Calculating GDP – Government Expenditure

After adding consumption expenditure and investmentsÂ when calculating GDP we add an additional entity to the hypothetical countryâ€”the government. The government, like people, consumes goods and services that firms produce, and performs two additional tasksâ€”collecting taxes, and paying benefits plus subsidies, also called transfer payments. Since the collecting of taxes is a monetary flow from the households to the government, and transfer payments are a negative flow from householdsÂ  to the government, we can net these two flows to call it net taxes, or simply taxes, which can be assumed as taxes less transfer payments.

Figure: Hypothetical Economy with Households, Firms and the Government

Computing GDP – adding government expenditures

With the addition of government we see that now firms receive Consumer expenditure (C) + Investments (I) + Government spending (G) and pay out incomes (Y).

In this new economy aggregate expenditure is now:

E = C + I + G and E = Y

Households receive this income (Y) and the outflow is Consumer spending (C) + Savings (S) + Taxes (T).

Therefore, Y = C + S + T, and since Y = E

C + S + T = C + I + G or

S + T = I + G

We also see something interesting here. If G=T e.g. government expenditure equals government revenue in the form of taxes (a balanced budget), then S = I (all savings flow to fund investments made by firms), as in the simpler economy without the government entity. So with the introduction of the government we can see that the government competes with firms for capital when government expenditures exceed revenues. The government is said to be â€œcrowding outâ€ the private sector while competing for capital.

Lastly we will add the rest of the world to compute the final gross domestic product.