Summary Sheet Measurement of Growth National Income and Per Capita Income

MEASUREMENT OF
GROWTH: NATIONAL
INCOME & PER
CAPITA INCOME
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Contents
1 Part I: Basics of Economy .......................................................................................................................4
1.1 What is Economy?...........................................................................................................................4
1.2 Why do we study Economy? ...........................................................................................................5
1.3 Meaning of Macroeconomics .........................................................................................................6
1.3.1 Distinction between Macroeconomics and Microeconomics .................................................6
1.4 Factors of Production ......................................................................................................................7
1.4.1 Land..........................................................................................................................................7
1.4.2 Labour ......................................................................................................................................7
1.4.3 Capital ......................................................................................................................................7
1.4.4 Entrepreneurship .....................................................................................................................8
1.5 Factor Payments .............................................................................................................................8
1.6 Economic Agents .............................................................................................................................8
1.6.1 Households ..............................................................................................................................8
1.6.2 Firms ........................................................................................................................................9
1.6.3 Government .............................................................................................................................9
1.6.4 Foreign Sector ........................................................................................................................10
1.7 Types of Economic System ............................................................................................................10
1.7.1 Capitalism ..............................................................................................................................10
1.7.2 Socialism ................................................................................................................................11
1.7.3 Mixed Economy .....................................................................................................................12
1.8 What are the various sectors of Economy? ..................................................................................13
1.8.1 Primary activities ...................................................................................................................13
1.8.2 Secondary activities ...............................................................................................................13
1.8.3 Tertiary activities ...................................................................................................................13
1.8.4 Quaternary activities .............................................................................................................13
1.8.5 Quinary activities ...................................................................................................................13
1.9 What are the different types of Goods? .......................................................................................14
1.9.1 What are Goods? ...................................................................................................................14
1.9.2 Economic Goods and Free Goods ..........................................................................................15
1.9.3 Consumer Goods and Producer Goods .................................................................................15
1.9.4 Single Use and Durable Use Goods .......................................................................................15
1.9.5 Private Goods and Public Goods............................................................................................16
1.9.6 Intermediate Goods ...............................................................................................................17

1.9.7 Intermediate Goods Versus Consumer & Capital Goods ......................................................18
1.9.8 Distinction Between Goods & Services .................................................................................18
2 Part II: Circular Flow of Income in a Simple Economy ..........................................................................19
2.1 Two Sector Model .........................................................................................................................19
2.2 Four Sector Model ........................................................................................................................21
3 Part III: Calculating Gross Domestic Product........................................................................................23
3.1 Product or Value Added Method ..................................................................................................23
3.2 Expenditure Method .....................................................................................................................27
3.3 Income Method.............................................................................................................................29
3.4 Comparison of the Three Methods of Estimating GDP ................................................................30
4 Part IV: Important Macroeconomic Identities .....................................................................................31
4.1 Gross Investment, Depreciation and Net Investment ..................................................................31
4.2 Net Domestic Product ...................................................................................................................32
4.3 Gross National Product .................................................................................................................33
4.4 Net National Product ....................................................................................................................34
4.5 Net National Product at Market Price (NNPMP) & Net National Product at Factor Cost (NNPFC) .34
4.6 Personal Income............................................................................................................................35
4.7 Personal Disposable Income .........................................................................................................37
4.8 Per Capita Income .........................................................................................................................37
4.9 Nominal and Real GDP ..................................................................................................................38
4.9.1 Nominal GDP..........................................................................................................................38
4.9.2 Real GDP ................................................................................................................................39
4.9.3 Base Year................................................................................................................................40
4.9.4 Why is calculating Real GDP important? ...............................................................................40
4.9.5 GDP Deflator ..........................................................................................................................41
4.10 Factor Cost, Basic Prices and Market Prices .................................................................................42
4.11 Why is GVA calculated? ................................................................................................................44
5 Part V: Growth, Welfare & Development ............................................................................................45
5.1 Sources of Economic Growth ........................................................................................................45
5.2 Types of Economic Growth ...........................................................................................................45
5.3 GDP & Welfare ..............................................................................................................................46
5.4 Limitations of GDP ........................................................................................................................46
5.5 What is development? ..................................................................................................................48
5.6 What is the difference between Growth and Development in the above context? ....................49

6 Part VI: Summary ..................................................................................................................................50
6.1 Gross Domestic Product at Market Prices (GDPMP) ......................................................................50
6.2 GDP at Factor Cost (GDPFC) ...........................................................................................................50
6.3 Net Domestic Product at Market Prices (NDPMP) .........................................................................50
6.4 NDP at Factor Cost (NDPFC) ...........................................................................................................50
6.5 Gross National Product at Market Prices (GNPMP) .......................................................................51
6.6 GNP at Factor Cost (GNPFC) ...........................................................................................................51
6.7 Net National Product at Market Prices (NNPMP)...........................................................................51
6.8 NNP at Factor Cost (NNPFC) OR National Income (NI) ..................................................................51
Welcome to the exciting world of Economy learners! You may surely wonder what is exciting about
Economy. But as you go through this course, you will start developing a crystal-clear understanding of
Economy in general and Indian Economy in particular. You will start developing a logical understanding of
concepts that were earlier rote learnt, ignored or dreaded. You will forever be a part of an Economy and
this course will help you appreciate the various facets, ups and downs of the economy that you are a part
of. We have sub-divided this chapter into the following six parts:
1 Part I: Basics of Economy
1.1 What is Economy?

• It is the system of production, distribution, and consumption of goods and services that a society
uses to address the problem of scarcity.
• The essential task of an economy is to transform resources into useful goods and services (the act of
production), then distribute or allocate these products to useful ends (the act of consumption).

ADAM SMITH: A Scottish professor (born 1723, died 1790) who is considered the father of modern
economics for his revolutionary book, entitled ‘An Inquiry into the Nature and Causes of the Wealth
of Nations’ published in 1776.
Concept Check
Q. ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ was published by
(a) David Ricardo
(b) Jean-Baptiste Say
(c) Thomas Malthus
(d) John Stuart Mill
(e) Adam Smith
Answer: E
1.2 Why do we study Economy?

• The basic problem of scarcity requires every society to determine: What goods to produce? How to
produce the goods? and Who receives the goods that are produced?
• The three basic questions that an economy must answer because of limited resources and unlimited
wants and needs are: What? How? and For Whom?
• Answering the 'What?' question of allocation determines the types and quantities of goods and
services produced with society's limited resources. Should we produce more food crops or cash crops?
Luxury items or essential items? Weapons or medical equipment?
• Answering the "How?" question of allocation determines how society's limited resources will be
combined in the production goods. Do we produce houses with wood or bricks? Do we make cars
with automated robots or human labor?
• The third of the three questions of allocation is: Who receives the goods and services produced with
society's resources? What if people buy goods with their incomes? Now, there is a thought. But, what
about people who have no income? With limited resources, the production of goods is also limited.
With limited goods, everyone cannot have everything. Society has to decide who gets what.
As resources are always in short supply, the British economists Lionel Robbins in 1935 described
Economics as 'the science of scarcity'.
Concept Check

Q. Economics is often defined as a
(a) science of prosperity.
(b) science of wealth.
(c) science of money.
(d) science of scarcity.
(e) science of thrift.
Answer: D
1.3 Meaning of Macroeconomics

• Macroeconomics, as a separate branch of economics, emerged after the British economist John
Maynard Keynes published his celebrated book The General Theory of Employment, Interest and
Money in 1936.
• Macroeconomics is a branch of economics that studies how an overall economy—the market systems
that operate on a large scale—behaves. Macroeconomics studies economy-wide phenomena such as
inflation, rate of economic growth, national income, gross domestic product (GDP), and changes in
unemployment.
JOHN MAYNARD KEYNES: A British economist (born 1883, died 1946) who is most noted for his work
‘The General Theory of Employment, Interest, and Money’, published 1936. The ‘The General Theory’
revolutionized economic theory of the day, forming the foundation of Keynesian economics and
creating the modern study of macroeconomics.
Animal spirits is the term Keynes used in ‘The General Theory’ to describe the instincts, proclivities and
emotions that ostensibly influence and guide human behavior, and which can be measured in terms of,
for example, consumer confidence.
1.3.1 Distinction between Macroeconomics and Microeconomics

• Meaning
o Microeconomics: It studies issues and problems at the level of an individual firm, an individual
household etc.
o Macroeconomics: It studies issues and problems at the level of the economy as a whole.
• Concern
o Microeconomics: It is basically concerned with determination of output and price for an
individual firm or industry.

o Macroeconomics: It is basically concerned with determination of aggregate output and
general price level in the economy as a whole.
• Focus
o Microeconomics: Its focus is on maximisation of individual’s gain.
o Macroeconomics: Its focus is on maximisation of social welfare.
• Scope
o Microeconomics: It has a narrow scope, i.e., an individual person, an individual market, etc.
o Macroeconomics: It has a very wide scope, i.e. a state, or a country.
Concept Check
Q. Macroeconomics does not study
(a) inflation rate.
(b) trend of gross domestic product.
(c) changes in unemployment levels.
(d) profitability of a firm.
(e) distribution of national income.
Answer: D
1.4 Factors of Production

• These are four basic factors used to produce goods and services in the economy-- Land, Labour,
Capital and Entrepreneurship.
1.4.1 Land
• Land is the naturally occurring materials of the planet that are used for the production of goods and
services, including the land itself; the minerals and nutrients in the ground; the water, wildlife, and
vegetation on the surface; and the air above.
1.4.2 Labour
• Labour is the mental and physical efforts of humans (excluding entrepreneurial organization) used
for the production of goods and services.
1.4.3 Capital
• Capital is the manufactured, artificial, or synthetic goods used in the production of other goods,
including machinery, equipment, tools, buildings, and vehicles. Capital is the produced factor of
production.

1.4.4 Entrepreneurship
• Entrepreneurship is the special sort of human effort that takes on the risk of bringing labor, capital,
and land together to produce goods. Risk is a key component here.
Concept Check
Q. Capital formation in an economy is undertaken by
(a) Firms
(b) Households
(c) Government
(d) External Sector
(e) None of the above
Answer: A
1.5 Factor Payments

• Factor payments are frequently categorized according to the services of the productive resource.
o Wages are paid for the services of labour.
o Interest is the payment for the services of capital
o Rent is the payment for the services of land.
o Profit is the factor payment to entrepreneurship.
Concept Check
Q. Indicate whether the statement is true or false.
Wages are an example of a transfer payment because there is a transfer of payment from the firm to
the worker.
Answer: False
1.6 Economic Agents

• By economic units or economic agents, we mean those individuals or institutions which take economic
decisions.
• Four, broadly defined, economic agents are: households, firms, government and “the rest of the
world”.
1.6.1 Households
• All those people living under one roof are considered a household.
• Households do two fundamental things vital to the economy.
o Demand goods and services from product markets
o Supply labour, capital, land, and entrepreneurial ability to resource markets.
• Households use their limited resources (labour, capital, land, and entrepreneurial ability) to fulfil their
wants.
• Households undertake consumption expenditure.
• Consumer spending (or consumption expenditure) is the total money spent on final goods and
services by individuals and households for personal use and enjoyment in an economy.
Contemporary measures of consumer spending include all private purchases of durable goods,
nondurable goods, and services.
1.6.2 Firms
• The business sector includes the profit-motivated firms that engage in the production of goods and
services.
• These firms combine the services of the four factors of production, which they acquire from the
household sector, to pursue their productive activities.
• The primary reason for the existence of the business sector is to produce the goods that satisfy the
wants and needs of the household sector.
• Although the business sector is largely responsible for producing and supplying goods and services to
the household sector and the rest of the economy, they do a little buying of their own. From a
macroeconomic perspective, the business sector is responsible for capital investment expenditures.
• Investment Spending (or investment expenditure): Money spent on capital goods, or goods used in
the production of capital, goods, or services. Investment spending may include purchases such as
machinery, land, production inputs, or infrastructure. Investment spending should not be confused
with investment, which refers to the purchase of financial instruments such as stocks, bonds, and
derivatives. It is also called as capital formation.
1.6.3 Government
• The government sector includes all levels of government--federal, state, and local. These three levels
intervene in the economy by collecting and spending tax revenue and by establishing and enforcing
laws, rules, and other regulations.
• The Role of the Government
o Establishing and Enforcing the Rules of the Game.
o Promoting Competition
o Regulating Natural Monopolies
o Producing public goods
o Income redistribution
o Employment, price stability, economic growth

• To fund its activity, government raises revenue by way of collecting taxes, fees and fines.
• Government expenditure refers to the purchase of goods and services, which include public
consumption and public investment, and transfer payments consisting of income transfers (pensions,
social benefits).
1.6.4 Foreign Sector

• The foreign sector includes anything and everything that lies beyond the borders of a nation.
• The primary role it plays in the domestic economy is foreign trade. The domestic household,
business, and government sectors purchase imports produced in the foreign sector. The foreign
sector buys exports produced by the domestic business sector.
o Exports and imports are often combined into a single concept--net exports. Net exports are
simply exports minus imports. This single term provides a handy, short-cut way of noting the
trade interaction with the foreign sector. If net exports are positive, then exports exceed
imports. If net exports are negative, then imports exceed exports.
1.7 Types of Economic System
1.7.1 Capitalism
• Capitalism, also called market economy, is a type of economy based on
o private ownership of most resources, goods, and other stuff (private property);
o freedom to generally use the privately-owned resources, goods, and other stuff to get the
most wages, rent, interest, and profit possible; and
o a system of relatively competitive markets.
• While government establishes the legal "rules of the game" for capitalism and provides assorted
public goods, like national defense, education, and infrastructure, most production, consumption, and
resource allocation decisions are left up to individual businesses and consumers.
• In capitalism, only those consumer goods will be produced that are in demand, i.e., goods that can
be sold profitably either in the domestic or in the foreign markets.
• In a capitalist society the goods produced are distributed among people not on the basis of what
people need but on the basis of Purchasing Power—the ability to buy goods and services.
Adam Smith (1723-1790) laid down certain ideas that led to the birth of capitalism. He raised his voice
against the heavy-handed government regulation of commerce and industry of the time which did not
allow the economy to tap its full economic worth and reach the level of well-being. Stressing 'division
of labour', an environment of 'laissez-faire' (non-interference by the government), he proposed that
the 'invisible hand' of 'market forces' (price mechanism) will bring a state of equilibrium in the
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economy and a general wellbeing to the countrymen. For such an economy to function for public well-
being, he has acknowledged the need of competition in the market.
Concept Check
Capitalism: What does the capitalist thinker say about the following in a capitalistic market system:
1. prices,
2. competition,
3. private property,
4. exchange,
5. government,
6. income distribution,
7. and power?
Do attempt the question before taking a sneak-peak at the answer!
Answer: 1. Prices – controlled by market; 2. Competition – multiple sellers compete to sell their goods
and services; 3. Private Property – allowed; 4. Exchange – driven by market forces; 5. Government –
role of facilitator and regulator; 6. Income distribution – based on one’s earnings in the market
economy; 7. Power – what do you think?
1.7.2 Socialism
• In theory, an economy that is a transition between capitalism and communism.
• It is based on
o government, rather than individual, ownership of resources
o worker control of the government, such that workers, rather than capitalist, control capital
and other productive resources
o income allocated on need rather than on resource ownership or contribution to production
(using the needs standard rather than the contributive standard).
• In a socialist society the government decides what goods are to be produced in accordance with the
needs of society.
Rooted in the ideas of historical change proposed by the German philosopher Karl Marx (1818-1883)
more specifically, this kind of economic system came up in the erstwhile USSR after the Bolshevic
Revolution (1917) and got its ideal shape in the People's Republic of China (1949).

* Market failure happens when the price mechanism fails to allocate scarce resources efficiently or
when the operation of market forces lead to a net social welfare loss. Complete market failure occurs
when the market simply does not supply products at all - we see "missing markets". Partial market failure
occurs when the market does actually function but it produces either the wrong quantity of a product or
at the wrong price.
Concept Check:
Socialism: What does the socialist thinker say about the following in a capitalistic market system:
1. prices,
2. competition,
3. private property,
4. exchange,
5. government,
6. income distribution,
7. and power?
Answer: 1. Prices – controlled by government; 2. Competition – limited competition between
government firms; 3. Private Property – not allowed; 4. Exchange – determined by government; 5.
Government – role of producer, facilitator and regulator; 6. Income distribution – based on one’s need;
7. Power – what do you think?
1.7.3 Mixed Economy

• An economy, or economic system, that relies on both markets and governments to allocate
resources.
• While, in theory, we could have a pure market economy or a pure command economy, in the real
world all economies are mixed, relying on both markets and governments for allocation decisions.
• Markets allocate resources through voluntary choices made by living, breathing people. Government
forces allocation through involuntary taxes, laws, restrictions, and regulations. Both institutions play
vital roles in an economy.
Concept Check
Q. According to the analysis of the British economist John Maynard Keynes...
a) ...markets coordinate supply and demand so that a policy of laissez-faire would prevent recession.
b) ...economic fluctuations were the cumulative result of mistakes made by businesses and
households in an uncertain world.

c) ...government demand could be used to smooth fluctuations in aggregate output and income.
d) ...supply creates its own demand through the circular flow of economic activity
e) None of the above
Answer: C
1.8 What are the various sectors of Economy?

• A nation’s economy can be divided into sectors to define the proportion of a population engaged in
different activities.
1.8.1 Primary activities

• The primary sector of the economy extracts or harvests products from the earth such as raw
materials and basic foods.
• Activities associated with primary economic activity include agriculture (both subsistence and
commercial), mining, forestry, grazing, hunting and gathering, fishing, and quarrying. The packaging
and processing of raw materials are also considered to be part of this sector.
1.8.2 Secondary activities

• The secondary sector of the economy produces finished goods from the raw materials extracted by
the primary economy. All manufacturing, processing, and construction jobs lie within this sector.
• Activities associated with the secondary sector include metalworking and smelting, automobile
production, textile production, the chemical and engineering industries, aerospace manufacturing,
energy utilities, breweries and bottlers, construction, and shipbuilding.
1.8.3 Tertiary activities

• The tertiary sector of the economy is also known as the service industry.
• Activities associated with this sector include retail and wholesale sales, transportation and
distribution, restaurants, clerical services, media, tourism, insurance, banking, health care, and law.
1.8.4 Quaternary activities

• The fourth sector of the economy, the quaternary sector, consists of intellectual activities often
associated with technological innovation. It is sometimes called the knowledge economy.
• Activities associated with this sector include government, culture, libraries, scientific research,
education, and information technology.
1.8.5 Quinary activities

• Some economists further narrow the quaternary sector into the quinary sector, which includes the
highest levels of decision-making in a society or economy.

• This sector includes top executives or officials in such fields as government, science, universities,
nonprofits, health care, culture, and the media.
• It may also include police and fire departments, which are public services as opposed to for-profit
enterprises.
• Economists sometimes also include domestic activities (duties performed in the home by a family
member or dependent) in the quinary sector. These activities, such as child care or housekeeping, are
typically not measured by monetary amounts but contribute to the economy by providing services for
free that would otherwise be paid for.
Concept Check
Q. Match the following:

Select the correct answer using the code given below:
Sector of
Economic Activity
Economy
1. Primary A. Fashion
2. Secondary B. Forestry
3. Tertiary C. Shipbuilding
4. Quaternary D. Information
(a) 1 – C, 2 – B, 3 – A, 4 – D
(b) 1 – B, 2 – C, 3 – A, 4 – D
(c) 1 – B, 2 – C, 3 – D, 4 – A
(d) 1 – B, 2 – A, 3 – C, 4 – D
Answer: B
1.9 What are the different types of Goods?
1.9.1 What are Goods?

A commodity, or a physical, tangible item that satisfies some human want or need, or something that
people find useful or desirable and make an effort to acquire it.

1.9.2 Economic Goods and Free Goods
Economic Goods
• Economic goods are those goods (manmade or free gifts of nature) whose demand is more than
supply (i.e. they are scarce). They command a price and they can be bought in the market.
• Example: toothpaste, soap, shaving cream etc.
Free Goods
• We can define free goods as goods which possess utility but which are not scarce.
• Free goods are free gifts of nature. They are available in abundance i.e. in unlimited quantity and the
supply is much more than the demand.
• Example: Sand, clean air, water etc.
1.9.3 Consumer Goods and Producer Goods

Consumer Goods
• Consumer goods are those goods, which satisfy the want of consumers directly. They are goods,
which are used for consumption.
• Example: bread, fruits, milk, clothes etc.
Producer Goods
• Producer goods are those goods, which satisfy the want of consumers indirectly. As they help in
producing other goods, they are known as producer goods.
• Example: machinery, tools, raw materials, seeds, manure and tractor etc. are all example of producer
goods.
1.9.4 Single Use and Durable Use Goods

Single Use Goods
• Single use goods are those goods, which can be used only once. They are finished in one use itself.
• Example: bread, butter, egg, milk etc. are the single use consumer goods as they are consumed
immediately and once and for all.
• Similarly, single use producer goods are exhausted in one production process. Example: coal, raw
material, seeds, manure etc.
Durable Use Goods
• Durable use goods are those goods, which can be used again and again for a long period of time.

• Durable use consumer goods are cloth, furniture, television, scooter etc. that can be used by
consumer again and again.
• Durable use producer goods are used in production again and again for example, machines, tools,
tractors and implements etc. This does not mean that repeated use of these goods does not make
any difference to them.
• In fact, the value of these goods gets depreciated after continuous use.
Concept Check
Which of the following is/are examples of durable consumer goods?
1. Petrol
2. Computer
3. Bread
4. Automobiles
(a) 1, 3 and 4 only
(b) 2 only
(c) 2 and 4 only
(d) 1, 2, 3, and 4
Answer: C
1.9.5 Private Goods and Public Goods

Private Goods
• All goods that are privately owned and are exclusively enjoyed by individuals are called private
goods. For example, all the goods owned by you are private goods.
• Examples: watch, pen, scooter, books, table, chair, bed, clothes etc. If you own a factory then its
building, machinery; tools etc. are your private goods.
Public Goods
• Public goods are those goods, which are owned and enjoyed by the society as a whole. They are
available to all people in a society without any discrimination, i.e. no one is denied from the
consumption of public goods.
• Both government and private entrepreneurs may produce public goods, but it is usually the former.
• Example: roads, bridges, park, town hall etc. are all collectively owned.
• Economists refer to public goods as "non-rivalrous" and "non-excludable," and most such goods are
both.

• Their non-rivalry refers to the fact that the goods don't dwindle in supply as people consume them;
a country's defenses, for example, do not run out or diminish as its population grows.
• Non-excludability means just that; the good is available to all and cannot be withheld, even from
people who do not contribute to its public funding.
• That characteristic, in turn, leads to what is called the free-rider problem with public goods. Since you
need not contribute to the provision of a public good to benefit from it, some people will inevitably
choose to use the good and yet shirk the public responsibility to help pay for it.
Concept Check
Q. Which of the following options is correct with respect to ‘Public Goods’?
(a) They are considered non-rivalrous as they don't dwindle in supply as people consume them.
(b) They are considered non-excludable as they are available to all and cannot be withheld even from
people who do not contribute to its public funding.
(c) They are associated with free-rider problem.
(d) All of the above
Answer: D
1.9.6 Intermediate Goods

• An intermediate good is a product used to produce a final good or finished product—also referred to
as a consumer good.
• Intermediate goods are vital to the production process, which is why they are also called producer
goods. Industries sell these goods to each other for resale or to produce other goods.
• These goods are also called semi-finished products because they are used as inputs to become part
of the finished product. When they are used in the production process, they are transformed into
another state.
Concept Check
Q. Which of the following is not an example of ‘intermediate good’?
(a) Cotton fiber used by a spinning mill.
(b) Sugarcane used by a sugar mill.
(c) Coffee beans used by a café.
(d) Tea leaves used at home.
(e) Synthetic rubber used by a tire manufacturer.
Answer: D

1.9.7 Intermediate Goods Versus Consumer & Capital Goods
• Intermediate goods can be used in production, but they can also be consumer goods. How it is
classified depends on who buys it.
• If a consumer buys a bag of sugar to use at home, it is a consumer good (final good). But if a
manufacturer purchases sugar to use during the production of another product, it becomes an
intermediate good.
• Capital goods, on the other hand, are assets that are used in the production of consumer goods. Key
thing to note about capital goods is that they don’t transform, or change shape in the production
process.
Concept Check
Q. Which of the following options is correct with respect to ‘Capital Goods’?
(a) They don’t transform, or change shape in the production process.
(b) They are bought for meeting immediate need of the consumer.
(c) They are naturally available.
Answer: A
1.9.8 Distinction Between Goods & Services

• Goods are tangible in nature i.e. they can be seen and touched. Services are non-tangible in nature
i.e. they can neither be seen nor be touched.
• There is a time gap between production and consumption of goods as they are produced first and
consumed later. There is no time gap between the production and consumption of services. That is
why they are produced and consumed simultaneously.
• Goods can be stored and utilized when required. Services cannot be stored.
• Goods can be transferred from one place to another. Transfer of service is not possible.
Concept Check
Q. Match the following pairs correctly:

Type of Good Example
1. Durable Use Good A. Coal

2. Consumer Good B. Highway
3. Single Use Good C. Sewing Machine
4. Public Good D. Television
5. Capital Good E. Milk
(a) 1 – A, 2 – C, 3 – D, 4 – B, 5 – E
(b) 1 – C, 2 – E, 3 – A, 4 – D, 5 – B
(c) 1 – C, 2 – D, 3 – B, 4 – A, 5 – E
(d) 1 – D, 2 – E, 3 – A, 4 – B, 5 – C
(e) 1 – E, 2 – C, 3 – D, 4 – B, 5 – A
Answer: D
2 Part II: Circular Flow of Income in a Simple Economy

Part II deals with ‘Circular Flow of Income in a Simple Economy’. In this part we will explore the linkages
between various economic agents about whom we have studied in Part I.
The circular flow model is a fundamental representation of macroeconomic activity among the major
players in the economy--consumers, producers, government, and the rest of the world.
2.1 Two Sector Model
• The simplest circular flow model contains two sectors (household and business) and two markets
(product and resource). This model highlights the core circular flow of production, income, and
consumption.

• The households receive their payments from the firms for productive activities they perform for the
latter.
• The aggregate consumption by the households of the economy is equal to the aggregate
expenditure on goods and services produced by the firms in the economy.
• We can measure the uppermost flow (at point A) by measuring the aggregate value of spending that
the firms receive or for the final goods and services which they produce. This method will be called
the expenditure method.
• If we measure the flow at point B by measuring the aggregate value of final goods and services
produced by all the firms, it will be called product method.
• At point C, measuring the sum total of all factor payments which is made by firms to households in
consideration of factor services will be called income method.
KEY DEFINITION
Gross Domestic Product (GDP): GDP is the total monetary or market value of all the final goods and
services produced within a country's borders in a specific time period. GDP provides an economic
snapshot of a country, used to estimate the size of an economy and growth rate. It can be calculated in
three ways, using expenditures, production, or incomes.
Final Goods and Services: Goods and services that are available for purchase by their ultimate or
intended user with no plans for further physical transformation or as an input in the production of other
goods that will be resold. Gross domestic product seeks to measure the market value of final goods.
Final goods are purchased through product markets by the four basic macroeconomic sectors
(household, business, government, and foreign) as consumption expenditures, investment
expenditures, government purchases, and exports.

Concept Check
Indicate whether the statement is true or false.
For an economy as a whole, income equals expenditure because the income of the seller must be equal
to the expenditure of the buyer.
Answer: True
2.2 Four Sector Model
• The circular flow model in four sector economy provides a realistic picture of the circular flow in an
economy. Four sector model studies the circular flow in an open economy which comprises of four
economic agents viz, the household sector, business sector (firms), government sector, and foreign
sector.
• Household Sector
o Receipts:
1. The household sector receives factor income in the form of factor payments (rent,
wages, interest, and profit) from the business sector (firms). Similarly it provides factor
services to government, external sector in consideration of factor income.
2. Households also receives transfer payments from the government sector. Transfer
payments are payments which are made without any counterpart of services received
by the payer. For examples, gifts, scholarships, pensions.
3. Borrowings from the financial market.
o Payments:

1. The income of the household sector flows into the business sector, government sector,
financial markets and foreign sector in the form of consumption expenditure, tax
payment, savings and imports respectively.
• Firms
o Receipts: The principle receipts of the business sector constitute of
1. Income from the sale of goods and services (firms receive consumption expenditure
from households).
2. Receipts from exports.
3. Subsidies from the government sector.
4. Borrowings from the financial market.
o Payments: Factor payments, tax payments, import payments, and savings constitute the
principal payments from the business sector to the household sector, government sector,
foreign sector and the financial market respectively.
• Government Sector
o Receipts: The major source of income for the government sector include the taxes paid by
household and business sector. Government can also borrow money from the financial market.
o Payments:
1. The government sectors make payments to different sectors in the form of transfer
payments, subsidies, grants, etc.
2. It pays to the business sector in return for the goods purchased, makes transfer
payments like pension funds, scholarships, etc. to the household sector.
3. If the government receipts are greater than the expenses, the surplus goes to capital
market.
4. In case of cash deficit, the government borrows from the capital market to maintain a
balance in the economy.
• Foreign Sector (External Sector)
o Receipts: The foreign sector receives income from the households and the business sector (of
the domestic country, say India) in return for the goods and services imported by the latter.
o Payments: Foreign sectors need to make payment to the business sector (of the domestic
country, say India) from where imports have been made. Foreign sector also makes payment
for factor services provided by households in the domestic sector.
Concept Check
Q. Which of the following is not a leakage from the circular flow of income and expenditure
(a) Imports

(b) Government purchases
(c) Taxes net of government transfers
(d) Saving
Answer: B
3 Part III: Calculating Gross Domestic Product

There are multiple approaches that can be adopted for the estimation of GDP. First approach is referred
to as the Product or Value Added Method. In this approach we simply add the ‘value added’ by various
agents in an economy. Let us understand the meaning of the term ‘value added’ and how it can help us in
estimating the GDP.
3.1 Product or Value Added Method

Example of Value Added
Example 1
Example 2
In the above examples, we can visualise the process of value added as follows:
• Example 1: A farmer starts his operation using tools, seeds, water and fertiliser apart from other
inputs. All these inputs help in the production of cane sugar. So essentially, seed + water + fertiliser
+ farmer’s efforts has resulted in the formation of cane sugar. This cane sugar can be converted

into sugar or into sugarcane juice! Now imagine if you were hungry, what would you prefer to
have? Would you prefer to have seeds or fertiliser? Or would you prefer to have cane sugar? Or
would sugarcane juice be the best? I think sugarcane juice might be the best! This is what value
addition does. It transforms intermediate goods into final goods that can satisfy a consumer’s
needs.
• Example 2: Wheat is supplied by a farmer to a baker who then coverts the wheat into breads,
cakes and an assortment of other delicious products. Again, if you were hungry, what would you
prefer to have? Wheat, wheat flour or bread?
Now that you have understood the meaning of value addition let us consider a simplified (but a
conceptually correct) model that we will be using to calculate GDP.
• In product method we calculate the aggregate annual value of goods and services produced (if a year
is the unit of time).
Farmer-Baker Model
• Let us suppose that there are only two kinds of producers in the economy. They are the wheat
producers (or the farmers) and the bread makers (the bakers). The wheat producers grow wheat and
they do not need any input other than human labour. They sell a part of the wheat to the bakers. The
bakers do not need any other raw materials besides wheat to produce bread.
• Let us suppose that in a year the total value of wheat that the farmers have produced is Rs 100. Out
of this they have sold Rs 50 worth of wheat to the bakers. The bakers have used this amount of wheat
completely during the year and have produced Rs 200 worth of bread. What is the value of total
production in the economy? If we follow the simple way of aggregating the values of production of
the sectors, we would add Rs 200 (value of production of the bakers) to Rs 100 (value of production
of farmers). The result will be Rs 300.
• A little reflection will tell us that the value of aggregate production is not Rs 300. The farmers had
produced Rs 100 worth of wheat for which it did not need assistance of any inputs. Therefore the
entire Rs 100 is rightfully the contribution of the farmers. But the same is not true for the bakers. The
bakers had to buy Rs 50 worth of wheat to produce their bread. The Rs 200 worth of bread that they
have produced is not entirely their own contribution. To calculate the net contribution of the bakers,
we need to subtract the value of the wheat that they have bought from the farmers. If we do not do
this, we shall commit the mistake of ‘double counting’. This is because Rs 50 worth of wheat will be
counted twice. First it will be counted as part of the output produced by the farmers. Second time, it
will be counted as the imputed value of wheat in the bread produced by the bakers.

• Therefore, the net contribution made by the bakers is, Rs 200 – Rs 50 = Rs 150. Hence, aggregate
value of goods produced by this simple economy is Rs 100 (net contribution by the farmers) + Rs 150
(net contribution by the bakers) = Rs 250.
• The term that is used to denote the net contribution made by a firm is called its value added. We
have seen that the raw materials that a firm buys from another firm which are completely used up in
the process of production are called ‘intermediate goods’. Therefore, the value added of a firm is,
value of production of the firm – value of intermediate goods used by the firm.
KEY DEFINITION
Value added: Net contribution made by a firm in the process of production. It is defined as, Value of
production – Value of intermediate goods used.
Double Counting: The act of including the value of intermediate goods more than once in the value of
gross domestic product. Because the value, or price, of final goods includes the cost, or value, of all
intermediate goods used, including market transactions for intermediate separately in the
measurement of gross domestic product would lead to double counting.
• The value added of a firm is distributed among its four factors of production, namely, labour, capital,
entrepreneurship and land. Therefore wages, interest, profits and rents paid out by the firm must add
up to the value added of the firm.
Table summarising above explanation (all values in Rupees)
Farmer Baker
Total
100 200
Production
Intermediate
0 50
Goods Used
Value Added 100 200-50 = 150
• If we sum the gross value added of all the firms of the economy in a year, we get a measure of the
value of aggregate amount of goods and services produced in the economy in a year (just as we had
done in the wheat-bread example). Such an estimate is called Gross Domestic Product (GDP). Thus,
• GDP = Sum total of gross value added of all the firms in the economy.
• If there are N firms in the economy, each assigned with a serial number from 1 to N, then
o GDP = GVA1 + GVA2 + ..... + GVAN
• Therefore, GDP = ∑ GVAi
KEY DEFINITION
Gross Domestic Product (GDP): GDP is the total value of all finished goods produced in the country in
one financial year. It doesn't matter if it is produced by citizens or foreigners. If they are located within
the country's boundaries, their production is included in GDP. To avoid double-counting, GDP includes
the final value of the product, but not the parts (or intermediate goods) that go into it. For example,
an Indian footwear manufacturer uses laces and other materials made in India. Only the value of the
shoe gets counted; the shoelace does not.
Concept Check
Q. Gross Domestic Product is the sum of the market value of the
(a) intermediate goods.
(b) final goods and services.
(c) manufactured goods.
(d) inferior goods and services.
(e) normal goods and services.
Answer: B
KEY DEFINITION
• Value Added method of calculating national income: Method of calculating the national income by
measuring the aggregate sum of gross value added of all the firms in an economy over a period of
time.
Concept Check
Q. Which of the following is/are not considered while calculating the Gross Domestic Product (GDP)
of a country?
(a) Purchase of vegetables by a restaurant
(b) Ice cream used by the households
(c) Plant and machinery used in a factory
(d) Garments purchased by consumers
Answer: A
Concept Check

If a timber mart sells Rs 1,000 of timber to a carpenter and the carpenter uses the timber to build
furniture which he sells for Rs 5,000, the contribution to GDP is Rs 6,000.
Answer: False
3.2 Expenditure Method

The expenditure method is a system for calculating gross domestic product (GDP) that combines
consumption, investment, government spending, and net exports.
It is the most common way to estimate GDP. It says everything that the private sector, including
consumers and private firms, and government spend within the borders of a particular country, must add
up to the total value of all finished goods and services produced over a certain period of time.
The GDP under this method is calculated by summing up all of the expenditures made on final goods and
services.
There are four main aggregate expenditures that go into calculating GDP:
Consumption by households
• Let C be the aggregate final consumption expenditure of the entire economy.

• Notice that a part of C is spent on imports of consumption goods.
• Let Cm denote expenditure on the imports of consumption goods.
• Therefore C – Cm denotes that part of aggregate final consumption expenditure that is spent on the
domestic firms.
Investment by Businesses
• Let I be the aggregate final investment expenditure of the entire economy.

• Notice that a part of I is spent on imports of investment goods.
• Let Im denote expenditure on the imports of investment goods.
• Therefore I-Im denotes that part of aggregate final investment expenditure that is spent on the
domestic firms.
• Capital formation is a term used to describe the net capital accumulation during an accounting period
for a particular country. The term refers to additions of capital goods, such as equipment, tools,
transportation assets, and electricity. It is the result of investment activities undertaken by firms and
government.
Government Spending

• Similarly, G – Gm stands for that part of aggregate final government expenditure that is spent on
the domestic firms, where G is the aggregate expenditure of the government of the economy and
Gm is the part of G which is spent on imports.
Spending by External Sector
• Exports (X), which is nothing but spending by the external sector on purchasing goods and services
produced by the domestic sector.
The formula for GDP is:
GDP = (C – Cm) + (I – Im) + (G – Gm) + X
It can also be written as:
GDP = C + I + G + (X – Cm – Im – Gm)
GDP = C + I + G + (X – (Cm + Im + Gm))
GDP = C + I + G + (X – M)
Where, M = Cm + Im + Gm (i.e. M = total imports)
Let us revisit the Farmer-Baker model and calculate the GDP using Expenditure Method
In the Farmer-Baker example that we have described before, the aggregate value of the output in the
economy by expenditure method will be calculated in the following way.
• In this method we add the final expenditures that each firm makes.
• The Rs 50 worth of wheat that the Farmer consumed will be counted as the final expenditure received
by him. (Assume that Farmer’s family pays Rs 50 to the Farmer for the wheat that they consume.)
• The Rs 50 worth of wheat which the Baker buys from the Farmer counts as intermediate goods,
hence it does not fall under the category of final expenditure.
• The Rs 200 worth of bread that Baker sells to his customers will be counted as the final expenditure
received by him (i.e. final expenditure incurred by households in buying the bread from Baker).
• Therefore, the aggregate value of output of the economy is Rs 200 (final expenditure received by the
baker) + Rs 50 (final expenditure received by the farmer) = Rs 250 per year.
KEY DEFINITION
Expenditure method of calculating national income: Method of calculating the national income by
measuring the aggregate value of final expenditure for the goods and services produced in an economy
over a period of time.
Concept Check

Q. In an open economy, the Gross Domestic Product (Y) of the economy is: (C, I, G, X, M stand for
Consumption, Investment, Govt. Expenditure, total exports and total imports respectively.)
(a) Y = C + I + G + X
(b) Y = I + G –X + M
(c) Y = C + I + G + (X – M)
(d) Y = C – G + I + (X – M)
Answer: C
3.3 Income Method

The income approach to measuring gross domestic product is based on the accounting reality that all
expenditures in an economy should equal the total revenue generated by the production and sale of all
economic goods and services.
Therefore, by adding all of the sources of income together, a quick estimate can be made of the total
productive value of economic activity over a period.
The formula for GDP is:
GDP = W + P + In + R where
W = Total wages and salaries received by all factors of production
P = Total profits received by all factors of production
In = Total interest received by all factors of production
R = Total rent received by all factors of production.
Let us revisit the Farmer-Baker model and calculate the GDP using Income Method
In the Farmer-Baker example that we have described before, the aggregate value of the output in the
economy by income method will be calculated in the following way.
• In this method, we add the final income that each household receive.
• Since there are two actors in our story – the farmer and the baker, let us similarly assume that there
are only two households in the economy – farmer household and baker household.
• What is the income that the farmer household receive? You will remember that using no intermediate
products, farmer was able to produce wheat worth Rs 100. Hypothetically, if farmer were to sell this
entire output for Rs 100, what would be the farmer’s profit? It will be Rs 100. Assume that farmer

household pays Rs 50 to the farmer for the wheat that they consume. And we know that baker paid Rs
50 to the farmer for the wheat former purchased from the latter. So essentially the income that farmer
takes back (in the form of profit) to his household is Rs 100.
• What is the income that the baker household receive? You will remember that using intermediate
goods worth Rs 50, baker produces output worth Rs 200. So, what is the profit that the baker makes?
It is Rs 150. So essentially the income that the baker takes back (in the form of profit) to his household
is Rs 150.
• Knowing that farmer and baker households are the only two households in the economy, what is the
GDP of this simple farmer-baker economy by income method? It is nothing but the sum of income
received by the two households, i.e. Rs 100 + Rs 150 = Rs 250.
KEY DEFINITION
Income method of calculating national income: Method of calculating national income by measuring
the aggregate value of final factor payments (= income) made in an economy over a period of time.
Concept Check
Q. As per the income method of calculating GDP, which of the following act as factors of production?
(a) Land
(b) Capital
(c) Entrepreneur
(d) Labour
(e) All of the above
Answer: E
3.4 Comparison of the Three Methods of Estimating GDP

Example: There are two firms, A and B. Suppose A uses no raw material and produces cotton worth Rs.
50. A sells its cotton to firm B, who uses it to produce cloth. B sells the cloth produced to consumers for
Rs. 200.
GDP in the Phase of Production or the Value Added Method
Value Added (VA) = Sales – Intermediate Goods

Thus,
VAA = 50 - 0 = 50
VAB = 200 - 50 = 150
Thus,
GDP = VAA + VAB = 200

GDP in the Phase of Disposition or the Expenditure Method
GDP = Sum of final expenditure or expenditures on goods and services for end use
In the above case, final expenditure is expenditure by consumers on cloth. Therefore, GDP = 200.
GDP in the Phase of Distribution or Income Method
Let us look at the firms A and B again.

Now, of this 50 received by A, the firm gives Rs. 20 to the workers as wages, and keeps the remaining 30
as its profits.
Similarly, B gives 60 as wages and keeps 90 as profits (recall that 50 has been paid by B to A for cotton).
Recall that GDP by income method = sum total of factor incomes, which is equal to total wages received
(workers of A and B) and total profits earned (by A and B), which is equal to 80 + 120 = 200.
Concept Check
Q. Gross Domestic Product can be measured as the sum of
(a) final goods and services, intermediate goods, transfer payments, and rent.
(b) consumption, investment, government purchases, and net exports.
(c) consumption, transfer payments, wages, and profits.
(d) Net National Product, Gross National Product, and Disposable personal income.
(e) investment, wages, profits, and intermediate production.
Answer: B
4 Part IV: Important Macroeconomic Identities
4.1 Gross Investment, Depreciation and Net Investment

• That part of our final output that comprises of capital goods constitutes gross investment of an
economy. These may be machines, tools and implements; buildings, office spaces, storehouses or
infrastructure like roads, bridges, airports or jetties.
• But all the capital goods produced in a year do not constitute an addition to the capital stock already
existing.
• A significant part of current output of capital goods goes in maintaining or replacing part of the existing
stock of capital goods. This is because the already existing capital stock suffers wear and tear and
needs maintenance and replacement.
• A part of the capital goods produced this year goes for replacement of existing capital goods and is
not an addition to the stock of capital goods already existing and its value needs to be subtracted
from gross investment for arriving at the measure for net investment. This deletion, which is made

from the value of gross investment in order to accommodate regular wear and tear of capital, is called
depreciation.
• So new addition to capital stock in an economy is measured by net investment or new capital
formation, which is expressed as
o Net Investment = Gross investment – Depreciation
KEY DEFINITION
Gross investment: Addition to the stock of capital which also includes replacement for the wear and
tear which the previously installed capital stock undergoes.
Depreciation: Wear and tear or depletion which capital stock undergoes over a period of time.
Net investment: Addition to capital stock; unlike gross investment, it does not include the replacement
for the depletion of capital stock.
Concept Check
Q. With reference to ‘depreciation’, which of the following option is/are correct?
(a) It refers to that portion of the capital goods which goes in maintenance and replacement of existing
goods due to wear and tear.
(b) To obtain net investment in an economy, depreciation is subtracted from the gross investment.
(c) If we include depreciation in value added then the measure of value added that we obtain is called
Gross Value Added.
Answer: D
4.2 Net Domestic Product

• This measure allows policy-makers to estimate how much the country has to spend just to maintain
their current GDP.
• If the country is not able to replace the capital stock lost through depreciation, then GDP will fall.
• NDP = GDP – Depreciation
• This way, NDP of an economy has to be always lower than its GDP for the same year, since there is no
way to cut the depreciation to zero.
• However, NDP is not used in compare the economies of the world. This is due to the different rates of
depreciation which is set by the different economies of the world.

Concept Check
Q. The aggregate production of final goods and services taking place within the domestic economy
during a financial year, exclusive of depreciation is known as:
(a) Gross Domestic Product (GDP)
(b) Gross National Product (GNP)
(c) Net Domestic Product (NDP)
(d) Net National Product (NNP)
Answer: C
4.3 Gross National Product

• GNP and GDP are very closely related concepts, and the main differences between them comes from
the fact that there may be companies owned by foreign residents that produce goods in India, and
companies owned by Indians that produce goods for the rest of the world and revert earned income
to domestic residents in India.
• For example, there are a number of foreign companies that produce goods and services in India and
transfer any income earned to their foreign residents. Likewise, many Indian corporations produce
goods and services outside of Indian borders and earn profits for India’s residents.
• Where GDP looks at the value of goods and services produced within a country's borders, GNP is the
market value of goods and services produced by all citizens of a country—both domestically and
abroad.
• Thus, GNP is an estimate of total value of all the final products and services turned out in a given
period by the means of production owned by a country's citizens.
• GNP is commonly calculated by taking the sum of personal consumption expenditures, private
domestic investment, government expenditure, net exports and any income earned by residents
from overseas investments, minus income earned within the domestic economy by foreign
residents.
• The formula for GNP is:
o GNP = GDP + (Factor income earned by the domestic factors of production employed in the
rest of the world – Factor income earned by the factors of production of the rest of the world
employed in the domestic economy)
• Hence, GNP = GDP + Net factor income from abroad

o (Net factor income from abroad = Factor income earned by the domestic factors of
production employed in the rest of the world – Factor income earned by the factors of
production of the rest of the world employed in the domestic economy).
KEY DEFINITION
Gross National Product (GNP): GDP + Net Factor Income from Abroad. In other words, GNP includes
the aggregate income made by all citizens of the country, whereas GDP includes incomes by foreigners
within the domestic economy and excludes incomes earned by the citizens in a foreign economy.
The different uses of the concept of GNP are as follows:
• This is the ‘national income’ according to which the IMF ranks the nations of the world in terms of the
volumes – at Purchasing Power Parity (at PPP).
• It is a more exhaustive concept of national income than GDP, as it indicates the internal as well as the
external strength of the economy.
Concept Check
If India’s GDP exceeds its GNP, then foreigners produce more in India than Indian citizens produce in
the rest of the world.
Answer: True
4.4 Net National Product

• We have already noted that a part of the capital gets consumed during the year due to wear and
tear. This wear and tear are called depreciation.
• If we deduct depreciation from GNP the measure of aggregate income that we obtain is called Net
National Product (NNP).
• The formula for NNP is:
o NNP = GNP – Depreciation
4.5 Net National Product at Market Price (NNPMP) & Net National Product at Factor Cost (NNPFC)
• It is to be noted that all the variables discussed so far are evaluated at market prices.
• But market price includes indirect taxes. When indirect taxes are imposed on goods and services,
their prices go up.
• Indirect taxes accrue to the government. We have to deduct them from NNP evaluated at market
prices in order to calculate that part of NNP which actually accrues to the factors of production.

• Similarly, there may be subsidies granted by the government on the prices of some commodities. So,
we need to add subsidies to the NNP evaluated at market prices.
• Example: Market price of commodity X should be Rs 100 per unit; since government wants to reduce
price of commodity X for the end user, it decides to give a subsidy of Rs 20 per unit to the manufacturer
and asks the manufacturer to sell commodity X at Rs 80 per unit; so essentially, manufacturer is still
getting Rs 100 per unit for commodity X; it is this Rs 100 that gets distributed amongst various factors
of production. That is why we need to add subsidy to market price to arrive at factor cost.
• The measure that we obtain by doing so (reducing indirect taxes and adding subsidies to NNP at
market prices) is called Net National Product at factor cost or National Income.
• The formula for NNP at factor cost (which is also referred to as National Income):
o NNPFC = National Income (NI) = NNPMP – Indirect taxes + Subsidies
o NNPFC = National Income (NI) = NNPMP – (Indirect taxes – Subsidies)
o NNPFC = National Income (NI) = NNPMP – Net indirect taxes
▪ Where, Net indirect taxes = Indirect taxes – Subsidies.
Concept Check
Let us take a very hypothetical example. Suppose, the cost of making a product is Rs.1000. The
indirect tax levied on it by the government is 10%. Let us suppose the government grants a subsidy
of Rs.150 on the product. Now, what is its Factor cost and Market Price (in Rs)?
(a) 1000, 950
(b) 950, 1000
(c) 1100, 950
(d) 850, 950
Answer: (a) 1000, 950
4.6 Personal Income

• We can further subdivide the National Income into smaller categories. Let us try to find the expression
for the part of NI which is received by households. We shall call this Personal Income (PI).
• First, let us note that out of NI, which is earned by the firms and government enterprises, a part of
profit is not distributed among the factors of production. This is called Undistributed Profits (UP).
We have to deduct UP from NI to arrive at PI, since UP does not accrue to the households.
• Similarly, Corporate Tax, which is imposed on the earnings made by the firms, will also have to be
deducted from the NI, since it does not accrue to the households.

• On the other hand, the households do receive interest payments from private firms or the
government on past loans advanced by them. And households may have to pay interests to the firms
and the government as well, in case they had borrowed money from either. So, we have to deduct
the net interests paid by the households to the firms and government.
• The households receive transfer payments from government and firms (pensions, scholarship, prizes,
for example) which have to be added to calculate the Personal Income of the households.
• The formula for Personal Income (PI):
o Personal Income (PI) = NI – Undistributed profits – Net interest payments made by
households – Corporate tax + Transfer payments to the households from the government
and firms.
KEY DEFINITION
Undistributed profits: That part of profits earned by the private and government owned firms which
are not distributed among the factors of production.
Corporate tax: Taxes imposed on the income made by the corporations (or private sector firms).
Net interest payments made by households: Interest payment made by the households to the firms –
interest payments received by the households.
Transfer payments to households from the government and firms: Transfer payments are payments
which are made without any counterpart of services received by the payer. For examples, gifts,
scholarships, pensions.
Personal Income: National Income – Undistributed profits – Net interest payments made by households
– Corporate tax + Transfer payments to the households from the government and firms.
Concept Check
Q. Which of the following is not an example of a transfer payment in the sense of the national income
accounts?
(a) Government family allowances
(b) Public unemployment insurance benefits
(c) Dividends paid by corporations to stockholders
(d) Disability pensions paid from the social insurance system
Answer: C

4.7 Personal Disposable Income
• Even Personal Income is not the income over which the households have complete say. They have to
pay taxes from PI.
• If we deduct the Personal Tax Payments (income tax, for example) and Non-tax Payments (such as
fines) from PI, we obtain what is known as the Personal Disposable Income.
• The formula for Personal Disposable Income (PDI):
o Personal Disposable Income (PDI) = PI – Personal tax payments – Non-tax payments.
• Personal Disposable Income is the part of the aggregate income which belongs to the households.
They may decide to consume a part of it, and save the rest.
KEY DEFINITION
Personal tax payments: Taxes which are imposed on individuals, such as income tax.
Non-tax payments: Payments made by households to the firms or the government as non-tax
obligations such as fines.
Personal Disposable Income (PDI): PI – Personal tax payments – Non-tax payments.
Concept Check
Which of the following statements is correct about disposable income?
(a) It is the money available with households after deduction of income tax.
(b) It is the liquid money available with households.
(c) It is the gross money earned by a household.
(d) It is the money available to the household once savings are made.
Answer: A
4.8 Per Capita Income

• Per capita income is a measure of the amount of money earned per person in a nation or geographic
region.
• Per capita income can be used to determine the average per-person income for an area and to
evaluate the standard of living and quality of life of the population.
• Per capita income for a nation is calculated by dividing the country's national income (Net National
Income at Factor Cost) by its population.
Note:

1. NNPMP = GNPMP – Depreciation
2. NNPMP = NDPMP + NFIA
3. National Income = NNPFC – Indirect Taxes + Subsidies
4. Per capita income = National Income / Population
5. Therefore, we can say that higher the rates of depreciation, lower the per capita income of the nation.
Concept Check
Is it possible for GDP to rise while at the same time per capita income is falling? Is it possible for GDP to
fall while per capita income is rising?
Answer: Yes, and yes. The answer to both questions depends on whether GDP is growing faster or
slower than population. If population grows faster than GDP, GDP increases while GDP per capita
decreases. If GDP falls, but population falls faster, then GDP decreases while GDP per capita increases.
Concept Check
Q. The most appropriate measure of economic growth is its:
(a) Gross Domestic Product of a country
(b) Net Domestic Product
(c) Net National Product
(d) Per Capita Real Income
Answer: D
4.9 Nominal and Real GDP
4.9.1 Nominal GDP

• Nominal GDP, or nominal gross domestic product, is a measure of the value of all final goods and
services produced within a country’s borders at current market prices. In calculating nominal GDP,
we only use current quantities at current year prices.
• If, for instance, India produced only three products—coffee, tea, and rubber, let’s say—nominal GDP
would be calculated by first multiplying the quantity of each product produced by its current market
price, and then adding the three results together. In order to calculate it, we first need to know the
quantity of each product produced and the up-to-date average price for that product.
• Therefore, (coffee quantity x coffee’s current market price) + (tea quantity x tea’s current market
price) + (rubber quantity x rubber’s current market price) = Nominal GDP

• It can then be further reduced to the nominal GDP per capita by dividing the nominal GDP by the
country’s population.
Concept Check
With reference to ‘Nominal GDP’, which of the following statements is correct?
(a) It measures total economic output produced valued at a constant market price.
(b) It is used for comparison across years and across countries.
(c) It concentrates on volume growth only and does not include price growth.
(d) None of the above
Answer: D
4.9.2 Real GDP

• Real GDP is GDP evaluated at the market prices of some base year.
• Base year is the year whose prices are being used to calculate the real GDP.
• For example, if 2012 were chosen as the base year, then real GDP for 2019 is calculated by taking the
quantities of all goods and services purchased in 2019 and multiplying them by their 2012 prices.
KEY DEFINITION
Base year: The year whose prices are used to calculate the real GDP.
Real GDP: The total market value, measured in constant prices, of all goods and services produced
within the political boundaries of an economy during a given period of time, usually one year. The key
is that real gross domestic product is measured in constant prices, the prices for a specific base year.
Real gross domestic product, also termed constant gross domestic product, adjusts gross domestic
product for inflation.
Concept Check
If nominal GDP in 2005 exceeds nominal GDP in 2004, real output must have risen.
Answer: False
Concept Check
Q. Real GDP is a measure of a country's
(a) wealth

(b) money
(c) economic transactions
(d) physical output
Answer: D
4.9.3 Base Year

• It is a specific year against which the economic growth is measured.
• It is allocated a value of 100 in an index.
• The estimates at the prevailing prices of the current year are termed as "at current prices", while those
prepared at base year prices are termed "at constant prices".
• The base year is changed periodically to take into account the structural changes which take place in
the economy.
• The first official estimates of national income were computed by CSO (now National Statistical Office
{NSO}* with base year 1948-49 for the estimates at constant prices.
• A base year has to be a normal year without large fluctuations in production, trade and prices of
commodities in general.
• Reliable price data should be available for it. It should be as recent as possible.
• For example, if we take a year which had a severe drought, in that year the agriculture produce would
have been very less and thus the prices would have been very high. So, taking this year as a base year
would not be appropriate as this year was a one-off case because of the occurrence of drought.
* In May 2019, Government of India had decided to merge Central Statistical Office and National Sample
Survey Office into the National Statistical Office.
4.9.4 Why is calculating Real GDP important?

Consider the following statements:
• For example, suppose a country only produces bread.

• In the year 2000 it had produced 100 units of bread, and price of bread in year 2000 was Rs 10 per
bread. GDP at current price was Rs 1,000. (This is the nominal GDP of year 2000)
• In 2001 the same country produced 110 units of bread at price Rs 15 per bread. Therefore, nominal
GDP in 2001 was Rs 1,650 (=110 × Rs 15).
• If one were to only compare nominal GDP of year 2001 with that of year 2000, without paying
attention towards the prevailing price levels, one may conclude that since there is a 65% increase in
nominal GDP (from Rs 1,000 to Rs 1,650), there may be a 65% increase in bread production.

• But is there a 65% increase in bread production? No! There is only a 10% increase in bread
production (from 100 units to 110 units), whereas there is a 50% increase in the price level (from Rs
10 to Rs 15 per bread)!
• This is where Real GDP helps us. It helps us in cancelling out the effect of price change and correctly
measure the changes in production levels.
• Real GDP in 2001 calculated at the price of the year 2000 (2000 will be called the base year) will be
110 × Rs 10 = Rs 1,100.
• When we compare real GDP of year 2001 with nominal GDP of year 2000 (which is also the real GDP
since base year is 2000 itself), we notice an increase of 10% (from Rs 1000 to Rs 1100), which is the
same as the increase in bread production.
• If production in year 2002 increases to 120 breads, real GDP in 2002 (assuming 2000 as the base year)
will be 120 X Rs 10 = Rs 1200. This indicates a 20% increase over 2000, which is also the same as the
increase in bread production between 2000 and 2002.
Concept Check:
For cross-country comparison, which is a more suitable indicator: nominal GDP or real GDP?
Answer: Real GDP
4.9.5 GDP Deflator

• Let us understand this concept using a numerical example.
• For example, suppose a country only produces bread. In the year 2000 it had produced 100 units of
bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the same country
produced 110 units of bread at price Rs 15 per bread. Therefore, nominal GDP in 2001 was Rs 1,650
(=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000 (2000 will be called the base
year) will be 110 × Rs 10 = Rs 1,100.
• Notice that the ratio of nominal GDP to real GDP gives us an idea of how the prices have moved from
the base year (the year whose prices are being used to calculate the real GDP) to the current year.
• In the calculation of real and nominal GDP of the current year, the volume of production is fixed.
Therefore, if these measures differ it is only due to change in the price level between the base year
and the current year.
• The ratio of nominal to real GDP is a well-known index of prices. This is called GDP Deflator. Thus, if
GDP stands for nominal GDP and gdp stands for real GDP then, GDP deflator = GDP/gdp.
• In the previous example, the GDP deflator is 1,650/1,100 = 1.50 (in percentage terms this is 150 per
cent). This implies that the price of bread produced in 2001 was 1.5 times the price in 2000. Which is

true because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP deflator, we can have
GNP deflator as well.
KEY DEFINITION
GDP Deflator: A price index calculated as the ratio nominal gross domestic product to real gross
domestic product. It is used as an indicator of the economy's average price level.
Concept Check
Q. Which of the following is the correct description of GDP deflator?
(a) It is the ratio between the nominal GDP and real GDP.
(b) It is the ratio between the GDP in the current year and GDP in the base year.
(c) It is the relation between the change in GDP and the corresponding change in employment rates.
(d) It is the measure used to compare GDPs of different countries
Answer: A
4.10 Factor Cost, Basic Prices and Market Prices
Factor Production Basic

Cost Taxes Price
Basic Product Market

Price Taxes Price

• In India, the most highlighted measure of national income has been the GDP at factor cost. The Central
Statistics Office (now NSO) of the Government of India has been reporting the GDP at factor cost and
at market prices.
• In its revision in January 2015 the CSO replaced GDP at factor cost with the GVA at basic prices, and
the GDP at market prices, which is now called only GDP, is now the most highlighted measure.
• The distinction between factor cost, basic prices and market prices is based on the distinction between
net production taxes (production taxes less production subsidies) and net product taxes (product taxes
less product subsidies).
• Production taxes and subsidies are paid or received in relation to production and are independent
of the volume of production such as land revenues, stamp and registration fee.
o Production taxes/subsidies are independent of the quantity (volume) of production.
o It is often imposed even if the products are not produced (Eg: tax —land revenues, stamps
fees, registration fees tax on the profession)
o Production subsidies — subsidies to Railways, input subsidies to farmers, subsidies to the
village and small industries, administrative subsidies to corporations or cooperatives, etc).
o Note: Net Production Taxes = Production taxes - Production subsidies
• Product taxes and subsidies, on the other hand, are paid or received per unit or product, e.g., excise
tax, service tax, export and import duties etc.
• Factor cost includes only the payment to factors of production, it does not include any tax.
Example: A bread is being made in a bakery. The raw material used is wheat (it costs Rs.50), one person
is involved in making it (he charges Rs.10). Now the factor cost of the bread is going to be
Rs.50+Rs.10=Rs.60. (We are ignoring the other charges for simplicity like the rent of the place where
bakery functions, the electricity bill etc.)
• In order to arrive at the market prices, we have to add to the factor cost the total indirect taxes less
total subsidies.
• The basic prices lie in between: they include the production taxes (less production subsidies) but not
product taxes (less product subsidies). Therefore, in order to arrive at market prices, we have to add
product taxes (less product subsidies) to the basic prices.
Remember: Market Price > Basic Price > Factor Cost

• As stated above, now the CSO (now NSO) releases GVA at basic prices. Thus, it includes the net
production taxes but not net product taxes.

• In order to arrive at the GDP (at market prices) we need to add net product taxes to GVA at basic
prices.
• The formula for GVA at basic prices:
o GVA at factor costs + Net production taxes = GVA at basic prices
• The formula for GVA at market prices:
o GVA at basic prices + Net product taxes = GVA at market prices
Concept Check
Q. Which of the following is not typically considered to be a ‘product tax’?
(a) Excise tax
(b) Sales tax
(c) Stamp Duty
(d) Customs Duty
(e) Service tax
Answer: C
4.11 Why is GVA calculated?

• GVA and GDP give a picture of economic activity from producer’s (supply side) and consumer’s
(demand side) perspective respectively, because GVA is the net receipt of the producers and GDP is
the expenditure incurred by the consumers.
• Both these measures need not match and there could be a sharp divergence due to net indirect taxes
(NIT = Indirect Taxes – Subsidies), which are counted in GDP calculation (GDP is the sum of GVA and
NIT).
• GVA provides a better measure of economic activity because GDP can record a sharp increase just on
account of increased tax collections due to better compliance /coverage and not necessarily due to
increase in output.
• GVA is a better reflection of the productivity of the producers as it excludes the indirect taxes, which
could distort the production process.
• A sector-wise breakdown provided by the GVA measure can better help policymakers to decide which
sectors need incentives/stimulus or vice-versa.
Concept Check
Q. With reference to Gross Domestic Product (GDP) and Gross Value Added (GVA), which of the
following option is/are correct?
(a) GDP gives a picture of economic activity from producer’s side.

(b) GVA gives a picture of economic activity from consumer’s side.
(c) GVA is the sum of GDP and Net Indirect Taxes.
Answer: E
5 Part V: Growth, Welfare & Development
5.1 Sources of Economic Growth

• Economic growth is achieved by increasing the economy's ability to produce goods and services. This
goal is best indicated by measuring the growth rate of production. If the economy produces more
goods this year than last, then it is growing.
o An economy is able to achieve the goal of economic growth by increasing the quantity or
quality of the resources.
Concept Check
Q. Economic growth in country X will necessarily have to occur if
(a) there is technical progress in the world economy
(b) there is capital formation in X
(c) the volume of trade grows in the world economy
Answer: B
5.2 Types of Economic Growth

• There are two types of economic growth allocated in economic theory - intensive and extensive.
• Extensive type of growth is characterized by quantitative increase of use of one or more factors of
production. Accordingly, there are capital, labour and resource subtypes of extensive economic
growth.
• When there is a qualitative improvement in the factors of production, such as use of ultra-precise
modern equipment in goods production, cost-effective non-waste technologies and more skilled
workforce, we can talk about the intensive, or qualitative, type of economic growth.
Concept Check
Q. Which of the following programmes / schemes of Government of India can help bring about
‘intensive growth’?

(a) Soil Health Card Scheme
(b) Skill India Mission
(c) Amended Technology Upgradation Fund Scheme
(d) Women Entrepreneurship Platform
Answer: E
5.3 GDP & Welfare

Can the GDP of a country be taken as an index of the welfare of the people of that country? If a person
has more income, he or she can buy more goods and services and his or her material well-being improves.
So it may seem reasonable to treat his or her income level as his or her level of well-being. GDP is the sum
total of value of goods and services created within the geographical boundary of a country in a particular
year. It gets distributed among the people as incomes (except for retained earnings). So we may be
tempted to treat higher level of GDP of a country as an index of greater well-being of the people of that
country. But there are many reasons why this may not be correct.
5.4 Limitations of GDP

Quality of Life
• What it means? Sometimes called “well-being”; the standard of health, happiness, security, and
material comfort of an individual, a group of people, or a nation.
• GDP gives no idea about Quality of Life.
Non-market transactions
• What it means? Economic activity that takes place in the informal sector (from babysitting, to lawn
mowing, to illegal drug sales), sometimes called the grey market or the black market economy;
• Non-market transactions are not recorded, taxed, or officially monitored by the government
therefore not included in the calculation of a nation’s GDP.

Income Inequality
• What it means? when a disproportionate share of a nation’s income is earned by a small minority
of households; for example, according to Oxfam report in January 2020 – India’s richest 1% hold
• GDP does not account for income distribution in any way.
Sustainability
• What it means? The ability of a system to endure indefinitely into the future;
• An increase in GDP will only be sustainable as long as it does not deplete natural resources too
rapidly nor exploit the environment in a way that diminishes the quality of life of the nation’s
households over time.
Economic Bads
• What it means? Any outcome from economic activity that creates negative value for society, such
as air pollution from cars that harms human health and the environment;
• Unsustainable economic growth may diminish the quality of life of a nation’s people.
Depreciation of Capital
• What it means? The decrease in the value of a nation’s capital stock over time;
• GDP accounts for investment in new capital but does not subtract the lost value of depreciated
capital. Because of this, GDP may overstate the amount of economic activity in nations with rapidly
depreciating capital stocks.
Real GDP per capita
• What it means? The real gross domestic product of a nation, divided by the nation’s population; this
measure is an indication of the average income of a nation’s people.
Concept Check
Q. Increase in absolute and per capita real GNP do not connote a higher level of economic
development, if
(a) industrial output fails to keep pace with agricultural output.
(b) agricultural output fails to keep pace with industrial output.
(c) poverty and unemployment increase.
(d) imports grow faster than exports.
Answer: C
Concept Check
Q. Which of the following does not enter GDP?
(a) public service

(b) public education
(c) life expectancy
(d) national defense
Answer: C
5.5 What is development?

• Economic development can be referred as the quantitative and qualitative changes in the economy.
• Economic development can be defined as the enlargement of the range of people choices.
• Economic development focuses on the spectrum of spheres ranging from health, education,
employment, safety, environmental sustainability, social exclusion, gender empowerment,
infrastructure, and other activities whereas economic growth measured in terms of rise in GDP or
market productivity.
• Economic development mainly concerned in expansion of people’s entitlements and their
corresponding capabilities, morbidity, nourishment, literacy, education, and other socio-economic
indicators.
• According to Amartya Sen, “Development consists of the removal of various types of unfreedoms
that leave people with little choice and little opportunity of exercising their reasoned agency”. Sen
defines the major factors that limit freedom as “poverty as well as tyranny, poor economic
opportunities as well as systematic social deprivation, neglect of public facilities as well as
intolerance or over activity of repressive states”.
• Economic growth set the prerequisite condition for economic development. The economic growth
accompanied by proper distribution of resources across the population, building institutional
mechanisms which ensure qualitative change in the lives of people, and environmental sustainability
guaranteed the economic development.
Concept Check:
Is it possible that a country may be experiencing rapid ‘growth’, but the ‘developmental’ indicators of
that country may actually be deteriorating?
Answer: Yes. If the country were to not invest in health, education, research and development, family
planning, development of cleaner and better technologies, it can happen that a country may experience
rapid growth even while developmental indicators may deteriorate.

5.6 What is the difference between Growth and Development in the above context?
Concept
• Development: Economic development is a much broader concept than economic growth. Economic
development = Economic Growth + Standard of Living
• Growth: Economic Growth is a narrower concept than economic development.
Scope
• Development: Economic Development is considered as a Multidimensional phenomenon because it
focuses on the income of the people and on the improvement of the living standards of the people of
the country.
• Growth: Economic Growth is considered as a single dimensional in nature as it only focuses on the
income of the people of the country.
Time-frame
• Development: Long term process
• Growth: Short term process
Measurement
• Development: Both Qualitative & Quantitative Terms: HDI (Human Development Index), gender-
related index, Human poverty index, infant mortality, literacy rate etc.
• Growth: Quantitative Terms: Increases in real GDP.
Relevance
• Development: Economic Development is related to Underdeveloped and developing countries of the
world.
• Growth: Economic Growth is related to developed countries of the world.
Effect
• Development: Qualitative and Quantitative Impact on the economy. Improvement in life expectancy
rate, infant, literacy rate, poverty rates, and mortality rate.
• Growth: Brings a quantitative impact on the economy. Increase in the indicators like per capita income
and GDP, etc.
Concept Check
Q. With reference to growth and development, which of the options given below is not correct?
(a) Growth is quantitative and value neutral
(b) Development means a qualitative change which is always value positive
(c) A positive growth always leads to development
(d) Economic growth set the prerequisite condition for economic development.

Answer: C
6 Part VI: Summary
6.1 Gross Domestic Product at Market Prices (GDPMP)

• GDP is the market value of all final goods and services produced within a domestic territory of a
country measured in a year.
• All production done by the national residents or the non-residents in a country gets included,
regardless of whether that production is owned by a local company or a foreign entity.
• Everything is valued at market prices.
• GDPMP = C + I + G + X – M
6.2 GDP at Factor Cost (GDPFC)

• GDP at factor cost is gross domestic product at market prices, less net product taxes.
• Market prices are the prices as paid by the consumers. Market prices also include product taxes and
subsides.
• The term factor cost refers to the prices of products as received by the producers.
• Thus, factor cost is equal to market prices, minus net indirect taxes (NIT).
o NIT = Indirect Taxes – Subsidies
• GDP at factor cost measures money value of output produced by the firms within the domestic
boundaries of a country in a year.
• GDPFC = GDPMP – Indirect Taxes + Subsidies
• GDPFC = GDPMP – NIT
6.3 Net Domestic Product at Market Prices (NDPMP)

• This measure allows policy-makers to estimate how much the country has to spend just to maintain
their current GDP.
• If the country is not able to replace the capital stock lost through depreciation, then GDP will fall.
• NDPMP = GDPMP − Depreciation
6.4 NDP at Factor Cost (NDPFC)

• NDP at factor cost is the income earned by the factors in the form of wages, profits, rent, interest,
etc., within the domestic territory of a country.
• NDPFC = NDPMP – Net Product Taxes – Net Production Taxes

6.5 Gross National Product at Market Prices (GNPMP)
• GNPMP is the value of all the final goods and services that are produced by the normal residents of
India and is measured at the market prices, in a year.
• GNP refers to all the economic output produced by a nation’s normal residents, whether they are
located within the national boundary or abroad.
• To arrive at the value of GNP, Net Factor Income from Abroad (NFIA) is added to GDP.
• Everything is valued at the market prices.
• GNPMP = GDPMP + NFIA
6.6 GNP at Factor Cost (GNPFC)

• GNP at factor cost measures value of output received by the factors of production belonging to a
country in a year.
• GNPFC = GNPMP – Net Product Taxes – Net Production Taxes
6.7 Net National Product at Market Prices (NNPMP)

• This is a measure of how much a country can consume in a given period of time.
• NNP measures output regardless of where that production has taken place (in domestic territory or
abroad).
• NNPMP = GNPMP – Depreciation
• NNPMP = NDPMP + NFIA
6.8 NNP at Factor Cost (NNPFC) OR National Income (NI)

• NNP at factor cost is the sum of income earned by all factors in the production in the form of
wages, profits, rent and interest, etc., belonging to a country during a year.
• It is the National Product and is not bound by production in the national boundaries. It is the net
domestic factor income added with the net factor income from abroad.
• NI = NNPMP – Net Product Taxes - Net Production Taxes
• NNP = NDP + NFIA

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MEASUREMENT OF

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1 Part I: Basics of Economy

1.1 What is Economy?

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1.2 Why do we study Economy?

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1.3 Meaning of Macroeconomics

1.3.1 Distinction between Macroeconomics and Microeconomics

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1.4 Factors of Production

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1.5 Factor Payments

1.6 Economic Agents

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1.6.4 Foreign Sector

1.7 Types of Economic System

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1.7.3 Mixed Economy

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1.8 What are the various sectors of Economy?

1.8.1 Primary activities

1.8.2 Secondary activities

1.8.3 Tertiary activities

1.8.4 Quaternary activities

1.8.5 Quinary activities

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Q. Match the following:

1.9 What are the different types of Goods?

1.9.1 What are Goods?

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1.9.3 Consumer Goods and Producer Goods

1.9.4 Single Use and Durable Use Goods

Durable Use Goods

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1.9.5 Private Goods and Public Goods

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1.9.6 Intermediate Goods

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1.9.8 Distinction Between Goods & Services

Q. Match the following pairs correctly:

Type of Good Example

1. Durable Use Good A. Coal

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3. Single Use Good C. Sewing Machine

4. Public Good D. Television

5. Capital Good E. Milk

2 Part II: Circular Flow of Income in a Simple Economy

2.1 Two Sector Model

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2.2 Four Sector Model

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3 Part III: Calculating Gross Domestic Product

3.1 Product or Value Added Method

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