Measuring the value of Economic

Activity
GDP and its Components

Learning Outcome

Defining National Income

Studying related aggregates
Knowing the methods of calculating NY
Understanding the logic behind NY identity

Gross Domestic Product (GDP)

Money value of final goods & services produced in the domestic

territory of a country during a period of one year.

Examples of goods: Rice, cotton, textiles, fabrics, steel, etc

Examples of services: by doctors, lawyers, teachers, consultancy,

etc.

All the firms (like SAIL, HLL, etc) and the individuals (like doctors,
farmers, shopkeepers, etc) who produce goods and services in the
country constitute the business sector of the country.

All the individuals who earn factor incomes in return for their
participation in the process of production constitute the HH sector.

Classification of goods and services

Intermediate goods & services

Used in the process of production.
Examples- yarn for weaving cloth, iron ore for producing steel, steel for
making automobiles, fertilisers for producing wheat.
Final goods & services:
Which are not used up in the process of production. Consist of
(a) Consumption goods/ consumer goods & services:
(a.1) non durable: consumed when purchased by ultimate
consumers
Examples- food, clothing, fees paid to doctors, fare for riding an
auto rickshaw.
(a.2) durable: sufficient durability, resale value, incur wear and tear
Examples- TV, refrigerator, computers
(b) Capital goods:
Durable goods used in the process of production
Though they are final goods but not final to be consumed as such.
Undergo wear and tear
They are the crucial backbone of any production process.
Examples- plant, machinery, tools, roads, bridges

Double Counting

It arise when while attempting to estimate GDP, the value of

intermediate goods and services also gets included.

In value added approach, all purchases of materials & services

from other firms are excluded because they have been counted
as final products of other firms.

Example: Bread Receipts, Costs and Value Added

(in cents per loaf)
Stage of
production

Sales receipts Cost of

intermediate
goods

Value added

Wheat

24

24

Flour

33

24

Baked dough

60

33

27

Delivered
bread

90

60

30

total

207

117

90 (sum of
value added)

Stocks and Flows

Stocks
Measured at a point of time.
Examples- balance sheet,
inventories

foreign

exchange

reserves,

wealth,

Flows
Measured over a period of time.
Examples- profit & loss statement, inflation, income, saving, investment
Change in stocks are flows
Reason- A particular machine can be apart of capital stock for many
years but that machine can be part of the flow of new machines added
to the capital stock only for a single year when it was initially installed.

Gross and Net Investment

Gross investment/ capital formation

The part of final output that comprise of capital goods.

Net investment/ capital formation

It includes net additions to societys stock of capital goods.

Depreciation
All the capital goods produced in a year do not constitute an addition to
capital stock already existing.
Some part of current output of capital goods goes in maintaining/ replacing
the part of existing capital stock.
This is because the already existing capital stock suffers wear and tear.
Net Investment = Gross Investment - Depreciation

Why gross?

Gross emphasises that any allowance for using up the capital

(depreciation) has not been provided for.

Example- what would you think of a statistician who estimated the

change in human population by just adding up the gross births
without subtracting the deaths that have taken place during the
same time period?

The same holds for economic equipments and buildings.

A warning

To economists, investment always means real capital formationproduction of added goods in inventories or production of new
plants, houses, tools, etc. This must not be confused with a common
mans notion of investment which implies using money to buy
physical or financial assets.

Example- if I take Rs.1000 and put them in a bank account or invest

in equity, the economist say that neither investment nor saving has
gone up with this act.

Only if some physical capital formation takes place, investment

happens.

Only if society consumes less than its income, devoting resources to

capital formation, saving takes place.

The concept of TRADE OFF

The total production of final goods during a year can be in the form
of
Consumption
Investment

Trade off- If an economy produces more of consumer goods, lesser

resources will be diverted towards production of capital goods and
vice-versa.

Circular flow of Income and methods of

calculating National Income

Product/ value added approach

Measuring the aggregate value of final goods and services produced
by all the firms.
Income approach
Measuring the sum total of all factor payments.

Expenditure approach
Measuring the aggregate value of spending that firms receive for
final goods and services which they produce.
Note- GDP calculated by these three methods will give identical
results.

I Approach- Product/ Value Added Method

Recall Intermediate goods, final goods, value addition, double

counting.

Example on value addition

Value addition = value of production of the firm value of
intermediate goods used by the firm

Value addition is a flow variable.

Net and Gross Value Addition

Net value addition = gross value addition depreciation
Example

A firm produces Rs 100 worth of goods in a year

Rs 20 is the value of intermediate goods used by it during the year
Rs 10 is the value of capital consumption
Gross value of the firm= Rs 80
Net value of the firm = Rs 70

Inventory

During a year, the firm may be unable to sell all of its produce- there may be
unsold stock at the end of the year.

Inventory- stock of unsold finished goods, semi finished goods, raw

materials which a firm carries from year to year.

Accumulation- a higher value of inventories at the end of the year as

compared to the beginning of the year

Decumulation- a lower value at the year of the year as compared to the

value at the beginning of the year
Change in inventories of a firm during a year = production of the firm during
a year sale of the firm during the year

Inventory is a stock variable

Change in inventory is a flow variable

Moving ahead
Gross value added = gross value of output intermediate goods

Gross value added = value of sales + value of change in inventories

value of intermediate goods

GDP is the sum total of gross value added of all the firms in the
economy.

II approach- Expenditure Method

Calculating GDP by looking at the demand side of the products.

Obtained by adding up the final expenditures (not undertaken for

intermediate purposes) that each firm makes.

Final expenditures is incurred on the following accounts:

C- Final consumption expenditures
I- Final Investment expenditures
G- final consumption and investment expenditures of government
NX- net exports
Thus GDP = C + I + G + NX

III Approach- Income Method

Since the revenues received by the firms must be distributed as
factor payments, the sum of final expenditures in the economy must
be equal to the incomes received by all the factors of production
taken together.
GDP = W + I + R + P

Some Macro Economic Identities

Net Factor Income from Abroad (NFIA)
Example- The earnings of an Indian Citizen working in Saudi Arabia
is a part of Indias GNP and S.As GDP.
GNP = GDP + NFIA

Some Macro Economic Identities

Depreciation

Net Domestic Product (NDP) = Gross Domestic Product (GDP)

Depreciation

Some Macro Economic Identities

Factor cost = market price indirect taxes

When indirect taxes are imposed on goods and services, their prices
go up.
They accrue to the government
In order to calculate that part which accrues to factors of production,
indirect taxes have to be deducted from market prices
Subsidies are granted by the government so they have to be added
at the market prices.
Net indirect taxes = indirect taxes subsidies

Real and Nominal GDP

Price changes over the years make GDP comparisons difficult.

Example:
If a country produces only bread.
In the year 2000, it produced 100 packets of bread, price being Rs
10 per packet of bread. So GDP at current price = Rs 1000.
In 2001, it produced 110 packets, at Rs15 per packet. Now GDP at
current prices= Rs 1650.
But GDP at base year prices (year2000) = Rs 1100

Real and Nominal GDP

Real GDP

Goods and services are evaluated at some constant prices (base

year prices).
Since prices are constant, if Real GDP goes up, this leads us to
conclusion that production volumes have surely increased.
Nominal GDP
It values GDP at prevailing prices
Does not take into account the effect of inflation/deflation.

GDP DEFLATOR
Numerical factor by which GDP valued at current prices
must be discounted/ deflated so as to remove the impact of
increased prices & to obtain real GDP
GDP Deflator = nominal GDP / Real GDP

EXAMPLE

GDP at current price in 2002 = Rs 300 billion

GDP at current price in 2003 = Rs 390 billion
Inflation is 20%
Price index is 100 in 2002 & 120 in 2003
GDP deflator = 120/ 100 = 1.2
Real GDP for 2003 = 390/ 1.2 = Rs 325 billion

CONSUMER PRICE INDEX (CPI)

Measures cost of buying a standard basket of goods

& services, representing consumption pattern of
population, at diff points of time

Appropriate for evaluating impact of rising prices on

consumers

EXAMPLE
PRODUCT

SHARE IN
CONS
BASKET

PRICE INDEX
2002

WEIGHTED
INDEX

2003

Food

0.10

100

110

11

Clothing

0.05

100

100

20

Housing

0.25

100

120

30

Fuel

0.10

100

110

11

Transportati
on

0.20

100

115

23

Education

0.30

100

90

27

Total

100

INFLATION IS 24%

124