PGDM (2019-21)

Term 2 ( September- December)

Dr. Kalpana Tokas
Recall..

• Classicals v/s Keynesians

• Simple Circular Flow : Households & Firms/ Businesses, Complex Circular

Flow : Households, Firms/ Businesses, Government and Foreigners.

• GDP : The market value of the final goods and services produced in the
territory of a country during a given period of time.

• GNP – GDP = NFIA

• Real v/s nominal GDP.

Measuring GDP
• GDP can be valued at Factor cost or at Market Prices.

• When GDP is valued at Market prices, it includes indirect taxes such as

sales tax, excise tax and subsidies which doesn’t necessarily equal the
price seller’s receive.

• Valuation at factor cost is reflective of the net price received by the seller
netting the indirect taxes and subsidies.

GDP at market Price = GDP at factor cost + Indirect Taxes - Subsidies

• Value of output in terms of prices fetched in market = Market Prices.

• Value of output in terms of costs of factors of production = Factor Cost

1. Expenditure Approach : Measures GDP as an aggregation of expenditures in the
economy.

Y = C + I + G + NX

Y = GDP = Total Value of output

C + I + G + NX = Total expenditure

• Consumption Expenditure, C
• Gross Private Domestic Investment, I
• Government spending, G
• Net exports, NX : Exports – Imports ( X- M)
Consumption Expenditure, C : Spending on goods and services by Households

• Consumption Expenditure on newly produced goods and services. Sale of used

goods is not included as a part of GDP as it is not an addition an economy’s output.
Largest component of final demand.

• Includes consumer durables(Have a lifespan of more than three years such as

cars, TV, Refrigerators), non-durables ( Have a smaller life span Food, clothing)
and services (Hair cut, laundry, doctor etc.).

• Purchases of new homes is not included in Consumption expenditure but in

Investment spending.

• This consumption expenditure also includes the imputed gross rent of

owner-occupied dwellings.
Investment Spending, I : Goods bought for future use. By definition, it only
includes capital goods that are newly produced such as equipment , machinery
etc. but not financial investments such as stocks and bonds.

• Investment = Business Fixed Investment + Residential Investment + Inventory

Investment

• Business Fixed Investment = Purchase of new plants and equipment by

firms

• Residential Investment = Purchase of new housing by households

• Inventory Investment = Net change in firms’ inventories. The part of

production that is produced in a period but not sold in the market.

Financial investments/stocks are not included. New capital must be created

to be counted as investment.
Inventory Investment
• Firms invest in inventories, which are produced goods held in storage in anticipation of later
sales. Goods held in inventories are counted for the year produced, not the year sold.

• Inventory investment this year = Stock of inventories at the end of this year – Stock of
inventories at the end of last year.

For example,

When a publisher produces and stores 10,000 copies of a newly printed book in his ware house,
the books are counted in GDP as inventory investment. Even though no one has yet purchased
the books, they must be counted in GDP because they have been produced. If subsequently you
purchase a book directly from the publisher, consumption is up by one book and inventory is
down by one book. GDP does not change, nor should it since there is no production. When the
publisher sells a book to a bookstore, the publisher’s inventory is down by one book and the
bookstore’s inventory investment is up by one book. Therefore, there is no change in the GDP.
Inventory Investment: Period 1
Output Value of Avengers DVDs = Rs.100000 : 1000 DVDs at Rs. 100 each
Sales = Rs. 80000
Inventory Investment = + Rs.20000
GDP = C + I + G + (X –M)
= 80000 + 20000 + 0 + (0-0)

Inventory Investment: Period 2

Output value of Avengers CDs = Rs.50000
Sales = Rs. 70000
Inventory Investment = -Rs. 20000
GDP= C + I + G + (X- M)
= +70000 + (-20000) +0+ (0-0)
• If the economy is slowing down, possibly entering a recession, the bearer of
the bad news will often be an undesired accumulation of inventories. As
consumers reduce their purchases, sales of goods and services slow,
inventories build up, and firms slash production (laying off employees) to
reduce unwanted inventories.

Although inventories are a relatively minor component of GDP, rapid changes

from their desired levels can have important economic consequences.

• When inventories accumulate beyond desired levels, an economic slowdown

may be on the horizon as producers reduce their output.

• Or if inventories are rapidly being depleted, then economic growth and

possibly inflation may soon rise as wage and price pressures build.

Economic analysts monitor the divergence of inventories from desired levels as

a leading indicator of potential changes in future economic growth rates.
Government Expenditure, G ( Running Cost, Procurement of supplies)

• It includes value of Goods and Services purchased by Central, State and local
governments. It includes government spending on defence, infrastructure etc.

• It does not include transfers to individuals (unemployment benefits, social

security benefits) as this counts as mere transfer of purchasing power and no
goods or services are produced as a result. Also, transfers to citizens are
already counted under consumption expenditure.

• G also excludes grants to states and local governments as well as interest

payments as they are not related to current expenditures.

• Investment expenditures by the Government are covered in G and not I since I

covers only private investment.

Pay Commission Hike??

Net Exports ( X – IM)

• NET EXPORTS = X - M

• X : Total Exports to foreigners M : Total Imports from foreigners

• Net exports measure net foreign demand in the economy as when foreigners
buy our goods, it adds to the demand for domestically produced goods.

• Question :
Why are we subtracting Total Imports from Total Exports in the expenditure
Method? Isn’t it enough just to add Total Export to include the value of goods and
services sold abroad?
• Both GNP and GDP are time bound measures. They refer only to current
production usually for a given year or quarter.

• Both include only the value of final goods and services. The value of
intermediate goods and services is not included.

• Some outputs are not sold on the market and hence there are no observed
prices to value them. In such cases the output is valued at the cost of the inputs
needed to produce them. (Usually for government output and services and
items such as self-owned housing where rent is imputed).

• Illegal products not included in GDP ( Underground economy)

• In India, a large part of economic activity takes place in an unorganized
sector, for which the data is difficult to obtain. This data is generally collected
through extrapolation of periodical surveys.

• Certain non-market transactions, though creating value are not counted as a

part of the GDP. E.g. All the work that spouses do at home. Goods produced
and consumed at Homes are not included in GDP.

• Treatment of investment goods run slightly counter to the rule that only final
goods are to be counted. The capital goods are in a sense intermediate goods
used in production process. In national accounting, they are seen as final
goods purchased by firms themselves.
2. Value Added Method/ Output Method : Summing up the value added in
production in an economy. It is a measure of the value that is added to each product
by firms at each stages of production

• Value Added by a firm = Revenue from selling a product – Amount paid for
goods and services used as inputs purchased from other firms.

• For Toyota, for example, value added is the revenue from selling cars less the
amount it pays for steel, glass, and the other inputs it buys. For a car dealer, value
added is the revenue from selling cars less the wholesale cost of the cars. Wages
,rents, interest, and profits are what make up value added at each firm.

• This concept is useful as it helps avoid double counting, since the differentiation
between final good and intermediate good is sometimes difficult, as it depends
upon what use the good is put to.
Stage of Production Value of transaction Value Added
1. Farmer grows wheat and sells Rs. 12 Rs. 12
the wheat to the miller
2. Miller converts the wheat to Rs. 28 Rs. ( 28 – 12) = Rs. 16
flour and sells to baker
3. Baker bakes the bread and sells Rs. 60 Rs. (60 – 28) = Rs. 32
it to the supermarket.
4. Supermarket sells the bread to Rs. 75 Rs. (75 – 60) = Rs. 15
the consumer
Rs. 75 (Price of Bread)
Discussion
• India
Primary Sector: Agriculture, hunting, fishing (16%)
Secondary Sector : Manufacturing (30%)
Tertiary Sector : Services (54%)

• Structural changes in Indian economy involved a shift from agriculture to

Services.With the manufacturing sector being stagnant.

• Value added per worker in agriculture sector is very low.

• The value added for the three sectors help understand the composition of the
economy and helps policy makers in taking appropriate measures.
• Services Sector : Growth hasn’t been employment intensive since the
industry is highly skill intensive since the major push has been through
finance, IT, BPO services etc. The service basket needs to be diversified with
services like tourism, distribution etc. which employs people across a range
of skills.

• Demographic Dividend? Boon or Bane

3. Income Approach / Factor Payments Approach :

Households provide factors of production to firms i.e. Labor, Land, Capital and
Entrepreneurial activity. The National Income is computed by summing the
payments made to these factors of production i.e. Wages, rent, interest , profits and
proprietor’s income.

Labor : Wages, Salaries etc.

Land : Rental income received by owners of land, houses, buildings, farms etc. as
well as Implicit rent if the owner occupies the land.

Capital : Capital receives interests

Entrepreneurial Activity : Proprietorial Income, Corporate Profits

National income is the total income earned by current factors of production
supplied by the residents of an economy.

NI = Compensation of employees by firms and government ( wages)

+ Net interest ( Interest paid by domestic business and the interest earned
from foreigners)
+ Rental Income ( income of landlords for leasing property and imputed
rent )
+ Proprietor's income + Corporate Profits ( Income of corporates after
paying for wages and creditors)

• Personal Income is the income that accrues to households after adjustments in

national income. We subtract from the NI the part that accrues to the corporate
sector and add dividends the HHs receive from government and personal
interest income.

• PI = NI – Corporate Profits – social security and other contributions +

Dividends + Government Transfers + Personal Interest Income
•Personal Disposable Income ( PDI ) = PI – Personal Taxes

• PDI determines the actual level of consumption and savings in the economy.
• Net Domestic Product (NDP) It measures the net amount of good produced in
the territory of a country in a given period as it nets out depreciation or the
value of portion of the nation's capital equipment that is used up within a year.

• NDP = GDP – Depreciation

• GDP = C + I + G + NX
• NDP = C + (I – Depreciation) + G + NX
Depreciation accounts for Reduction in the value of capital goods over a one-
year period due to physical wear and tear as well as obsolescence. It is also
known as capital consumption allowance.
• Net Investment = I – Depreciation
• NDP = C + Net I + G + NX
• It is an important indicator of how much can be consumed today without any
reduction in the capital stock and the production possibilities for next year.

• It measures the output level required to keep out production possibilities intact
and to replace the capital consumed in the production of goods and services.

• Therefore, some of every year’s output should include newly produced plant
and equipment or other investment goods in order to enable production
tomorrow. The total plant and equipment will only grow when gross investment
exceeds depreciation of capital stock and the net investment being positive.
• They do not account for improvement in quality of products or services over time.
Improved quality forms an aspect of increased welfare. The advancement in
technology often causes the prices of goods to fall which is not completely
captured by national accounts.

• The ways to measure GDP attaches no value/ utility to leisure time.

• Non market activities which generate value but are not transacted in markets are
excluded from GDP such as household services, domestic help, illegal activities,
informal sector activities, small business sales, cash incomes etc. This grossly
underestimates the value of transactions in an economy, especially developing
ones.

• GDP measure pays no attention to distribution of income and equity.

• Certain outputs are not transacted in the markets like some of the
expenditures made by the Government and their values need to be imputed
which can lead to erroneous estimates.

• The production based approach doesn’t account for negative social and
environmental effects of market transactions into consideration. It doesn’t
measure the impact of ‘economic bads’ such as pollution and crime on
welfare.
• New GDP Series for India
• Change in base year ( 2011-12)
• Calculating GVA (Gross value added) at market prices
• MCA21 (Ministry of Corporate Affairs) v/s ASI (Annual Survey of Industries)
Data for corporate activity

• Estimation of GDP numbers are important for budget estimates, projection of

deficits etc.

• Inconsistencies ??

• Other measures??
Arvind Subramanian’s Argument :

These didn’t gel with data such as the Index of Industrial Production (IIP), production of two-
wheelers and cars, output of cement, infrastructure and construction activities, growth in real
investment or the real value of exports and imports.

Electricity consumption, two- and three-wheeler sales, commercial vehicles and tractor sales,
the index of industrial production, petroleum consumption, output of cement and steel, real
credit and real exports and imports of goods and services.

the growth rates of at least 11 of the 17 indicators in the second period were well below that of
the corresponding GDP growth.