HAPTER 3 - quest.smar.inquest.smar.in/Downloads/CBSE/Class_XII/Material... · for in the computation of this measure. Gross Domestic Product : The Output Approach Gross Domestic Product

The structure of the macro economy hasbeen portrayed in the circular flow ofoutput and income as dealt with in theprevious chapter. This circular flowdepiction of macroeconomic activitiesprovides logical foundation for theconcepts and measurement of nationalincome aggregates. A strikingly uniquefeature of national income concepts isthat they are quantifiable and are notabstract ones. Hence, they render asmuch precision as feasible in thenational income statistics, given thelimitations in the estimation of nationalincome aggregates and in theconstruction of national incomeaccounts. There have been manyattempts in the past to evolve methodsof national income accounting and theseefforts have contributed to the systemthat we have at present. In this chapter,we shall present principal methods tomeasure national income aggregates. Itis pertinent at this juncture to remindourselves of an important observationmade in respect of the circular flow ofmacroeconomic activities. We have, inthat context, stated that the value of

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CHAPTER 3

aggregate output equals the value ofaggregate income, which in turn mustequal to the aggregate expenditure.Based on this, national incomemeasurement can be categorised intothree approaches : output or productapproach, income approach andexpenditure approach. All these must,in principle, yield the same result.

Measuring Gross Domestic ProductLet us first take up the measurementof the value of all that is produced inthe economy. This is expressed as GrossDomestic Product. Here, themeasurement procedure is actuallythree-fold. We use the product method,the income method and the expendituremethod to compute the Gross DomesticProduct. As this aggregate is held to bevery important for macroeconomicassessment, greater attention is calledfor in the computation of this measure.

Gross Domestic Product : The OutputApproach

Gross Domestic Product (GDP) is asummary statistic, which is widely usedby economists and policy analysts to

INTRODUCTORY MACROECONOMICS18

assess the rate of growth of an economyduring a year. GDP is generallyrecognised to be the primary measure.

GDP is defined as the market valueof all final goods and services producedby the factors of production located inthe country during a period of one year.A key phrase in this definition is ‘finalgoods and services’ which require someelaboration.

Final goods are those that are meantfor final use by consumers or firms. Thesegoods are not required to enter intofurther stages of production or resale tochange their form and content. They arefinished goods meant only for finalconsumption and investment.

Measurement of GDP includes onlythe aggregate value of final goods. Also,from a development perspective, thestrength of an economy is seen in itscapability of producing final goods andservices.

It may be useful at this stage to drawa distinction between final goods andintermediate goods. The latter are not

taken into account in the measurementof GDP.

Intermediate goods are thosegoods that are used to produce othergoods and therefore they always movefrom one stage of production to anotherin the manufacture of a final product.

Let us now show the differencebetween final and intermediate goods withthe example of producing an automobile.

The industrial process tomanufacture an automobile involvesmaterials such as steel, paint, rubber,foam, plastic, glass, cables, battery, etc.and a variety of component parts. Allthese items are produced by therespective firms only to be used in theproduction of another product; in ourexample it is the automobile. But oncethe process of producing an automobilestarts, all these are converted intointegral parts of an automobile. So,these goods are not important in theirown right; they are just a means to anend. Such goods are called intermediategoods. The automobile that is produced

Clip 3.1

PIONEERS IN NATIONAL INCOME ANALYSIS

In the contemporary world now, national income concepts and accounting methodsare widely recognised and applied to measure the economic performance of countries.However, these concepts and methods became popular only a few decades ago.

Simon Kuznets

A seminal contribution to the field of National Income andProduct Accounts (NIPA) made by Simon Kuznets (1901–1985)set the trend of using national income aggregates to measurethe direction of growth of economies. He was a great pioneer inthis field and due to his research efforts, the first nationalincome figures for the US economy was published in 1934 asan official document of the US Senate. This helped immenselyto understand the severe impact of the Great Depression in1929. His monumental book of two exhaustive volumes, NationalIncome and its Composition, 1919-1938 (New York; NBER, 1941)

NATIONAL INCOME ACCOUNTING : CONCEPTS AND MEASUREMENT 19

earned him the worldwide recognition. This was followed by two of his landmarkcontributions, namely, National Product since 1869 (New York; NBER, 1947) andEconomic Growth of Nations : Total Output and Production Structure (Cambridge Mt,Harvard University Press, 1971). For his contributions, Kuznets was honouredwith the Nobel Prize in 1971 in recognition of his empirical interpretation ofeconomic growth.

in the final stage of the assembly line isthe final good.

Hence, the rationale for not takinginto account the value of intermediategoods in the measure of GDP is to avoidthe problem of double counting. That

is, no product should be counted twoor more times. Double counting willonly exaggerate or over-estimate thevalue of GDP.

The procedure by which we eliminatethe values of intermediate goods from GDP

Among these, the most systematic work was that of V.K.R.V. Rao in his bookNational Income in British India 1931-32 (London; MacMillan 1940), which formedthe basis of national income estimation in the post-independence period. In1949, the Government of India formed the National Income Committee underthe Chairmanship of P.C. Mahalanobis, with V.K.R.V. Rao and D.R. Gadgil asmembers. From then onwards the national income estimation has been steadilystrengthened. Now, the Central Statistical Organization (CSO) is entrusted withthe task of publishing National Accounts Statistics (NAS).

Richard Stone

Another important contribution in this field is that ofRichard Stone (1913-1991). Stone worked with JohnMaynard Keynes as a research assistant. Stone during theearly 1940s prepared a statistical profile of the Britisheconomy. After the World War II, Stone headed a UnitedNations project to develop standard national incomeaccounting model.

In India, prior to 1947, the estimation of national incomewas attempted by individual economists and scholars forspecific years.

D.R. GadgilV.K.R.V. Rao P.C. Mahalanobis


is through the method of value added.This is discussed in the following section.

Concept and Measurement of ValueAdded

The concept of value added is very basicto the measure of GDP. Value-added isdefined as the difference between totalvalue of output of a firm and value ofinputs bought from other firms. It thusmeasures the value, which the firmconcerned has added by its processof production.

Most goods go through multiplestages of production. This means that

a good’s value increases at each stageuntil its final value is obtained in thelast stage. It follows therefore that thevalue of final good will have to be equalto the sum of the value-added at eachstage of production. This is shown witha numerical illustration in Table 3.1.

Consider the production and saleof a cake to the Household sector forfinal consumption. The process ofproduction starts with a farmer raisingwheat crop and harvesting it. Since weare starting with the stage of wheatcultivation, let us not go into thebackward production linkages of the

Table 3.1 : Numerical Illustration of GNP Measurementusing Value Added Method

Stage I Stage II Stage III Stage IV(Wheat) (Flour) (Cake at Bakery) (Cake at Retailer)

FarmerBlack’s Purchasesfrom other firms

None

Miller White’s Baker Brown’s Retailer Green’s

Value Added Rs. 1.00 Purchasesfrom Farmer

Rs. 1.00 Rs. 2.00

ValueAdded

Purchasesfrom Miller

Rs. 1.50 Purchasesfrom Baker

ValueAdded

Rs.0.50

ValueAdded

Rs. 0.50

Break-up ofvalue added

Value of Finalgood = Rs.2.50

Profit 0.20 + 0.25 – 0.40 + 0.28 = 0.33Wages 0.60 + 0.10 + 0.70 + 0.05 = 1.45Rent 0.05 + None + None + None = 0.05Interest 0.05 + 0.10 + 0.01 + 0.02 = 0.18Depreciation 0.02 + 0.02 + 0.09 + 0.07 = 0.20Property andsales taxes

0.08 + 0.03 + 0.10 + 0.08 = 0.29Sum of valueadded

Total (in Rs.) 1.00 + 0.50 0.50 0.50 2.50+ +

======

Rs. 0.50


farmer. Therefore, the farmer’s value-added in the cultivation stage will bejust the value of his output as such (thatis one rupee). In the second stage, themiller buys the wheat from the farmerand grinds it into flour, and sells it tothe baker for Rs.1.50. By this, he addsa value of 50 Paise. The baker makesthe cake and sells it to the retailer forRs. 2.00, thereby adding a value of 50paise. The retailer who buys the cakefrom the baker sells it to the finalconsumer for Rs. 2.50, thereby addinga value of 50 paise. This means that thevalue of the final good, namely, the cakeis Rs. 2.50 at the retail store. This finalvalue of the cake is the sum of the valueadded from the stage of cultivation tothat of retail sale at the shop, that is,total value added equals Rs.1.00 + 50Paise + 50 Paise + 50 Paise = Rs. 2.50.

On the other hand, if we hadincluded the value of all theintermediate stages, preceding the retailsale, cake’s value would have increasedmanifold, due to the problem of double- counting. That is, wheat would havebeen counted four times, floor threetimes and baked items twice. This is thereason why we take the final value ofthe output as a sum of all values addedin producing a good.

This procedure of value addedmethod demonstrated for an individualproduct is applied at the aggregate levelfor the measurement of GDP.

Concepts of Value Added(i) Value of output by a Firm = Sales +

Change in Stock(ii) Value Added = Value of output –

Intermediate goods cost

(iii) Net-value added at Market Price =Gross value added at Market price– Consumption of fixed capital(Depreciation)

(iv) Net-value added at Factor Cost =Net value added at Market Prices –Net indirect taxes (Net Indirect Taxes= Indirect Taxes – subsidies)

(v) Net value added at factor cost = TotalFactor IncomeNow, let us look into the

computation of value added as shownin the illustration below:Example 1: From the following datacalculate the value added by Firm A andFirm B.

(Rs. in Lakhs)(i) Closing stock of Firm A 20(ii) Closing stock of Firm B 15(iii) Opening stock of Firm A 5(iv) Opening stock of Firm B 10(v) Sales by Firm A 300(vi) Purchases by Firm A from 100

Firm B(vii) Purchases by Firm B from 80

Firm A(viii) Sales by Firm B 250(ix) Import of raw material 50

by Firm A(x) Exports by Firm B 30

As first step calculate the value ofoutput for each Firm. Then find thevalue added.Step 1. Value of output of Firm A

= Sales + Change in stock(Closing stock – Opening stock)= 300 + (20 – 5)= Rs. 315 lakhs

Step 2. Value added by Firm A= Value of output – purchases


from Firm B – imports byFirm A= 315 – 100 – 50= Rs. 165 lakhs

Repeat the same procedure for Firm B

Step 3. Value of output of Firm B= Sales + Change in stock(Closing stock – Opening stock)+ Exports by Firm B= 250 + (15 – 10) + 30= Rs. 285 lakhs

Step 4. Value added by Firm B= Value of output – purchasesfrom Firm A= 285 – 80= Rs. 205 lakhs

Gross Domestic Product : As Sum ofExpenditure

GDP can be measured by taking intoaccount all final expenditures in theeconomy. There are three distinct typesof expenditure as they are committedby Households, Firms and Governmentrespectively. These expenditures areclassified into following types :

(i) Private Consumption (C)Expenditure

(ii) Investment Expenditure (I)

(iii) Government Purchases of (G)Goods and Services

(iv) Net Exports (X – M)

Let us discuss these items of finalexpenditures with respect to the sectorsconcerned.

(i) Private Consumption expenditure

The private consumption component ofGDP measures the money value of

goods and services that are purchasedby households and non-profitinstitutions for current use during atime period. Considering the fact thatconsumption expenditure is asignificant part of GDP, it requiresspecial attention by economists andgovernment. Private consumption is thedemand for consumer goods andservices. While goods are tangibles,(that is, you can see a car) the servicesare intangibles (that is, you cannot seea service such as car insurance).Further in the case of goods,consumption or use of a good can beseparated from the place of itsproduction and can be separated intime, that you can consume or use agood at your convenient place or time.But services should necessarily be usedat the time and place in which they areproduced. For instance, banking servicewill take place at the place and timespecified by the banker and customersutilise their banking facilities accordingly.

Consumption can be divided intothree sub-categories such as,consumer services, consumer non-durable goods and consumer durablegoods. Non-durable goods are used upimmediately or within a short span oftime. Durable goods in contrast couldbe used for a longer period of time.Food items are non-durableconsumption goods whereas furniture,stereo equipment, washing machinesare durable consumption goods. Butusually this distinction is based onlyon the given length of time within whichconsumer goods are used. Durabilitydoes not imply a state of permanence.


Durable goods also have their limitedperiod of use value, after which they aregiven up. Private final consumption willinclude expenditure on all these threecategories mentioned here.

(ii) Investment

Investment is an addition to the stock ofcapital during a period. The GrossPrivate Domestic Investment shows theaggregate value in this regard. Unlikethe intermediate goods which are usedup entirely in the process of makingother goods, capital is only partiallydepleted in making other goods. Thatis, a steel mill may have a useful life ofsay, 50 years. In providing steel in anyone year, only a small portion (1/50th)of the mill is used. This using up ofcapital is called depreciation.Depreciation is the value of the existingcapital stock that has been consumedor used up in the process of producingoutput. Usually an asset is depreciatedat a predetermined rate and monetaryvalue is assigned to the rate ofdepreciation of a physical asset inone year. This is also described ascapital consumption allowance1. Wheninvestment is expressed as GrossInvestment or Net Investment it meanswhether investment has or has not beenadjusted against depreciation. Grossterm includes depreciation while Netterm is obtained after deducting thedepreciation amount.

Investment component could beclassified under four categories : they are(a) Business fixed investment

(b) Inventory investment(c) Residential construction investment(d) Public investment

(a) Business Fixed Investment (BFI) isthe amount spent by business units onpurchase of newly produced plant andequipment. The two measures of BFI areGross Business Fixed Investment (GBFI)and Net Business Fixed Investment(NBFI). Gross Business Fixed investmentis the gross amount spent on newlyprovided plant and equipment, that is,capital goods. If depreciation isdeducted from it, then we obtain NetBusiness Fixed Investment.

The inclusion of capital goods in thefinal product along with the goods andservices produced by them wouldinvolve double counting. For this reasonit is important to make provision fordepreciation. If in every year we deductfrom investment (and therefore fromdomestic product) the amount by whichcapital stock has been used up over theyear, then over the whole lifespan of thecapital good, we will have deductedfrom the domestic product the wholevalue of the capital good. In this waywe will have avoided counting in thedomestic product both the asset andthe goods produced by it and so shallhave avoided double counting. BFI isusually the result of a consciousdecision by firms to augment theirproductive capacity.

(b) Inventory Investment is the netchange in inventories of final goods

1 The usage of fixed assets lead to their wear and tear; so, we must provide for consumption offixed capital as a prerequisite in accounting the product.


awaiting sale, semi-finished goods, orof materials used in the productionprocess (inputs). These must beincluded since they represent currentlyproduced output not included in thecurrent sales of final output.

Changes in inventory are usuallythe result of unintentional short rundeviations between supply anddemand. Stock changes play a crucialrole in income determination. Forexample, if there is a sudden doublingof the demand for television sets, it isunlikely that the production of them willalso double overnight. So, the first effectof the increase in demand relative tosupply will be a fall in the inventory oftelevision sets normally held in theeconomy (inventory that is held by theproducer, wholesaler or retailer), in theattempt to satisfy the sudden increasein demand. This process will continueuntil production is augmented tomatch the increased demand.Conversely, a sudden fall in demand willlead to a rise in inventories of televisionsets until production adjusts itself tothe lower level of demand.

(c) Residential Construction Investmentis the account spent on the building ofhousing units. This is also expressedin terms of either gross or net dependingon whether depreciation has beensubtracted or not.

(d) Public Investment includes allcapital formation carried out by thegovernment such as building of roads,hospitals, schools etc. This is also givenin gross or net value depending onwhether depreciation has beensubtracted or not.

Now the investment component asa whole can be thought of in thefollowing two ways :

Gross Investment = Gross BusinessFixed Investment + Gross ResidentialConstruction Investment + Gross PublicInvestment + Inventory Investment

Net Investment = Net Business FixedInvestment + Net ResidentialConstruction Investment + Net PublicInvestment + Inventory Investment

As pointed out earlier, the differencebetween gross investment and netinvestment is depreciation.

(iii) Government Purchases ofGoods and Services

This component summarises thegovernment spending on goods andservices. Remember that governmentpurchases is a proxy measure forgovernment output.

As a matter of fact, governmentpurchases from private producerswould be intermediate goods andgovernment wages and salaries wouldbe part of the income side of thenational accounts. Instead of doing thiswe take the government purchases aspart of the final product.

In the above we have understoodgovernment as a producer of goods andservices. This is an important functionof the government. At the same time weshould also be aware of another functionof government – that is, makingpayments to certain categories of peopleor firms to compensate them as a matterof its social obligation. This is calledGovernment Transfers, which refer to the


total value of payments made bygovernment sector towards householdsand firms as income supplements andsubsidies respectively. This is also knownas Transfer Payments, and they are notcounted in the GDP because there is noproduction of goods due to them.Transfer Payments are basically welfare-oriented expenditures of theGovernment.

(iv) Net Exports

This is the difference between Exports (X)and Imports (M) of a country, that is(X – M).

Based on the expenditure flowsin the economy, Gross DomesticProduct is the total value of the sumof consumption and investmentexpenditure along with governmentpurchases and net exports.

In other wordsGDP = C + I + G + (X – M)

Where,C = Consumption expenditure by

households

I = Investment expenditure by firms

G = Government purchases of goodsand services.

X-M = Net Exports.

Gross Domestic Product : A Measureof Income

The third approach to the measurementof GDP is to compute it by addition of allfactor incomes generated in theproduction of goods and services.Because each rupee of goods andservices produced is matched by a rupeeof income, we can arrive at the samefigure for GDP on the income side as we

did on the product side. While measuringGDP we must include only those incomeflows that originate with the productionof the goods and services within theparticular time period.

The components of factor income are:

1. Employee compensation2. Profits

3. Rent

4. Interest

5. Mixed income

Now let us look into the details ofeach one of these.

1. Employee Compensation

Compensation to employees in the formof wages, salaries and benefits makesup the largest single component ofincome generated with production ofGDP. Wages and salaries are payablein cash, kind or both.

2. Profits

Profits are the reward the owners offirms receive for being in business.Firms’ desire to earn profits is the mainmotivating force behind production ina market economy.

3. RentRental income is, for example, incomeearned by owners of rental housing. Themeaning of rent in the national incomeaccounts is that it is a charge for thetemporary use of some capital asset.4. InterestHouseholds both receive and payinterest. We include in GDP only the netinterest, that is the difference betweeninterest amount paid and the interestincome received by households.


5. Mixed Income

Mixed income will include the income ofown account workers and profits anddividends of unincorporated enterprises.In other words, it may be called as mixedincome of the self employed.

All the above mentioned componentsof income measure of the GDP have animportant implication for the economyas such. Their relative share in GDPshows the manner in which each ofthese income flows changes overtime.

It is possible to show by way of anillustration as to how the sum of valueadded is equal to the total of the abovetypes of income earned during theprocess of production. This is shownin Table 3.1

GDP as measured by theaggregation of factor incomes is alsocalled as Gross Domestic Income (GDI).

Gross National Product

After getting GDP we can add Net FactorIncome from abroad to estimate thevalue of Gross National Product (GNP).How is Net Factor Income from Abroaddefined? What are included in it?

Net Factor Income from Abroad isthe difference between the factor incomereceived from the rest of the world, i.e.abroad for rendering factor services, andthe income paid for factor servicesrendered by non-residents inside thedomestic territory of the country. As weknow that factor incomes includecompensation to employees and incomefrom property and entrepreneurship,then Net Factor Income from abroad isthe difference with respect to these itemsreceived by residents abroad and given

to non-residents working in thedomestic territory during a givenaccounting year. Hence, the componentsof Net Factor Income from abroad are :

(i) Net compensation to employees(ii) Net income from property and

entrepreneurship, which includesrent, interest, dividends, etc.

(iii) Net retained earnings of residentcompanies abroad

Hence,

Gross Domestic Product + Net FactorIncome from abroad = Gross NationalProduct

Now we may distinguish betweenGross National Product and GrossDomestic Product. The differencebetween the two arises from Net FactorIncome from Abroad. Note that the(X – M) component of GDP representsonly goods and services other thanfactor incomes.

Real and Nominal GNP

Having presented the measurement ofGNP it remains to be seen as how thechanges in the GNP value are expressedin relation to price level changes as pricechanges affect the value of the nationalincome aggregates. For this we mustexplain the two ways of computingnational income data at current marketprices and constant prices.

Current Market Prices

If the GNP (or any other relatedaggregates) is measured in terms ofcurrent market prices, then it is referredto as Nominal GNP. Since the nominalGNP measures the value of currentlyproduced goods and services at market


prices, GNP will change when either theoverall price level changes or when theactual volume of production changesor when both change simultaneously.

Constant Prices

However, for certain purposes we maywant to have a measure of output thatchanges only when the quantity of goodsproduced changes. This measure of onlyquantity change, not prices, is the methodof using constant prices. Accordingly,GNP that is computed at constant priceswill be called the Real GNP. Usually,under this method GNP value isexpressed in terms of prices prevailing ina year chosen to be the base year.

Real GNP has the followingadvantages:(a) It is useful in finding out the effect of

increased production of goods andservices on the real developmentcapacity of the economy in general.But the nominal GNP cannot showthis as we cannot segregate thechange in output alone, since, thecurrent market prices in terms ofwhich it is measured prevent suchan exercise;

(b) Real GNP also enables one to makea year-to-year comparison of thechanges in the growth of output ofgoods and services. An expansionphase of the economy is a period ofrising real GNP. On the contrary arecession is a period in which realGNP falls consecutively; and

(c) Real GNP is also often used inmaking international comparisonsof economic performance across thecountries.Having explained the concepts of

Nominal and Real GNP, let us proceedto know the method by which we obtainthe value of Real GNP through theconstant prices.

The purpose of using constantprices is to eliminate the effect of pricechanges. For this, we are supposed toexpress the value of current year’s GNP(Nominal GNP) in terms of pricesprevailing during a reference year in thepast, which is called the Base year. Thatis, the account for the value of currentyear’s GNP as if the price level is sameas that of the base year. As you may beaware that the price level is usuallymeasured by the Wholesale Price Indexor the Consumer Price Index Number.2

If the GNP in the current year isvalued at current market prices, it willnot be possible for us to find out howmuch of the increase in GNP is due toincrease in prices (inflation) and howmuch of the increase is due to anincrease in the production of goods andservices. To know whether GNPincrease actually means an increase inthe output of goods and services, wemust eliminate the effect of priceincreases.

We shall explain, through thefollowing illustration, the calculation of

2 An index number is a representative number to decode the changes in price level. The consumerprice index number is used to represent the average change over time in the prices paid by thefinal consumer of a specified group of goods or services.


nominal GNP and real GNP as well asGNP deflator (Table 3.2).

Let us assume that our imaginaryeconomy has only three final goods :

Oranges - Consumption good

Computers - Capital goodand Government purchases of cloth.

Let us take up the calculationof nominal GNP through theexpenditure approach. Let us thereforefind out the expenditure on each goodand obtain the total expenditure atcurrent prices.

Consumption expenditure (oranges)is Rs. 4452, investment (computers) is

Table 3.2: Nominal GNP, Real GNP and the GNP Deflator

Current Period Base Period

Item Quantity Price Expenditure Price Expenditure(Rs) (Rs) (Rs) (Rs)

Oranges 4,240 Kgs. 1.05 per kg. 4,452 1 per Kg 4,240Computers 5 2100 each 10,500 2000 each 10,000Government 1,060 1 per 1,060 1 per meter 1,060Purchases meters meterof Cloth

Nominal GNP 16,012 Real GNP 15,300

Deflators for the current period

104.7100Rs.15300

Rs.16012

GNPReal

100GNPNominalDeflatorGNP =×=

×=

Consumption Expenditure Deflator

105.0100

Rs.4240

4452Rs.100

eexpenditurnconsumptioperiodBase

eexpenditurnconsumptioperiodCurrent

=×=×=

105.0100Rs.10000

05001Rs.100

investment period Base

investmentperiodCurrentDeflatorInvestment =×=×=

100.0100Rs.1060

0601Rs.100

urchasespGovernment period Base

urchasespGovernmentperiodCurrent

PurchasesGovernment =×=×=


GNPMP

(-)net in

come from

abroa

d

(–) net indirect taxes




GDPMPGNP

FC

(–)net in

come

from a

broa

d

GDPFC

-depreciation

(-)depreciation

(–)depreciation

NNPFC

NDPFC

NNPMP

(–)net in

come

from a

broa

d

NDPMP

(–)net in

come

from a

broa

d

(-) depreciation

Rs. 10,500, and government expenditureis Rs. 1,060, so the nominal GNP is Rs.16012.

Now, let us calculate real GNP. Thisis, as mentioned before, calculated byvaluing the current period quantities atthe base period prices. Accordingly, theconsumption expenditure is Rs. 4240,investment is Rs.10,000 and governmentexpenditure is Rs.1,060. So the realGNP is Rs.15,300.

Finally, the concept of GNP deflatorrequires explanation. The GNP deflator

measures the average level of the prices ofall the goods and services that make upGNP. It is calculated as the ratio of nominalGNP to real GNP, multiplied by 100.

In the above example, we dividenominal GNP (Rs.16,012) by real GNP(Rs. 15,300) and multiply the results by100. We obtain GNP deflator as 104.7.

It is also possible to calculatedeflator for specific expenditures as wewould like to know the real value ofthese expenditures. This is also shownin Table 3.2.

Fig 3.1: Relationships between Different aggregates of National Income3

3 Wilfred Beckerman, An Introduction to National Income Analysis, 3rd Edition, Universal BookStall, New Delhi, 1999.


Important National AccountsAggregates

Gross National Product is the coreconcept of national income accounting.From this several other measures arederived, each having its specific purposeto interpret the performance of a giveneconomy. All these concepts andmeasures are interrelated which isshown in Figure 3.1. From this, we mayobserve eight major national accountsconcepts as given below and they maybe derived following the direction givenin the diagram.

1. GNP at Market Prices (GNPMP

)4 =Value of all the final goods andservices produced in the economy+ Net Factor Income from Abroad

2. NNP at Market Prices (NNPMP) =GNPMP –Depreciation

3. GDP at Market Prices (GDPMP

) =GNPMP – Net Factor Income fromAbroad

4. NDP at Market Prices (NDPMP

) =GDPMP – Depreciation

5. GNP at Factor Cost (GNPFC) = GDPMP

+ Net Factor Income from Abroad –Net Indirect taxes

6. NNP at Factor Cost (NNPFC

) =GNP

FC – Depreciation

7. GDP at Factor Cost (GDPFC) = GDPMP

– Net Indirect taxes

8. NDP at Factor Cost (NDPFC)= GDPFC

– Depreciation

National5 Disposable Income

In addition to the above, we may alsoinclude the concept of NationalDisposable Income. National DisposableIncome is the income from all sources tothe residents of a nation for spending onconsumption as well as saving during ayear. It is given by the following :

National Disposable Income= NNPMP + Other Current Transfersfrom the rest of the world6

This is the maximum available incomefor a country. National DisposableIncome for a country is what thePersonal Disposable Income (PersonalIncome – Personal Taxes) is for anindividual.

4 A particular value may be expressed at Market Prices or at Factor Cost. If a quantity is expressedin terms of its current prices it is referred to as market price. Suppose the total value added iscomputed on the basis of current prices of inputs then we may call this as value added at MarketPrices. On the other hand, if the value added is arrived at by adding the payments to factors(land, labour, capital and entrepreneurship) such as rent, wages, interest and profit, (as wasdone in Table 3.1) then it is described as value added at Factor Cost. In the same manner, all theconcepts of national income may be shown either at market prices or at factor costs.

5 It may be necessary to give the meaning of ‘Domestic’ and ‘National’ used in National Incomeaggregates. Domestic here simply means ‘domestic territory’. So, domestic product would implythe value of all goods and services produced by the normal residents of a country. ‘National’refers to the addition of the net factor income from abroad to the domestic product.

6 Current transfers from the rest of the world may include gifts, cash, consumer goods and evenmilitary equipment.


The above definitions may beunderstood as general principles of howthese measures are conceptualised. Inpractice each country follows its ownmethod of compilation and hencedefinition of specific items, whichconstitute an aggregate measure, willbe different from others. In India, thenational accounts are prepared inaccordance with System of NationalAccounts (SNA) since 1975.Subsequently, there has been asignificant improvement in thestatistical statements in terms ofdatabase and coverage. Presently theSNA 1993 is being used.

Concepts of National Product andNational Income: A Summary

GNPMP = Value of all final goods andservices produced in theeconomy+Net factor incomefrom abroad

NNPMp

= GNPMp

– DepreciationGDPMp = GNPMp – Net factor income

from abroadNDP

Mp= GDP

Mp – Depreciation

GNPFc = GNPMp – Net indirect taxesNNPFc = GNPFc – Depreciation =

National incomeGDPFc = GDPMp – Net indirect taxesNDPFc = GDPFc – Depreciation

Three Methods of Measurement ofNational Product

(i) Expenditure MethodGNPMp = Personal consumptionexpenditure + Gross Investment(Gross business fixed investment +Inventory investment + Grossresidential construction investment+ Gross public investment) +

Government purchases of goods andservices + Net exports (Exports – imports)+ Net factor income from abroad.

(ii) Income MethodGNPMp = Employee compensation(wages and salaries + employers’contribution towards socialsecurity schemes) + profits + rent +interest + mixed income +depreciation + net indirect taxes(Indirect taxes – Subsidies) + Netfactor income from abroad.

(iii) Value Added MethodGNPMp = (Value of output in primarysector – intermediate consumptionof primary sector) + (value of outputin secondary sector – intermediateconsumption of secondary sector)+ (value of output in tertiary sector– intermediate consumption oftertiary sector) + Net factor incomefrom aboard.

The following numerical examples willhelp us to understand various nationalincome aggregates.Example 1: From the following datacalculate the Gross National Product atMarket Price through the ExpenditureMethod

(Rs. in crores) i. Inventory Investment 10 ii. Exports 20 iii. Net factor income from abroad (–5) iv. Personal consumption 350

expenditure v. Gross residential 30

construction investment vi. Government purchases of

goods and services 100 vii. Gross public investment 20viii. Gross business fixed 30

investment ix. Imports 10


Solution:

GNPMp =Personal consumption = 350expenditure+ Gross Investment = 90which include:

Gross Business Fixed = 30InvestmentGross Residential = 30Construction InvestmentGross public Investment = 20Inventory Investment = 10

+ Government purchases of = 100goods and services+ Net exports = 10which include:

Exports = 20Imports = 10

+Net Factor Income From Abroad = –5GNPMp = 545

So, GNPMp is Rs. 545 crores.Example 2: From the following datacalculate the Gross National Product atMarket Price via the Income method

(Rs. in crores) i. Wages and Salaries 700 ii. Rent 100 iii. Depreciation 50 iv. Net factor income from abroad –10 v. Mixed income 400 vi. Subsidies 100 vii. Profits 400viii. Indirect taxes 300 ix. Employers contribution 50

to social security schemes x. Interest 40

Solution:Employee Compensation whichinclude = 750

Wages & Salaries = 700Employers’ contribution to = 50social security schemes+ Profits = 400+ Rent = 100+ Interest = 40

+ Mixed Income = 400+ Depreciation = 50+ Net Indirect taxes which = 200includeIndirect taxes = 300Subsidies = 100

+ Net Factor Income from Abroad = –10GNP

Mp=1930.

So the GNPMp is Rs.1930 crores

Example 3: From the following datacalculate the Gross National Product atMarket Price via the Value Added method

(Rs. in croroes) i. Value of output in primary 1,000

sector ii. Net factor income from abroad –20 iii. Value of output in tertiary sector 700 iv. Intermediate consumption 400

in secondary sector v. Value of output in secondary 900

sector vi. Intermediate consumption in 500

primary sector vii. Intermediate consumption in 300

tertiary sector

Solution:Value of output in primary sector = 1,000– Intermediate consumption of primary sector = 500+ Value of output in secondary = 900 sector– Intermediate consumption in = 400 secondary sector+ Value of output in tertiary = 700 sector– Intermediate consumption = 300 of tertiary sector+ Net factor income from abroad = –20GNPMP = 1380So, GNPMp is Rs. 1380 crores.


Example 4: From the following datacalculate the GNP, GDP, NNP, NDP at bothfactor cost and market prices.

(Rs. in crores) i. Gross Investment 90 ii. Net exports 10 iii. Net indirect taxes 5 iv. Depreciation 15 v. Net factor income from abroad –5 vi. Personal consumption 350

expenditurevii. Government purchases of 100

goods and services

Solution:

a) GNPMP =Personal consumption expenditure = 350+ Gross investment = 90+ Government purchases of = 100 goods and services+ Net exports = 10+ Net factor income from abroad = –5

GNPMP = 545

So, GNPMP is Rs. 545 croresb) NNPMP = GNPMP – Depreciation

= 545 – 15 = 530So, NNPMP = Rs. 530 croresc) GDPMP = GNPMP – Net Factor

Income from Abroad= 545 – (–5) = 545 + 5= 550

So, GDPMP = Rs. 550 croresd) NDPMP = GDPMP – Depreciation

= 550 – 15 = 535So, NDPMP = Rs. 535 crorese) GNPFC = GNPMp – Net indirect

taxes= 545 – 5 = 540

So, GNPFC = Rs. 540 croresf) NNPFC = GNPFC – Depreciation

= 540 – 15 = 525So, NNPFC = Rs. 525 croresg) GDPFC = GDPMp – Net indirect

taxes= 550 – 5 = 545

So, GDPFC = Rs. 545 croresh) NDP

FC= GDP

FC –

Depreciation

= 545 – 15 = 530So, NDP

FC= Rs. 530 crores

Items that are Excluded from GNPMeasurement

It may be recalled that GNP is themeasure of the value of the final goodsand services produced in one year. Butin reality many transactions occur inthe economy that have either nothingto do with the final goods and servicesproduced or that they are non-marketactivities or illegal activities whosemeasurement has its own limitations,both conceptual and empirical. We shallnow enumerate a few of thesetransactions that are excluded in theestimation of GNP.1. Purely Financial TransactionsThere are three generate types of purelyfinancial transactions. They are(a) Buying and Selling of securities(b) Government Transfer Payments(c) Private Transfer Payments

Now, let us examine thesetransactions in detail.

(a) Buying and selling of securities

In the financial markets as shownearlier in circular flow model, potentialsavers and investors buy and sellfinancial assets such as shares andbonds. While someone buys a sharethere is only a transfer of ownershipright. It is a claim to ownership of assets.In the case of bonds, it isacknowledging a debt transaction.There is no production activity but onlyexchange of funds for financial claims.Trading in financial instruments does


not imply production of final goods andservices. As such these are not includedin the GNP.

(b) Government Transfer Payments

As defined earlier, transfer paymentsare payments for which no goods orservices are provided in exchange.Pension payments, Employees’ socialsecurity measures, adhoc assistancedue to certain exigencies like floods,drought, etc. and subsidies areexamples for government transferpayments. As there is no production offinal goods and services in response totransfer payments, the transferpayments are not included in the GNP.

(c) Private Transfer Payments

Items such as pocket money given byparents to their children, elders giftingmoney to the young ones are privatetransfer payments. This is merely atransfer of money from one individualto another. Hence this is also notincluded in the GNP.

2. Transfer of Used Goods

GNP refers to the value of the final goodsand services produced in a given year.Hence, goods produced in the previoustime period cannot be included in theGNP. For instance, when a person buysa used car, it cannot be recognized inGNP measurement as the car wasproduced in an earlier year. Spendingon a used car simply reflects a change inthe ownership of a pre-existing output.

3. Non-market Goods and ServicesMany final goods and services are notacquired through regular market

transaction – vegetables can be grownin the backyard instead of bought inthe super market, or an electrical faultcan be repaired by the house ownerhimself or herself instead of hiring anelectrician. These are examples of non-marketed goods and services that havebeen consumed without usingorganised markets. But GNP includesonly those transactions that occurthrough market activities. Bartertransactions and production for self-consumption by household are notincluded in the GNP. It is in this context,there is a debate as to whetherhousewives services should be includedor not. If so, how do we value theirservices at current market prices?

4. Illegal Activities

GNP does not include trade in illegalgoods and services even though theyare final products and are purchasedin market transactions. Activities suchas smuggling, gambling, crime for hire,drug trafficking, illegal arms sale aresome cases in point.

These illegal activities create an‘underground economy’ wherein‘production’ is unreported orunaccounted either because it isunlawful or those involved want toevade the government tax-net. As aresult these illegal and concealedtransactions create a huge volume ofunaccounted money that is popularlycalled the black money. Black moneyis the main driving force ofunderground economy or “paralleleconomy”. As in the case of non-marketgoods, it is difficult to fix exact market


value for transactions in theunderground economy. Technically, asper the law of the land, these activitiesare classified under economic offenses.Hence their exclusion from GNP.

5. The Value of LeisureLeisure is regarded as an economicgood. It may be that, other things beingequal, more leisure is better than lessleisure. When the levels of incomeincrease, the resultant state of affluencewould induce people to prefer moreleisure than less of it. This means thatwith higher economic security the richersegment of our society would cut downtheir work effort, which in turn meansproducing less GNP. But that would notimply or suggest that people becomeworse off than before. In fact, choice ofmore leisure is simply an increase inutility. However, it would be verydifficult to measure the intangible itemlike leisure and include it in the GNP.

Nevertheless, in a modern economy,there is wide range of businessopportunities to provide for leisure timeactivities. So, though leisure as suchcannot be measured, the servicesprovided by the business sector tocapture the demand for leisure-timeactivities could be brought under finalservices for inclusion in the GNP.Leisure-time activities are in greatdemand from the middle and richerclasses of society.

However, leisure per se cannot bebrought within the treatment of nationalaccounts mainly because there is novaluation possible and imputing valueis both difficult and not useful for anyanalysis.

Does GNP Measure EconomicWelfare?For a very long period of timeeconomists have used GNP quiteuncritically as the principal measure ofeconomic growth and development.Maximisation of national income wastaken synonymous with maximisationof growth; hence rising GNP is good anddeclining GNP is bad for the economy.But a whole range of questionsconcerning it are being raised thesedays. They are such as, what is or oughtto be growth? What happens todistribution of income and wealth withan increase of GNP? What does anincreasing GNP do to the use of non-renewable natural resources? Is therea necessary association betweenincrease in national income andnational welfare? Can the increase innational income accomplish goodquality of life and human development?All these and other questions have beenresearched into in the recent past andat present GNP measure is under closescrutiny by economists and policymakers. In recent times more and moreeconomists have shown keen interest tocritically look at GNP as the indicator ofgrowth and development of a nation.

Measurement of GNP is subject tothe rules of national income accounting.These rules may rigidly classifyproduction activities to be included inor excluded from GNP. Hence GNP as astatistic can be misleading as the basisof overall development of an economy.Therefore, the main question that needsto be discussed is : Does the GNPmeasure economic welfare?


J.R. Hicks once wrote that, “Thepurpose of income calculation... is togive people an indication of theamount they can consume withoutimpoverishing themselves”7.

In the contemporary economies,particularly in the developingcountries, we are confronted with theserious issue of inequality in theincome distribution, environmentaldegradation, and deterioration in thequality of life. All these and relatedproblems have not only introducedgaps between different classes of peoplein terms of their social and economicstatus but also between nations,involving categorisation such asdeveloped, developing, less developedand least developed countries.

It is beyond the scope of thischapter to probe into the developmentdebates over the questions narratedabove. Suffice it to say that increase in

7 J.R.Hicks, Value and Capital, Oxford University Press, 1975, Page 172.

GNP as the sole objective of developmentwill be counter productive. It isimportant to test whether growth inGNP results in equitable distribution ofincome, sustainable development andgood quality of life for people. Theprocess of development must createsustainable societies withoutendangering the natural resources andecological systems.

Therefore, attempts to enhance GNPat any cost may create economic ‘bads’such as poverty and pollution. Thisrequires an alternate measure, whichwould allow GNP to measure humanwelfare. Some economists have suggestedthe concept of “green” GNP. Such a ‘greenGNP’ would help attain a sustainable useof the natural environment and equitabledistribution of the benefits ofdevelopment. It may be useful to debatethese issues related to GNP.

SUMMARY

� Circular flow of income forms the basis for measurement of macroeconomicactivities.

� Product approach, Income approach and Expenditure approach are threeways in which Gross National Product can be measured.

� In the product approach, only the final goods and services are included tofacilitate the aggregation of the value added by the producing units.

� Income approach is concerned with summation of factor incomes which inturn must equal to total value added. Hence product is also income innational accounts.

� Aggregate expenditure is obtained by adding all expenditures onconsumption, investment and government purchases of goods and services.

� Real GNP and Nominal GNP are outlined by taking the value of nationalproduct at constant prices and current prices respectively.

� GNP deflator is used to measure the average level of the prices of all goodsand services.

� Purely financial transactions, government and private transfers, used goods,illegal activities, non-market goods, etc. do not get included in the GNP.


EXERCISES

Section I

1. Define:(i) GNP at market prices(ii) NNP at market prices(iii) GNP at factor cost(iv) NNP at factor cost.

2. Define the concept of value added.3. Show how the sum of value added is equal to sum of factor incomes.4. What is the difference between final good and intermediate good?5. What is depreciation?6. What are the components of aggregate expenditure?7. What are factor incomes?8. What is meant by double counting? Why should it be avoided?9. What are transfer payments?

10. Explain the meaning of non-market activities.11. What is called ‘Green GNP’?12. Differentiate between national income at current price and constant

price.13. Define: (a) Nominal GNP and (b) Real GNP14. What is a GNP deflator?15. Give reasons for not including leisure in GNP.

Section II

16. Explain product and income approaches to measure national income.17. Explain the value-added method with the help of an example.18. What are the items that are excluded from GNP? Give reasons.19. Does GNP measure national welfare?20. Explain the components of factor income.21. Explain the following terms:

(a) Business fixed investment(b) Inventory investment(c) Residential construction investment(d) Public investment.

Section III

22. Calculate the value added by Firm A and Firm B from the followingdata:

(Rs. in lakhs)

(i) Purchase by Firm A from the Rest of the world 30(ii) Sales by Firm B 90(iii) Purchases by Firm A from Firm B 50


(iv) Sales by Firm A 110(v) Exports by Firm A 30(vi) Opening stock of Firm A 35(vii) Closing stock of Firm A 20(viii) Opening stock of Firm B 30(ix) Closing stock of Firm B 20(x) Purchases by Firm B from Firm A 50

23. Calculate value added by Firm X and Firm Y from the following data:(Rs. in lakhs)

(i) Sales by Firm X 100(ii) Sales by Firm Y 500(iii) Purchases by households from Firm Y 300(iv) Exports by Firm Y 50(v) Change in stock of Firm X 20(vi) Change in stock of Firm Y 10(vii) Imports by Firm X 70(viii) Sales by Firm X to Firm Y 250(ix) Purchases by Firm Y from X 200

24. From the following data calculate the Net National Product at MarketPrices by (a) Expenditure Method (b) Income Method:

(Rs. in Crores)(i) Personal consumption expenditure 700(ii) Wages and salaries 700(iii) Employers contribution to social security schemes 100(iv) Gross Business fixed investment 60(v) Gross Residential construction investment 60(vi) Gross public investment 40(vii) Inventory investment 20(viii) Profits 100(ix) Government purchases of goods and services 200(x) Rent 50(xi) Exports 40(xii) Imports 20(xiii) Interest 20(xiv) Mixed income 100(xv) Net factor income from abroad –10(xvi) Depreciation 20(xvii) Subsidies 10(xviii) Indirect taxes 20

25. From the following data calculate the Gross Domestic Product at FactorCost by (a) Expenditure Method (b) Income Method:

(Rs. in Crores)(i) Personal consumption expenditure 700(ii) Wages and salaries 700


(iii) Employers’ contribution to social security schemes 100(iv) Gross business fixed investment 60(v) Profits 100(vi) Gross residential construction investment 60(vii) Government purchases of goods and services 200(viii) Gross public investment 40(ix) Rent 50(x) Inventory investment 20(xi) Exports 40(xii) Interest 20(xiii) Imports 20(xiv) Net factor income from abroad –10(xv) Mixed income 100(xvi) Depreciation 20(xvii) Subsidies 10(xviii) Indirect taxes 20

26. From the following data calculate the Gross Domestic Product at MarketPrices:

(Rs. in crores)(i) Value of output in primary sector 2,000(ii) Intermediate consumption of secondary sector 800(iii) Intermediate consumption of primary sector 1000(iv) Net factor income from abroad – 30(v) Net indirect taxes 300(vi) Value of output of tertiary sector 1,400(vii) Value of output of secondary sector 1,800(viii) Intermediate consumption of tertiary sector 600

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