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I disagree with the first answer here because depreciation is not connected to inflation or COLAs or things like that. Depreciation is the decline in the value of capital goods (like machines in a factory) that is due to the machines aging.
The reason that depreciation must be counted (and it is actually subtracted and not added) is that depreciation essentially happens when the machines are "used up" while making the goods that actually get sold.
So, when you look at a business's income, you have to subtract out the amount of money that it lost due to the wear and tear on its machines. This is why you subtract depreciation when figuring GDP.
Because income fluctuates along with and parallel to inflation, and the value of the dollar changes from year to year based on a variety of factors such as the money supply, international markets, and national debt load. Many salaries are tied to inflation, or receive Cost of Living Adjustments (COLAs) periodically, as do those who receive pensions and government support and Social Security.
Adding depreciation when using this method of computing the GDP makes the figures the formula generates more accurate in terms of the economy's size, growth and overall health, which in the end, is the point of calculating GDP in the first place.
He asked about the income approach. not the expenditure approach. the reason that GDP is added in the income approach is because we want a measure of all income, including income that results from firms' replacement of plant and equipment. Firms would have subtracted this amount from their calculation of profits by subtracting depreciation as an expense. If depreciation was not added then GDP would be underestimated. The word "Gross" in Gross Domestic Product is actually indicating that the value of depreciated/replaced capital is incorporated.
GDP is the total value of all final goods and services produced for the marketplace during a given year within a nation's boundary.
In computing GDP, depreciation is subtracted, and not added, from total investment to arrive at the net investment spending component of the GDP. This is because the net increase in value of capital goods in the country during a year is the actual amount spent on such goods less the depreciation charged during the year. In this way depreciation is like the intermediate goods consumed in production of the final goods and services.
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