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GDP ± Gross Domestic
Product
! A measure of the total flow of goods and
services produced by the economy over a
specified time period. It is obtained by
valuing outputs of goods and services at
market prices and then aggregating. Note
that all intermediate goods are excluded and
only goods used for final consumption or
investment goods (capital) or changes in
stock are included. This is because the
values of intermediate goods are implicitly
included in the prices of final goods.
GDP ± Gross Domestic
Product

! The word µgross¶ means that no

deduction for the value of expenditure
on capital goods for replacement
purposes is made. The word
µdomestic¶ is used to highlight the fact
that income arising from investments
and possessions owned abroad is not
included.
GNP ± Gross National Product

! GNP is GDP plus the income accruing

to domestic residents arising from
investment abroad less income earned
in the domestic market accruing to
foreigners abroad.
! GNP = GDP + Exports - Imports
National Income

! A measure of the money value of goods

and services becoming available to a
nation from economic activity during a
prescribed period. It can be calculated by
three different methods:
1. By adding all the incomes generated in the
country by economic activity ± wages,
interest, profit and rent. The money value
or price of a commodity is exactly equal to
the sum of the various incomes generated
in its production.
National Income
2. By adding together the values of all goods and
services produced in a country ie. Prices minus
indirect taxes, while avoiding double counting.
3. By adding the values of what has been consumed
(deducting indirect taxes plus subsidies) and what
has been invested in the country to give total
expenditure.
! Whichever method is adopted, the final gross
amount should be the same. Allowance may be
made for the depreciation of assets to give a µnet¶
figure.
GDP

! The GDP is the most comprehensive

measure of a nation¶s total output of goods
and services. It is the sum of the monetary
values of consumption (C), gross investment
(I), government purchase of goods and
services (G), and net exports (X) produced
within a nation during a given year.
! GDP = C + I + G + X
]easurement of GDP ±
Goods flow and Earnings flow

! Flow of Product Approach

! Each year the public consumes a wide
variety of goods and services. We include
only final goods ± goods ultimately bought
and used by consumers.
! ]arket prices are used as weights in valuing
different commodities because market
prices reflect the relative economic value of
diverse goods and services.
]easurement of GDP ±
Goods flow and Earnings flow

! Earnings or Cost Approach

! There are various costs of doing business ±
wages to be paid to labor, rent to be paid to
land, profits to be paid to capital and so on.
But these business costs are also the
earnings that households receive from firms.
By measuring the annual flow of these
earnings or incomes we can arrive at the
GDP.
The Problem of Double
Counting

! A final product is one that is produced and

sold for consumption or investment. GDP
excludes intermediate goods ± goods that
are used up to produce other goods. GDP
therefore includes bread but not wheat and
home computers and not computer chips.
! To avoid double counting of intermediate
goods, we calculate value added at each
stage of production.
eal Vs. Nominal GDP
! We can measure the GDP for a particular
year using the actual market prices of that
year. This gives us the nominal GDP, or
GDP at current prices. But we are usually
more interested in determining what has
happened to the real GDP, which is an
index of the volume or quantity of goods and
services produced. eal GDP is calculated
by tracking the volume or quantity of
production after removing the influence of
changing prices or inflation.
eal Vs. Nominal GDP

! The difference between the growth of

nominal GDP and real GDP is the
growth in the price of GDP, sometimes
called the GDP deflator.
Consumption

! Consumption is by far the largest

component of GDP, equaling about
2/3rd of the total. Consumption
expenditures are divided into three
categories: durable goods such as
automobiles, nondurable goods such
as food, and services such as medical
care. The most rapidly growing sector
is services.
Investment and Capital
Formation

! Investment consists of the additions to

the nation¶s capital stock of buildings,
equipment, software etc. during a year.
The national accounts include tangible
capital (buildings, computers etc.) but
omit most intangible capital ( D,
Education etc.)
Composition of U.S. GDP in 2001
Composition of U.S. GDP in 2001
Consumption as a Share of GDP:
U.S. and Japan, 1955-2001
Circular flow of
macroeconomic activity
$
Consumption purchases

(a)
Final goods and services
(bread, computers, haircuts, etc.)

Purchasers
(households, Producers
governments«) (businesses)

(b)
Productive services
(labor, land, etc.)

$
Wages, rents, profit, etc.
Value added accounting

! To avoid double counting of

intermediate products, we calculate
value added at each stage of
production. This involves subtracting
all the costs of materials and
intermediate products bought from
other businesses from total sales.
 Value added accounting
Bread Receipts, Costs, and Value Added (cents per loaf)
    
  

  
 



  



 




 




 
   
  !
È eat 23 0 = 23
Flour 53 23 = 30
Baked Doug 110 53 = 57
Final product : 190 110 = 80
bread

Total 376 186 190

(sum of value
added)
 National income calculation

@ 
  " #     "

 

 

 
 #   
  
 

 

Consumption (C) Compensation of labor(wages, salaries and supplements)
+ Gross private domestic investment (I) + Corporate profits
+ Government purc ases (G) + Ot er property income (rent, interest, proprietors¶ income)
+ Net exports (X) + Depreciation
+ Production taxes
#$ %

 
#$ %

 

National income calculation

! The previous table presents the major

components of the two sides of the national
accounts. The left side shows the
components of the product approach. The
symbols C, I, G and X are the four items of
GDP. The right side shows the components
of earnings or cost approach. Each
approach will ultimately add up to exactly
the same GDP.
GDP Deflator
! Nominal GDP (PQ) represents the total
money value of final goods and services
produced in a given year where the values
are expressed in terms of the market prices
of each year. eal GDP (Q) removes price
changes from nominal GDP and calculated
GDP in terms of goods and services. The
GDP price index (P) is the ³price of GDP´
and is approximately determined as follows:

*
 

      
GDP Deflator

`

   
|   `  
( '
 *
 ` 


&' 
 &'))
 ` 

 

))   +

1929 104 1.00 104 / 1.00 104

1933 56 0.75 56 / 0.75 76
GDP to National income to
Disposable income
et exports epreciation

overnment
Taxes

Investment Trans er payments

et business saving

ational Income
I
onsumption

ross domestic product ational Income isposable Income

( ) ( I) ( I)
GDP to National income to
Disposable income
! Important income concepts are
1. GDP, which is total gross income to all
factors
2. National income, which is the sum of factor
incomes and is obtained by subtracting
depreciation from GDP
3. Disposable personal income, which
measures the total incomes, including
transfer payments but minus taxes, of the
household sector.
Price Indexes and Inflation

! A price index is a level of the average

level of prices.
! Inflation denotes a rise in the general
level of prices.
! The rate of inflation is the rate of
change of the general price level.
! Deflation is a fall in the general level of
prices.
Price indexes
! When news papers report ³inflation is
rising´, they are really reporting movement
of a price index.
! A price index is a weighted average of the
prices of a number of goods and services. In
constructing price indexes, economists
weight individual prices by the economic
importance of each good. The most
important price indexes are the consumer
price index, the GDP price index (GDP
deflator) and the producer price index.
]onetarism Vs Fiscalism
]onetary Policy

! ³The management of the expansion

and contraction of the volume of the
money in circulation for the explicit
purpose of attaining a specific
objective such as full employment´ ±
aymond P Kent
]onetary Policy

! The objectives of monetary policy are

a. Stability of price
b. Stability of exchange rate
c. Full employment
d. Economic growth
]onetary Policy - Objectives
a. Stability of price
Fluctuations in price level are always
accompanied by fluctuations in the level of
business activity. However, price instability
creates difficult problems of production and
distribution affecting different sections of the
people in the country differently. During periods
of falling prices, there is widespread collapse of
businesses resulting in tremendous increase in
unemployment and decrease in production and
income.
]onetary Policy - Objectives
Periods of rising prices, on the other hand, witness shifts
in the distribution of wealth and income from the poor to
the rich.
Only periods of relatively stable prices have been able to
combine an active and stable prosperity with a largely
neutral effect on wealth distribution. ]oreover, periods of
price and business fluctuations have also witnessed
economic and political turmoil. Therefore, stabilisation of
internal prices is a major objective of the monetary policy.
]onetary Policy - Objectives
b. Stability of exchange rate
Stable exchange rate is an essential condition for promotion of
healthy foreign trade. Fluctuations in exchange rates result in
flight of capital and lack of investor confidence. It also results in
speculative activity in the foreign exchange market. Hence,
monetary policy lays great emphasis on exchange rate stability
which is deemed to be the best guarantee for maximum
economic and social welfare. In recent times, however, the
formation of economic unions like European Union and ASEAN
as also the emergence of international bodies like I]F and IBD
have taken this objective out of the sole ambit of monetary
policy.
]onetary Policy - Objectives
c. Full employment
In cases of economies suffering from unemployment
because of deficiency of investment, monetary policy
could try to: (a) create additional bank deposits, (b) create
additional money, and (c) increase velocity of circulation of
money through activating of idle cash balances. All these
necessitate reduction in rate of interest to stimulate
borrowings from banks for investment. Hence, monetary
policy designed to promote investment and ultimately
achieve full employment is commonly known as cheap
money policy.
]onetary Policy - Objectives
d. Economic growth
The monetary authorities strive to establish an efficient
currency and banking system to facilitate and foster
economic growth. Horizontal penetration of the banking
system into rural and semi-urban areas and vertical
penetration into sophisticated and specialised money
markets in the urban areas is a vital task of the monetary
authorities.
The Central Bank must ensure money supply that is
adequate to the growth process and is sufficiently elastic.
Paper money must replace coins and banking instruments
must gradually takeover paper money.
]onetary Policy - Objectives
As economic growth reaches maturity, monetary system
becomes less important. In the later stages of development,
the monetary system becomes part of the entire financial
mechanism which controls the flow of funds as well as
securities. But in the meantime, the monetary authorities must
help the continuous expansion of the banking and financial
systems.
]onetary authorities have another important responsibility as
regards growth viz. creation of new financial institutions for
mobilising savings for productive use. Presently, the credit
system is more prone to providing credit to large estates,
plantations, export industries and so on. Credit facilities are
not readily available to peasants, small industries and small
traders.
]onetary Policy - Objectives
Finally, the monetary authorities must solve the BOP
problem that every developing country faces. To counter
adverse BOP, Central Bank must resort to direct control
over foreign exchange and bank rates.
³Central banking in a planned economy can hardly be
confined to the regulation of the overall supply of credit or
to a somewhat negative regulation of the flow of bank
credit. It would have to take a direct and active role. Firstly,
in creating or helping to create the machinery needed for
financing development activities all over the country, and
secondly, in ensuring that the finance available flows in the
direction intended.´ ± Planning Commission.
]onetary Policy ± an
evaluation
! Firstly, monetary policy is not given any major importance in the
expansion and development of the economy. It is well realized
that GOI would play the pivotal role in stimulating the economy
and sustain economic growth. The role of BI is minor and is one
of overseeing steady finance for developmental needs.
! Secondly, the powers and weapons available to BI aid in
exercising control only on commercial and scheduled banks. To
the extent of controlling inflation, BIs selective controls are
effective. But in India, inflation has been more on accord of deficit
financing and real physical shortages over which BI has no
control.
! Thirdly, extensive use of black money in the country for hoarding
and speculating limits the efectiveness of monetary policy.
Fiscal Policy - Objectives
! Fiscal policy means the policy of the Finance ]inistry of the
GOI and is also called the budgetary policy (Fisc means
Treasury). ]any economists including Keynes advocated
use of fiscal policy to:
a. achieve optimum allocation of economic resources,
b. bring about equal distribution of income and wealth,
c. maintain price stability,
d. promote and achieve full employment, and
e. attain rapid economic growth.
Fiscal Policy - Objectives
! Fiscal policy has three tools: taxation, public expenditure and
public debt management.
! Taxation is meant to bring revenue to the government but can
also be used to encourage or restrict private expenditure on
consumption and investment.
! Public expenditure is usually in the form of normal govt.
expenditure and expenditure on relief works and subsidies. While
taxation reduces the income of the general public, public
expenditure increases the income of the general public.
! Govt. borrowing and public debt influence the volume of liquid
assets with the public. Subscription to public debt transfers funds
from the public to the Govt.while repayment of debt will have the
opposite effect.
Fiscal Policy and Stabilization of
business

! Keynes opines that depression and unemployment are due

to deficiency of aggregate demand and recommends active
usage of fiscal policy to overcome this situation. Fiscal
policy increases aggregate demand either by increasing
GOI expenditure or by inducing general public to increase
consumption or investment.
! Tax Policy during Depression ± Fiscal policy during
depression aims to stimulate purchasing power,
consumption and investment. Such a policy aims at
reducing (a) personal income tax, corporate tax and direct
taxes to promote saving and investments; and (b) excise
and sales taxes which will promote consumption.
Fiscal Policy and Stabilization of
business

! Public Expenditure during depression: Public expenditure

may be undertaken with the express purpose of
compensating the decline in private investment
proportionately. This is also called compensatory public
spending. Public expenditure may also be undertaken to
help revive economic activity. Such expenditure is called
pump priming.
! Public expenditure creates capital assets like railways,
canals, airports etc. which help in direct employment and
also stimulate secondary and tertiary sector employment.
They constitute social and economic infrastructure that
promotes real output and income of the economy.
Fiscal Policy and Stabilization of
business

! However, corrective public expenditure has the following

limitations: (a) it is difficult to forecast business depressions
and the required corrective expenditure, (b) there are
delays in starting public works programs, (c) public
expenditure financed out of borrowings entails huge burden
on future generations, and (d) public works programs have
to be completed even after the period of business
depression expires.
To eliminate these shortcomings economists often suggest
alternative patterns like transfer payments, unemployment
insurance, social security schemes and others.
Fiscal Policy and Stabilization of
business

! Public debt policy to check a depression: The following

points determine the efficacy of public debt policy ± (1) This
policy has positive benefits only if idle funds are mopped up
and not if these funds are transferred from private
investments. (2) Funds borrowed from the Central Bank
must contribute to increase in money supply. (3) The GOI
must prevail on BI to follow a policy of cheap money.
! Keynes opines that while monetary policy impacts effective
demand indirectly, fiscal policy impacts effective demand
directly.
Fiscal Policy and Inflation
! Fiscal policy is effective in controlling demand-push, cost-
pull and sectoral inflations.
Taxation helps in rationalization of liquidity in the economy.
Taxes are of two types ± direct and indirect. Direct taxes
are immediately effective as the impact and incidence of
taxation is on a specific target income group. Indirect taxes
are essentially used to mop excess purchasing power of
the public. Taxation also aids in equitable distribution of
wealth and reallocates purchasing power in order to curb
sectoral inflation.
Fiscal Policy and Inflation
! Since inflation is caused by increased public expenditure, a
reduction in Govt. expenditure has a dampening effect on
inflation. Control of aggregate demand is of vital
importance. Often, a part of Govt. expenditure is non-
essential and can be easily curtailed. During times of
inflation, it is prudent to have a surplus budget wherein the
revenue is more than expenditure. Deficit budgets have the
effect of increasing the incomes of the public. Developing
countries also face the problem of balancing their defense
and developmental expenditure.
Fiscal Policy and Inflation
! Government borrowing during inflation results in transfer of
money from the public to the government. This borrowing
must basically be from non-banking institutions and
individuals which will curtail money supply in the economy.
On the other hand, government borrowing from BI and
the banking system expands money supply. The proper
debt policy would, therefore, be to redeem that portion of
public debt which is held by the BI and banking system
and increase borrowing from individuals and non-banking
institutions.
Fiscal policy ± an evaluation
! Firstly, fiscal policy invariably has an inflationary impact on
the economy because creation of money income is always
preceding the availability of goods and services.
! Secondly, increasing taxation and public borrowing have
their own limitations. While high taxation adversely impacts
production, loans from the general public may not be
adequate for govt. spending. Private expenditure cannot be
kept down through fiscal action. Hence fiscal policy only
moderates inflationary pressures and does not eliminate
them completely.
! Lastly, fiscal devises are more efficient as supports or
supplements to other policies than as independent policies
during inflation.
]onetary policy and Fiscal policy :
A comparison

! There is no intrinsic contradiction between monetary and

fiscal policies as their objectives are mostly identical in
nature. For instance, to control inflation, monetary policy
aims at high interest rates and tight money conditions with
the object of reducing investment and expenditure; with the
same end in view, fiscal policy aims at higher levels of
taxation and surplus budgeting. To support the fiscal policy
of compensatory spending monetary policy should maintain
a low bank rate and thus bring about cheap money
conditions in the country.
]onetary policy and Fiscal policy :
A comparison

! Both fiscal policy and monetary policy

are formulated and implemented by
the government, but through two
different institutions ± monetary policy
through the central bank and fiscal
policy through the finance ministry.
Hence, the two policies are
complementary and supplementary to
each other.
à
 
 

INFLATION - definitions

! Too much currency in relation to the

physical volume of business being
done
! Too much money chasing too few
goods
! Prices rise due to an increase in the
volume of money as compared to the
supply of goods
! Abnormal increase in the quantity of
money
Inflation
! Keynes relates inflation to a rise in price
level which comes into existence after the
stage of full employment. Keynes states that
the rise in prices up to the stage of full
employment is a good thing for the country
since there is an increase in output and also
in employment. He differentiates two types
of rises in price:
! A. rise in prices accompanied by increase in
production
! B. rise in prices not accompanied by
increase in production
Kinds of Inflation

! DE]AND ± PULL INFLATION

! This is caused by increased demand for
goods that are not accompanied by relative
increase in supply of goods. Bottlenecks
may prevent supply to increase
commensurate with increase in demand.
Increase in demand is essentially rapid
economic development, rising private
investment or high government expenditure.
Kinds of Inflation

! COST ± PUSH INFLATION

! Costs of production are essentially on
account of increase in wage rates
(through trade union activities) or
increased profit margins for the
manufacturers. Higher taxation,
profiteering, hoarding and speculating
are the other causes for this type of
inflation.
Kinds of Inflation
! Sectoral Demand Shift Theory
! Inflation is confined to one sector of the
economy but because of the importance of
this sector, the inflationary impulses
percolate to other sectors also. Increase in
agricultural prices, petroleum prices or
tertiary sector prices will have a overbearing
and overarching effect on all the other
sectors of the economy. This concept also
explains the simultaneous existence of
inflation in one sector and deflation in
another sector called ³Stagflation´.
Consequences of inflation
! On Production and Employment:
! Firms find it profitable to hoard rather than
produce and sell
! Agriculturists find it profitable to hold surplus
stocks in the hope of getting better prices
! Labour unions resort to strikes to enhance
wages which adversely affects production
! Beyond a certain stage, surplus stocks
accumulate, profits decline, investment,
production, income and employment will fall.
Consequences of inflation
! Distribution of income:
a. Producing classes ± producers, traders and
speculators gain during inflation because of
windfall profits. Prices of goods rise much faster
than costs of production as there is a time lag
involved.
b. Fixed income groups ± adversely affected as their
income can buy less because of rising prices. The
middle class and pensioners fall in this category
c. Working classes ± as wages do not rise in
proportion to rise in prices, the working classes
suffer during an inflation. Though trade unions
demand higher wages, there is a time lag between
price hike and wage hike.
Control of inflation

! Anti-inflationary measures are of four

kinds:
1. ]onetary policy
2. Fiscal policy
3. Price control and rationing
4. Other methods
Control of inflation
1. ]onetary policy ± during inflationary times,
money supply is reduced, interest rates are
hiked, reserve ratios of banking system are
increased and foreign exchange
restrictions are placed on importers
2. Fiscal policy ± inflation is sought to be
curbed by lessening government
expenditure, increasing tax rates, public
debt management and mopping up
operations of excess liquidity.
Control of inflation

3. Price control and rationing ± prices of

critical, essential and inflation-sensitive
commodities are controlled by the
government. Further, to ensure equitable
distribution of scarce commodities, the
availability of goods are rationed to people.
4. Other methods ± government may increase
supply of goods through increased
production and increased imports.
Deflation and Stagflation

! Deflation is a situation where prices fall

and adversely impact on income and
employment. This is the opposite of
inflation.
! Stagflation is the simultaneous
existence of inflation and deflation. It is
typical of a mixed economy where
certain sectors are stagnating while
certain other sectors suffer inflationary
trends.
Philips curve analysis
! A W Philips identified an inverse
relationship between the rate of
unemployment and rate of increase in
money wages through an empirical study
of the UK economy. He found that :
a. When unemployment was high, the rate of
increase in money wage rates was low.
b. When unemployment was low, the rate of
increase in money wage rates was high.
This trade-off is depicted in the succeeding
graph
Philips curve

 



È1

È2

È3

Ò1 Ò2 Ò3 Ò


Philips curve analysis

! Paul Samuelson and obert Solow

extended the Philips curve analysis to
the relationship between the rate of
change in prices and the rate of
unemployment and concluded that
there is a trade-off between the level of
unemployment in a country and the
rate of inflation. This is illustrated by
the following graph:
Philips curve analysis



Ò1 Ò2 Ò3 Ò


Trade Cycles
! WC ]itchell ± Business cycles are a
species of fluctuations in the economic
activities of organised communities. The
word ³Business´ implies that these
fluctuations are purely commercial and
³Cycle´ implies that these fluctuations occur
regularly.
! Keynes ± A trade cycle is composed of
periods of good trade characterised by
rising prices and low unemployment
percentage, alternating with periods of bad
trade characterised by falling prices and
high unemployment percentage.
Phases or stages of a trade
cycle
! In monetary jargon, the five phases of a trade
cycle are identified as depression, reflation, full
employment, disinflation and deflation.
a. Depression ± Level of economic activity and price
levels are very low. Profits cease to exist with
mounting losses and unemployment. Interest,
wages and profits are low. A period of great
suffering, low income, heavy unemployment and
utter pessimism.
b. eflation ± Depression gives place to recovery
and revival of business activity. Demand for goods
and services start rising as also the wages,
interest and profits. Pessimism gives way to
optimism. Employment and national income
increase
Phases or stages of a trade
cycle
c. Full employment ± The recovery process culminates in the
economy reaching full employment with optimum level of
economic activity. There is all round economic stability in
output, wages, prices and income.
d. Boom or inflation ± Beyond full employment, investments will
put pressure on men and material. Speculative investments
create overcapacity for production and results in over
employment of resources. Bank credit increases
significantly. However, bottlenecks start showing up.
e. ecession ± Over investment and over optimism during the
boom period do not yield desired results because of full
employment. Generally, a company or a bank will burst and
puncture over optimism. During this phase, business
expansion and credit are sharply curtailed. Unemployment
and hoarding are on the incline. Stock markets crash and
there is general economic gloom.
Phases or stages of a trade cycle


 


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