Economics Unit 4 SLM

8/3/2019 Economics Unit 4 SLM

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Course:

Economics and Econometrics

Unit-4:

National Income and Related

Concepts


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Table of Contents

4.1. Learning Objectives .................................................................................................................... 34.2. Introduction ................................................................................................................................. 34.3. National Income Measurement ................................................................................................... 54.4. Gross Domestic Product (GDP) and Gross National Product (GNP) ........................................ 8

4.4.1. Computing GDP .................................................................................................................. 104.4.2. Components of GDP ............................................................................................................ 114.4.3. Real GDP vs. Nominal GDP ................................................................................................ 124.4.4. GDP Deflator ....................................................................................................................... 144.4.5. GDP per Capita .................................................................................................................... 154.4.6. Net Domestic Product .......................................................................................................... 15

4.5. Gross National Product (GNP) and Gross National Income (GNI) ......................................... 164.6. Gross National Income (GNI) and Net National Income (NNI)............................................... 17

4.6.1. NNI at Market Prices (NNIMP)Net National Income at Factor Cost (NNIFC) ..................... 194.7. National Income (NI), Personal Income (PI), Disposable Income (DI) ................................... 204.8. Methods of Measurement .......................................................................................................... 224.9. Equilibrium Output................................................................................................................... 274.10. Other Related Concepts .......................................................................................................... 28

4.10.1. Inventory goods ................................................................................................................. 284.10.2. Real and Nominal Income (Y) ............................................................................................ 294.10.3. Deflator and rate of inflation .............................................................................................. 304.10.4. Growth Rate of Income and Per Capita Income .................................................................. 32

4.11. Construction of Index Number and CPI ................................................................................ 334.11.1. Problems with the CPI ................................ ....................................................................... 36

4.12. Wholesale Price Index (WPI) .................................................................................................. 374.13. Summary .................................................................................................................................. 374.14. References ................................................................................................................................ 38

4.14.1. Book references ................................................................................................................. 384.14.2. Web References ................................................................................................................. 38


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4.1. Learning Objectives

By the end of this unit, you will be able to:

Explain how the economy as a whole functions and changes over time.

Describe different methods of measuring the output of an economy.

Identify how spending in economy affects national output.

Analyse the relevance of equilibrium output to policy measures particularly in goods market.

We come to know about growth recorded by various countries on news channels and read it in financialmagazines and newspapers. But we may not know, what is the relevance of these figures and how do

various countries compile the data. We may even dont know how these figures are useful to us.

This unit discusses on how the national income is computed and also about various other macroaggregates and their measurement.

4.2. Introduction

There is a fine distinction between micro and macroeconomic branches of analysis. Microeconomics

mainly deals with individual and small units of economic activities. Macroeconomics is more concerned

with aggregate economic activity at the social and national levels.

Macroeconomics deals with the aggregate quantities and the problems arising out of activities, such as

the once mentioned below.

Supply of money

National consumption

Investment

The Global Economy

Developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and

5.9% growth in 2008. When China and India are excluded, GDP in the remaining developingcountries is projected to fall by 1.6%, causing continued job losses and throwing more people into

poverty. Global growth is also expected to be negative, with an expected 2.9% contraction of

global GDP in 2009.

Global GDP growth is expected to rebound to 2% in 2010 and 3.2% by 2011. In developing

countries, growth is expected to be higher, at 4.4 % in 2010 and 5.7 % in 2011, albeit subdued

relative to the robust performance prior to the current crisis.

Source: Global Development Finance, World Bank (www.worldbank.org)


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Level of effective demand

Government spending

National savingsAnnual growth of the economy

Foreign trade

Balance of payments

Exchange rates

These aggregates can be quantified easily subjected to a mathematical approach. Expectations of futurechanges and uncertainties about these components create a dynamic environment for analysis which has

fascinated economists for a long time.

The simplest way of understanding how economy functions, would be through personal experience. In a

localised situation like functioning of a production unit, this method works out well. However, when wescale up the activity, it may not accurately reflect the changes in the economy.

Moreover, the reliability of this method becomes constrained considering the fact that economyincorporates thousands of activities. So, economists and social scientists have designed different models

in an effort to study and explain how the economy as a whole functions and changes over time. By-and-large they rely on observational methods.

Exhibit: 4.1

India's GDP in 2008-09

India's gross domestic product (GDP) has increased by 7.5%, 9.5%, 9.7% and 9% in the first four

years from fiscal year 2004-05 to 2007-08 recording a sustained growth of over 9 per cent for three

consecutive years for the first time. According to Pranab Mukherjee, India is the second fastest

growing economy in the world with 7.1 per cent GDP in 2008-09.

With per capita income growing at 7.4 percent per annum, this represented the fastest ever

improvement in living standards over a four-year period. The gross domestic savings rate increased

from 29.8 % to 37.7 % during this period. The growth drivers for the period were agriculture,

services, manufacturing along with trade and construction.

The Indian economy witnessed moderation in growth in 2008-09 in comparison with the robustgrowth performance in the preceding five years. The deceleration in growth was broad based,

across three major constituent segments of GDP, i.e. agriculture, industry and services. Moreover,

deceleration in industry and services sector also persisted over four consecutive quarters of the

year. Reflecting the contraction in global demand, exports declined. Domestic aggregate demand

also moderated due to sharp deceleration in the growth of private consumption demand.

(Cont. on next page)


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4.3. National Income Measurement

The basic elements have to be measured, to prepare a database of statistics which provides informationabout the entire economy, rather than simply about a single household or firm.

(Cont. from previous page)

Exhibit: 4.1

India's GDP in 2008-09

Reflecting the expansionary fiscal policy response to the slowdown in growth, government

consumption demand increased by 20.2 per cent. The contribution of government consumption

expenditure to overall growth accordingly increased to 32.5 per cent from an average contribution

of 5.9 per cent in the preceding five years. Corporate performance remained dampened, with

significant fall in sales growth in the second half of the year, and decline in profits in last three

consecutive quarters of the year.

In 2009-10 so far, emerging signs of recovery are yet to indicate any clear trend, and the deficientmonsoon and the depressed export performance have to be seen along with the improving growth in

core infrastructure sector, recovering industrial production and more optimistic business outlook.

Recognising the balance of risks to growth, the First Quarter Review of Monetary Policy for 2009-

10 placed the projection for GDP growth at 6.0 per cent, with an upward bias. The inflation

environment remained highly volatile during 2008-09; WPI inflation rose to a high of 12.9 per cent

in August 2008 and declined sharply thereafter to below 1 per cent by the end of the year, before

turning negative since June 2009. The currently observed negative inflation essentially reflects the

impact of the high base of the previous year, and this transitory trend may not persist beyond few

months.

Within WPI, essential commodities continue to exhibit high inflation. Moreover, inflationexpectations have not abated as much as the overall decline in WPI inflation and inflation as per

different consumer price indices remain stubbornly high. The adverse impact of the deficient

monsoon on food prices, notwithstanding the record food grains production in 2008-09 and the

high buffer stocks, also indicates upside risks to inflation, besides the evidence from the Reserve

Banks Survey of inflation expectations suggesting increase in inflation over the coming threemonths to one year. The First Quarter Review of Monetary Policy for 2009-10 took into account the

emerging outlook on inflation and revised the inflation projection upwards from the earlier 4.0 per

cent to 5.0 per cent, while reiterating 3.0 per cent as the medium term inflation objective

Source: Rediff News, February 2009 (http://www.rediff.com)

Summary of the Annual Report of RBI for the year ended June 2009 (www.rbi.org.in)


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Gross domestic product, or GDP, is an indicator of economic performance that measures the marketvalue of goods and services produced within a country and equals the total income within an economy.

The consumer price index, or CPI, is a cost of living indicator; it measures the total cost of goods andservices purchased by a typical consumer within a country. GDP and CPI show how much income

exists within an economy and how much this income can purchase.

The concepts of GDP and CPI open the door to a scientific understanding of the functioning of theeconomy on a large, or macro, level. By understanding the concepts of GDP and CPI, the world of

macroeconomics begins to unfold.

Two key factors which serve as object of the study for any macroeconomists involve:

1. Measuring the output of the economy2. Measuring the cost of living in the economy

The most basic and publicised tools of measuring the output and cost of living used bymacroeconomists, policy makers, and consumers to understand and describe the

economy are mentioned below:

Gross domestic product (GDP): An indicator used to measure the output of theeconomy.

Consumer Price Index (CPI): An index constructed to measure the cost of living

in the economy.

Exhibit 4.2

Need for the Study of National Income

A national income measure serves various purposes regarding economy, production, trade,

consumption, policy formulation. A study of national income is needed to:

To measure the size of the economy and level ofcountrys economic performance

To trace the trend of the economic growth in relation to previous year(s) and to compare it

with other countriesTo make international comparison of peoples living standards

To know the structure and the composition of the national income in terms of various sectors

and industries

To make projections about the future development trends of the economy

To help government formulate development plans and policies to increase growth rates

To fix various development targets for different sectors of the economy

To help business firms in forecasting future demand for their products


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The following are some definitions of national income by famous economists.

The labour and capital of the country acting on its natural resources produce annually a certain netaggregate of commodities, material and immaterial, including services of all kinds This is the net

annual income or revenue of the country, or the national dividend.

Alfred Marshal

The national dividend or income consists solely of services as received by ultimate consumers,

whether from their material or from their human environment.

Irving Fisher

National Income is the money value of all goods and services produced in a country during a year.

J.M. Keynes

Gross national product (GNP) is the most comprehensive measure of a nations total output of

goods and services. It is the sum of the dollar (money) value of consumption, gross investment,government purchase of goods and services and net exports.

Paul A. Samuelson

The definition makes use of several terms such as- 'money value', 'market price', 'all final goods and

services', 'national citizens'. Moreover, the statistical methods remain error prone creating a possibilityof arriving at an approximate and a less exact value of national income. All these national aggregates

are however mutually related and serve the purpose of a self correcting device of aggregative values tomake them as accurate as possible.

In other words,

The national income can be simply defined as the money value or market price value ofall the final goods and services produced by the national citizens of a country during

every financial year.

National Income = National Product = National Expenditure


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Figure 4.1

4.4. Gross Domestic Product (GDP) and Gross National Product (GNP)

The first pair of the national aggregates is in the form of Gross Domestic Product (GDP) and Gross

National Product (GNP) values. The value of GDP is the result of all productive activities carried outwithin the country. GDP is the monetary value of all final goods and services produced by normal

residents as well as non-residents in the domestic territory of a country. This makes the GDP valueimportant for measuring national income. However, in modern times, there are large-scale

international transactions taking place between countries as well. Citizens of a country like technicians,doctors, lawyers, bankers etc. go abroad and earn considerable incomes. Questions arise whether this

income should form part of national income or not. One school of thought suggests that this shouldgenuinely form part of the national income of a country. But it is not earned within the territory of the

country. GDP, being a geographic concept does not include the overseas earning by the domesticcitizens; but these earnings form a part of GNP. GNP is the total market value of all final goods and

services produced in a year in a country.

In computing GNP such income (N) earned by domestic residents abroad is added to GDP. Nondomestic residents like foreign citizens may be working inside the country and contributing to the

value of the GDP. Since they are not the nationals their contributions (F) are deducted to arrive at an

accurate value of the GNP. In other words net of the income earned abroad (N-F) when adjusted to theGDP gives the GNP.

GNP = GDP + (NF)

Where,

(N-F) = Net Factor Income from Abroad (NFIA)

This can be strengthened by Caselet1 given below.

Three measures of

national income of acountry

The sum of all final

goods and services

produced

Sum of all incomes (in

cash and kind) accruing

to factors of production

in a year.

Sum of consumersexpenditure, net

investment expenditure

and govt. expenditure ongoods and services.


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A point to note here is that GNP will be more or less than GDP according to relative amounts of N andF.

For all practical purposes, the distinction between GDP and GNP remains by-and-large inconsequential.Since the majority of production within a country is by citizens of that country, GDP and GNP are

usually very close together. This has resulted in economists and policymakers adopting GDP as themeasure of a country's total output.

Caselet 1

If a U.S. based company runs its production operations in India, whatever goods and servicesit produces in India is a contribution towards Indian GDP. But if the MNC, being of U.S.origin, have U.S. residents being a part of operations in Ind ia, then those employees income

will be a part of U.S. GNP and not Indian GNP.

It is the same in case of Indian employees working in U.S. for Indian based companies. The

goods/services produced by Indian companies will be a part of U.S. GDP. But, in the case of

income accrued by Indian employees working in U.S., it will be a part of Indian GNP.

Lets assume some values for GDP and try to understand the relation between GDP and GNP. LetGDP India, income earned by Indian citizens in U.S. (N) and income earned by U.S. citizens in

India (F) be Rs. 1780, Rs. 230, and Rs. 310 respectively. Then, using equation. 4.1, we find GNPas follows:

F)(NGDPGNP Rs.310)(Rs.230Rs.1,780

Rs.1,700GNP

On the other hand, if we begin with GNP, then:

F)(NGNPGDP Rs.310)(Rs.230Rs.1,700

Rs.1,780GDP

(Cont. in topic Gross National Income (GNI) and Net National Income (NNI))

If N will be greater than F then GNP would be greater than GDP. That is;

If N > F GNP > GDP

If N will be less than F, GNP will be smaller than GDP. That is;

If N < F GNP < GDP


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4.4.1. Computing GDP

Production of goods and services in an economy always refers to the total quantity of goods andservices produced in an economy. It does not take in to consideration the demand from the economy.

For e.g., if we produce 1000 bikes in the current year but the demand in the economy for current yearturns out to be 800 bikes. GDP computation involves production and thus 1000 bikes will be taken as

the output and not the number that is actually sold. We know that in an economy, GDP is the monetaryvalue of all final goods and services produced.

In the real world, the market values of many goods and services must be calculated to determine GDP.

While the total output of GDP is important, the breakdown of this output into the large structures of theeconomy can often be just as important. In general, a standard set of categories is used to decompose an

economy into its major constituent parts.

Illustration: 4.1

Let's say a country only produces apples and oranges.

Table 4.1. Price and Quantity of Oranges and Apples in a CountryYear Quantity of

Oranges

Price of

Oranges (inRs.)

Quantity of

Apples

Price of

Apples (inRs.)

1 5 10 5 25

2 10 10 7 25

3 10 20 9 25

In year 1 the production is 5 oranges that are worth Rs.10 each and 5

apples that are worth Rs. 25 each.

The GDP for the country in this year equals (quantity of oranges x price oforanges) + (quantity of apples x price of apples) or (5 x Rs.10) + (5 xRs.25) = Rs.175.

As more goods and services are produced, the equation lengthens.

In general,

GDP = (quantity of a x price of a) + (quantity of b x price of b) + ... +(quantity of n x price of n)

Where, a, b and n shows the goods and services produced within the

country.

(Cont... in topic Real GDP vs. Nominal GDP)


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In this equation Y captures every segment of the countrys economy. So, Y represents both the GDP

and the national income. When money changes hands, it is expenditure for one and income for theother, and Y, captures all these values, thus represents the net of the entire economy.

4.4.2. Components of GDP

Thus, GDP is the sum of consumer spending (C), investment (I), and

government purchases (G), and net exports (Nx), as represented by theequation:

Y = C + I + G + Nx


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Figure 4.2

4.4.3. Real GDP vs. Nominal GDP

Exhibit 4.3 Real GDP growth rates

Year GrowthRate (%)

2008-09 7.1

2007-08 9.0

2006-07 9.6

2005-06 9.0

2004-05 7.5

2003-04 8.5

Source: http://rbidocs.rbi.org.in

GDP of a

country is asum of 4

elements

Investment (I):expenditures on

capital equipment,inventories, and

structures, such as-

machinery,unsoldproducts, housing.

Consumer

spending (C):

spending ondurable goods,

nondurable goods,

clothing, food, and

healthcare.

Government spending (G):sum of expenditures by all

government bodies on goodsand services, such as naval

ships and salaries to

governmentemployees.

Net exports (Nx):Difference between theexports and the imports


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GDP can be distinguished further as nominal GDP and real GDP.

The first step to calculating real GDP is choosing a base year.

Lets understand how to calculate real GDP through the illustration 4.1.

Nominal GDP is the total value of all final goods and services at current price,

produced in a year. This is the GDP that is explained in the sections above.Nominal GDP is more useful than real GDP when comparing absolute output,

rather than the value of output, over time.

Real GDP is the total value of all final goods and services at constant price,

produced in a year. The prices used in the computation of real GDP are collectedfrom a specified base year. By keeping the prices constant in the computation of

real GDP, it is possible to compare the economic growth from one year to the nextin terms of production of goods and services rather than the market value of these

goods and services. In this way, real GDP enables year-to-year comparisons ofoutput from the effects of changes in the price level.

(Cont. From topic Computing GDP)

Illustration 4.1

If we need to calculate the real GDP for year 3 follow the steps shown below:

Use year 1 as the base year.

Use the GDP equation with quantities of year 3 and prices of year 1.

The real GDP is

Rs.275Rs.25)(9Rs.5)(10 .

For comparison, the nominal GDP in year 3 is

Rs.325Rs.25)(9Rs.10)10( .

Because the price of oranges increased from year 1 to year 3, the nominal

GDP increased more than the real GDP over this time period.

(Cont... in topic GDPDeflator)


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4.4.4. GDP Deflator

When comparing GDP between years, nominal GDP and real GDP capture different elements of thechange.

Nominal GDP captures both changes in quantity and changes in prices.

Real GDP captures only changes in quantity and is insensitive to the price level.

After computing nominal GDP and real GDP, a third useful statistic GDP deflator can be computedbecause of the above said difference.

The GDP deflator is the ratio of nominal GDP to real GDP for a given year. Toget the GDP deflator in percentage term deduct one from the deflator ratio and

multiply it with hundred. In effect, the GDP deflator illustrates how much ofthe change in the GDP from a base year is reliant on changes in the price level.

(Cont... from topicReal GDP vs. Nominal GDP)

Illustration 4.1

Let's calculate, the GDP deflator for Country X in year 3, using year 1 as

the base year.

In order to find the GDP deflator, we first must determine both nominal

GDP and real GDP in year 3

Nominal GDP in year 3 = Rs.325Rs.25)(9Rs.10)(10

Real GDP in year 3 = Rs.275Rs.25)(9Rs.5)(10

(with year 1 as base year)

The ratio of nominal GDP to real GDP is.

18.18%1Rs.275

Rs.325

This means that the price level rose 18.18% from year 1, the base year, to

year 3, the comparison year.


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The GDP deflator allows for the calculation of nominal GDP by multiplying real GDP and the GDPdeflator. This equation demonstrates the unique information shown by each of these measures of

output.

Figure 4.3

Deflators can be calculated for NDP, NNP, GNP, etc. along the same lines but usually are not

publicised.

4.4.5. GDP per Capita

While GDP may be useful in capturing the size and growth of a country's economy, it will not providethe linkage to the standard of the living in the economy. After all, the economy itself is less important to

the citizens of a country, than the standard of living that the economy provides.

GDP per capita is the total GDP divided by the size of the population. GDP per capita is the amount ofGDP that each individual gets on an average. So, it provides a reasonable measure of standard of living

within an economy.

GDP per capita indicates by its very definition the average income of an individual in the economy. Asa general rule, higher the GDP per capita, higher is the standard of living. GDP per capita is of greater

importance due to the fact that there are huge differences in population across countries.

If a country has a large GDP and a very large population, each person in the country may have a lowincome and thus may live in poor conditions. On the other hand, a country may have a moderate GDP

but a very small population and thus a high individual income.

GDP per capita attempts to counter the problem of division of GDP among the inhabitants in the

country and serves to compare standard of living across countries.

4.4.6. Net Domestic Product

Nominal GDP captures both changes in

prices andchanges in quantities

Real GDP catures changes in quantities GDP deflator captures changes in price

level

The net domestic product (NDP) equals the gross domestic product (GDP) minus

depreciation on a country's capital goods.


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Net domestic product accounts for capital that has been consumed over the year in the form of housing,

vehicle, or machinery deterioration. The depreciation is also known as capital consumption allowanceand represents the amount needed in order to replace those depreciated assets.

This is an estimate of how much the country has to spend to maintain the current GDP. If the country is

not able to replace the capital stock lost through depreciation, then GDP will fall. In addition, a growinggap between GDP and NDP indicates increasing obsolescence of capital goods, while a narrowing gap

would mean that the condition of capital stock in the country is improving.

4.5. Gross National Product (GNP) and Gross National Income (GNI)

Gross National Product (GNP) is the total of the market price values of all final goods and services,

whereas Gross National Income (GNI) is the aggregate income received by all members of the societyengaged in productive activities.

Whenever the goods are produced and sold, the total yield gets distributed among various agents of the

production. In the theory, we can classify the agents which contribute to the productive activity andreceive the income into four categories. The four such categories of the income are mentioned below:

Exhibit 4.4 Gross National Product at Factor Cost for India

Year At Current Prices At Constant Prices

(1999-2000)

GNP

(Rs. incr)

Per Capita

GNP (Rs.)

GNP

(Rs. incr)

Per

CapitaGNP

(Rs.)

1999-00 17,71,094 17,693 17,71,094 17,693

2000-01 19,02,284 18,668 18,41,755 18,074

2001-02 20,77,658 19,977 19,51,935 18,769

2002-03 22,44,725 21,257 20,29,482 19,2192003-04 25,19,921 23,507 22,04,913 20,568

2004-05 28,55,331 26,220 23,66,886 21,734

2005-06 32,49,554 29,381 25,93,160 23,446

2006-07* 37,60,285 33,514 28,45,156 25,358

2007-08** 42,81,795 37,457 31,09,361 27,323

* Quick Estimate

** Revised Advance Estimate

Source: www.rbi.org.in


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Profits to the producer (P)

Wages to the labour (W)Rent to the owner of land and natural resources (R)

Interest payment on loans and capital transactions (I)

In practice, there may arise some disparity between these two aggregates. These could be attributed tovarious causes:

1. There may be some members in society who live on donations and hence earn income withoutperforming any productive functions. An instance can be cited of the unemployed living onsocial security allowances in US and some European countries.

2. Some part of the goods produced may not be marketed but utilized for self-consumption.3.

There can be errors in computation or others which may cause some difference in these twovalues.

4.6. Gross National Income (GNI) and Net National Income (NNI)

The distinction between Gross and Net values of the national income has both theoretical and practical

significance. The adjustment factor is Depreciation charges (D) against the utilization of the services ofthe stock of capital goods while producing current output. Such capital goods are of longer duration

and have to be replaced a few years after their utility is over. Such an allowance for wear and tear ofthe fixed capital equipment is also known as capital replacement (Cr) cost.

The two values (D and Cr) are somewhat different in their computation and purpose. Though it isdifficult to accurately predict the future replacement cost of the present capital assets, the usual

procedure is to set aside a certain percentage (say 8 to 10 percent) of the national income in the form ofdepreciation charges. This adjustment is done as follows:

Therefore the value of GNI can be stated as:

GNI = W + R + P + I

For every income generated, there is some corresponding productive activity

performed and vice versa. Therefore, the two values GNI and GNP must beconceptually identical.

GNI = GNP

An allowance for wear and tear of the fixed capital equipment is also known as capitalreplacement (Cr) cost.


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The significance of the depreciation allowance can be explained with the help of a simple exampleshown in illustration 4.3:

NNI = GNI - D........Eq. 4.01

(Cont... from topic Gross Domestic Product (GDP) and Gross National Product (GNP))

Illustration 4.1

Earlier in our illustration, we found out GNP of Rs. 1700 for India.

GNI = Rs. 1700 (because GNP = GNI)

Assume Depreciation (D) = 10% of Rs. 1700 i.e. Rs. 170

DGNINNI

Rs.170Rs.1700NNI

= Rs. 1530

The reverse operation will be:

DNNIGNI

Rs.170Rs.1530NNI

= Rs. 1700

So, Net National Income for India is Rs. 1530.

(Cont... on topic NNI at Market Prices (NNIMP)Net National Income at Factor Cost (NNIFC))

Illustration 4.2

If a farmer produces 200 quintals of grain every year then the entire production cannot be

marketed or used for his family consumption. He will keep aside say 10 quintals, to be used as

seeds for the next harvest and self consumption. In this case seeds worth 10 quintals are the

depreciation allowance in the absence of which no output can be produced in the next harvest.


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Only after making the adjustment of depreciation charges what remains in the form of NNI is available

for current consumption purposes. Hence, it should be understood that the term 'national income' inthis analysis refers to it in its net form.

4.6.1. NNI at Market Prices (NNIMP)Net National Income at Factor Cost (NNIFC)

Another important distinction is between NNI in its market price value and NNI in its factor cost value.

When national income value is computed in terms of market prices, the presence of two elements maynot allow for the estimation of the true factor expenditure or cost of production of these goods. Market

price incorporates the presence of taxes and subsidies. In presence of taxes like Sales tax, Excise etc,the incidence is on the end consumer and not on the producer. Therefore there will be disparity

between the cost of production and the market prices. Therefore, few additions and deletions have tobe made before we arrive at NNPFC. The two elements contained in the market price are:

1. Indirect taxes (IT) such as sales tax, excise duty etc. - The estimate of NNI will exceed the true costof production to the extent of the IT value. Therefore, the value of indirect tax is to be deducted fromthe estimated value of the NNI at market prices in order to arrive at the factor cost value of the NNI.

2. Subsidy (S) or assistance in cash and kind provided by the government to private producers - Onthe other hand, the presence of subsidies unduly reduces the correct value than what it would otherwisehave been in the form of cost of production. Therefore, the value of subsidies is to be added to the

estimated value of NNI at market prices in order to arrive at the factor cost value of the NNI.

(Cont... from topic Gross National Income (GNI) and Net National Income (NNI))

Caselet 1

Assume indirect taxes of Rs. 460 and subsidy of Rs. 120 for India

SITNNINNI MPFC

Rs.120Rs.460Rs.1,530NNIFC

= Rs. 1190

In its reverse form:

Rs.1,530NNI

Rs.120Rs.460Rs.1,190NNI

SITNNINNI

MP

MP

FCMP

(Cont on topic National Income (NI), Personal Income (PI), Disposable Income (DI))


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4.7. National Income (NI), Personal Income (PI), Disposable Income (DI)

Having understood the process of arriving at the value of NI, we need to consider two more variables.The first one relates to Personal Income (PI) and the second Personal Disposable Income (PDI),

sometimes referred to as Disposable Income (DI).

Lets begin with personal income (PI) value. In modern times, with an increased public expenditure,

the government undertakes a considerable amount of transfer of incomes in the form of gifts, loans,assistance etc. Some citizens may also receive similar donations from foreign countries. With suchgratuities the individuals capacity to spend will be enhanced. However, this additional compensation

is not a part of the NI. On the other hand, big corporate agencies are subjected to corporate tax to theextent of which national income reduces before it falls in private hands. Some corporate bodies may

also set aside part of their profits in a reserve (undistributed profit, UP) to utilize it for futureinvestment. This also reduces the size of the NI before it becomes Personal Income.

In macroeconomics, national income value (NI) is stated in its factor cost version.

Therefore unless otherwise stated we will refer to this value as NI (that is, NationalIncome at factor cost).

(Cont. From topic Net National Income at Market Prices (NNIMP)Net National Income at FactorCost (NNIFC))

Caselet 1

Assume that Corporate Tax (CT) = Rs. 80, Undistributed Profit (UP) = Rs. 90 and Unearned

Income (UI) = Rs. 310. From the previous calculation we found NNI as Rs. 1190.

Lets calculate Personal Income (PI):

UP)(CTNNIPI Unearned income

Rs.310Rs.90)(Rs.80Rs.1190

= Rs. 1330

In a reverse operation we have:

NNI = PI - Unearned Income + (CT + UP)

= Rs. 1330Rs. 310 + Rs. 170

= Rs. 1190


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Disposable income is the income available to an individual for spending. Further the entire personalincome is not available for disposal and for private consumption or investment expenditure. Part of the

Personal Income is taxed away in the form of personal income tax (PT). The value of DisposableIncome will be smaller than that of Personal Income to the extent of the tax.

The total sum of disposable income is not used for consumption but a part of it may be also saved for

future spending. So, disposable income in case of current consumption is high it naturally results beingfuture spending moderate. At the same time, current consumption is low means future consumption may

be more. This results in more savings which in turn is a key perspective for any business manager.

(Contfrom topic National Income (NI), Personal Income (PI), Disposable Income(DI)

Caselet 1

If we assume Personal Income Tax as Rs. 130, then Disposable Income (DI):

DI = PI - PT

Rs.1200

Rs.130Rs.1330

In its reverse form:

PI = DI + PT

Rs.1330

Rs.130Rs.1200

The disposable income also reflects the purchasing power and living standards of thepeople in the economy.

Disposable income = Consumption + Saving


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4.8. Methods of Measurement

We use income for purchasing goods and services. When demand for goods and services go up,production increases. Thus, income leads to expenditure which in turn leads to increased production.

Summarising the Aggregates

After having defined and explained various national aggregates lets reviewthem. Aggregates are to be interpreted as values in millions or billions in the

currency of respective countries such as dollars, pounds, marks, francs, rupees,

yens etc.

As per illustration 4.1,

GNP = GNI

= Rs. 1700

GDP = GNPN + F

= Rs.310Rs.230Rs.1700 = Rs. 1780

NNP = GNP - D

Rs.170Rs.1700

= Rs. 1530

NNPMP= Rs. 1530

NNPFC = NNPMPIT + S

= Rs.120Rs.460Rs.1530

= Rs. 1190

NI = NNPFC = Rs. 1190

PI = NI(CT+UP) + PT

Rs.310Rs.170Rs.1190

= Rs. 1330

DI = PI - PT

Rs.1200

Rs.130Rs.1330


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Figure 4.4

Figure 4.4 shows how production, income and expenditure are mutually related. Economic activity is

directly related to these three stages. Based on this, three methods are used for calculating nationalincome. They are:

Production method

Income methodExpenditure method

(1)Production methodThis method aggregates the market values of all final goods and services produced to arrive at thenational income value. This requires a proper and satisfactory maintenance of records of every small

and private productive activity. But this method has limited significance since it suffers from certaindrawbacks like the ones mentioned below:

1. Under production method, care has to be taken to include values of the final products. The values ofintermediate products should be excluded in order to avoid double counting.

Expenditure

Production

Income

For instance, if we consider the case of garment manufacturing industry; the rawmaterials pass through various stages before it is transformed into the final product.

These include production of cotton thread, cloth and garments. Therefore, we have toinclude in the national income only the value of the ready-made garments as final

products, plus the value of some amount of cotton thread and cloth which might havebeen used for direct consumption.


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2. The emphasis on production of tangible goods undervalues the role of intangibles. Therefore, it ispossible that useful services such as those of teachers, musicians etc. get excluded or underestimated.

3. Under product method, part of the goods produced such as grains, vegetables, fruit etc. may not bemarketed at all but used for self-consumption by the household members of the producers. Evaluatingthe contribution of non-marketed products and adding it to the national income becomes a difficult task.

Hence, the value of this method is limited.

(2)Income methodThis is the simplest and most convenient method of computing national income. As per convention, allpossible incomes earned (N), fall under one of the four categories. These are wages (W), rent (R),

profits (P) and interest (i). When these four categories of income are aggregated at the national level andadded up, we get the total of the national income.

N = W + R + P + i

Though this method is simple it suffers from some inherent limitations, few of which are describedbelow:

1. All possible occasions of earning income are never accurately recorded. Therefore, informationavailable is often incomplete. Government administration, big corporations, factories, semi governmentorganizations etc. maintain their wages, salaries and profit accounts. However availability of

information becomes a problem in case of a large number of small units, self employed persons, smallartisans etc. where account maintenance is hardly present. Besides, even if, such accounts are

maintained, we may not be able to lay hands on them. Collection of data is practically difficult if notimpossible.

Illustration 4.3

The table explains the stages of producing bread and factor incomesinvolved at each of these stages:

Stage of

production

Sales

receipts

Cost of

intermediate

products

Value

added

Factor

incomes

(1) (2) (3) (4) (5)

Wheat 24 0 24 R + W + i+ P

Flour 33 24 9 R + W + i+ P

Dough 60 33 27 R + W + i+ P

Bread 90 60 30 R + W + i+ P


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2. Authenticity of the income information presents yet another task of computing National Income throughthis method. There are instances where people may deliberately understate their income. Instances of

some people overstating their income, to make it appear that they are richer than what they are, appearsequally possible.

3. National income value is expected to correspond with national production of goods and services. Insome cases, a part of the goods produced or possessed may be used for self consumption, then noincome will be earned, yet the product value needs to be taken account of. A farmer producing 200

quintals of rice may use 20 quintals of it for self consumption. This product has not been marketed andno income is earned. This possesses a question about its inclusion in the National Income. Moreover, it

is difficult to identify how much output was actually sold and what portion was used for selfconsumption.

4. The case is the opposite when unproductive income is earned. There may be some people receivinggovernment transfer earnings in the form of pension or insurance assistance. Though these are incomes,there is no corresponding productive activity and hence need not be included in the national income

accounts. The incomes earned illegally by a section of society such as gamblers, criminals, smugglersetc. should also not find place in the national income accounting.

5. Finally, there are some borderline cases. Some sections of the society are either not paid or areunderpaid for the services that they render which are otherwise valuable. Housewives, social reformers,voluntary agencies fall under this category. The national income account remains inaccurate to the

extent that these services are not accurately evaluated, or no complete information is received aboutthem.

(3)Expenditure MethodBoth product and income methods have their own limitations. Therefore the expenditure method is

often employed as an alternative or as a remedial measure.

In an over simplified equation as above, only private consumption and private investment values havebeen taken care of. But actually, there are two more categories of expenditure which make significant

contributions to national income accounts. These are in the form of public spending or government

The value of national income (Y) is equal to total income earned either in the form ofexpenditure on the consumption (C) of goods or investment (I). On the other hand,

whatever income earned by the society is spent on purchasing goods (C) or remainsunspent and saved (S). The terms income and expenditure in this respect are relative

and flexible. One persons expenditure is anothers income and vice versa.

According to Income approach Y = C + I

According to Expenditure approach Y = C + S


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expenditure (G) and foreign trade. Under the foreign trade sector a variety of to and fro transactions arecontinuously taking place. These are called imports (M) and exports (X).

Therefore, the values of imports tend to reduce and values of exports tend to enhance the national

wealth or income. We therefore take account of the net export (X - M) that is, Nx of foreign trade andmake adjustments in the national income accounts.

The expenditure method is a useful device to collect and present information. Under this approach, we

are only required to take account of the expenditure of the final products. Therefore, we have toexclude all such expenditure on intermediate goods and services. In this way, double counting of

intermediate goods can be avoided because of which the national income estimate would be highlyexaggerated in its value.

In this respect, like the earlier two methods, this also has its limitations:

1. As noted earlier, those who receive pension, insurance and other benefits contribute to expenditure butdo not contribute in a countrys productive activities in any way. All such expenditure will have to beset aside from the national income accounts.

2. On the other hand, part of the income genuinely earned may not be spent at all and not even be savedand deposited with the banks. Such a practice is called hoarding of income or of purchasing power.The national income accounts cannot be satisfactory to the extent of such hoarded income.

Imports are liabilities, for which the government has to pay to foreign producerswhereas; Exports are assets for which payments are received.


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4.9. Equilibrium Output

Output is considered to be at equilibrium level when the quantity of output produced is equal to

quantity of output demanded. At equilibrium level of output, firms are selling as much as they produce,people are buying the amount they want to purchase, and there is no tendency for the level of output to

change. We now proceed to define equilibrium level of output as one at which aggregate demand forgoods is equal to output (Y).

Summary of methods of national income

Lets present income and expenditure methods of national income accounting in the form of a summary. But before we do so, we have to introduce two adjustment

factors which we have not taken in to account so far. These are in the form of

depreciation charges (D) and indirect taxes (IT). Market prices of goods and

services are marked to the extent of indirect taxes and depreciation charges.

Therefore these values form part of the aggregate expenditure. But they are not

present in the aggregate income under the income method of measurement.

Therefore in order to strike a balance between the two methods either we have to

deduct (D + IT) from the expenditure side or add it to the income side. We have

then:

Table 4.2

Expenditure Account Income AccountConsumption

Investment

Government Expenditure

Foreign Trade (Net

Export)Less:Depreciation

Indirect Taxes

C

I

G

Nx

Wages

Rent

Profits

Interest

W

R

P

i

D

IT

Gross National Product Gross National Product

ORTable 4.3

Expenditure Account Income Account

ConsumptionInvestment

Government Expenditure Foreign Trade (NetExport)

C

I

G

Nx

Wages

Rent

Profits

Interest

Plus:

Depreciation

Indirect Taxes

W

R

P

i

D

IT

Gross National Product Gross National Product


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AD = C + I + G + Nx = Y

Where, AD - Aggregate demand

In national income accounting, investment included unintended changes which occur when firms findthemselves selling more than they had planned to sell.

Thus a fine distinction emerges between actual aggregate demand measured in accounting context and

economic context of planned aggregate demand. In national income accounts, aggregate demand ( C + I+ G + Nx) should be equal to output (Y).

If firms miscalculate the output, there will be unsold goods (inventories) which count as investment.

Therefore there is a mismatch between desired investment and actual investment. This creates inventoryinvestment.

IU= Y-AD

Where, IU is unplanned investment or inventory investment.

Summarizing

a. Aggregate demand determines equilibrium level of outputb. At equilibrium, unintended changes to inventories are zeroc. An adjustment process for output based on these unintended inventory changes will actually

move the output to its equilibrium level.

4.10. Other Related Concepts

4.10.1. Inventory goods

A special mention needs to be made of the inventory goods which find an important place in the

present national income accounts. This has not been mentioned earlier because it forms part of thecurrent investment expenditure, other than consumption expenditure. It has three distinct elements:

1. Depreciation charges (D)2. Expenditure on new capital equipment and goods produced or purchased

3. Inventories

Aggregate demand can be defined as the amount of goods people want to buy whereas

consumption and investment (private, government and external) are amounts of goodsactually bought.


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As we know, depreciation measures the amount of GNP that must be spent on new capital goods tomaintain the existing physical capital stock. Net or current investment therefore, is investment minus

depreciation. Besides, producers or sellers maintain large stocks of finished goods and raw materials inwarehouses. These are not yet sold but are available for sales. Such stocks both of finished goods and

of raw materials together constitute inventories of the producers.

Normally, producers have some quantity of inventories which are intended to be sold. Howeversometimes there may also be unintended inventories when part of the goods remains unsold. In either

case, these inventory goods form part of the business expenditure and act as a future asset. Therefore,these are included in the context of net investment expenditure. At the end of the year each business

firm shows its investment account which includes a value of such inventories.

Exclusions

1. Only services which are received or performed in the current year for respective goods andservices will be taken into consideration. A good produced in the past year but sold in the current

year will not be taken up for consideration while calculating the current years GDP. Unsoldinventories and second hand goods are therefore excluded from GDP calculations.

2. Even though large amount of activities happens outside the market it doesnt gets into real GDPbecause, lack of common measurement across the market.

3. The GDP will not assign any cost to the welfare of the people and irreplaceable resources whichmight have developed by inefficiency in the system.

4.10.2. Real and Nominal Income (Y)

By definition national income is the total value of all final goods and services at market price. Thus,

every year all productive activities are evaluated at current market prices for this purpose. This ishowever the nominal value of the national income. We cannot use it to compare with the national

income value of the last or earlier years. This is because of the fact that market prices contain anelement of inflation and to that extent actual or real changes in the national income are not accurately

recorded by the nominal value. To ensure a fair comparison is possible between the national incomeestimates of two or more years, it is necessary to make the prices uniform and price index applicable to

adjust all such values.

The process is called conversion of nominal values into real value or conversion of national incomefrom current to constant prices. Generally, national income is symbolically denoted as Y. For example

take Y1 and Y0 as the national income values measured in current prices of respective years (say P 1 andP0). In this case Y1 and P1 are national income and price values of the current year and Y0 and P0 are

similar values of the base year or of the initial year with which the comparison is to be made. Then,when Y1 value is converted into P0 price, such a conversion is known as translating nominal income Y 1

(n) into real income Y1 (r).


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Therefore, conversion of current to constant price or nominal into real income value by multiplying it

by P0/P1 ratio makes the comparisons realistic and enables to remove the element of inflationary price

rise. The process is also therefore, known as deflating current income into constant prices.

4.10.3. Deflator and rate of inflation

Deflator refers to the extent to which nominal income has been deflated or reduced in its value in order

to convert it into its real value. It is a coefficient computed as follows:

Illustration 4.4

Let us assign numerical values to the variables:

Let us say national income in the year 1 (Y1) is Rs. 2400 crores, the income in the

base year (Y0) is Rs. 1600 crores, and the increase in income can be calculated

as:

50%or150100Rs.1,600cr

Rs.2,400cr100

Y

Y

0

1

But part of this income is only nominal and not real, because of the corresponding

rise in the price. This is clear if we divide each years nominal income value by

the respective prices. In this way we can obtain real or physical variations in the

units of goods produced. Assume the price for base year is Rs. 4/ unit and the

price for year 1 is Rs. 5/ unit.

Thus, in the year Y0 and Y1 physical units of goods produced are:

units400Rs.4

Rs.1600

P

Y

0

0 and units480Rs.5

Rs.2400

P

Y

1

1

Therefore, real or physical increase in the volume of output produced is only 80

units.

That is, increase.20%100400

80 Y1(r) = Rs. 1920cr

This is exactly the extent of increase in the real income shown by Y1 (r).

20%120100Rs.1,600cr

Rs.1,920cr100

Y

Y

0

1(r)


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100YReal

YNominalY

1

1

deflator

In illustration 4.5, the value of the deflator will be,

1251001920

2400Ydeflator

OR

The deflator value is 25 percent. This is exactly the same proportion in which the prices of the two

years have changed.

25%1004

5100

P

P

0

1

Hence, under the real income computation process we have removed the 25 percent effect of the rise inthe price. Since, to this extent we have deflated the value of nominal income, if we increase real

income by 25 percent; once again we arrive at nominal income.

Thus, we have 1920 + 25% = 1920 + 480 = 2400. Since, real income on multiplication by deflatorfactor results into nominal income value it can also be called as conversion factor.

100%]100

indexyearBase-Deflator[

Deflator explains the rate of inflation. In the present case it is 25 percent. In a more systematic and

general form rate of inflation can be stated as:

In our example, 25%100%]100

100125[

In illustration 4.5, the price P1 is higher than P0 and hence there is an inflationary rise in the price levelby 25% during Y0 to Y1 year. This is a normal case. But in an exceptional year if the current price is

lower than the base year price the deflator value will be less than 100 and the rate of inflation will benegative. In that case, it is called rate of deflation. Therefore, when the rate of inflation is positive, an

inflationary rise in prices has occurred, but if the rate of inflation is negative the price level is said tohave deflated.


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4.10.4. Growth Rate of Income and Per Capita Income

Computation of annual national income and its conversion into real or constant price value are veryimportant activities. It serves the purpose in analyzing a variety of economic problems on the national

scale. One such use of national income statistics is to make comparisons from year to year. Whennational income in real terms is compared, we get a clear picture of the conditions of the economy. It is

a convenient tool to assess whether an economy is making any progress or not and at what rate it hasgrown. Such a growth rate (g) of the economy is an indicator of economic prosperity of the country.

The growth rate can be computed as follows:

100]Y

Y-Y[g

r0

r0r1

This is a ratio of difference in the real national income value of two subsequent years divided by baseyear real income. On multiplying this ratio by 100 we get the percentage change in the real national

income which is the growth rate of the economy. In illustration 4.5 we have,

20%100]1600

320[

100]1600

1600-1920[g

The economy can be said to have grown by 20 percent over the two periods Y0 and Y1.

Comparison of national income and computation of real growth rate, though important, is not a

satisfactory indicator. It is only an absolute measure and gives an idea about gross improvements in the

countrys wealth. However, it does not explain ultimate improvement in the living standards of the

population of the country. This is because while computing the growth rate we have not related it to thesize of the population.

If over the same period, the size of the population has also increased from say N 0 to N1, than the share

of each citizen in the national income must have increased only by a smaller proportion. Such a share ofevery citizen in the national income is called per capita income (P.C.) which is obtained as ratio of real

national income to the population.

42Nwhere45.71,42

1920

N

YP.C

40Nwhere40,40

1600

N

YP.C

1

1

r11

0

0

r0

0

Though the real national income has shown a growth rate of 20 percent, the per capita growth rate isonly 14.27. This is because of the fact that increased national income has been shared by a greater


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number of people with an expansion of population (say from 40 to 42 in the example). Hence thoughthe national income in real terms has increased at a larger pace, living standards of the people have

improved at a slower pace. The population growth rate over this period is 5%.

The difference between growth rate of income (20%) and growth rate of per capita income (14.27%) isapproximately equal to the same proportion as the population growth rate. Hence normally per capita

growth rate is indicated as a difference between income and population (g - N) growth rates. The P.C.and its growth rate is a relative measure of comparing economic conditions of a society and is a power

tool of analysis.

4.11. Construction of Index Number and CPI

Exhibit 4.5

Why is the CPI Important?

The CPI is important because many of its applications affect most persons in some way. The CPI

is used by employers and other agencies for the adjustment of wages and salaries; by labour

unions in collective bargaining; by economists as a gauge for assessing the current performance

of the economy; as a measure of inflation and by government in formulating and evaluating many

economic policies.

How is the Basket Created?

The items in the basket are determined from information obtained from Household Income and Expenditure surveys conducted by the Central Statistical Office. During a specified period, a

predetermined number of households from around the country provide information on their

spending habits by maintaining a diary of everything bought during that specific period.

This information is used to update the basket on which the CPI is based. This update allows for

new goods and services that have become significant in households budgets, like Internet Service,to be included in the basket, and other items which have lost importance to be excluded or have

their weights reduced.

Once the basket is set up, the quality and quantity of the items in the basket are kept constant.However, the total cost of this fixed basket will vary from one period of time to another, as the

prices of the items in the basket change. Price changes resulting from such a constant or fixedbasket are defined as pure price movements, which is what the CPI, in essence, measures. The

All Items index therefore gives in a single figure the percentage change in the cost ofpurchasing the contents of the basket over a period of time.

Source:CPI Questions and Answers, October 2001, Eastern Caribbean Central Bank (www.eccb-centralbank.org)


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Earlier we have computed the deflator and used it as a tool for measurement of the inflationary rise inprices. This is one example of an index number. There are a variety of index numbers or indices

constructed and used for the purpose of comparing several quantitative changes as listed below:

Prices

Money supply

Wages

National income

Population

Others

Some of the examples of price indices are Wholesale, Retail, Standard of living etc. There are certainstandard index numbers of which three are commonly used. These are Paasches, Laspeyres and

Fishers index numbers. Of these, Sir Irving Fishers index number is foolproof and is completelyunbiased.

Consumer Price Index (CPI) is considered as a standard or basic tool of comparison of the extent of

and effect of changes in the price level.

Let the base year quantity of goods consumed and their prices be denoted as q0, p0 and q1, p1 forcurrent year as quantities and prices respectively. Then the value of the CPI can be computed as:

100pq

pqCPI

00

11

The is a sign of summation. Therefore CPI is a ratio of sum of the quantity multiplied by the prices

of the current year, divided by sum of the quantity multiplied by the prices of the base year. The ratiovalue is then multiplied by 100 to obtain the percentage change in the CPI value. The quantities are

also known as weights.

An illustration showing the method of constructing CPI is given below.


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Precautions to be taken to ensure that the value of the CPI is representative and reliable are listed below:

There has to be proper selection of goods to be included in the construction of CPI.

Weightages should be accurately assigned.

Illustration 4.5

For convenience lets limit our example only to three goods - wheat, gold and paper. Then we

have quantities of the three goods as consumed in the base year with their respective prices.

Similarly we have current year quantities and prices.

Table 4.4.

Base Year Current Year

Goods Quant

ity

Price

(Rs.)

Total

(Rs.)Expendi

ture

Quan

tity

Price

(Rs.)

Total (Rs.)

Expenditure

q0

p0

q0p

0q

1p

1q

1p

1

Wheat 10 6 60 9 7 63

Gold 8 10 80 7 12 84

Paper 16 3 48 15 3.5 52.5

q0p0 188 q1p1 199.5

The CPI value is therefore:

100pq

pqCPI

11

11

106.11100188

199.5

Therefore, CPI value over this period has increased by 6.11 percent. The rise in the CPI is

considered the rise in the price level or the rate of inflation. Note that base year expenditure

value is equated to 100 therefore the CPI index value for the base year is 100.

100100188

188CPIbase

It is a matter of both convenience and convention to assume base year value as 100. This enablesus to compare with a similar value of any other year and to state the difference as a percentage

change.


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These attributes are selected based on their composition in the regular consumption of an averageman. Normally the goods included in CPI construction are food, clothing, fuel, transport,

education, housing some other items.Again the data about the statistical information on these items is to be collected from averagemembers of the society.

4.11.1. Problems with the CPI

The CPI is a convenient way to compute the cost of living and the relative price levels. But, as thecomputation of CPI is based on a fixed basket of goods, it does not provide an accurate estimate of the

cost of living. There are three major problems associated with the computation of CPI, namely- thesubstitution bias, the introduction of new items, and quality changes. Let's examine each of these in

detail.

a) Substitution bias:When the prices of goods and services change from year to year, they do not change by the same

amount. The number of goods purchased by consumers depends on the relative prices of these goods.But as the basket of goods is fixed, the CPI does not reflect consumer's preference for goods whose

prices have changed little from one year to the next. For example, if the price of grapes in a countryincreased to Rs. 30 per kg in year 1 while the price of bananas remained fixed at Rs. 17 per kg

consumers are likely to purchase more bananas and fewer grapes. This phenomenon of consumerssubstituting purchase of high priced goods for lower priced goods is not accounted for by the CPI.

b) Introduction of New Items:As time passes consumers add new goods in the basket of goods and services purchased by them. Forexample, if in year 1 in country consumers began to purchase a toy introduced recently; this would

need to be included in the calculation of CPI to get an accurate estimate of the cost of living. But since,the CPI uses only a fixed basket of goods; the introduction of a new product cannot be reflected.

Instead, the new goods are left out of the calculation, in order to keep the time periods comparable withone another.

c) Quality Changes:When there is an increase or decrease in the quality of a good, the value and desirability of that goodchange. For example, if grapes in a year suddenly became much more satisfying than in earlier year,

but the price of grapes did not change from Rs. 30, then the cost of living would remain the same whilethe standard of living would increase. This change would not be reflected in the CPI from one year to

the next. While the Bureau of Labour Statistics attempts to correct this problem by adjusting the priceof goods in the calculations, in reality this remains a major problem for the CPI.


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4.12. Wholesale Price Index (WPI)

The wholesale price index (WPI) is an indicator designed to measure the changes in the price levels of

commodities at the wholesale level. The index is a vital guide in economic analysis and policyformulation, and as basis for price adjustments in business contracts and projects. It is also intended to

serve as an additional source of information for comparison in the international front. WPI signals

changes in prices facing the producer.

1

4.13. Summary

The discussion above revolves around on the measurement of output and data used in suchmeasurement. The central idea is capturing the performance of the economy. The interest is one the

welfare of the economy which economists believe that increase in output increases the welfare.

1National Statistics Office, Philippines, Technical Notes on The Wholesale Price Index (WPI), www.census.gov.ph

Exhibit 4.6

India's wholesale price index (WPI) is forecast to have fallen 1.35% in the 12 months to June 20, a

third straight fall. If realised, it would be more than the WPI's annual 1.14% drop in the previous

week, but smaller than a record 1.61% annual fall on June 6. WPI, the main measure of price

pressures in India, fell below zero in early June for the first time since weekly data was released in

the 1977/78 fiscal year. But the central bank and analysts see the deflation as a statistical

correction, and not a sign of a weakening economy.

Analysts see the WPI number at below zero for some more weeks but inflationary pressures are

expected to build up in the coming months because of a rise in global oil and commodity prices.

Most analysts expect headline inflation above 5% by the end of March. The WPI is more closelywatched by financial markets than the monthly consumer price index (CPI) because it includes

more products and is published on a weekly basis.

Source: India WPI seen down 1.35% (YoY)Reuters. (http://www.utvi.com)


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4.14. References

4.14.1. Book references

Oliver Blanchard,Macroeconomics, Pearson Education Publications, 4th

edition, 2007

Ahuja,Macroeconomics Theory and Policy, S.Chand Publications, 2008

Gregory Mankiw, Macroeconomics, Worth publications, 6th

edition, 2008, chapter 2 (pg 16 to

43)

4.14.2. Web References

Visual statics on GDP Deflator in India (http://www.eyestat.com/en/GDP-

Deflator/India/graph.html)

Economics Unit 4 SLM

Documents