National Accounts Identity
Recall that the concept of the circular flow of income makes it clear that, in a given period of time, the amount of expenditure in the economy must equal the value of output sold in return which then must equal the incomes paid to the owners of the factors which were used to produce the output. This identity between expenditure, output and income is so important that it is worth stating explicitly.
Expenditure = Output = Income
The national accounts identity is the basic principle underlying the measurement of GDP since it implies that the total value of output produced could be calculated in any of three separate ways, each of which would necessarily give the same answer.
• Income method – the total of all factor incomes (wages, rent, interest, profits) is calculated. Transfer incomes (e.g. pensions, social security benefits, grants) are not included.
• Output method – the sum total of the value added by every firm in the economy is calculated. Value added = sales less purchases of working capital (materials, components etc.) Note that purchases of fixed capital inputs (machinery, buildings etc.) are not deducted since these are not immediately used up in production. Value added is used rather than the value of sales to avoid double counting.
• Expenditure method – the total of all final expenditure on consumer goods and capital goods by households, firms, government and foreign residents is calculated. Intermediate expenditure by firms on working capital inputs is excluded, again to avoid double counting.