The income approach to measuring gross domestic product (GDP) is based on the accounting reality that all expenditures in an economy should equal the total income generated by the production of all economic goods and services. It also assumes that there are four major factors of production in an economy and that all revenues must go to one of these four sources. Therefore, by adding all of the sources of income together, a quick estimate can be made of the total productive value of economic activity over a period. Adjustments must then be made for taxes, depreciation, and foreign factor payments.
Ways to Calculate GDP
There are generally two ways to calculate GDP: the expenditures approach and the income approach. Each of these approaches looks to best approximate the monetary value of all final goods and services produced in an economy over a set period of time (normally one year).
The major distinction between each approach is its starting point. The expenditure approach begins with the money spent on goods and services. Conversely, the income approach starts with the income earned (wages, rents, interest, profits) from the production of goods and services.
Formula for Income Approach
It's possible to express the income approach formula to GDP as follows:
TNI=Sales Taxes+Depreciation+NFFIwhere:TNI=Total national incomeNFFI=Net foreign factor income
Total national income is equal to the sum of all wages plus rents plus interest and profits.
Why GDP Is Important
Some economists illustrate the importance of GDP by comparing its ability to provide a high level picture of an economy to that of a satellite in space that can survey the weather across an entire continent. GDP provides information to policymakers and central banks from which to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon.
The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists, and businesses to analyze the impact of such variables as monetary and fiscal policy, economic shocks (such as a spike in oil price) as well as tax and spending plans on the overall economy and on specific components of it. Along with better informed policies and institutions, national accounts have contributed to a significant reduction in the severity of business cycles since the end of world War II.
However, GDP does fluctuate because of business cycles. When the economy is booming, and GDP is rising, inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central banking authorities to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation. As interest rates rise, companies cut back, and the economy slows down and companies cut costs. To break the cycle, the central bank must loosen monetary policy in order to stimulate economic growth and employment until the economy is strong again.