Distance Learning Programme. IAS Prelims INDIAN ECONOMY

Size: px

Start display at page:

Download "Distance Learning Programme. IAS Prelims INDIAN ECONOMY"

Nora Waters
5 years ago
Views:

1 Distance Learning Programme IAS Prelims INDIAN ECONOMY

2 CONTENTS 1. Introduction to Economics Concepts of National Income Human Development Poverty, Unemployment & Inequality Inflation Public Finance Planning Financial Markets Banking Agriculture Industry Infrastructure External Sector in India International Economic Organizations World Trade Organisation (WTO) Economic Reforms and Liberalization Previous Years' Upsc Questions

Chapter-2 Concepts of National Income Measures of National Income Introduction: National income is the total value a country s final output of all new goods and services produced in one year.

Value is added at each intermediate stage, and at the final stage, the product is given a retail selling price.

3 Chapter-2 Concepts of National Income Measures of National Income Introduction: National income is the total value a country s final output of all new goods and services produced in one year. Typically, goods are produced in a number of 'stages', where raw materials are converted by firms at one stage, then sold to firms at the next stage. Value is added at each intermediate stage, and at the final stage, the product is given a retail selling price. The retail price reflects the value added in terms of all the resources used in all the previous stages of production. To avoid the problem of double counting, only the value of the final stage, the retail price, is included, and not the value added in all the intermediate stages - the costs of production, plus profits. Following are the measures of National Income: National Income (NI) GDP GNP GNI NDP NNP NNI 1. Gross Domestic Product (GDP) GDP is the final value of the goods and services produced within the geographic boundaries of a country during a year. GDP growth rate is an important indicator of the economic performance of a country. The gross domestic product (GDP) is one of the primary indicators used to gauge the health of a country's economy. In India, contributions to GDP are mainly divided into 3 broad sectors agriculture and allied, industry and service sector. 2. Net Domestic Product (NDP) The net domestic product (NDP) equals the gross domestic product (GDP) minus depreciation on country s capital goods. 12

4 Concepts of National Income Net domestic product accounts for capital that has been consumed over the year in the form of housing, vehicle, or machinery deterioration. NDP = GDP Depreciation Capital Goods: Capital Goods are tangible assets such as buildings, machinery, equipment, vehicle, and tools that an organization uses to produce goods or services in order to produce consumer goods and goods for other businesses. Gross and Net Concepts Net domestic product is GDP adjusted for depreciation. Depreciation is the amount of capital used up in producing that year's GDP. The depreciation is often referred as Capital Consumption Allowance (cca) and represents the amount of capital that would be needed to replace those depreciated assets. The depreciation of assets figure is determined by assessing the loss of value of assets attributed to normal use and ageing. Understanding the Capital Consumption Allowance (CCA) The capital consumption allowance provides a mechanism to measure the need to replace certain assets and resources to maintain a specified level of national productivity. It is generally divided into two categories: physical capital and human capital. Physical capital can include real estate, machinery or any other tangible resource used in the production of goods and services aside from the human element. Human capital covers the skills, knowledge and abilities of a workforce to produce goods and services, as well as the necessary training or education that may be required to maintain production standards. Physical capital experiences depreciation based on physical wear and tear, while human capital experiences depreciation as workforce turnover declines. BOOSTER 3. Gross National Product (GNP) GNP is an estimate of total value of all the final products and services produced in a given period by the means of production owned by a country's residents. 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. Hence, GNP is the value of final goods and services produced by the residents. Net exports here represent the difference between what a country exports minus any imports of goods and services. The Difference between GNP and GDP GNP and GDP are very closely related concepts, and the main difference between them comes from the fact that there may be companies owned by foreign residents that produce goods in the country, and companies owned by domestic residents that produce products for the rest of the world and earned income to domestic residents. For example, there are a number of foreign companies that produce products and services in the United States and transfer any income earned to their foreign residents. Likewise, many U.S. corporations produce goods and services outside of the U.S. borders and earn profits for U.S. residents. 13

5 Indian Economy If income earned by domestic corporations outside of the United States exceeds income earned within the United States by corporations owned by foreign residents, the U.S. GNP is higher than its GDP. GNP (calculated from GDP) = GDP + (income earned on all foreign assets) (income earned by foreigners in the country). The net foreign factor income (NFFI) is the difference between a nation s gross national product (GNP) and gross domestic product (GDP). Net foreign factor income (NFFI) is the difference between the aggregate amount that a country s citizens and companies earn abroad, and the aggregate amount that foreign citizens and overseas companies earn in that country. NFFI = GNP GDP 4. Gross National Income (GNI) Gross national income is a measurement of a country's income. It includes all the income earned by a country's residents and businesses, including those earned abroad. GNI measures all income of a country's residents and businesses, regardless of where it is produced. Gross domestic product (GDP), on the other hand, measures the income of anyone within a country's boundaries, regardless of who produces it. Difference between GNI and GNP GNI measures income earned, including that from investments that flows back into the country. Gross National Product (GNP) includes the earnings from all assets owned by residents. It even includes those that don t flow back into the country. It then omits the earnings of all foreigners living in the country, even if they spend it within the country. Calculation of GNI and NNI GNI (calculated from GDP) = GDP + (income from citizens and businesses earned abroad) (income remitted by foreigners living in the country back to their home countries). GNI (calculated from GNP) = GNP + (income spent by foreigners within the country) (foreign income not remitted by citizens). Net National Income (NNI) = GNI Depreciation = NDP + (income from citizens and businesses earned abroad) (income remitted by foreigners living in the country back to their home countries). GNP is estimated on the 'Basis of Product Flows', GNI is estimated on the 'Basis of Money Income Flows (Ex., Wages, Profits, Interest, etc)'. Why there is difference in GNP, GNI and GDP? In many emerging markets, such as India, residents move to other countries where they can earn a better living. They send lots of money back to their families in their home country called remittances. This income is large enough (remittances around 60 billion dollar) to drive economic growth in India. It is counted in GNI and GNP, though not in GDP. Hence, comparisons of GDP by country will understate the size of these countries' economies. 14

6 Concepts of National Income 5. Net National Product (NNP) The net national product (NNP) is the monetary value of finished goods and services produced by a country's citizens, whether overseas or resident, in a year (i.e., the gross national product, or GNP) minus depreciation. The NNP can be calculated from the GNP by subtracting the depreciation of any assets, also known as the capital consumption allowance (CCA), from its total. The relationship between a nation's GNP and NNP is similar to the relationship between its gross domestic product (GDP) and net domestic product (NDP). GNI per Capita GNI per capita is a measurement of income divided by the number of people in the country. It compares the GNI of countries with different population sizes and standards of living. The World Bank provides GNI data for all countries. In order to compare incomes between countries, it removes the effects of currency exchange rates. This is done by converting everything to the U.S. dollar using purchasing power parity (PPP). Suppose that 1 USD = 50 INR. Need of PPP In the United States, wooden cricket bats sell for $40 while in India, they sell for 750 Rupees. Since 1 USD = 50 INR, the bat which costs $40 USD in U.S. costs only 15 USD if we buy it in India. Clearly there's an advantage of buying the bat in India, so consumers would be happier to buy the bat in India. Purchasing power parity (PPP) is an economic theory that states residents of one country should be able to buy the goods and services at the same price as inhabitants of any other nation over time. Given enough time, everyone's purchasing power will become equal, or reach parity. PPP depends on the law of one price. It states that once the difference in exchange rates is accounted for, then everything would cost the same everywhere. In this way, National Income figures by converting them into PPP can be compared. That's not true in the real world on a day-to-day basis. That's because of differences in transportation costs, taxes, and tariffs. The problem with the PPP method for comparison of national income, though, is that it converts all goods and services in a country to what it would cost in the United States. On one hand, the method works well for goods like McDonald's hamburgers that are sold across the world. On the other hand, it does a poor job of estimating the value of goods not sold in America. Bullock carts are one such example. Uses and Limitations of National Income Figures Why is it important to measure national income? Make international comparisons. Analyse the standard of living. Analyse changes in distribution of income between income groups. Assist government in policy decisions. 15

7 Indian Economy Limitations Distribution of income might mask inequalities. No account taken of Nature of Goods. Fails to take account of Population. Figures won't explain level of government involvement in economy. Using GDP statistics for national income accounting overly simplifies standard of living as GDP figures don't show human development standards i.e., life expectancy, adult literacy, education attainment etc. National Income (NI) at Current Price and Constant Price NI at current price It is the value of final goods and services produced by residents of a country in a year, measured at the prices of the prevailing current year. For example: When goods and services produced during the year are valued at prices of the same year, i.e , it will be called national income at current prices for the year Hence, it is called Nominal National Income as it doesn t give the real picture of growth as any increase in nominal national income may be due to rise in price level without any change in physical output. In order to eliminate effect of inflation or price rise, the real GDP at constant price is calculated. Real GDP and the Price Level Real GDP is the value of final goods and services produced in a given year when valued at constant prices. Calculating Real GDP The first step in calculating real GDP is to calculate nominal GDP. Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. NI at Constant Price: It is the value of final goods and services produced by residents of a country in a year measured at base year price. Base year is a year which is normally free from high fluctuations of price. Presently, base year for Indian economy is Hence, if we measure India s National Income of at the prices of , then it is termed as National Income at constant price. It is called real national income. It shows the true picture of economic growth of a country as any increase in real national income is due to increase in output only. The effects of inflation are taken out. It helps in comparison of Indian economy one year with another year through GDP growth rate. Conversion of National Income at Current Price into Constant Price This can be done by eliminating the effects of price change on national income with the help of a Price Index. Price Index is an index number which shows the change in price level. 16

8 Concepts of National Income It indicates whether a rise or a fall in the national income from one year to another is real or not. GDP deflator is a suitable price index, which is defined as: National Income at Current Price (Nominal GDP) GDP deflator = National Income at Constant Price (Real GDP) 100 GDP at Factor Cost and Market Prices GDP at Factor cost is measured as a payment made to the factors of production. Land, Labor, Capital, Entrepreneurship are factors of production to which Rent, Wage, Interest, Profit has to be paid. GDP at market price is the sum total of gross value added (GVA ) in production of all goods and services within the country. Thus, the difference between the two is the net indirect taxes (Indirect taxes paid - Subsidies received). GDP at factor cost = GDP at Market price + Subsidies Indirect taxes. GDP, NDP, GNP, GNI and NNP all can be calculated on both factor cost and market prices Methods of Measuring National Income There are various methods to calculate National Income. To have better understanding there is need to see flow of income between different players who take part and contribute in National Income. Generally there are four players in an economy these are- individuals or households, business firms or investors, foreign nationals, and government. For making it simple we only take two players i.e. individuals or households and business firms. The flow diagram below shows the circular flow of income between individuals or households and business firms. The arrows on the upper part shows demand side of economy and arrows on the lower part shows supply side of economy. Fig: Circular Flow of Income As it is evident from the flow diagram arrows in the lower part indicates household supplying factor of production i.e. labour, land, capital, and entrepreneur to business firms to produce goods and services. In return, the business firm is giving wage, rent, interest and profit in lieu of labour, land, capital, and entrepreneur. 17

9 Indian Economy So, it can be said that one s income is expenditure to other and vice-versa. Thus income of one player and expenditure of other player are equal. As a result National Income can be computed by compiling the income of all or expenditure of all. Hence, calculation of National Income can be done by three methods which are: z Income Method z Expenditure Method z Product Method Income Method In this method the National Income is calculated by compiling income of factors of production i.e. labour, land, capital, and entrepreneur. National Income = Total wage + Total rent + Total interest + Total profit The computation of National Income by this method is different in Indian context which is in accordance with System of National Income Accounting Framework (SNA), It is as follows: GDP = Compensation of employees + Consumption of fixed capital + (Other taxes on production Subsidies on production) + Gross operating surplus Where, Compensation of employees is wages paid as salaries in cash and kind, and other benefits. Consumption of fixed capital means replacement of wear and tear parts with new parts of machinery. As it adds to income of machinery so the value is added here. Other taxes on production minus subsidies are the net tax on production. Gross operating surplus is the balance of value added after deducting the above three components. It goes to pay interest on capital and rent of land. Expenditure or Consumption Method In this method consumption expenditure of consumers (C), consumption expenditure of investors or entrepreneurs (I), consumption of government (G), and net exports (X) is added. GDP = C + I + G + X According to the SNA Framework 1993, this formula can be extended as: GDP = Household final consumption expenditure + Consumption expenditures incurred by general government and NPHIs + Savings + Gross capital formation Where, C = Household final consumption expenditure; I = Savings and Gross capital formation; G = Consumption expenditures incurred by general government and NPHIs. X = Exports Imports (net exports) Here, Household final consumption expenditure is expenditure made by households for goods or services. 18

10 Concepts of National Income Consumption expenditure incurred by government is expenditure on welfare schemes and others and NPHIs i.e. Non-profit Institutions incurring investment on households such as NPOs, and NGOs. Savings is the amount that is not spent on expenditure rather it is the saved amount. Investment made on the fixed asset is known as Gross capital formation. Product Method or Output Method In this method National Income is computed by calculating the gross value of final goods and services produced in a country in one year. The concept of GDP is based on Gross Value Added. Gross Value Added (GVA) = Output of final goods and services Intermediate Consumption GDP = GVA + Indirect Taxes Subsidies Revision of Base Year and Method of Calculation of GDP in India There are three important changes made in the calculation of the GDP in 2015: Widening of the data pool: Earlier data was sampled from Annual Survey of Industries (ASI), comprising of about two lakh factories. The new database draws from the five lakh companies registered with the Ministry of Corporate Affairs (MCA). While the earlier data captured only a factory-level picture, the new data records at the enterprise level. Revision of the base year: From to The base year is usually revised every 5 years. Change in Calculation method of GDP (Replacing factor costs with market prices): Until recently, India used factor costs for calculating GDP but now it has shifted towards market prices. By the recent changes in 2015, it has now shifted towards calculating the GDP by measuring the Gross Value Added (GVA) at market prices. The shift from factor costs to market prices indicates that India is conforming to international standards such as System of National Accounting (SNA) of UN as most countries use market prices for calculating the GDP. Hence, GDP = Gross Value Added (GVA) at market prices To calculate GVA at market prices, GVA at basic prices has to be calculated first. GVA at basic prices in India: In the revision of National Accounts statistics done by Central Step by Step Changes to Old GDP GDP at factor cost (old series) Step 1 GDP at factor cost* + production taxes production susidies = GVA at basic prices Step 2 GVA at basic prices + product taxes product subsidies = GDP Step 3 GDP adjusted for inflation GDP at constant market prices (new series) * Calculated using a new database 19

Class-12 NATIONAL INCOME What is National Income? 1. Concept and Meaning of National Income

Class-12 NATIONAL INCOME What is National Income? 1. Concept and Meaning of National Income National Income is a measure of the total flow of earning of the factor-owners through the production of goods