The sum of final expenditures in the economy must be equal to the incomes received by all the factors of production taken together (final expenditure is the spending on final goods, it does not include spending on intermediate goods). This follows from the simple idea that the revenues earned by all the firms put together must be distributed among the factors of production as salaries, wages, profits, interest earnings and rents.
Let there be M number of households in the economy. Let Wi be the wages and salaries received by the i-th household in a particular year. Similarly, Pi, Ini, Ri be the gross profits, interest payments and rents received by the i-th household in a particular year.
Therefore GDP is given by
It is to be noted that in above equation, I stands for sum total of both planned and unplanned investments undertaken by the firms.
It may be worth examining how the households dispose off their earnings. There are three major ways in which they may do so. Either they consume it, or they save it, or pay taxes with it (assuming that no aid or donation, ‘transfer payment’ in general, is being sent abroad, which is another way to spend their incomes).
Let S stand for the aggregate savings made by them and T be the sum total of taxes paid by them.
Therefore, GDP ≡ C + S + T
From above diagram, C + I + G + X – M ≡ C + S + T
Cancelling final consumption expenditure C from both sides we get I + G + X – M ≡ S + T
In other words (I – S) + (G – T) ≡ M – X
- G – T measures by what amount the government expenditure exceeds the tax revenue earned by it. This is referred to as budget deficit.
- M – X is known as the trade deficit – it measures the excess of import expenditure over the export revenue earned by the economy (M is the outflow from the country, X is the inflow into the country).
If there is no government, no foreign trade then G = T = M = X = 0. That is I ≡ S. This is simply an accounting identity.
Out of the GDP, a part is consumed and a part is saved (from the recipient side of the incomes). On the other hand, from the side of the firms, the aggregate final expenditure received by them (≡ GDP) must be equal to consumption expenditure and investment expenditure. The aggregate of incomes received by the households is equal to the expenditure received by the firms because the income method and expenditure method would give us the same figure of GDP. Since consumption expenditure cancels out from both sides, we are left with aggregate savings equal to the aggregate gross investment expenditure.
Bibliography : NCERT – Introductory Macroeconomics