As noted above, GDP is the measure of an economy's total output. It is also used as a measure of total income and total expenditure in that economy. Figure 4.1 clearly shows that factor incomes received by the public is being spent to buy the output of goods and services produced.
Hence, income is equal to expenditure and expenditure is equal to the value of output produced in the economy.
Income = expenditure = output
Y = E = O
The model can further be extended by adding the other components of national income namely investment (I), government (G), and foreign trade (X-M). In the extended model, savings of public, taxes and import payments will be deducted from the income. Hence, they are called leakages from the circular flow. Similarly, investment expenditure, government expenditure and net expenditure on trade will be added in to the circular flow. These additions are called injections. However, after aggregating all leakages (outflow) and injections (inflow) in any one year, the total income components of the economy will be equivalent to the total expenditure or total output. Therefore, all the three methods are supposed to give same results.
1. Output or Product Method
In the output or product method, the measures of GDP are calculated by adding the total value of the output (of goods and services) produced by all activities during any time period, such as a year. The major challenge of this method is the problem of double-counting.
The output of many businesses is the inputs of some other businesses. For example, the output of the tyre industry is the input of racing bike industry. Counting the final output of both industries will result in double-counting of the value of tyre. This problem can be avoided by including only the value added at each stage of production or by adding only the final value of output produced.
2. Income Method
In the income method, the measures of GDP are calculated by adding all the income earned by various factors of production which are engaged in the production of output. The various incomes included to compute the gross national income are: Interest
Rent
Surplus of government enterprises
Net flow of income from abroad
All of them are known as factor incomes and they are paid in return for the inputs engaged in some productive process which have resulted in corresponding output. The sum of all these incomes (or factor prices ) provide us the measure of national income.
3. Expenditure Method
In the expenditure method, the measures of GDP are calculated by adding all the expenditures made in the economy. The essential components of expenditure are:
C = consumption expenditures
I = domestic investment
G = government expenditures
X = exports of goods and services
M = imports of goods and services
NR = net income receipts from assets abroad
The sum of all these aggregate expenditure provides us the measure of national income.
GDP = E = C + I + G + (X-M)
where E is aggregate expenditure.
All the above three methods must yield the same results because the total expenditures on output must by definition be equal to the value of the output produced which must be equal to the total income paid to the factors that produced these goods and services. However, in practice, there will be minor differences between these results due to changes in inventory levels and timing discrepancies. The following are some of the national income identities.
NNP = GNP - Depreciation
NNI = NNP -Indirect taxes
PI = NNI - Retained earnings, corporate taxes and interest on public debt
PDI = PI - Personal taxes.
Where, GNP - Gross National Product
NNP - Net National Product
NNI - Net National Income
PI - Personal Income
PDI - Personal Disposable Income