Module 2

Kartik Yadav

2020
What is Economics?
• Economics is the academic study of the production, distribution, and
consumption of goods and services.

• Keyword 1- limited
• Keyword 2- alternate

• Macro vs Micro
• Loss of Individual identity, Gaining wider perspective.
• The Scarcity Principle
• Boundless wants cannot be satisfied with limited resources.
• Therefore, having more of one thing usually means having less of another.
• Because of scarcity we must make choices.

• Three Problems All Economic Systems Must Address

• What should be produced?
• How should it be produced?
• For whom will it be produced?
• Microeconomics
• The study of individual choice under scarcity and its implications for the
behavior of prices and quantities in individual markets

• Macroeconomics
• The study of the performance of national economies, and of the policies that
governments use to try to improve that performance
• Three primary aggregate variables studied :
1. Economy’s Output
2. Price Levels
3. Rate of unemployment.

Four Five Outcomes:

1. Full Employment
2. Price Stability : Average Price level in the economy is stable and inflation is moderate.
3. Efficiency : Maximum possible output produced with given output and technology.
4. Economic Growth : Sustained expansion of an economy’s consumption and production
possibilities.
5. Equity : Equitable income distribution to reduce poverty and enable all to benefit.
 Schools Of Thought

• There exists considerable difference in ideologies regarding these

goals.
• These differences arise due to different ideologies about the
efficiency of markets as well as the role of government intervention
in an economy.
Module 1 : National Income Accounting

Question: How to measure the performance of an economy.

 Gross Domestic Product (GDP)
The market value of the final goods and services produced in the territory
of a country during a given period of time.

• Market Value
• Market value is used to aggregate the quantities of different goods and
services into one measurement
Calculating GDP:
Total production = 4 apples, 6 bananas, and 3 pairs of shoes
Price of apples = INR 0.25
Price of bananas = INR 0.50
Price of shoes = INR 20
Calculating GDP for Orchardia
GDP = (4 x INR 0.25) + (6 x INR 0.50) + (3 x INR 20) = INR 64
Final Goods and Services

• Final Goods or Services

Goods or services consumed by the ultimate user; because they are the end products
of the production process, they are counted as part of GDP.

• Intermediate Goods or Services : Goods or services used up in the production of final

goods and services and therefore not counted as part of GDP.

• To avoid double counting

• Price of the final good includes the value of intermediate goods.
• Example: Lock + Glass + Steel
• Produced in the territory of a country

• Produced : Only current production is counted. Sale of used goods isn’t counted

• Domestic : Only production that takes place within a country’s border

Examples

 Cars produced in India by foreign owned companies are counted in India’s

GDP.

 Cars produced in Europe by Indian owned companies are not counted in

India’s GDP.

 Remittances by an Indian Resident working in the Middle East will not be

counted in India’s GDP.
Period Of Time

• GDP is a flow variable measured over a period of time, usually quarterly

or an year.
 Gross National Product (GNP)
• The market value of the final goods and services produced by domestically
owned factors of production (regardless of where they work) during a given
period of time.

• Example
• Profits accruing to a Japanese car manufacturer in India is included in
India’s GDP and Japan’s GNP.

• Remittances of an Indian resident working in Middle East is counted in

Middle Eastern country’s GDP and India’s GNP.
GDP v/s GNP

• NFIA (Net factor Income from Abroad) = Factor income earned by our residents from
ROW minus factor incomes earned by non residents from our country

GNP – GDP = NFIA

• When GNP > GDP => NFIA is positive. Earnings by our residents abroad is greater than
earnings by non residents/foreigners in our country.

• GDP is the most commonly used measure as it is an indicator of employment and

production potential of an economy.
Real v/s Nominal GDP
• GDP is the value of all final goods and services produced. It is monitored to assess
growing demand/output of goods and services.

• GDP = P x Q . Thus changes in GDP reflect changes in :

• aggregate demand/output
• price level.

Therefore, there can be a sustained rise in GDP without changes in Q, but only rising P.

• Nominal GDP measures these values using current prices.

GDP = Price in current year X Quantity in current year

• Real GDP measures these values using the prices of a base year (constant prices )
GDP = Price in base year X Quantity in current year
• Real GDP allows one to compare physical output between time periods by
adjusting for price changes over this period.

• Thus, real GDP is a better indicator of the actual performance of the

economy in terms of producing goods and services. It measures how much
the output has really increased in an economy.

• Base year problems- constantly updated, normal year.

An Example
Good/ Service Base Year Current Year
P Q P Q
Bread 2 40 3 60
Clothes 8 90 10 150
Television 80 100 90 110
Automobiles 70 120 80 130

Current GDP (Nominal) = 3x60 + 10x150 + 90x110 + 80x130 = 21,980

Current GDP ( Real) = 2x60 + 8x150 + 80x110 + 70x 130 = 19, 220

Base year GDP = 2x40 + 8x90 + 80x100 + 70x 120 = 17, 200

Nominal GDP Growth = ( 21, 980- 17, 200)/ 17, 200 x 100 = 27. 8 %

Real GDP Growth = ( 19, 220 – 17, 200)/ 17, 200 x 100 = 11. 7%
Questions for Practice
• Real GDP controls for changes in population. Yes/No?

• Nominal GDP is always larger than Real GDP. Yes/No?

• If a country’s nominal GDP increases, it means the country is

producing more goods and services.
Three Approaches To Measure GDP
1. Expenditure Approach

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 ( Gross Fixed Capital Formation)
• Government spending, G
• Net exports, NX : Exports – Imports ( X- M)
2. Value Added Method/ Output Method : Summing up the value added in
production in an economy.
• Value Added by a firm = Revenue from selling a product – Amount paid for
goods and services 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 to avoid double counting, as the distinction between

final good and intermediate good is sometimes difficult, as it depends upon the
use in which the product is put.
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

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

• GDPfc need not equal GDPmp

• 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.

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

 All you wanted to know about calculating GDP-
The Hindu Businessline (February 02, 2015)

Suddenly the Indian economy is looking much better than it did two weeks ago, thanks to
a little sleight of hand. The Government’s statistics wing made two changes to the GDP
calculation last week which have had the happy effect of lifting growth to 6.9 per cent for
2013-14 instead of 4.7 per cent as estimated earlier.

There have been two changes to the GDP calculations. One was a change in the base
year for the calculation which is done routinely every five years or so. The other was to
adopt a new method to measure output- starting now, Indian GDP will be measured by
using gross value added (GVA) at market price, rather than factor cost.

You can question the timing, but the change in method of calculation has brought Indian
GDP calculations more in line with global practice.
 Calculating National Income:

• Step 1: From Gross to Net

• Net Domestic Product (NDP) It measures the net amount of good produced in a country
in a given period.

• NDP = GDP – Depreciation

• NDP = C + (I – Depreciation) + G + X
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.
• Net Investment = I – Depreciation
• NDP = C + Net I + G + X
Why Is NDP Important?

• It is an important indicator of how much one can consume today without

reducing the capital stock and the production possibilities for next year.

• It measures the output level required to maintain our production possibilities

and to replace the capital consumed in the process.

• The total collection of plant and equipment will only grow when gross
investment exceeds depreciation of capital stock i.e. net investment is positive.
 NDP = GDP - Depreciation

 GNP = NFIA + GDP

• NNP = GNP – Depreciation

NNP or Net National Product measures the net amount of goods produced by the domestically
owned factors of production of a country within a given period of time. It is the total value of
production by residents (GNP) less the value of capital used up ( depreciation of capital) to
produce that output.

National Income = NNP – Indirect Business Taxes

National income is the total income earned by residents of a country.

National Income = NNPfc

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

• PI = NI – Income earned but not received (Corporate Profits, Social security and other
contributions) + Income received but not earned (Dividends + Government Transfers)

• Personal Disposable Income ( PDI ) = PI – Personal Taxes

• PDI determines the actual level of consumption and savings in the economy.

• Saving or Consumption? Recall the Broken Window Fallacy.

• Japan vs USA vs India

From GDP to Per-Capita Income

1.GDP is usually expressed in nominal terms.

2. GDP needs to be converted into real GDP.

3. GNP= GDP + NFIA

4. GNPmp – Net indirect taxes = GNPfc

5. GNPfc – Depreciation = NNPfc (also called National Income)

6. NNPfc / Population = Per Capita Income.

Limitations Of GDP Estimates

• 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 etc. This grossly underestimates the value of transactions
in an economy, especially developing ones.
• 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.

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

 Comparing GDP between Countries
• Important to get a sense of how standard of living of people varies across
countries.

• Important to talk about per-capita GDP

• Important to keep a single currency (USD).

 Comparing GDP between Countries
• Important to get a sense of how standard of living of people varies across
countries.

• Important to talk about per-capita GDP

• Important to keep a single currency (USD).

• India ranks 126

• Misleading because of differences in purchasing power.

• Haircuts: 20 USD vs Rs 80

• India ranks 3rd.

Comparing Between Cities
The Circular Flow
Income ($)

Labor

Households Firms

Goods

Expenditure ($)
 The expenditure components of GDP

• consumption, C
• investment, I
• government spending, G
• net exports, NX
An important identity:
Y = C + I + G + NX

value of aggregate
total output expenditure
Consumption (C)
• Spending on goods and services by Households
• 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 income.
• Largest component of final demand.
• Purchases of new homes is not included in Consumption expenditure.
• Consists of:
• durable goods
last a long time e.g., cars, home appliances
• nondurable goods
last a short time e.g., food, clothing
• services
work done for consumers e.g., dry cleaning, air travel
Investment (I)
• Spending on goods bought for future use
• Includes:
• Business fixed investment: Spending on plant and equipment
• Residential fixed investment: Spending by consumers and landlords on housing
units
• Inventory investment: The change in the value of all firms’ inventories: part of
production that is produced but not sold in the market.
Investment vs. Capital
Note: Investment is spending on new capital.
Example (assumes no depreciation):
• 1/1/2018:
economy has $500b worth of capital
• during 2018:
investment = $60b
• 1/1/2019:
economy will have $560b worth of capital
 Flow Stock

Questions:

1. Number of college graduates this year?

2. Number of people with college degree?

3. Your monthly credit card bill?

 More on Inventory Investment
• Goods held in inventories are counted for the year produced, not the year sold.

• When a publisher produces and stores 10,000 copies of a newly printed book in its
ware house, the books are counted in GDP as inventory investment.
• If you purchase a book, consumption is up by one book and inventory investment is down by one
book.
• GDP does not change, nor should it since there is no production.

• 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.
Government spending (G)
• G includes all government spending on goods and services.
• G excludes transfer payments like subsidies.
• Investment expenditures by the Government are covered in G and
not I since I covers only private investment.
Net Exports ( X – IM)

• NET EXPORTS = X - M

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

Stage of Production Value of transaction Value Added
1. Farmer grows wheat and sells the Rs. 12 Rs. 12
wheat to the miller
2. Miller converts the wheat to flour Rs. 28 Rs. ( 28 – 12) = Rs. 16
and sells to baker
3. Baker bakes the bread and sells it to Rs. 60 Rs. (60 – 28) = Rs. 32
the supermarket.
4. Supermarket sells the bread to the Rs. 75 Rs. (75 – 60) = Rs. 15
consumer
Rs. 75 (Price of Bread)
 Value Added by a firm = Revenue from selling a product – Amount paid for goods
and services purchased from other firms.

This difference is somebody’s income.

Example : A car dealership

The difference between selling price of a car and the wholesale cost of the car :

 Wages paid by the car dealer to salesmen and mechanics.

 Rent paid by the car dealer to the landlord for the showroom.
 Interest that the car dealer pays to a bank for loans to finance inventory.
 The rest of the difference is profit, which goes into the income of the owner of the
car dealership.

• Since the sum of all firms’ value added is GDP, the sum of all incomes must also
equal GDP.
Discussion
• India
Primary Sector: Agriculture, hunting, fishing
Secondary Sector : Manufacturing
Tertiary Sector : Services

• Structural changes in Indian economy (1988 onwards) 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
• Majorly finance, IT, BPO services.

• 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

Contribution to GDP
2007-08 2008-09 2009-10 2010-11 2011-12 2012-13

Agriculture 16.81 15.77 14.64 14.45 14.1 13.69

Industry 20.65 20.14 20.43 20.32 19.64 18.94

Services 62.54 64.1 64.94 65.23 66.25 67.41

Source: RBI
Categories of the population

• employed
working at a paid job
• unemployed
not employed but looking for a job
• labor force
the amount of labor available for producing goods and
services; all employed plus unemployed persons
• not in the labor force
not employed, not looking for work
Two important labor force concepts

• unemployment rate
percentage of the labor force that is unemployed
U/(U+E) * 100
• labor force participation rate
the fraction of the adult population
that “participates” in the labor force.
(U+E)/Adult Population * 100
NOW YOU TRY:
Computing labor statistics
Number employed = 140 million
Number unemployed = 10 million
Adult population = 200 million

Use the above data to calculate

 the labor force
 the number of people not in the labor force
 the labor force participation rate
 the unemployment rate
NOW YOU TRY:
Answers
data: E = 140, U = 10, POP = 200
 labor force
L = E +U = 150
 not in labor force
NILF = POP – L = 200 – 150 = 50
 unemployment rate
U/L x 100% = (10/150) x 100% = 6.66%
 labor force participation rate
L/POP x 100% = (150/200) x 100% = 75%
 Korn Ferry’s The Global Talent Crunch Study reveals India as the only

country with a talent surplus by 2030.

1. Demographic Dividend:

2. Countries with Major Labour Shortages:

1. Japan

2. Europe: (Immigration Crisis)

3. Canada
 Inflation
• Inflation is a sustained increase in the general price level of goods and services in
an economy over a period of time.

• Deflation refers to falling prices; or in other words, the opposite of inflation.

• Disinflation doesn't refer to the direction of prices (as inflation and deflation do),
but rather the rate of change: it's a slowdown in the rate of inflation
 How to Measure Inflation: PRICE INDICES

• Used to measure price movements in the economy.

• Compare the average prices of a basket of goods and services over two different
time periods.

• Movement enables to understand changes in average price levels and take policy
measures to control inflation.

• Three important price indices – Consumer Price Index (CPI), Wholesale Price Index
(WPI) and GDP deflator.
Consumer Price Index (CPI)
• CPI is a weighted average of prices for a basket of goods and services
commonly purchased by households, at the retail level, and expressed
in relation to a base year with an index value of 100.

• It does not include exports, but includes imports.

• Used to adjust wages and pensions, to make cost of living adjustments

for contractual payments and to measure changes in purchasing power
of currencies/ exchange rates.

• Over the years, CPI has been used as an indicator of inflation, and also
as a tool by Government and Central Bank for targeting inflation and
monitoring price stability.
• India started releasing Consumer Price Indices (CPI) on base 2010=100 for all-
India and States/UTs separately for rural, urban and combined with effect from
January, 2011.

• Once in 10 years, surveys are used to determine a representative basket of goods

and services and the importance of each commodity.

• Price surveys are conducted every year.

• The CPI for any year is given by the formula:

CPI = Rs. 1020 / Rs 950 = 1.0737 * 100 = 107. 37

The inflation rate is the percentage change in CPI i.e. 7. 37 per cent here.
Problems With CPI

1. Comparisons between years that are far apart can be erroneous and misleading
since the representative basket is fixed. However, there are changes in the
availability of goods and services as well as consumer spending patterns as well as
preferences over time. A narrow basket makes CPI less representative.

2. It does not account for changes in quality of goods and services produced.

3. With rise in prices, consumers tend to substitute with other products, reducing the
weights of expensive products in consumer basket. But because of a fixed weights in
the consumer basket, CPI tends to overestimate the price rise. This is known as
SELECTION BIAS.
 Wholesale Price Index (WPI)
• WPI is a weighted average of the prices for a basket of goods and services that are
commonly purchased by a firm in a given period.

• Represents important inputs in the production process including raw materials and semi-
finished goods.

• Construction of WPI is similar to CPI and the composition of a representative input basket is
determined through a producer survey.

• As WPI is measured at early stages of production and distribution, it signals inflationary

pressures earlier than CPI.

• In April 2014, the RBI had adopted the CPI as its key measure of inflation.
• The base year for the current WPI series for India is 2011-12.

• Changes in prices at the producer level get transmitted to consumers?

• Steady surge in WPI reading is most certainly an indicator of inflationary pressure in the
economy and eventually will get reflected in the CPI numbers.

PROBLEMS WITH WPI:

• Less likely to fluctuate, relative to CPI. But few countries use WPI.

• Fails to capture impact of taxes and distribution margins.

• WPI excludes services altogether.

CPI VS WPI
 GDP Deflator
• It measures changes in economy’s price level by measuring the changes in prices between
the base and current year for all output in an economy.

Nominal GDP
GDP deflator = 100 
Real GDP
CPI/WPI v/s Deflator

• GDP Deflator is a broader index than the CPI or WPI. The former covers all goods
and services produced in the economy while the latter includes only a
representative goods basket.

• Deflator includes only domestically produced goods and does not account for the
impact of import prices.

• The CPI/WPI gives fixed weights to the prices of different goods while the deflator
has changing weights.
 Two measures of inflation in the U.S.
15%

CPI
from 12 months earlier
Percentage change

10%

5%

GDP deflator
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010