Expenditure Method: What It Is, How It Works, Formula

What Is the Expenditure Method?

The expenditure method is a system for calculating gross domestic product (GDP) that combines consumption, investment, government spending, and net exports. It is the most common way to estimate GDP. It says everything that the private sector, including consumers and private firms, and government spend within the borders of a particular country, must add up to the total value of all finished goods and services produced over a certain period of time. This method produces nominal GDP, which must then be adjusted for inflation to result in the real GDP.

The expenditure method may be contrasted with the income approach for calculated GDP.

Key Takeaways

  • The expenditure method is the most common way of calculating a country's GDP.
  • This method adds up consumer spending, investment, government expenditure, and net exports.
  • Aggregate demand is equivalent to the expenditure equation for GDP in the long-run.
  • The alternative method to calculate GDP is the income approach.

How the Expenditure Method Works

Expenditure is a reference to spending. In economics, another term for consumer spending is demand. The total spending, or demand, in the economy is known as aggregate demand. This is why the GDP formula is actually the same as the formula for calculating aggregate demand. Because of this, aggregate demand and expenditure GDP must fall or rise in tandem.

However, this similarity isn't technically always present in the real world—especially when looking at GDP over the long run. Short-run aggregate demand only measures total output for a single nominal price level, or the average of current prices across the entire spectrum of goods and services produced in the economy. Aggregate demand only equals GDP in the long run after adjusting for price level.

The expenditure method is the most widely used approach for estimating GDP, which is a measure of the economy's output produced within a country's borders irrespective of who owns the means to production. The GDP under this method is calculated by summing up all of the expenditures made on final goods and services. There are four main aggregate expenditures that go into calculating GDP: consumption by households, investment by businesses, government spending on goods and services, and net exports, which are equal to exports minus imports of goods and services.

The Formula for Expenditure GDP is:

 G D P = C + I + G + ( X M ) where: C = Consumer spending on goods and services I = Investor spending on business capital goods G = Government spending on public goods and services X = exports M = imports \begin{aligned} &GDP = C + I + G + (X - M)\\ &\textbf{where:}\\ &C = \text{Consumer spending on goods and services}\\ &I = \text{Investor spending on business capital goods}\\ &G = \text{Government spending on public goods and services}\\ &X = \text{exports}\\ &M = \text{imports}\\ \end{aligned} GDP=C+I+G+(XM)where:C=Consumer spending on goods and servicesI=Investor spending on business capital goodsG=Government spending on public goods and servicesX=exportsM=imports

Main Components of the Expenditure Method

In the United States, the most dominant component in the calculations of GDP under the expenditure method is consumer spending, which accounts for the majority of U.S. GDP. Consumption is typically broken down into purchases of durable goods (such as cars and computers), nondurable goods (such as clothing and food), and services.

The second component is government spending, which represents expenditures by state, local and federal authorities on defense and nondefense goods and services, such as weaponry, health care, and education.

Business investment is one of the most volatile components that goes into calculating GDP. It includes capital expenditures by firms on assets with useful lives of more than one year each, such as real estate, equipment, production facilities, and plants.

The last component included in the expenditure approach is net exports, which represents the effect of foreign trade of goods and service on the economy.

Expenditure Method vs. Income Method

The income approach to measuring gross domestic product 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.

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.

Limitation of GDP Measurements

GDP, which can be calculated using numerous methods, including the expenditure approach, is supposed to measure a country's standard of living and economic health. Critics, such as the Nobel Prize-winning economist Joseph Stiglitz, caution that GDP should not be taken as an all-encompassing indicator of a society's well-being, since it ignores important factors that make people happy.

For example, while GDP includes monetary spending by private and government sectors, it does not consider work-life balance or the quality of interpersonal relationships in a given country.