Why is GDP calculated by either the “Income” or the “Expenditure” approach?

Actually the question that was sent over to me was much longer than that, but it can be summarised as basically that.

Quick note to students – knowing the concepts behind how GDP is computed is a must.

Not only will there be questions in the “A” level Economics paper asking for explicit calculations (in Case Studies), but occasionally questions have appeared asking for how material standard of living can be measured for a given population (i.e. an explanation of GDP).

As I often tell my students, ignore these “boring” details at your peril!

Definition of GDP

Yup, it is that long string of words that every student commit to memory. But as you will see shortly, it plays a key role in the characterising and subsequently, computating of GDP:

GDP is the total money value of all final goods and services produced within the geographical boundary of a country, regardless of whether the resources are owned by its residents or foreigners, before deduction for depreciation, in a given period of time.

The Circular Flow of Income

In a rather simplified form, economic activity in an economy can be described by the Circular Flow of Income model which is illustrated below:

At equilibrium state, the sum of income flows must equal the sum of expenditure flows.

It should also be pointed out that this may only occur when the sum of injections (Investments, Government Expenditure, Export Revenue) equal the sum of withdrawals (Savings, Tax, Imports).

Therefore, in terms of measuring economic activity, as in the case of GDP (refer to the definition above), computing for one flow will suffice (i.e. either sum of income, or sum of expenditure), since they are two sides to the same coin.

Therefore at equilibrium, the National Income identity is often reflected as:

GDP = C + I + G + ( X – M )

Where:

C = (Domestic) Consumption Expenditure, after savings set aside;

I = Investment Expenditure;

G = Government Expenditure; and

X – M = Net Exports = Export Revenue – Import Expenditure.

Short and Sweet.

This short explanation above cuts straight to the chase, at least in the context of ‘A’ level Economics, why GDP can be calculated by either the “Income” or “Expenditure” approach.

Don’t ignore the Circular Flow of Income model!

For more detailed explanation, please refer to my notes here.