MTP

SESSION 2

Reading
1. This set of slides
2. From Blanchard :
Chapter 2 – page 40 - 42
Chapter 3 – page 63 – 65
3. https://www.business-standard.com/about/what-is-gross-national-product-gnp
4. https://www.tutor2u.net/economics/reference/measuring-national-income-gdp
Measuring
the economy’s performance
GDP
= GROSS DOMESTIC PRODUCT
= value of all final goods and services (at current market prices) produced within the economy at the
current year

GNP
= GROSS NATIONAL PRODUCT
= value of all final goods and services (at current market prices) produced by nationally held factors
at home or abroad at the current year
= GDP + income earned by nationally held factors abroad – income earned at home by foreign
owned factors
= GDP + net factor income from abroad

See https://rbi.org.in/Scripts/PublicationsView.aspx?id=16445
https://rbi.org.in/Scripts/AnnualPublications.aspx?head=Handbook%20of%20Statistics%20on%20Indian%20Economy
• Only final products are measured.

• Intermediate inputs are excluded to avoid double counting

• Whether a good is final or intermediate depends on the use.

• Intermediate products produced this year but not used up this year are included.

• Exported intermediate goods are included.

• Transaction of old items are excluded.

Exercise

Suppose GDP is Rs.6000.

Domestic residents receive factor payments from abroad of Rs. 200.
Foreigners receive Rs. 400 as factor payments from this country.
What is the value of GNP?

GNP = 6000 + 200 – 400 = 5800

Exercise

The imputed rental income of owner-occupied housing is included in GDP,

but the market value of the house is not. Why?

If you give Rs. 5 to a beggar should that be included in the GDP?

What if he sings a song?
Exercise

What happens to the GDP if the govt. hires an unemployed worker, who had
been getting Rs.1000 per month as unemployment benefit, as a govt.
employee on Rs.1000 per month?
What if this employee does not work at all?
 The total income of the economy can be measured in
different nodes in the circular flow.

1. As total expenditure made on firms’ produce, which is

then transferred to households as income
Measuring the - The Expenditure Approach
Aggregate Income
of the Economy 2. As total earning of the household sector
- The Income Approach

3. As The Total Value of Production

- The Production Approach
Circular flow of Income

Wages w, rent r,
profit Π, interest
payments i etc.

Labour, land, Capital

etc.

Households Firms

Goods and services

Consumption expenditure on
goods and services ‘C’
Imagine the circular flow of
the economy as a flow of
water in a circular pipe.

If there is no leakage in the

pipe,
No matter where in the pipe
you measure,
The volume of water will be
the same.

But if there are leakages,

water flow may vary at
different points of the
circular pipe.
 Key question 1:
Income
approach How much income has been generated for the
household?
 Aggregate income as measured by The Income Approach

Every earning citizen belongs to the household sector.

So total Earning of the economy can be measured as
Financial total earning of the household sector. Household earns
Institutions in the form of wages, profits, rents and interest
earnings.
So Aggregate Income
= Wages + Profits + Interest Payments + Rents
Government = W + P + Int + R

Households

1. The Households Firms

sector earns income Rest of
the world
 Aggregate income as measured by The Income Approach

Every earning citizen belongs to the household sector.

So total Earning of the economy can be measured as
Financial total earning of the household sector. Household earns
Institutions in the form of wages, profits, rents and interest
earnings.
So Aggregate Income
= Wages + Profits + Interest Payments + Rents
Government = W + P + Int + R

Households

1. The Households Firms

1200 sector earns income Rest of
the world
 Key question 2:
Income
approach How has the household used its income?
 Aggregate income as measured by The Income Approach

W+I+R+P = income = C+S +T

Financial Income from all possible Sources = Income
4. Savings S Institutions used up all possible ways
The is an identity.
The two sides are equal by definition of
3. Taxes T income.
Government

Households Firms

2. Consumption
Expenditure C Rest of
the world
1. The Households
sector earns income
 Aggregate income as measured by The Income Approach

W+I+R+P = income = C+S +T

Financial Income from all possible Sources = Income
4. Savings S Institutions used up all possible ways
200 The is an identity.
The two sides are equal by definition of
3. Taxes T income.
Government
400

Households Firms
600
2. Consumption
Expenditure C Rest of
1200 the world
1. The Households
sector earns income
 Key question:
Expenditur
e approach How much expenditure have people made for the
(country’s) firms’ produce?
 Aggregate income as measured by The Expenditure Approach

The households earn their income from

the firm sector. The revenue earned by
Financial firms are passed to the households as
4. Savings S Institutions 6. income.
Investmen
t Funds I C, I, G and X are sources of the firm’s
revenue.
3. Taxes T
Government 5.
Govt.
Exp. G
Rest of
Households Firms the world
2. Consumption
Expenditure C
1. The Households 7.
sector earns income Export
Earnings
 Aggregate income as measured by The Expenditure Approach

The households also spends on imports from the

rest of the world. Imports are made through the
Financial firm sector. So out of the total ‘C’ that the firm
4. Savings S Institutions 6. sector receives from households, the import bill
Investmen ‘M’ is passed to the rest of the world.
t Funds I
In effect the firm receives a net expenditure of C
3. Taxes T – M from the households.
Government 5.
Govt.
Exp. G
8. Import Rest of
Households Firms Bill M the world
2. Consumption
Expenditure C
1. The Households 7.
sector earns income Export
Earnings
 Aggregate income as measured by The Expenditure Approach

Total expenditure made on firm’s produce

Financial =C–M+I+G+X
4. Savings S Institutions 6. =C+I+G+X–M
Investmen
t Funds I
3. Taxes T
Government 5.
Govt.
Exp. G
8. Import Rest of
Households Firms Bill M the world
2. Consumption
Expenditure C
1. The Households 7.
sector earns income Export
Earnings
 Aggregate income as measured by The Expenditure Approach

Total expenditure made on firm’s produce

Financial =C–M+I+G+X
4. Savings S Institutions
200 6. =C+I+G+X–M
200 Investmen
t Funds I
3. Taxes T
400
Government 5.
400
Govt. 1200
Exp. G
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 300
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
 Aggregate income as measured by The Expenditure Approach
in g ive
Us rnat s Total expenditure made on firm’s produce
e
alt ber
u m Financial =C–M+I+G+X
n
4. Savings S Institutions
300 6. =C+I+G+X–M
200 Investmen
t Funds I
3. Taxes T
500
Government 5.
400
Govt. 1300
Exp. G
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 400
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
 Key question:
Production
approach What is the total value of production?
 Aggregate income as measured by The Production Approach

Value of its final products.

Say there are n final products – good 1, good 2……. good n.
Quantity sold of good 1 is Q1 at a price P1,
Quantity sold of good 2 is Q2 at a price P2,
Quantity sold of good 3 is Q3 at a price P3 ….. And so on.

So, Total Value of final goods = P1.Q1 + P2. Q2 + …… + Pn. Qn.

The value added by all production units (including those producing

intermediate goods and services) can also be added up to arrive at the
value of final production.
Value Added by a production unit (VA)
= value of output – value of intermediate inputs (both domestic and imported)

Value of output (VO)

= Sales (domestic and exports) + Change in stocks (that is closing stock – opening
stock)

∑ Value of final goods = ∑ value added in all final and intermediate goods
P1.Q1 + P2. Q2 + …… + Pn. Qn. = VA1 + VA2+…. VAm

n = number of final goods m = number of goods (final or otherwise)

To show that ∑ Value of final goods = ∑ value added in all final and intermediate goods

Garment
Total value = 400 Value of the final good (Garment
)
VA= 100 = 400

Textile Value added of all sectors

Total value = 300 = 100 + 80 + 40 + 180
= 400
VA = 80 Yarn
Cost of Total value = 220
textile = Cotton
300 VA= 40
Total value = 180
Cost of
yarn =
220 Cost of VA= 180
cotton =
180
In absence of any ‘leakage’ all three
measures of output should be
identical
 No Leakage: the economy neither grows nor shrinks

C+S+T=C+I+G+X-M
Financial
4. Savings S Institutions
200 6. Aggregate Aggregate
200 Investmen supply Demand
t Funds I
3. Taxes T
400
Government 5.
400
Govt.
Exp. G
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 300
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
 The trade leakage
If export revenue and import bill are unequal.

The budget leakage

If government’s receipt of taxes and spending are unequal.
Forms of leakage

The saving investment leakage

If savings hat flow into the financial institutions and the
investment fund that flows out from financial institutions are
unequal.
 Trade Leakage : X = 300 ≠ M = 400. GDP of 1200 becomes GDP
of 1100
AS = C + S + T = 1200
Financial AD = C + I + G + X – M
4. Savings S Institutions
200 6. = 600 + 400 + 200 + 300 – 400
200 Investmen
= 1100
t Funds I Economy
3. Taxes T shrinks due to
400
Government 5. negative trade
400 leakage
Govt. 1100
Exp. G
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 400
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
 Saving – Investment Leakage : S = 200 ≠ I = 500. GDP of 1200 becomes GDP of
1500
AS = C + S + T = 1200
Financial AD = C + I + G + X – M
4. Savings S Institutions
500 6. = 600 + 400 + 500 + 300 – 300
200 Investmen
= 1500
t Funds I Economy grows
3. Taxes T due to positive
400 Saving
Government 5.
400 Investment
Govt. 1500
Exp. G leakage
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 300
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
 Budget Leakage : T= 400 ≠ G = 350. GDP of 1200 becomes GDP of 1150

AS = C + S + T = 1200
Financial AD = C + I + G + X – M
4. Savings S Institutions
200 6. = 600 + 350 + 200 + 300 – 300
200 Investmen
= 1150 Economy shrinks
t Funds I
3. Taxes T due to negative
350 Budget leakage
Government 5.
400
Govt. 1150
Exp. G
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 300
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
NOTE

That whether the economy grows or shrinks depends on the

overall leakage.

If AD = C + I + G + X – M > AS = C + S + T then it’s a positive

overall leakage. The economy will grow.

If AD = C + I + G + X – M < AS = C + S + T then it’s a negative

overall leakage. The economy will shrink.
 Should the economy grow or shrink?

Financial
4. Savings S Institutions
300 6.
200 Investmen
t Funds I
3. Taxes T
500
Government 5.
400
Govt. 1300
Exp. G
8. Import Rest of
Households Firms Bill M the world
600
2. Consumption 400
Expenditure C
1200 300
1. The Households 7.
sector earns income Export
Earnings
 Inflow and
outflow may
Foreign
Foreign not match…
sector, Govt.
Household sector, Govt. and cause
and FI
uses the and FI use leakage
receive
income money
money

AD
this
period

May be > = or <

Household Firms
receives
Firms
disburse
Firms
Firms AS
disburse receive last
income payments receive
payments revenue period
to factors revenue
to factors
If AD > AS => growth
If AD < AS => shrinkage