Equivalence of the income, output and expenditure approaches
The circular flow of income
In subtopic 1.1.4, we introduced the circular flow of income.
Circular flow of income
An income flow in an economy where the value of the output produced is equivalent the total income earned from its production, which is also equivalent to the expenditures spent on purchasing that output.
The circular flow of income, illustrates how an economy consists of firms and households, which are connected together as a cycle:
- Households provide the factors of production (upper dashed blue arrow).
- Firms pay national income to households in return for the factors of production (solid pink arrow).
- Firms supply the goods and services to households, forming the national output (dashed pink arrow).
- Households use this income to purchase the goods and services from firms as national expenditure (solid blue arrow).
National output
The total value of the final goods and services produced by an economy, often measured by real GDP. It is also known as aggregate output.
National income
The total income of an economy, composed of the sum of wages, interest, rent and profit.
In other words, the circular flow of income indicates that:
National output = National income = National expenditure.
We saw that this flow of income can be represented by the circular flow of income model, provided in Figure 1.
Circular flow of income model
A model illustrating the flow of resources from households to firms, the movement of goods and services from firms to households, and the associated monetary flows, including household income generated from selling resources and firms' revenues from selling their products.
The circular flow of income model, illustrates how an economy consists of firms and households, which are connected through the economy:
- Households provide the (upper dashed blue arrow).
- Firms pay national income to households in return for the factors of production (solid pink arrow).
- Firms supply the goods and services to households, forming the national output (dashed pink arrow).
- Households use this income to purchase the goods and services from firms as national expenditure (solid blue arrow).
Figure 1 represents a closed economy. However, in the real-world, economies are open, and so also have leakages and injections from and into their income flow.
Leakages
The removal of funds from the income flow, represented by savings, taxes, or imports.
Injections
The addition of funds into the income flow through investment, government spending, or exports.
An open economy with leakages and injections is illustrated by Figure 2 below.
Leakages represent money leaving the circular flow, reducing the size of the economy. Leakages are composed of:
- Savings: income saved in financial markets instead of being spent.
- Taxes: paid to the government instead of being used for consumption.
- Imports: money spent on foreign goods and services.
Injections represent money entering the circular flow, increasing the size of the economy. Injections are:
- Investment: funds from financial markets used to produce capital goods.
- Government Spending: expenditures by the government on public services.
- Exports: foreign spending on domestically produced goods and services.
As can be seen by Figure 2, even in an open economy:
National output = National income = National expenditure.
The main difference of an open economy versus a closed economy is the impact of leakages and injections on the size of the economy.
The circular income, output, and expenditure approach
There are 3 main approaches to national income accounting (measuring the activity of an economy):
- The income approach: measures the income generated by the factors of production of an economy.
- The output approach: measures the value of the output (final goods and services) generated in an economy.
- The expenditure approach: measures the total consumer spending in an economy.
All the 3 approaches to national income accounting are equivalent (yield the same result), because as we have seen with the circular flow of income:
National output = National income = National expenditure.
The income approach
The income approach calculates national income by summing up the earnings of all factors of production within an economy over a specific time period (typically a year).
The income earned by the factors of production is composed of:
- Wages from labor.
- Rent from land.
- Interest from capital.
- Profits from entrepreneurship.
The total of these incomes represents national income, which serves as an indicator of economic activity.
NoteThe income approach provides insights into:
- The distribution of income among the factors of production.
- Changes in these shares over time, and comparisons across countries.
- Gain a better understanding of economic disparities.
The output approach
The output approach evaluates the total final value of goods and services produced in an economy during a specific time period (typically one year).
The output approach only sums up the value of all final goods and services to avoid double counting, which would occur if intermediate goods and services were included.
ExampleUnderstanding double counting
Giada has a pizza restaurant. She sells margheritas at a price of 10€ each. This value includes:
- The 4€ at which she bought the ingredients (flour, tomato, mozzarella, olive oil, basil, and salt).
- The 2€ she spends per pizza on owning the oven, tools, store, and the access to electricity.
- The 4€ she needs to pay herself for her labour.
Hence, the true value of the output for each margherita Giada produces is 10€, which is the price of the final good (the pizza).
If we also counted the price of intermediary goods the total value of the output would be 16€ (the value of the pizza + the ingredients + the physical capital).
However, by doing so, we would be double counting the value of the intermediary goods, since they are already included in the value at which Giada sells the pizza for!
Double counting leads too inflated national output, and so it is avoided by only accounting for the final value of all goods and services.
NoteThe output approach provides insights into:
- The value of output each economic sector produces.
- The economy is divided into sectors (agriculture, manufacturing, tourism, banking...)
- The value of output is calculated for each sector.
- These sectoral values are combined to determine the total economic output.
- Measuring the relative share in total output allows economists to make comparisons of this share over time and across economies.
The expenditure approach
The expenditure approach calculates the total spending on final goods and services produced within a country over a specific time period (typically one year).
Once again, only final goods and services are included to avoid double counting.
We will discuss how the expenditure approach calculates the national expenditure in the next section. We will also discuss the insights economists obtain from using the expenditure approach.
