dolar View original
Is this image relevant?
Equilibrium in the Income-Expenditure Model | Macroeconomics View original
Is this image relevant?
Calculating GDP | Macroeconomics View original
Is this image relevant?
Calculating GDP | Macroeconomics with Prof. Dolar View original
Is this image relevant?
Equilibrium in the Income-Expenditure Model | Macroeconomics View original
Is this image relevant?
1 of 3
- The income approach measures national income by summing the incomes earned by households and firms in the production of goods and services
- Includes wages, salaries, rent, interest, and profits
- The expenditure approach measures national income by summing the spending on goods and services by households, firms, the government, and foreign buyers
- Includes consumption, investment, , and
Theoretical Equivalence and Practical Differences
- Both approaches should theoretically yield the same result for national income, as total income must equal total expenditure in an economy according to the circular flow model
- The income approach is based on the costs of production, while the expenditure approach is based on the final sales of production
- The income approach can be more difficult to measure accurately due to the challenge of accounting for all forms of income
- Some income may be underreported or hidden (cash payments, informal sector)
- Certain forms of income are imputed rather than directly observed (owner-occupied rent)
- The expenditure approach relies on more readily available data on spending
- Consumption, investment, government purchases, and net exports are more easily tracked through surveys and administrative data
Calculating National Income
Income Approach Components
- The income approach calculates national income as the sum of:
- (wages, salaries, and supplements like employer contributions to social insurance and pension funds)
- Rent (income earned by property owners for the use of their land or structures)
- (payment received by lenders for supplying funds)
- (income of unincorporated businesses like sole proprietorships and partnerships)
- (income earned by corporations)
- (taxes imposed on the sale of products or services, such as sales taxes and excise taxes)
- (difference between factor income received from abroad and factor income paid abroad)
Expenditure Approach Components
- The expenditure approach calculates national income as the sum of:
- (spending by households on goods and services, excluding the purchase of new housing)
- (spending by firms and households on new capital goods, additions to inventories, and residential construction)
- Government purchases (spending by the government on goods and services, excluding transfer payments as they do not directly absorb resources or create output)
- Net exports (value of exports minus the value of imports)
- Exports are an injection into the circular flow, while imports are a leakage
Equality in the Circular Flow
Flows of Income and Expenditure
- The circular flow model represents the flow of money and resources between households and firms in an economy
- Demonstrates the interdependence of the income and expenditure approaches to measuring national income
- Households supply resources (labor, land, capital) to firms and receive income in return (wages, rent, interest, profits)
- Firms use the resources to produce goods and services, which they sell to households, generating revenue
Equality of Income and Expenditure
- The flow of money from firms to households (income) is equal to the flow of money from households to firms (expenditure)
- Every dollar of spending by a buyer is a dollar of income for the seller
- Leakages from the circular flow (saving, taxes, imports) are matched by injections (investment, government purchases, exports)
- The equality of leakages and injections ensures the equality of income and expenditure
- The basic circular flow model assumes a closed economy with no government sector for simplicity
- More complex models incorporate the government sector and foreign trade to capture additional leakages and injections (taxes, government purchases, imports, exports)
Key Terms to Review (26)
Circular Flow: Circular flow is an economic model that illustrates the movement of money, goods, and services between households and firms within an economy. It shows how resources flow from producers to consumers and back again, highlighting the interdependence of these two groups in the economy. This model serves as a foundation for understanding economic activity and can be analyzed through two main perspectives: income and expenditure, emphasizing how they relate to overall economic performance.
Classical economics: Classical economics is an economic theory that emphasizes free markets, competition, and the idea that markets function best when left to their own devices without government intervention. It posits that the economy naturally tends toward full employment and that all resources will be allocated efficiently in a competitive market. This concept is closely tied to several aspects of economic modeling and national accounting, which help in understanding income distribution and expenditure patterns in the economy.
Consumption Expenditure: Consumption expenditure refers to the total amount spent by households and individuals on goods and services over a specific period. This spending is a major component of the economy, influencing overall demand and economic growth. Consumption expenditure encompasses various categories, including durable goods, nondurable goods, and services, which play vital roles in shaping economic activity and informing fiscal and monetary policies.
Consumption spending: Consumption spending refers to the total amount of money that households spend on goods and services for personal use. It is a critical component of economic activity and plays a significant role in driving overall economic growth, influencing both the income and expenditure approaches to measuring economic performance.
Corporate Profits: Corporate profits refer to the earnings that corporations generate after all expenses, taxes, and costs have been subtracted from total revenue. These profits are crucial for understanding a company's financial health and impact the overall economy, as they influence investment decisions, stock prices, and economic growth. Corporate profits are also essential in both the income approach and expenditure approach to measuring gross domestic product (GDP), representing a key component in analyzing economic performance.
Economic Modeling: Economic modeling is the process of creating abstract representations of economic processes or relationships to analyze and predict how different factors interact within an economy. These models can take various forms, from simple equations to complex simulations, and help economists and businesses understand the potential impacts of policies or market changes. The insights gained from these models are essential for evaluating economic performance, forecasting future trends, and making informed decisions.
Employee Compensation: Employee compensation refers to the total monetary and non-monetary rewards that an organization provides to its employees in exchange for their work. This includes wages, salaries, bonuses, benefits, and any other incentives designed to motivate and retain employees. Understanding employee compensation is essential as it impacts both the income approach and expenditure approach in economic analysis, reflecting how compensation influences overall productivity and spending in the economy.
Expenditure approach: The expenditure approach is a method used to calculate a country's Gross Domestic Product (GDP) by measuring total spending on the nation’s final goods and services within a specific time frame. This approach considers consumption, investment, government spending, and net exports, providing a comprehensive view of economic activity. It helps to illustrate how different components contribute to the overall economy and is essential for understanding national accounts.
Government Purchases: Government purchases refer to the total spending by government entities on goods and services, which includes expenditures for public services, defense, infrastructure, and other projects. This term plays a crucial role in understanding how government spending influences overall economic activity, particularly when comparing the income approach and expenditure approach to measuring economic output.
Government spending: Government spending refers to the total amount of money that a government allocates for its various programs and services, including public goods, infrastructure, and welfare programs. It plays a critical role in the economy by influencing overall demand, contributing to Gross Domestic Product (GDP), and helping stabilize economic fluctuations through fiscal policies.
Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total monetary value of all goods and services produced within a country's borders in a specific time period, typically measured annually or quarterly. It serves as a broad indicator of economic activity and health, reflecting the overall size and performance of an economy. GDP is crucial for understanding the economic structure and performance, as it is influenced by factors such as income distribution, government policy, and consumption patterns.
Gross Private Domestic Investment: Gross private domestic investment refers to the total amount of money spent on the acquisition of fixed assets by private businesses and households within a country, without accounting for depreciation. This investment includes spending on structures, equipment, and intellectual property. It's a crucial component of the economy, reflecting business confidence and helping to drive economic growth through increased production capacity.
Income Approach: The income approach is a method used to measure the total income earned by the factors of production in an economy, including wages, profits, rents, and taxes minus subsidies. This approach connects directly to the structure of national accounts by providing a detailed view of how income is generated and distributed within the economy. It contrasts with the expenditure approach, which focuses on total spending in an economy, highlighting the different perspectives from which economic activity can be analyzed.
Indirect business taxes: Indirect business taxes are taxes imposed on goods and services rather than on income or profits, such as sales tax, value-added tax (VAT), and excise duties. These taxes are typically passed on to consumers as part of the product's price, making them an important factor in determining overall economic activity. Understanding indirect business taxes is crucial for analyzing both income and expenditure approaches to measuring economic performance.
Interest Income: Interest income refers to the earnings generated from lending money or allowing others to use your funds, usually expressed as a percentage of the principal amount over a specific period. This form of income plays a crucial role in the economy as it reflects the return on investments and savings, influencing consumer behavior and overall economic activity. In both the income and expenditure approaches to measuring economic performance, interest income serves as a key component, impacting the disposable income of households and the investment capacity of businesses.
Keynesian Economics: Keynesian economics is an economic theory that emphasizes the role of government intervention in stabilizing the economy during periods of recession and unemployment. It suggests that active fiscal policy, including government spending and tax adjustments, is essential to stimulate demand and promote economic growth, especially in times of economic downturn.
National Accounting: National accounting refers to the systematic method of measuring a country's economic performance by tracking all economic transactions that occur within its borders. This framework helps in assessing the economic health of a nation, allowing policymakers and economists to analyze trends, make informed decisions, and formulate effective economic policies. National accounting encompasses various approaches, including the income approach and the expenditure approach, which provide different perspectives on how to measure a nation's output and income generation.
Net Exports: Net exports refer to the value of a country's total exports minus the value of its total imports. This figure is crucial in understanding a nation's trade balance and is a key component in calculating Gross Domestic Product (GDP). Positive net exports indicate that a country sells more goods and services abroad than it buys, contributing to economic growth, while negative net exports suggest the opposite, potentially indicating economic challenges.
Net Foreign Factor Income: Net foreign factor income is the difference between the income earned by a country's residents from foreign investments and the income earned by foreign residents from domestic investments. This measure is crucial in understanding how income flows across borders, as it impacts the calculation of a nation's Gross National Product (GNP) versus its Gross Domestic Product (GDP). It reflects the economic interactions a country has with the rest of the world, influencing both income generation and overall economic health.
Net National Income (NNI): Net National Income (NNI) is a measure of a country's total income that accounts for depreciation, representing the total value of all goods and services produced by residents of a nation minus the loss of value due to wear and tear on capital goods. NNI is a crucial indicator as it reflects the income available for consumption and investment after considering the necessary adjustments for maintaining productive capacity. It connects closely with the income and expenditure approaches to understanding economic performance, providing insights into how income is generated and used within an economy.
Profits: Profits refer to the financial gains that a business earns after deducting all expenses from its total revenue. They are a key indicator of a company's financial health, reflecting the effectiveness of its operations and its ability to generate surplus value. Understanding profits is essential for evaluating economic performance, as they are influenced by both the income generated from goods and services and the expenditures necessary to produce them.
Proprietors' income: Proprietors' income refers to the earnings that owners of unincorporated businesses receive, which includes profits, rents, and other income sources from their enterprises. This income is essential in understanding the income generated in an economy, as it represents the rewards for entrepreneurship and risk-taking. It plays a significant role in economic analysis by reflecting the financial health of small businesses and self-employed individuals within the broader context of national income.
Real GDP: Real GDP measures the value of all final goods and services produced within a country in a given period, adjusted for inflation. This adjustment provides a clearer picture of an economy's true growth over time by stripping away the effects of price changes, making it essential for assessing economic performance, guiding fiscal and monetary policies, and understanding overall economic health.
Rent: Rent is a payment made for the use of land or property, typically paid to the owner or landlord. It reflects the income earned by landowners from leasing their property to tenants, which plays a significant role in the broader economic analysis through both the income and expenditure approaches. Rent can also influence decisions regarding investment and resource allocation in the economy.
Value Added: Value added refers to the enhancement a company gives its product or service before offering it to customers. It represents the difference between the cost of inputs used to produce a good or service and the selling price of that good or service. This concept connects closely with both income and expenditure approaches, as it plays a crucial role in measuring economic performance and productivity.
Wages: Wages are the compensation or payment that employees receive in exchange for their labor and services, typically calculated on an hourly, daily, or piecework basis. They play a crucial role in determining the income levels of individuals and households, influencing overall economic consumption and production. Wages are a key component of the income approach to measuring economic activity, as they directly impact disposable income and consumer spending.