Prelims Capsule : Measuring Economic Growth – GDP et al (Part 2)

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Measuring Economic Growth – GDP et al (Part 2)

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Click here to Download Prelims Capsule PDF (7 March 2017)

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In the previous post, we saw some basics of the Macroeconomics. The most important metric of an economy is its growth. Only if there is economic growth the wealth is being created and is increasing.

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Economic Growth

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Economic Growth is change in the value of the goods and services produced in the economy or an increase in the capacity of an economy to produce goods and services, compared from one period of time to another.

How do we measure the growth? There are several indicators and methods to calculate the same.

The most accepted measure of all is that of GDP- Gross Domestic Product.

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Gross Domestic Product

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The Gross Domestic Product measures the value of economic activity within a country. Strictly defined, GDP is the sum total of the market values, or prices, of all final goods and services produced in an economy during a period of time.

There are, however, three important distinctions within this seemingly simple definition:

• GDP is a number that is calculated in local currency.
• GDP tries to capture all final goods and services as long as they are produced within the boundaries of the country, thereby assuring that the final monetary value of everything that is created in a country is represented in the GDP.
• GDP is calculated for a specific period of time, quarterly, half yearly or annually.

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Calculating GDP

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Now that we have an idea of what GDP is, let’s go over how to compute it. We know that in an economy, GDP is the monetary value of all final goods and services produced.

For example, let’s say India only produces Apples and Bananas.

In year 1 we produce 5 bananas that are worth Rs. 2 each and 6apples that are worth Rs. 15 each.

The GDP for the country in this year equals (quantity of bananas X price of bananas) + (quantity of apples X price of apples) or (5 X 2) + (6 X 15) = 100.

As more goods and services are produced, the equation increases. In general, GDP = (quantity of A X price of A) + (quantity of B X price of B) + (quantity of whatever X price of whatever) for every good and service produced within the country.

• The calculation of production of final goods and services at the current prices is called Nominal GDP
  • Nominal GDP can change from time to time because of two reasons:
    • changes in the physical volume of output or
    • changes in the prices at which output is valued
  • We want to use GDP to look at changes in the physical volume of output. Since Nominal GDP can also change due to changes in the prices at which output is valued it is necessary to “deflate” the value recorded for Nominal GDP (GDP with inflation) into “real” so we can make comparisons across years.
• • Real GDP can change only because of changes in the physical volume of output. As a result Real GDP is considered a better measure of economic growth than nominal GDP.
  • The calculation of Production of final goods and services valued at the base year prices which are referred to as constant prices is called Real GDP.
  • GDP Deflator = Nominal GDP / Real GDP

(Final goods and services is important here, counting intermediate goods would lead to the double counting and increases the value of the output)

Here in the given example we have only two products and two actors, the Apples and Bananas and producer and consumer; but in a complex economy there are Government levying taxes, producers wanting to export, and sellers looking for profit and several other factors.

Consider this figure.

• The calculation of GDP at the actually transacted prices is called GDP at Market Prices. (This would include the indirect taxes levied, subsidies provided)
• The calculation of GDP at the actual cost of production of goods and services and not the sale is GDP at Factor Cost (This wouldn’t include indirect taxes but will include subsidies provided for the production)There are three different ways of calculating GDP.
  • Expenditure Approach
  • Income approach
  • Output Approach

The small example given above is the Output Approach – which adds the market value of final goods and services. The method of calculation should ideally give the same results as the other two approaches too. But owing to the levels of inventory where goods would have been produced but not sold, there will be differences. There will also differences due to the sale and purchase of the second-hand goods and newly produced goods have to be counted for the GDP.

The macroeconomists use indirect ways, a standard set of categories to breakdown an economy into its major constituent parts in order to calculate GDP.

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Expenditure Approach

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• GDP is calculated by the sum of consumer spending, investment, government purchases, and net exports, as represented by the equation:
  • Y = C + I + G + NX;
• In this equation Y captures every segment of the national economy;Y represents both GDP and the national income. This because when money changes hands, it is expenditure for one party and income for the other, and Y, capturing all these values, thus represents the net of the entire economy.
• Consumer spending (C)is the sum of expenditures by households on durable goods, nondurable goods, and services.
• Investment (I) is the sum of expenditures on capital equipment, inventories, and structures.
• Government spending (G) is the sum of expenditures by all government bodies on goods and services.
• Net Export (NX) is the difference between exports and imports.

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Income Approach

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This approach calculates National Income, NI. NI is the sum of the following components:

• Labour Income (W)
• Rental Income (R)
• Interest Income (i)
• Profits (PR)

NI = W + R + i + PR

Labour Income (W): Salaries, wages, and fringe benefits such as health or retirement.

Rental Income (R): This is income received from property received by households. Royalties from patents, copyrights and assets as well as imputed rent are included.

Interest Income (i):Income received by households through the lending of their money to corporations and business firms. Government and household interest payments are not included in the national income.

Profits (PR): The amount firms have left after paying their rent, interest on debt, and employee compensation.

But this is calculating National Income, instead of GDP.

With the income approach, the GDP of a country is calculated as its national income plus its indirect business taxes and depreciation, as well as its net foreign factor income. To express the income approach formula to GDP as follows:

GDP= Total National Income + Indirect Taxes + Depreciation + Net Foreign Factor Income

(Sometimes inclusion of Indirect Taxes is controversial

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GDP vs. GNP

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•  GDP calculation involves accounting profit and not economic profit.
• GDP is just one way of measuring the total output of an economy.
• Gross National Product, or GNP, is another method. GDP, as said earlier, is the sum value of all goods and services produced within a country.
• GNP is the sum value of all goods and services produced by permanent residents of a country regardless of their location.
• The important distinction between GDP and GNP rests on differences in counting production by foreigners in a country and by nationals outside of a country.

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Concept of Depreciation:

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The machinery or the capital goods undergo wear and tear this is called depreciation. GDP means that depreciation is not subtracted. If the depreciation is subtracted from GDP it become Net Domestic Product.

NDP = GDP – Depreciation.

Similarly

NNP = GDP – Depreciation, and NNP is called the “National Income”

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Slowdown, Recession and Recession

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•  A general decline in the economic activity across the economy but still clocking a positive GDP albeit lower than previous quarters is called slowdown.
• A recession is a large decline in activity across the economy like in industrial production, employment, real income and wholesale-retail trade.
• The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country’s gross domestic product (GDP).
• A depression is a deep and long-lasting recession. While no specific criteria exist to declare a depression, unique features of the last U.S. depression, the Great Depression of the 1930s, included a GDP decline in excess of 10% and an unemployment rate that briefly touched 25%.

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Per Capita Income

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• Per capita GDP is a measure of GDPdivided by the Population.
• The per capita GDP is especially useful when comparing one country to another, because it shows the relative performance of the countries.
• A rise in per capita GDP signals growth in the economy and tends to reflect an increase in productivity

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Purchasing power Parity (PPP)

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•  However, when comparing with performance of other countries, we should also be adjusting it with the purchasing power to avoid the disparities of direct conversion
• The following micro-example can illustrate that point. Suppose it costs $10 to buy a shirt in the U.S. It costs Rs 350 to buy the same shirt in India. To make the correct comparison the Rs. 350 in India needs to be converted into U.S. dollars. If the exchange rate (70) was such that the shirt in India costs Rs 700, the PPP would be 350/700, or 1.5. For every $1.00 spent on the shirt in the U.S., it takes $0.50 to obtain the same shirt in India.
• The actual purchasing power of any currency is the quantity of that currency needed to buy a specified unit of a good or a basket of common goods and services. PPP is determined in each country based on its relative cost of living and inflation rates.
• Then, GDP are adjusted for relative purchasing power parity or PPP. This adjustment is based on an attempt to convert nominal GDP into a number more easily comparable between countries with different currencies

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How is GDP calculated in India?

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The Data Collection Process

• The Central Statistics Office (CSO), under the Ministry of Statistics and Program Implementation(MoSPI), is responsible for macroeconomic data gathering and statistical record keeping.
• Its processes involve conducting an annual survey of industries(ASI) and compilation of various indexes like the Index of Industrial Production (IIP), Consumer Price Index (CPI), etc.
• The CSO coordinates with various federal and state government agencies and departments to collect and compile the data required to calculate the GDP and other statistics.
  • For example, data points specific to manufacturing, crop yields, or commodities, which are used for the Wholesale Price Index (WPI) and CPI calculations, are gathered and calibrated by the Price Monitoring Cell in the Department of Consumer Affairs under the Ministry of Consumer Affairs.
• Similarly, production-related data used for calculating IIP is sourced from the Industrial Statistics Unit of the Department of Industrial Policy and Promotion under the Ministry of Commerce and Industry.
• All the required data points are collected and aggregated at the CSO and used to arrive at GDP numbers

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GDP Calculation Process

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•  The GDP in India is calculated using two different methods, leading to differing figures that are nonetheless close in range.
• The first method is based on economic activity (at factor cost), and the second is based on expenditure (at market prices). Further calculations are made to arrive at nominal GDP (using current market price) and real GDP (inflation-adjusted).
• Among the four released numbers, the GDP at factor cost is the most commonly followed figure and reported in the media.
• The factor cost figure is calculated by collecting data for the net change in value for each sector during a particular time period. The following eight industry sectors are considered in this cost:
  • Agriculture, forestry and fishing
  • Mining and quarrying;
  • Manufacturing;
  • Electricity, gas and water supply;
  • Construction;
  • Trade, hotels, transport and communication;
  • Financing, insurance, real estate and business services;
  • Community, social and personal services.
• The GDP numbers from the two methods may not match precisely, but they are close. The expenditure approach offers a good insight into which parts contribute most to the Indian economy.
• For example, domestic household consumption, which forms 59.5% of the economy, is the reason why India remains unaffected to a good extent by global slowdowns.
• Any economy with a high concentration on exports will be more susceptible to the effects of global recessions.

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Timelines

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•  Each quarter’s data are released with a lag of two months from the last working day of the quarter.
• Annual GDP data are released on May 31, with a lag of two months. (The financial year in India follows an April to March schedule.)
• The first figures released are quarterly estimates. As more and more accurate datasets become available, the calculated figures are revised to final numbers.
• Recently there is a controversy going in the media that numbers are fudged, this is nonsense or you can say politically motivated, there may be inadvertent errors in the methodology due to large informal sector in India but the forging of numbers is not an option because there will be another set of revised data released later on which can’t deviate largely from the advanced estimates.

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Challenges and Drawbacks in GDP metric

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•  While GDP is a convenient way to get an idea about the state of an economy, it is by no means a perfect approach. One criticism that has been levelled is that there is no accounting for activities that are not part of the legalized economy.
• Thus, parallel economy, informal economy, drug dealing and such illegal activities that generate a lot of income create hurdles in calculating the GDP.
• Another criticism is that some activities that provide value are not factored into GDP. For instance, if you hire a maid to keep your house clean, a cook to prepare your meals and a nanny to care for your children, you will pay these hired helpers and such payments factor into GDP.
• On the other hand, if you do your own cooking and cleaning and care for your children without hiring a nanny, these activities do not contribute to GDP. And although GDP provides an idea about an economy’s performance, it doesn’t necessarily reflect the welfare of its citizens since it doesn’t account for softer aspects such as their levels of happiness. (CARE ECONOMY)
• Presence of Barter trade in some parts of the rural areas, it keeps the GDP estimates at lower level than the actual.
• GDP doesn’t account for the economic cost of the production of goods and services, like the river pollution in Ganga done by the industries by the side. Climate change due to increasing CO2.
• GDP doesn’t reveal inequalities of rich and the poor, and disparities in the Gender.
• It doesn’t measure the sustainability of the growth.

Stay tuned, in the coming posts will discuss the alternatives to GDP and few other related concepts.

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