Topic II

MEASUREMENT OF AGGREGATE ECONOMIC

VARIABLES

II.1 Circular Flow of Income, Output and Expenditure
Consider an economy that produces only one good called bread with two
Iactors oI production, labour and organization. The Iigure below explains all
the economic transactions that occur between two groups oI economic
agents, namely households and Iirms.

income wages and proIit (Rs)

labour and organisation

Households Firms

bread (output)

expenditure (Rs)


A part oI the households supply labour services to the Iirms, and the
remaining households constitute the organization that run the Iirms
producing bread. Firms sell bread to the households whose expenditures are
received by the Iirms as sales revenue. This revenue has two broad parts: a
part is paid to the labour as their (wage) income, and the remaining portion
is retained by the Iirms as their share oI income known as proIit. ThereIore,
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in this simple economy, money value oI output is equal to income which is
equal to expenditure.

II.2 Measures of Aggregate Economic Activities

According to the national income accounting methods, there are three
alternative methods to measure the aggregate economic activities oI a
country:
a) output method
b) income method, and
c) expenditure method

a) Output Method
Using this method Iour measures oI aggregate economic activities can be
constructed: GNP, GDP, NNP, and NDP.

Gross National Product (GNP) and Gross Domestic Product (GDP)
GNP is the value oI all final goods and services produced within and
outside a country in a given time period, by the domestically owned Iactors
oI production. Where as, GDP is the value oI all final goods and services
produced within a country in a given time period, by the domestically
owned as well as the foreign-owned Iactors oI production.

OIten GNP is deIined as GDP plus Net Factor Income from Abroad (NFI).
NFI can be either positive or negative, depending upon whether domestic
Iactors abroad are earning more (wages, rent etc) than what Ioreigner Iactors
inside the country are earning. For instance, Japan`s GNP is bigger than its
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GDP implying Japanese Iactors abroad are generating more income than
what Ioreign Iactors in Japan are earning. In the case oI the US, GNP and
GDP are close to each other.

The goods and services are valued at the prevailing market prices,
otherwise it is diIIicult to add apples and oranges. Goods and services that
are not sold in the market are valued at factor cost known as the imputed
value. Examples are housing services, government services and so on. In
case oI housing services, the rent paid by the tenant is considered part oI
aggregate income because it is considered the value oI housing services
provided by the landlord to the tenant. II a person resides in his own house,
then an imputed value is obtained Ior the services that he enjoys: the rent he
will pay iI he had rented his house. Imputations are also used in case oI
government services like the services oI the police Iorce, bureaucracy, etc.
These services are valued at factor cost, eg in terms oI wages and salaries
paid to the police Iorce, etc.

Similar imputations are also called Ior a number oI durable products like the
services oI a car, jewelry, lawnmower and similar household durable goods.
However, it is not being done to keep the computations simple. Other
examples that are leIt out oI GNP or GDP are meals cooked at home,
services oI the housewives, maids, selI employed people, and even the
economic activities oI the underground (eg illegal drug trade).

The intermediary goods and services are excluded to avoid double
counting. Many goods are produced in stages, eg raw materials that are
processed into intermediary goods by some Iirms and then used by other
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Iirms to produce the Iinal goods. In that case only the value oI the Iinal
goods are included in GNP or GDP, and the value oI the intermediary goods
are leIt out. Alternatively, the value added at each stage oI production is
considered in aggregate output. For instance, the value added when wheat is
grown is considered, and then the value added by the baker when he used the
wheat to produce bread is added, as opposed to the market value oI wheat
and the market value oI bread are counted separately in the variable
considered.

Trading activities are also excluded Irom GNP and GDP. However, the
services rendered in such activities are included in GNP and GDP. For
example, the realtor Iee paid in case oI a resale oI an old house will be
included in GNP but not the resale price oI the house.

How inventories are treated in GNP and GDP? What happens to the
unsold goods like bread produced by the bakeries? II the bread spoils, then
nothing will add to GNP or GDP. However, Iactor payments like wages etc
have already been made which have increased aggregate income oI the
country. This extra income gets compensated by an equivalent amount oI
decline in proIits oI the bakeries due to spoiled bread. On the other hand, iI
the unsold bread is put in the inventory to be sold later, they will be
considered in GNP and GDP under the assumption that the bakeries have
purchased the extra bread themselves. Later, when the inventories are sold
although no extra wages and other Iactor payments are made, they are not
considered in GNP or GDP. They are considered inventorv disinvestments
that do not inIluence the macro variables.

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Net National Product (NNP) and Net Domestic Product (NDP)
NNP and NDP are obtained aIter deducting Capital Consumption
Allowances (CCA) Irom GNP and GDP, respectively.

CCA is the amount set aside in a given year to replace the worn out stock oI
capital. In other words, it is the aggregate replacement cost oI capital oI an
economy in a given year.

b) The Income Method
This method computes the aggregate value oI the income generated in an
economy in a given year. The discrepancy between the incomes earned by
the Iactors oI production and the value oI the goods and services at market
prices is as Iollows. From a variable like the GNP, which is mostly valued at
market price except Ior some items like government services, one requires to
deduct.

(i) Indirect taxes
(ii) Surpluses of Public Enterprises

and then add
(iii) Subsidies

to obtain the income equivalent oI GNP known as GNP at factor cost. This
methodology can be used to obtain the Iactor cost valuation oI the other
three output method variables, namely GDP, NNP and NDP, all oI which are
measured at market price except Ior some items that are valued at Iactor
cost.
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National Income
According to some textbooks like Macroeconomics by N. Gregory Mankiw,
the National Income oI a country is also the NNP at Iactor cost. The most
important measure oI aggregate income oI a country is the National Income.
One can also obtain three more variables Irom it, namely Personal Income,
Personal Disposable Income and Disposable Income. Directly, National
Income is computed as the sum total oI the Iollowing five items:

Wages and Salaries
Corporate Profits
Proprietors` Income
Rental Income
Net Interest Income

All these items are measured at their respective pre-tax levels. Wages and
Salaries, also known as Compensation of Emplovees constitute the bulk oI
the national income oI any country. In the US it is slightly above 70.
Proprietors` Income is the aggregate income oI the unincorporated (or non-
corporate) sector, such as small businesses, partnership Iirms etc. In the US,
it is approximately 10 oI its National Income. Corporate profits
constitute over 12 oI US National Income.

Rental Income also includes the rovaltv pavments (earned by the authors or
user oI a technology developed by someone) beside the usual rental earnings
oI the landlords like the house rent (net oI depreciation expenses). Finally,
Net Interest Income includes the interest that domestic businesses pay out
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minus the interest they receive (say Irom buying government debts), plus the
interest these businesses earn Irom Ioreigners.

Personal Income
From National Income, one has to deduct

Corporate Profits
Net Interest Income
Contributions to Social Insurance

and then add
Dividends
Personal Interest Income
Government Transfer Payments

Contributions to Social Insurance include items like provident Iund
contributions, unemployment insurance contributions, etc. TransIer
Payments are not considered part oI the current economic activities oI the
country. Instead, they are a part oI the past income that the householders
receive in the current period. They include items like pension income,
unemployment insurance payments, etc that householders receive Irom the
government when they are either out oI work or unemployed. See
Samuelson, Introduction to Economics.

Personal Disposable Income
From Personal Income, one requires to deduct

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Personal Income Tax
Non - tax Payments

Non-tax payments include items like license Iees, traIIic tickets, etc.

Disposable Income
From National Income, one has to deduct

Personal Income Tax
Corporate Income tax
Other Direct Taxes
Non - tax Payments
Contributions to Social Insurance

and then add
Government Transfer Payments

Other direct taxes include property taxes, etc.

(c) The Expenditure Method
This method looks at the various components oI aggregate expenditures
incurred either by the domestic residents or Ioreign residents on goods and
services produced in a country. The goods and services include both the Iinal
and the intermediary products wherever value is added. The expenditures are
valued at the current market prices except Ior government expenditures that
are valued at current Iactor cost.

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The national income accounts divide GDP into Iour broad categories oI
spending:
Consumption expenditures
Gross Private Domestic Investment Expenditures
Government Expenditures
Net Exports

Consumption Expenditures
It contains the expenditures on both consumer durables (eg Iood items) and
consumer non-durables (eg music systems) and services (eg health services)
incurred by the households.

Investment Expenditures
It includes the gross domestic investment expenditures incurred on new
capital goods and on the replacement oI worn out capital goods in the private
sector. In any given year, the bulk oI these investment expenditures in a
country (over 80) are replacement expenditures to replace the worn-out
capital stock. It contains three types oI expenditures: business Iixed
investment, residential Iixed investment and inventory investment. Business
Iixed investment contains Iirm expenditures on plant and equipments.
Residential investment expenditures are incurred by households and
landlords on residences. Inventory investments include Iirm accumulation oI
Iinished goods and raw materials in their inventories. It can be also negative
implying Iirms are undertaking inventory disinvestments by running down
their stockpile oI inventories.

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Government Expenditures
It includes government spending on public goods like the bureaucracy, the
police services, deIense, inIrastructure etc. It excludes transIer payments to
households like pension income etc.

Net Export Expenditures
It contains the expenditures on a country`s goods and services by the Ioreign
residents net oI domestic residents` spending on imported goods and
services Irom other countries. It can be either positive or negative.

II.3 Real GDP and Price Indices
The GDP or GNP mentioned above measures the value oI output at current
market prices. A better measure oI economic well-being will be to obtain the
real value oI these goods and services which are independent oI price
changes. This real value will also enable to monitor the growth oI output oI a
country over time.

In most countries prices oI many goods and services are increasing over
time. An obvious method to obtain the real value oI GDP or GNP will be to
deIlate the nominal GDP or GNP by the prices oI goods and services. Since
there are many prices in the economy, one thereIore requires a measure oI
price level.

GDP Deflator
The GDP deIlator is the one commonly used to obtain real GDP oI a
country. It is computed as the ratio oI current nominal value oI all
domestically produced goods and services to the nominal value oI these
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products at base period prices. The prices oI imported goods are leIt out
Irom the GDP deIlator. The base period is chosen in such a way that it is
important Irom the point oI view oI the economy. For instance, the 1991-92
prices can be considered as a base period since major structural reIorms
were initiated in mid-1991.

GDP DeIlator
0
t t
i i
i
t
i i
i
P Q
P Q

Where P and Q denote prices and quantities oI goods and services. t reIers to
current time period and 0 reIers to the base period. Hence,

GDP DeIlator
Nominal GDP
Real GDP


An alternative method presently used in the US is the Chain-Weighted
Measure of Real GDP where real GDP oI any two successive years is
valued at an average oI the prices in those two years.


Consumer Price Index (CPI)
CPI is based on a Iixed basket oI goods and services which is representative
oI a typical consumer`s consumption habit. In India, CPI is obtained Ior
industrial workers`, urban non-manual employees` and agricultural
labourers`. Suppose a typical consumer belonging to any oI these three
groups consume 1 to j commodities. Then

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CPI
1
0
1
100
f
t
i i
i
f
i i
i
P Q
P Q
=
=

where Ps are the respective prices oI the j items whose respective quantities
are Q
i
s. The superscripts reIer to the current time period t and the base
period 0. The quantities are assumed to reIlect the consumption preIerences
oI an average consumer. It is expressed in percentage terms. Its base period
value is 100.

CPI versus GDP Deflator
There are important diIIerences between the CPI and the GDP DeIlator.
1. CPI contains the goods and services consumed by a tvpical consumer at
some point oI time. Where as, the GDP deIlator contains all goods and
services that are bought in a given year by all economic agents, namely
consumers, Iirms and government. Hence, CPI leaves out many goods and
services that are consumed in the country.


2. CPI may contain some imported goods and services, where as the GDP
deIlator contains only domestically produced goods and services. ThereIore,
an increase in the price oI imported goods that are typically consumed by an
average consumer will aIIect CPI.

3. The weights oI CPI usually remain 'Iixed Ior a long period oI time,
where as the GDP deIlator has 'variable weights that alter every year.
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Economists call a price index with Iixed weights a Laspeyres Index. The
GDP deIlator with variable weights is called a Paasche Index.

4. There are some problems with Iixed weights. For instance, when a
product disappears Irom the market due to some reasons like crop Iailure,
the good will not appear in the GDP deIlator. However, iI a Iew oI this item
still remains in the market at a very high price and iI it is included in the
CPI, the item may adversely aIIect the price index. A typical consumer will
substitute this product with suitable (less expensive) substitutes which will
be reIlected adequately in the GDP deIlator and will not do so in the CPI. In
other words, a Laspeyres index like the CPI will overstate the increase in the
cost oI living oI the consumers. The GDP deIlator, on the other hand, may
understate the increase in the cost oI living since the good does not appear in
the price index.

5. The CPI does not include new goods and services that are presently
produced in the country since its weights are Iixed.

6. Another problem is that the CPI does not reIlect the eIIects oI qualitv
improvements on consumer preIerences because its weights are Iixed.
WPI or Wholesale Price Index
This one like the CPI uses a Iixed basket oI goods and services. However,
WPI contains raw materials and semi-Iinished goods beside Iinal consumer
items. The objective is to use it to Iorecast major or signiIicant Iuture price
movements through the inclusion oI unIinished goods and raw materials
which are yet to reach the consumer. ThereIore, WPI includes several items
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which are at an early stage oI their distribution. The methodology to
construct the index is the same.

Inflation Rate
Any oI the price indices can be used to obtain the inIlation rate. For instance,


t
( CPI
t
- CPI
t - 1
) / CPI
t - 1
` 100

InIlation is a persistent rise in prices and not once in a while increase in the
price level.

II.4 Unemployment Rate
The unemployment rate is the ratio oI the working population who do not
have jobs to the total labour Iorce. It is expressed in percentage terms as
Iollows.

u U/L * 100
where u is the unemployment rate, U is the total number oI people
unemployed in the economy and L is the work Iorce consisting oI people
who are employed and unemployed.

A person is emploved iI he is a paid employee, or working in his own
business, or working as an unpaid worker in a Iamily member`s business, or
even iI he is temporarily absent Irom work because oI vacation or illness or
bad weather.

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A person is said to be unemploved when he or she is willing to work, is
available Ior work and is also actively looking Ior work, but couldn't Iind
work. Two broad shortcomings oI this deIinition are:
(a)it does not consider discouraged workers who have given up
looking Ior work actively; and
(b)part-timers who preIer to be Iully employed are not included in U.

A related statistic is the Labour-Iorce participation rate. At any point oI time
there are adult people who are not in the labour Iorce because oI a number oI
reasons. For instance, some people retire early, some men preIer to stay at
home and raise their children since more women Iind work, and some
remain at school longer than usual. The labour-Iorce participation rate is the
percentage oI the labour Iorce in total adult population. In the US it is 66
in 2004.