Product method
● Value added method measures national income in terms of value addition by
each producing enterprise in the economy during an accounting year.
● Also known as the net output method
● Estimation of the contribution of all producing enterprises in the domestic
territory of the country during the year is equal to GDP at market price.
● Value added is the difference between the value of output of an enterprise
and the value of its intermediate consumption.
● Intermediate consumption is the value of all non factor inputs (inputs other
than land, labor, capital, enterprise).
● Value of output refers to the market value of all goods and services produced
by a firm during an accounting year.
● If the entire output is sold during an year value of output = sales
● If some output remain unsold the value of output = sales + change in
stock
Illustration
Producing Value of output Cost of Value added
Enterprise intermediate
goods
Farmer 600 200 400
Flour Mill 800 600 200
Baker 1000 800 200
Shopkeeper 1200 1000 200
3600 2600 1000
● Gross value added by all producing enterprises is 1000.
Expenditure approach (also covers the components of GDP)
● Total expenditure is the total amount received by the producers of final
goods and services.
● Thus according to this approach GDP = C +I +G+ NX
Consumption
● Spending by domestic households on final goods and services, including
those produced abroad.
● Consumption is divided into a) consumer durables like cars, television,
furniture and nondurable goods like food and fuel, services like banking,
health care.
● Houses which are for consumption are included in investments.
● It is the largest component of expenditure, accounting for two thirds in the
US GDP. Private consumption expenditure as a percentage of GDP stood at
58.4% in Q2 of FY23, highest among the second quarters of all years since
2013-14 - supported by a rebound in contact intensive services like trade,
hotel and transportation (16% sequential growth) driven by auto sales and
broad based expansion of contact based services. Near universal coverage of
vaccination in India overseen by the government was the single most
important reason that brought people.
Investment expenditure
● Investment includes both spending on new capital goods called fixed
investment and increase in firms inventory holdings called inventory
investment.Investment includes spending on foreign produced goods.
● Investments are further classified as : a) business fixed investment like office
, softwares, tractors b) fixed investment by households in residential houses
c) fixed investment by governments like expenditure by the government on
the construction of roads, dams and bridges
● Inventory investment refers to the change in stock during a year.
● Gross fixed capital formation was 33.5 % of GDP in FY23.
Government final consumption expenditure
● It includes the expenditure on final goods and services by the government
like expenditure on purchase of goods for consumption by defense
personnel.
● GFCFE accounted for 9.4% of GDP in FY23
Net exports
● Exports less imports
● Exports are added to total spending because they represent spending ( by
foreigners) on final goods and services produced in a country.
● Imports are subtracted from total spending because consumption, investment
and government purchase are defined to include imported goods and
services.
● Subtracting imports ensures that total spending C+ I+G+NX reflects
spending only on output produced within the country.
● X were 23.7% and M 26.8 % in FY23
Exclusions and special treatment expenditure items
● Only final expenditure (expenditure on final goods and services) should be
considered to avoid double counting.
● Expenditure on second hand goods is excluded, as they were already
accounted for in the year of their production.
● Expenditure on shares and bonds are excluded as mere paper claims are not
related to the production of goods and services.
● Expenditure on transfer payments like old age pensions, scholarships are
excluded as they don't reflect production in the economy.
● Imputed value of expenditure on goods for self consumption as well as
imputed rent of owner occupied houses should be taken into account.
Income Method
● According to this approach national income is estimated in terms of factor
payments to the owners of factors of production. (factor payments -
compensation of employees, rent, interest, profit). Owners of factors of
production - labor ,land, capital, enterprise.
● Factor incomes are broadly classified as:
Compensation of employees : Includes the following components
(i) wages and salaries in cash
(ii) payments in kind - benefits like rent free accommodation given by
employers to employees
(iii)Employer’s contribution to provident fund - contribution like provident
fund contributions from employers on behalf of employees.
(iv) pension on retirement (which is not old age pension buyout a part of the
service contract)
Operating surplus : Refers to income from property and entrepreneurship
(i) rent
(ii) interest
(iii) profit
Profit is further subdivided into:
a) Dividend b) corporate profit tax c)undistributed profits
Mixed income : Refers to the income of self employed persons.= for which
separation into rent, interest and profit is difficult as factor services are not hired
from the market.
Exclusions and special treatment of items
● Transfer earnings like unemployment allowance, old age pensions,
scholarships are excluded.
● Income generated in the parallel economy is not included because no records
are available.
● commission/ brokerage on second hand transactions is included.
● commission/ brokerage on asset (bonds and shares) transactions is included.
● Windfall gains like lotteries are excluded as there is no corresponding
production in the economy.
● Imputed rent of owner occupied homes should be treated as rent income.
● Income tax is paid out of compensation of employees so it should not be
added again
● Wages and salaries in cash and kind as well as social security contribution
by employers is a part of COE.
Private disposable income
● Income of the private sector
● Amount of income available to the private sector for spending
● Includes the income received by the private sector adjusting for payment
received from the private sector by the government and taxes paid by the
government.
● Private disposable income = Y +NFP +TR +INT -T
Where Y = gross domestic product, NFP = Net factor income from abroad,
TR = transfers received from the government, INT = interest payment on
government debt, T= taxes.
Net government income
● The part of the GDP that is not at the disposal of the private sector.
● Net government income = T - TR -INT
Private disposable income + Net government income = GNP
Measures of Savings
The value of assets minus the value of liabilities is called wealth, for the entire
nation it’s called national wealth. A key determinant of wealth is the rate of
savings. Simply, current income less spending on current needs are savings.
Savings rate will be savings divided by its income. From the macroeconomic
perspective there are three measures of savings - private saving, government
savings and national saving.
Private saving : Private disposable income less consumption.
Private Saving = (Y +NFP -T +TR +INT) - C
Government Saving : Government receipts less government outlays (on
consumption only). Also known as the government budget surplus. When
government outlays exceed the government revenues, the savings are negative or
it’s a budget deficit.
Note : While defining government outlays only government’s purchase of goods
and services are considered and government capital expenditure is excluded from
this definition.
Government Saving = ( T - TR -INT) - G
National Saving : Private saving + Government saving or saving of the economy.
= private saving + government saving
= ( Y +NFP - T + TR +INT - C ) + ( T -TR -INT -G )
= Y + NFP - C - G
The uses of private savings
Using the income expenditure identity, we substitute C + I + G + NX for Y in the
expression for national savings.
S = (C+ I + G +NX) + NFP - C -G
Simplifying the expression , we obtain
S = I + (NX + NFP)
NX +NFP is the sum of net exports and net factor payments and is called the
current account balance, the CA. We can rewrite this as
S = I + CA , this is the expression for national savings.
To get private savings from this expression we subtract government savings from
both sides of the equation.
Private = I + (-Sgovt) + CA
Where -Govt is the government budget deficit.
Uses of private savings from the above identity
● Investment : Firms borrow from private savers to finance the purchase of
new capital, inventory investment and construction.
● When the government runs a budget deficit, it borrows from private savers
to cover the difference between outlays and receipts.
● Private savings finance an economy’s current account deficit.
Stocks and flow - self study
National Wealth
Real versus nominal GDP
If the GDP rises from one year to the next, there are two possibilities - (I) the
economy is producing a larger output (2) goods and services are being sold at a
higher price.
Economists are interested in measuring the quantity of goods and services that are
not affected by changes in prices of those goods and services. This is captured by a
statistic called the Real GDP
Nominal GDP : Production of goods and services values at current prices.
Real GDP : Production of goods and services valued at constant prices.
Real GDP is computed by selecting a base year , so that quantities across different
years can be computed using the base year prices. Thus Real GDP is a more
reliable measure of an economy's goods and services. The base year for GDP
calculation in India is 2011-2012.
Why has the base year not been revised in India?
GDP deflator:
● A price index note (it’s just an index number) that calculates the average
level of prices of the goods and services included in the GDP
● GDP deflator = Nominal GDP/ Real GDP *100
● GDP deflator is used to measure inflation
● GDP deflator will increase when the average level of prices are increasing (
ie ; inflation)
● GDP is 100 in base year
● Calculating inflation using GDP deflator.
● Inflation rate in year 2 = GDP deflator in year 2 - GDP deflator in year
1/GDP deflator in year 1
● GDP deflator is a measure that economists use to monitor the average level
of prices in an economy thus the rate of inflation.
● GDP deflator gets its name because it is used to take inflation out of the
nominal GDP (deflating the nominal GDP for the rise that is due to increase
in prices)
Consumer price Index (CPI)
● The GDP deflator measures the average level of prices of goods and services
included in the GDP.It is measured quarterly
● The CPI is one of the metrics used to measure inflation in the economy. It
measures the changes in a representative group of goods and services used
by retail consumers of the economy over time. The basket of goods and
services is representative of consumer’s retail expenditure over time within
an economy.
● In India it is released by National Statistics Office
● A basket of goods and services : The CPI is tied to a basket of regularly
purchased goods and services like food, medical care, education,
electronics, to measure the economy’s aggregate price level.CPI is
computed taking into account is about 400 items
● The CPI has various sub groups including food and beverages, fuel and
light, housing and clothing, bedding and footwear.
● There are four types of CPI - a) CPI for industrial workers b) CPI for
agricultural laborers c) CPI for rural laborer d) CPI (rural/urban
combined)
● First three are compiled by the Labour Bureau in the Ministry of Labour and
Employment. Fourth is compiled by the NSO in the Ministry of Statistics
and Programme Implementation.
● Base year for CPI is 2012
● Recently the Ministry of Labour and Employement released a new series of
Consumer Price Index for Industrial Worker (CPI - IW) with base year
2016.
● The Monetary Policy Committee (MPC) uses the CPI data to control
inflation. In April 2014, RBI adopted CPI as its key measure of inflation.
● As compared to CPI- IW WPI gives less weightage to food articles.
● Formula = Cost of the representative basket in the current year / Cost of
representative basket in the base year *100
Difference between CPI and WPI
● WPI tracks inflation at the producer level, CPI captures inflation at the
consumer level
● WPI does not capture change in prices of services, CPI captures
changes in the prices of services
● WPI gives more weightage to manufactured goods, CPI gives more
weightage to food items.
Trends of CPI in India
● In March 2020 when covid 19 was declared a pandemic.
The shock was amplified by the world’s strictest lockdown and
arguably the biggest migration in human history as migrant workers
fled cities in fear of what was regarded as an urban disease.
● As a direct consequence of this massive dislocation in the
mobility of goods and services inflation which has been
marinated in alignment with the target of 4% during Sep 2016 -
March 2020 broke out of the tolerable band and averaged 6.1%
in 2020-21.
● In its meeting in February 2022 MPC projected average
inflation at 4.5% during 2022-23 on ebbing covid 19 infections,
easing supply chain global commodity prices moving in a range
bound manner,s, normal monsoons and global commodity
prices moving in a range bound manner.
● The precipitation of geopolitical tensions into an outbreak of
war in Ukraine completely overturned macroeconomic
conditions.
● International prices of energy, industrial metals and food shot
up to unprecedented highs and supply chains disruptions
became acute.
● Inflation in India levitated to a peak of 7.8% in April 2022
before easing to an average of 6.8% during MAy-Nov.
What explains this gravity defying historic high inflation episode?
● Some drivers of inflation : Food constitutes 55% of CPI. The
initial contributors to food price build up were cereals, edible
oils, meat and fish, by May milk, prepared meals and spices had
also joined.
● The loss of supply of sunflower oil from the Black sea region (
accounts for close to a third of global supplies). Prepared meals
prices are hot because of the increase in the price of edible oils
and the increase in transport cost.
● Substantial part of inflation’s ascent in India was driven by
external factors: supply disruption in agriculture brought by
adverse weather conditions also contributed to the build up of
price pressures over successive months.
● Unprecedented heat wave conditions in march -may affected
the production of wheat and vegetables, uneven monsoon
distribution , intermittent heavy rain spells affected the paddy
harvesting season, this also explains the spike in vegetable
prices like tomatoes.
● Under transportation, the main driver was pump prices -
between March and April 2022 petrol and diesel retail selling
prices increased by 10 rupees in 14 revisions.
Why does CPI overstate inflation?
● The key takeaway is that inflation as measured by CPI may
overstate the true increases in the cost of living by as much as
1-2 percentage points per year.
Reasons
● Difficulty in trying to measure the quality of goods. For
example if the design of an air conditioner is improved as that
puts out 10% more cold air without increased use of electricity,
then a 10% increase in the price of air conditioner should not be
considered inflation. If this improvement in quality is ignored
by statisticians simply the 10% increase in price is noted it will
be misrepresented as inflation.
● In case of services, by what percentage does the availability of
24 hour ATM cash machines improve the quality of banking
services?
● If improvements in the quality of goods and services are
ignored , inflation will be overstated and this overstatement is
called quality adjustment bias.
● CPI can also be a misleading indicator of an increase in the true
cost of living. For example if consumers consume both chicken
and turkey and prefer both equally. For some reason if the price
of chicken increases sharply, it leads the consumers to consume
turkey almost exclusively.Because consumers are equally
satisfied with consuming chicken and turkey the switch does
not necessarily make them worse off. However the official CPI
figure will register a marked increase in the cost of living,
ignoring the fact that consumers can and do substitute cheaper
goods for more expensive ones.This source of overstatement is
called the substitution bias.
Implications
● If the increase in cost of living is overstated then
increases in important quantities like real family income (
purchasing power) are understated as a result the bias in
CPI may produce a gloomy view of the economy.
● In the US, many government payments like the social
security benefits are tied to the CPI. Social security
benefits automatically increase when CPI increases. IF
CPI inflation overstates true inflation then social security
recipients have been receiving much greater benefit
increases than necessary to compensate them for
increases in the cost of living.
Interest rate
Real interest rate
Nominal interest rate
Expected rate of interest
