Expenditure Method (or Spending Approach)
The expenditure method measures GDP as the aggregate of all the final expenditure on the gross domestic product at market price in an economy during an accounting year. Final expenditure means expenditure on final products.
The total income generated in the economy can be spent either on consumer goods or investment goods. Thus, we can get GDP by summing up all consumption expenditure and investment expenditure made by all individuals and the government and net foreign investment within a year. Then we add the net factor income from abroad to GDP, to get GNP. Lastly, we deduct the depreciation from GNP and obtain NNP.
GDPmp = C + I G + (X M)
GNPmp = C + I + G + (X – M) + (R P)
NNPmP = GNPmp – Depreciation
C = Private consumption Expenditure
I= Gross Private Domestic Investments
G = Government Expenditure (Public Consumption and Investment Expenditure)
X = Export Earnings
M = Import Expenses
R = Receipts from abroad
P = Payments made to abroad
Components of Expenditure Method
Let’s understand the components used in expenditure method:
1. Private (or Personal) Consumption Expenditure (C)
C component of expenditure method includes all types of expenditure made on final goods and services, including those produced abroad by the individuals or households of the country. It comprises,
- expenses on durable goods like watches, furniture, vehicle, etc., (but not residential houses, which are classified under investment)
- expenditures on non-durable goods like milk, rice, clothes, etc. and
- the expenditure incurred on services of all kinds like fees paid to doctors and lawyers, and bills paid for transport and communication, etc.
2. Gross Private Domestic Investment or Gross Capital Formation (I)
This I component of the expenditure method includes expenditures incurred by private enterprises on new investment and on replacement of old capital and also on inventory investment. It comprises the following expenditure:
a. Non-residential investment. All types of expenditures made by business firms on machines, tools, plants, vehicles, furniture, etc. make up non-residential investments because the firms purchase these goods for their own use.
b. Residential investment. All types of expenditures made on factories, warehouses, business complexes, office buildings, and new houses and apartments constitute residential investments. New houses and apartments are clearly investment good, because, like factories and warehouses, they are income-earning assets. Further, owner-occupied houses are rented out to yield a money income return. For these reasons, all residential constructions are considered investments.
c. Changes in business inventories. The change in business inventories is the amount by which firms (inventories) change during a period. Change in business inventories is the difference between closing stock and opening stock. Business inventories can be looked at as goods that firms now produce and intend to sell later.
d. Depreciation. It is the value of the capital that wears out during the period over which economic activity is being measured.
3. Government Expenditure (G)
Expenditures made by the government (central, state, or local) on final goods or services, including those produced abroad are a part of GDE (GDP). Expenditures on obligatory functions e.g. security expenses, administrative expenses, etc., and on optional functions (or socio-economic infrastructures) are added to government expenditures.
But expenditures on transfer payments (social security, benefits like pension, unemployment allowances, scholarship, etc.) are not added because these payments are not made in exchange for goods and services produced during the current year. These expenditures are also divided into government consumption expenditure and government investment expenditure.
4. Net foreign Investment (X – M)
This component of the expenditure method is the difference between export earnings and import expenses. Every country exports to or imports from foreign countries. The imported goods are not produced within the country and hence cannot be included in GDP, but the exported goods are manufactured within the country. So-net foreign investment is defined as the amount which foreigners spend on domestic goods and services and the amount our residence spend on foreign goods and services. Thus, net foreign investment, whether positive or negative, is included in GDE (or GDP).
The reason for including net exports in the definition of GDP is simple. Consumption, investment, and government spending (C, I, and G) include expenditures on goods produced both domestically and by foreigners. Therefore, C + I + G overstates domestic production because it contains expenditures on foreign-produced goods—that is, imports (M), which have to be subtracted out of GDP to obtain the correct figure. At the same time, C + I + G understates domestic production because some of what a nation produces is sold abroad and therefore not included in C, I, or G-exports (X) have to be added in. If a Nepalese firm produces carpets and sells them in Germany, the carpets are part of Nepalese production and should be counted as part of Nepalese GDP.
5. Net Factor Income from Abroad (NFIA) or Net Receipts (R-P)
Net factor income abroad (NFIA) is defined as the income paid to domestic factors of production by the rest of the world minus income paid to foreign factors of production by the domestic economy. In other words, it is the difference between the factor income received from abroad by normal residents of a country for rendering factor services in other countries and the factor incomes paid to the foreign residents for their factor services within the domestic territory of a country.
Net factor income earned from abroad has the following three components:
- Net compensation of employees
- Net income from property (rent and interest and income from entrepreneurship)
- Net retained earnings of the resident companies working in foreign countries.
While estimating national income by expenditure method, we need to take the following precautions:
- Second-hand sales: All expenditures on second-hand goods are to be excluded.
- Capital gains: Expenditures on financial assets, like shares and bonds within the country are excluded.
- Transfer payments: All government expenditures on transfer payments, such as an old-age pension, national debt interest, unemployment allowance, etc. should be excluded.
- Intermediate goods and services: Expenditures on all intermediate goods and services are also excluded because otherwise there would be double-counting in the national income.