The expenditure approach

Lesson 10

E>R>E phrases (to be written out from the English text) for translation by ear.

MEASURING GDP

Gross Domestic Product is measured in two basic ways: (a) the expenditure approach, (b) the income approach. Figure 1 illustrates these ap­proaches with a version of the circular flow model, which shows that everything bought (expenditures) is sold by someone who receives income from the sale.

Ideally, both methods would yield identical numbers because spending on output flows as income to resource owners. Unfortunately, most of the data available are recorded for ac­counting purposes, so the figures used to calculate GDP are only roughly suited for economic analysis. Figure 2 displays the proportional makeup of GDP by major types of income and expenditures.

THE EXPENDITURE APPROACH

Measuring GDP by the expenditure approach leads us to the final buyers of all U.S. output. Aggregate Expenditures are the sum of (a) consumer spending, (b) business investment, (c) government purchases, and (d) net spending by foreigners. This summation echoes the sources of Aggregate Demand described in a previous chapter. Figure 2 shows the division of the na­tional pie into consumption (C), investment (I), government purchases (G), and net exports [i.e., exports - imports (X - M)].³

Personal Consumption Expenditures (C): Household outlays include spending on non­durable goods (food and clothing), durable goods (appliances and cars), and services (e.g., medical care or haircuts). Personal consumption expenditures (C) are the values of all commodities and services that households and individuals buy. This category is familiar because we all engage in consumption every day.

Business Investment (I): Remember that in­vestment, as economists use the term, does not refer to the flows of money or documents that we term financial investment. Economic investment (I) refers to acquisition of new physical capital.

Business spending for new capital is called Gross Private Domestic Investment, or GPDI. Gross means that all purchases of new buildings, equipment, and the like are included. Whether investment replaces obsolete or worn-out capi­tal does not matter. Private means that government investment is excluded. Domestic means that the new capital is bought from U.S. pro­ducers. We exclude foreign investments by American firms, but investment by foreign com­panies in the United States is part of our GPDI. The major components of investment spending are: 1) All new construction, including housing; 2) All final purchases of new equipment (e.g., machinery and tools); 3) Changes in business inventories.

New production facilities, apartment build­ings, and office spaceclearly fit the definition of investment, but why not treat residential con­struction as consumer spending? One reason is that housing can be built for rental purposes. In addition, the useful life of housing is much longer than most consumer goods. Consequently, hous­ing is regarded as a capital good, and all new construction is included in investment. On the other hand, the rental value of owner-occupied housing is considered consumption; a home produces shelter year after year.

The second item, capital equipment, ex­pands the productive capacity of firms and, thus, is clearly investment. But what about stocks and bonds? Securities are financial rather than eco­nomic investments. Purchases of new stocks and bonds may facilitate business spending on real capital, but security transactions merely transfer purchasing power from buyers of stock to sellers without directly boost ing productive ca­pacity. Thus, purely financial transactions are not economic investment.

Inventory growth is also investment, while declines are disinvestment. Business inventories include (a) raw materials or intermediate goods bought for use as productive inputs and (b) fin­ished goods held in stock to meet customers' de­mands. Customers quickly switch to other firms if your firm fails to deliver promptly. Adjust­ments for inventory changes are needed because we use sales data to estimate production. If in­ventory growth were ignore d, GDP would un­derstate total production. Inventory growth adds to investment, while shrinkagereduces in­vestment. Goods held in business inventories should be counted in GDP in the year produced, not the year sold. Inventories vary from year to year, so changes in inventories must be esti­mated to consistently measure total production and our national income.

Government Purchases (G): We consume commodities and services both as private indi­viduals and collectively, through government. Government may buy goods in finished form from private firms, or it may pay for intermedi­ate (unfinished) goods or basic resources to pro­duce the final goods and services it provides. The most important resource government buys is its employees' labor.

Government purchases of goods and ser­vices (G), ranging from pay for police officers to fire hydrants to cancer research, are then pro­vided at zero or minimal prices to their users. Many goods and services that government pur­chases and then provides are not sold in mar­kets, so their value cannot be known with precision. Thus, all government goods enter the GDP accounts at the prices government pays for them— for GDP accounting purposes, govern­ment is assumed to add nothing to the value of the labor and other resources it uses.

Note that government purchases do not in­clude transfer payments (e.g., Social Security or federal payments for disaster relief) that merely shift funds from one set of households to another set. Because transfer payments do not require production, they affect consumption and, conse­quently, Aggregate Demand only when recipi­ents spend the funds received from government.

Net Exports (X-M): Net exports are defined as exports (X) minus imports (M). Exports are goods manufactured domestically and bought by foreigners. We clearly must include exports in GDP to mea­sure the value of all production in a year. But do imports reflect American production? The obvious answer is no. Imports are goods produced in foreign countries and consumed or invested in the United States.

A Hyundai purchased in the United States is part of Korean production (and adds to Korean consumption when the owners of re­sources that produce the car spend their pay). When Americans buy a Hyundai, the price paid to Korean producers must be subtracted from U.S. consumption or it will appear that the car was produced in the United States. Similarly, if Swiss machinery is installed in an American fac­tory, the purchase appears in the U.S. invest­ment category, but it should be subtracted from U.S. GDP. Thus, in the expenditures approach to calculating GDP, imports are subtracted from exports to estimate the net effect of foreign trade on our economy.

To summarize: Using the expenditure ap­proach, Gross Domestic Product is the sum of consumer spending (C), business investment (I), government spending for goods and services (G), and net exports (X - M): C + I + G + (X-M) = GDP.

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