Let’s understand how GDP is calculated through the expenditures method. We start by understanding the components and sub-components of GDP. Lets understand how this is done by taking an example of a simple hypothetical economy and then build on this model.
GDP Calculation – Building a Simple Hypothetical Economy
Now that we are clear about the basic economic definitions and why we need GDP as a measure of the economy, we start by understanding the components of GDP to understand how it is measured. We will now look at aggregate income, expenditure and products and see how GDP can be measured by one of the three ways:
- By summing up the totals of all income generated in a country â€“ this is the income method.
- The total of all expenditure on goods and services produced in and imported into a country. This is the expenditures method and the most popular one used to measure GDP.
- The third method is the production method, in which the total goods produced in an economy are aggregated.
Households and Firms
Letâ€™s start with our hypothetical country that has a simple economy with only two economic entities: households and firms/business. Households consume goods and services and provide the factors of production to firms that produce goods and services, hire factors of production, and pay households for these factors.
Figure – Hypothetical Economy with only Households and Firms
There are two kinds of flows take place between households and firms. The first kind are real flows, such as the factors of productionâ€”land, labor, capital from households to firms, and goods and services that firms provide to households. The second kind of flows are monetary flows such as incomes and expenditures on goods and services. In this simple economy with only two economic entities we can see that households spend money on the goods and services that firms produce and receive incomes forÂ supplying the factors of production to firms.
Letâ€™s further simplify this hypothetical economy. Assume that our hypothetical economy is an agrarian one. A typical income statement of the farm is shown in below.
Figure: Typical Income Statement of a Farm
This particular farmer receives money for $1000 worth of fruits and vegetables bought by households and in turn pays out $1000 for factors of production. Assuming there are 1 million farmers in the economy with the same income statement the gross national product will be $1000 million. We can see that aggregate households buy $1000 million worth of fruits and vegetables and aggregate firms, or farms in our case, have produced the $1000 million worth of produce.
Since we haven’t introduced savings as yet in our hypothetical economy, all the money earned by households will be spent in the consumption of fruits and vegetables. Therefore, in this two entity closed economy the incomes received by households is spent entirely on goods and services (income = expenditure). Also, we see that the value of goods and services produced by firms is equal to the value of goods and services consumed by households, e.g. all the farm’s produce is consumed by households andÂ (Expenditure = Production). And finally,
Aggregate Income = Aggregate Expenditure = Aggregate Products
In the hypothetical economy, aggregate income is the $1000 million that households earn for that year, which they spend on fruits and vegetables making the aggregate expenditure $1000 million. The total production by farmers is also $1000 million.
Figure: Income Statements of One Million Farmers
One might argue that households save a part of their income and not all their income is spent on consumption. So, next we look at a slightly more realistic world of savings by households and investments by firms.
Next we introduce savings and investments by firms.