Macroeconomic Analysis for Management

Lecture 3

IME, IIT Kanpur

GDP Deflator

GDP Deflator = (Current GDP/Real GDP) × 100

GDP deflator is a measure of price index. Two other measures are: CPI and
WPI.
The deflator is not based on a fixed basket unlike CPI and WPI. The deflator
is available only four times a year.
GDP Deflator

GDP Deflator = (Current GDP/Real GDP) × 100

GDP deflator is a measure of price index. Two other measures are: CPI and
WPI.
The deflator is not based on a fixed basket unlike CPI and WPI. The deflator
is available only four times a year.

Per Capita GDP = (GDP/Population).

Purchasing-Power Parity
– The ‘law of one price’ says that the same good cannot sell for
different prices in different market locations. Why?
Purchasing-Power Parity
– The ‘law of one price’ says that the same good cannot sell for
different prices in different market locations. Why?
There will be opportunity for arbitrage. Therefore, the supply will
increase in the market where price is higher, and vice versa, to make
the prices equal. What are the assumptions?
Purchasing-Power Parity
– The ‘law of one price’ says that the same good cannot sell for
different prices in different market locations. Why?
There will be opportunity for arbitrage. Therefore, the supply will
increase in the market where price is higher, and vice versa, to make
the prices equal. What are the assumptions?
That buyers are informed about the difference in prices, and that
there is no cost of going from one location to the other.
Purchasing-Power Parity
– The ‘law of one price’ says that the same good cannot sell for
different prices in different market locations. Why?
There will be opportunity for arbitrage. Therefore, the supply will
increase in the market where price is higher, and vice versa, to make
the prices equal. What are the assumptions?
That buyers are informed about the difference in prices, and that
there is no cost of going from one location to the other.

The law of one price applied to international marketplace is called

purchasing-power parity, or PPP.
Keeping this in mind, converting India’s GDP into $s using the
Rupee-Dollar Exchange rate may be misleading.
To resolve this, economists have devised the Purchasing-Power
Parity exchange rate. This is done by comparing the price of a
standard basket of consumption in the two countries. Presently 1
Dollar is equal to Rs. 18 approximately, in PPP terms.
India’s rank by various GDP measures

GDP Measure India’s rank (2018)

GDP in current US $ 7th (2.7 Trillion)
GDP per capita in current US $ 167th (2,010)
GDP in PPP in current international $ 3rd (10 Trillon)
GDP per capita in current international $ 129th (7,680)
GDP at Factor Cost

So far, we mentioned that GDP is the market price of goods and

services produced.
However, market prices include (indirect) taxes, and subsidies.
Example: A company decides the selling price of a good as Rs. 100.
If government levies a 5% tax on it, the market price becomes Rs.
105. On the other hand, if government provides a subsidy of 5%, the
market price is Rs. 95.

Rs. 100 is GDP at factor cost. Rs. 105, or Rs. 95 are GDP at the
market prices.
GDP at Factor Cost

So far, we mentioned that GDP is the market price of goods and

services produced.
However, market prices include (indirect) taxes, and subsidies.
Example: A company decides the selling price of a good as Rs. 100.
If government levies a 5% tax on it, the market price becomes Rs.
105. On the other hand, if government provides a subsidy of 5%, the
market price is Rs. 95.

Rs. 100 is GDP at factor cost. Rs. 105, or Rs. 95 are GDP at the
market prices.

Therefore,
GDP at factor cost = GDP at Market Prices−Indirect taxes+Subsidies
GDP at factor cost = GDP at Market Prices − Net indirect taxes
GDP at Factor Cost

So far, we mentioned that GDP is the market price of goods and

services produced.
However, market prices include (indirect) taxes, and subsidies.
Example: A company decides the selling price of a good as Rs. 100.
If government levies a 5% tax on it, the market price becomes Rs.
105. On the other hand, if government provides a subsidy of 5%, the
market price is Rs. 95.

Rs. 100 is GDP at factor cost. Rs. 105, or Rs. 95 are GDP at the
market prices.

Therefore,
GDP at factor cost = GDP at Market Prices−Indirect taxes+Subsidies
GDP at factor cost = GDP at Market Prices − Net indirect taxes
Which GDP is likely to be higher?
Disposable Income

‘Disposable income’ is the income available to the households for

consumption and saving.

Disposable Income =
GDP − Taxes
Disposable Income

‘Disposable income’ is the income available to the households for

consumption and saving.

Disposable Income =
GDP − Taxes + Transfers
Disposable Income

‘Disposable income’ is the income available to the households for

consumption and saving.

Disposable Income =
GDP − Taxes + Transfers − Undistributed profits(Dividends)
Disposable Income

‘Disposable income’ is the income available to the households for

consumption and saving.

Disposable Income =
GDP − Taxes + Transfers − Undistributed profits(Dividends) +
Net income from abroad
 Three Methods of Measuring GDP
Product Method, Income Method, and Expenditure Method
The Circulrar Flow of the Economy

Source: Macroeconomics by G. Mankiw

Three Methods of Measuring GDP - I

1. Product Method. Value added of all production units are summed

up. How is double counting avoided?

There are three companies, ‘A’, ‘B’ and ‘C’.

‘A’ sells its output to both ‘B’ (Rs. 40) and ‘C’ (Rs. 60), but not to final
consumers.
‘B’ sells its output to ‘C’ (Rs. 200), as well as to final consumers (Rs.
150).
‘C’ sells all its output only to final consumers (Rs. 500).
Three Methods of Measuring GDP - I

1. Product Method. Value added of all production units are summed

up. How is double counting avoided?

There are three companies, ‘A’, ‘B’ and ‘C’.

‘A’ sells its output to both ‘B’ (Rs. 40) and ‘C’ (Rs. 60), but not to final
consumers.
‘B’ sells its output to ‘C’ (Rs. 200), as well as to final consumers (Rs.
150).
‘C’ sells all its output only to final consumers (Rs. 500).

We can arrive at the GDP by two ways.

1) GDP = Rs. (500 + 150) = Rs. 650

2) GDP = Value added by ‘A’ + Value added by ‘B’ + Value added by

‘C’ = (100 - 0) + (350 - 40) + (500 - 60 - 200) = Rs. 650.
Three Methods of Measuring GDP - II

2. Income Method. Total Income earned by all factors of production.

The value added we were adding in the previous method is earned by

somebody, either the owner of capital, or labour. For example, value
added by firm ‘B’ , Rs. 350, must be earned by either the owner of
the machineries, or the labours employed.
Three Methods of Measuring GDP - III

3. Expenditure Method. It uses the identity that total value of sales is equal
to total expenditure in the economy.
Suppose the final output in the economy is Rs. 1000 in a year, of which Rs.
800 worth is sold.
The rest of the output is considered as expenditure by the firms on their own
product.
Three Methods of Measuring GDP - III

3. Expenditure Method. It uses the identity that total value of sales is equal
to total expenditure in the economy.
Suppose the final output in the economy is Rs. 1000 in a year, of which Rs.
800 worth is sold.
The rest of the output is considered as expenditure by the firms on their own
product.

But in a real economy, there is saving. How to account for that?

The Circulrar Flow of the Economy

Source: Macroeconomics by G. Mankiw

An example

Steel Company Car Company

Revenue from Sales $100 Revenue from Sales $200
Expenses $80 Expenses $170
Wages $80 Wages $70
Steel Purchase $100
Profit $20 Profit $30

– Calculate GDP by Product Method, Income Method, and

Expenditure Method.
An example

Steel Company Car Company

Revenue from Sales $100 Revenue from Sales $200
Expenses $80 Expenses $170
Wages $80 Wages $70
Steel Purchase $100
Profit $20 Profit $30

– Calculate GDP by Product Method, Income Method, and

Expenditure Method.
Product method: $(100 - 0)+$(200-100) = $200
An example

Steel Company Car Company

Revenue from Sales $100 Revenue from Sales $200
Expenses $80 Expenses $170
Wages $80 Wages $70
Steel Purchase $100
Profit $20 Profit $30

– Calculate GDP by Product Method, Income Method, and

Expenditure Method.
Product method: $(100 - 0)+$(200-100) = $200
Income method: earning by labour + earnig by capital owners =
$(80+70+20+30) = $200.
An example

Steel Company Car Company

Revenue from Sales $100 Revenue from Sales $200
Expenses $80 Expenses $170
Wages $80 Wages $70
Steel Purchase $100
Profit $20 Profit $30

– Calculate GDP by Product Method, Income Method, and

Expenditure Method.
Product method: $(100 - 0)+$(200-100) = $200
Income method: earning by labour + earnig by capital owners =
$(80+70+20+30) = $200.
Expenditure method: Total $200 has been spent to buy the car
produced.
Potential GDP

I Potential GDP represents the maximum sustainable level of

output that the economy can produce.
I When an economy is operating at its potential, there are high
levels of utilization of factors of production.
I When output rises above potential output, price inflation tends to
rise, while a below potential level of output may lead to higher
level of unemployment.
I Potential output is determined by the economy’s productive
capacity.

https://www.youtube.com/watch?v=7GJ0TFd_aw8
Limitations of GDP
– GDP measures income without distribution. Whether one person holds all
wealth of the country, or it is equally distributed among all citizens, GDP as
well as GDP per capita are same.
https://www.youtube.com/watch?v=QPKKQnijnsM
Limitations of GDP
– GDP measures income without distribution. Whether one person holds all
wealth of the country, or it is equally distributed among all citizens, GDP as
well as GDP per capita are same.
https://www.youtube.com/watch?v=QPKKQnijnsM
– It is not a measure of welfare/well-being. Consider this: Smoking
increases GDP, and treatment for diseases caused by it again increases
GDP
Limitations of GDP
– GDP measures income without distribution. Whether one person holds all
wealth of the country, or it is equally distributed among all citizens, GDP as
well as GDP per capita are same.
https://www.youtube.com/watch?v=QPKKQnijnsM
– It is not a measure of welfare/well-being. Consider this: Smoking
increases GDP, and treatment for diseases caused by it again increases
GDP
– Economic activities that are performed outside the market are not
included. Marrying one’s maid/driver lowers GDP!!
Limitations of GDP
– GDP measures income without distribution. Whether one person holds all
wealth of the country, or it is equally distributed among all citizens, GDP as
well as GDP per capita are same.
https://www.youtube.com/watch?v=QPKKQnijnsM
– It is not a measure of welfare/well-being. Consider this: Smoking
increases GDP, and treatment for diseases caused by it again increases
GDP
– Economic activities that are performed outside the market are not
included. Marrying one’s maid/driver lowers GDP!!
– A substantial chunk of India’s economy is informal. However, the GDP
estimation method is not well suited to account for this economic activity.
Limitations of GDP
– GDP measures income without distribution. Whether one person holds all
wealth of the country, or it is equally distributed among all citizens, GDP as
well as GDP per capita are same.
https://www.youtube.com/watch?v=QPKKQnijnsM
– It is not a measure of welfare/well-being. Consider this: Smoking
increases GDP, and treatment for diseases caused by it again increases
GDP
– Economic activities that are performed outside the market are not
included. Marrying one’s maid/driver lowers GDP!!
– A substantial chunk of India’s economy is informal. However, the GDP
estimation method is not well suited to account for this economic activity.
– GDP is not good in measuring quality. Therefore, especially for services
driven economies, GDP measure may not be accurate. Obtaining
information by googling is excluded from GDP measure. GDP goes down
when cameras, or alarm clocks are absorbed into Mobile phones.
Limitations of GDP
– GDP measures income without distribution. Whether one person holds all
wealth of the country, or it is equally distributed among all citizens, GDP as
well as GDP per capita are same.
https://www.youtube.com/watch?v=QPKKQnijnsM
– It is not a measure of welfare/well-being. Consider this: Smoking
increases GDP, and treatment for diseases caused by it again increases
GDP
– Economic activities that are performed outside the market are not
included. Marrying one’s maid/driver lowers GDP!!
– A substantial chunk of India’s economy is informal. However, the GDP
estimation method is not well suited to account for this economic activity.
– GDP is not good in measuring quality. Therefore, especially for services
driven economies, GDP measure may not be accurate. Obtaining
information by googling is excluded from GDP measure. GDP goes down
when cameras, or alarm clocks are absorbed into Mobile phones.
– Environmental damages are not accounted for in calculating GDP. This is
why, GDP is not a good measure for sustainable welfare.
Alternate measures

Human Development Index

HDI was developed by Amartya Sen and Mahbub ul Haq in the
1980s.
It is a composite index of three three parameters: Per capita income,
Educational achievement, and Life expectancy. India ranked 129th
among 189 countries in 2019.
India ranks 7th in terms of Nominal GDP in US dollars. It ranks well
below in per capita terms though.
Even HDI does not consider environmental damages so far.

Better Life Index constructed by the Organisation for Economic

Co-operation and Development (OECD).

Bhutan measures Gross Happiness Index.

GDP estimation in India
The Central Statistics Office (CSO) is responsible for estimating GDP
for India. It publishes GDP data on a quarterly basis. Here is a
sample publication by CSO.

There are operational problems in collecting data for GDP estimation.

Most data are survey based. However, a major concern, often
discussed in the media, is the collection of data for informal sector.

The formal sector is surveyed regularly. However, the estimates for

the unregistered sector are prepared initially for a benchmark year
using the results of the National Statistical Office (NSO) survey on
unorganised sector. The estimates for subsequent years are made by
extrapolating the benchmark estimates with the Index of Industrial
Production (IIP).
http://www.mospi.gov.in/133-gross-domestic-product

Appreciate the complexity involved in expressing the

performance of an Economy in one single number!
Importance of GDP

GDP is still the best proxy that most of the countries have to measure
its total output
GDP growth rate has been found to be correlated with other
development indicators.

Governments across the world take policy decisions based upon the
GDP numbers.
The major two instruments used by governments are:
– Fiscal Policy, and
– Monetary policy
Source: Financial Times
Components of GDP
Components of GDP

In an economy, the total expenditure is broadly classified into four groups:

1. consumption spending by households (C),
2. consumption spending by firms (I) – This is the spending on enhancing
stock of capital,
3. by government (G),
4. and by entities outside the country, or exports (X).
Components of GDP

In an economy, the total expenditure is broadly classified into four groups:

1. consumption spending by households (C),
2. consumption spending by firms (I) – This is the spending on enhancing
stock of capital,
3. by government (G),
4. and by entities outside the country, or exports (X).
Note that the nomenclature varies based upon who consumes. A car
purchased by you will go under ‘C’, but if purchased by a company for
improving its operations, it is an ‘I’. If the car is bought by the government, it
will fall under ‘G’, and if bought by a foreign national, it is an export ‘X’.
Components of GDP

In an economy, the total expenditure is broadly classified into four groups:

1. consumption spending by households (C),
2. consumption spending by firms (I) – This is the spending on enhancing
stock of capital,
3. by government (G),
4. and by entities outside the country, or exports (X).
Note that the nomenclature varies based upon who consumes. A car
purchased by you will go under ‘C’, but if purchased by a company for
improving its operations, it is an ‘I’. If the car is bought by the government, it
will fall under ‘G’, and if bought by a foreign national, it is an export ‘X’.

Now, the first three groups are spending some amount on goods and
services produced outside the country as well. This is denoted as imports
(M).
Components of GDP

In an economy, the total expenditure is broadly classified into four groups:

1. consumption spending by households (C),
2. consumption spending by firms (I) – This is the spending on enhancing
stock of capital,
3. by government (G),
4. and by entities outside the country, or exports (X).
Note that the nomenclature varies based upon who consumes. A car
purchased by you will go under ‘C’, but if purchased by a company for
improving its operations, it is an ‘I’. If the car is bought by the government, it
will fall under ‘G’, and if bought by a foreign national, it is an export ‘X’.

Now, the first three groups are spending some amount on goods and
services produced outside the country as well. This is denoted as imports
(M).
Then, GDP(Y ) = C + I + G + X − M = C + I + G + NX
Components of GDP
Components of GDP: Consumption (C)

– Consumption is the ultimate measure of economic well-being.

– When consumption grows rapidly, this increases total spending in
the economy. In other words, aggregate demand increases. This in
turn raises total output, and employment.
– However, savings, and thus investment has a very crucial role to
play in economic growth over longer run. High Consumption relative
to income leads to lower saving and investment, and slows growth.

– Presently consumption covers more than 65% of India’s GDP

What drives Consumption and Savings?
– Consumption (C) is determined primarily by Disposable Income. A
consumption function therefore relates consumption to disposable
income.
– Saving (S) is the amount of disposable income not devoted to
consumption.

Example
Item Amount (Rs.)
Personal Income 150,000
Less: Personal Taxes 30,000
Equals: Disposable Personal In-
120,000
come
Less: Consumption 96,000
Equals: Personal Savings 24,000

– Note that Consumption and savings varies according to income level.

Also, Income can be negative, but consumption cannot.
Engel’s Law: Proportion of income spent on food
decreases with rise in income

Source: Samuelson and Nordhaus

Why Households Save
Two main reasons of savings by households:
1.To Generate future income
2. To Protect against unexpected fall in income. “Precautionary motive”
Why Households Save
Two main reasons of savings by households:
1.To Generate future income
2. To Protect against unexpected fall in income. “Precautionary motive”

The relationship between savings and inequality is complex

– Subsistence: Problem at the bottom end. The poor may not be able to
afford savings, on the average. There might be cases of negative savings
for some individuals/households.
Why Households Save
Two main reasons of savings by households:
1.To Generate future income
2. To Protect against unexpected fall in income. “Precautionary motive”

The relationship between savings and inequality is complex

– Subsistence: Problem at the bottom end. The poor may not be able to
afford savings, on the average. There might be cases of negative savings
for some individuals/households.
– Conspicuous Consumption:Problem at the other end of the spectrum.
This may pull down the average rate of savings for the very rich. This is
particularly true for an income group where the precautionary motive for
saving is low or zero.
Why Households Save
Two main reasons of savings by households:
1.To Generate future income
2. To Protect against unexpected fall in income. “Precautionary motive”

The relationship between savings and inequality is complex

– Subsistence: Problem at the bottom end. The poor may not be able to
afford savings, on the average. There might be cases of negative savings
for some individuals/households.
– Conspicuous Consumption:Problem at the other end of the spectrum.
This may pull down the average rate of savings for the very rich. This is
particularly true for an income group where the precautionary motive for
saving is low or zero.
– Aspirations and savings: For the people at the middle of the spectrum,
saving becomes important because
• higher precautionary needs
• Aspirations to catch up with the lifestyles of people in the higher income
segment
Why Saving rate may decline?
Why Saving rate may decline?

1. Falling interest rate

2. Social security
3. Financial Markets
4. Increase in value of wealth
Why Saving rate may decline?

1. Falling interest rate

2. Social security
3. Financial Markets
4. Increase in value of wealth

Demand for safes has jumped in Japan as people look for options to stash
their cash following the the Bank of Japan’s introduction of negative interest
rates. - Wall Street Journal, Feb 22, 2016
https://www.wsj.com/articles/
japanese-seeking-a-place-to-stash-cash-start-snapping-up-safes-1456136223