gdp & gnp in a nutshell

 

Hello everyone!!

This blog is about understanding economy in a few easy steps. First, let’s start with Wheel of wealth a.k.a. Circular Flow of Income a.k.a. Income Flow. Through this economic philosophy, mankind sustained ever since trade began and that is, by offering services to an endemic region for a compensation.

Circular Flow of Income: Two-sector economy without savings

This is simply citizens earning wages from firms/farms so that they can buy commodities from firms/farms. This is how both the households and companies earned their revenues which is a significant part of this topic. There are difficulties in this model as the producers need to buy raw materials from other countries which reduces the income flow of this country and over that, they don’t have any savings.

 

Circular Flow of Income: Two-sector economy with savings

People later realized that it is impossible to live without some cash savings and this is where the  expression for savings had come up as

Savings (S) = Income(Y) – Consumption(C)

There is no fundamental flaw in this concept just because of the theory that, increase in savings decreases the circular flow of income because people spend less on goods and services back to the firms/farms. To mitigate this, banks have been founded to safe keep household savings and this bank will again give cash loans to producers and households increasing the circular flow of income.

Drawbacks- When Savings > Investments; the income flow declines because imprudent households hold a lot of cash in their cupboards and do not wish to invest anywhere nor spend and this weakens the income flows. Another fact is, they don’t get paid very well.

Advantages- When Investments > Savings, the income flow declines; banks make new investments and income flow rises again at a higher income level.

Facts- It is hard for an economist to ask all households to make investments to get an equilibrium of Savings = Investments. So, this equation comes true at different income levels.

Note: For further details about income-savings curve, read IS = LM economic model which expounds about how various factors like savings, investments and lending are influenced.

 

Circular Flow of Income: Three-sector economy

Till above, people could have suffered due to lack of governance while governments under the influence of monarchies or capitalists had run the country as an under-waged economy. So, the governments decided to intervene and ended laissez-faire markets and started imposing taxes on the public to raise revenues to endow them with further lawful perfect markets. Hence, the practice of imposing personal direct taxes and indirect tax had started. They also levied taxes on firms to earn revenues on every commercial transaction.

However, the governments were honest as they always accounted to maintain ‘Incomes = Expenditures’ being a not-for-profit company and also to avoid any misappropriation of taxes.

 

Circular Flow of Income: Four-sector economy

This is the model which all countries follow currently. This includes foreign trade transactions arising from globalization. The governments motto is simple, to keep Imports = Exports in order to avoid trade deficit, but in reality it is hard to maintain it as imports might exceed exports or vice-versa.  

When households, through firms pay money to import goods from other countries like US or Canada, those countries National Income will increase but there is no value added to Indian National Income. Hence, they try to manage or achieve either of the below first two

Exports > Imports, this will create a ‘Trade Surplus’

Or

Exports = Imports

But when

Exports < Imports, out circular flow of income reduces and this will give as ‘Trade Deficit’.

 

 Factors of production: (Also Factors of Income)

Natural resources, Capital, Labour, Technology and Skills. The two components of Economies of Scales:

a.     Real economies- Production, Selling and Warehousing is taken care of to generate output and sales.

b.    Pecuniary economies – Tries its best to obtain low cost raw materials; skilled-manpower; semi-skilled manpower; transportation; and loans.

All of the companies good performances on an aggregate, that is combined, will affect the size of National Income. Thus, there is a positive correlation under ideal conditions between a firm increasing its profits through economies of scales (Extra goods produced while fixed production costs remain the same for producing extra goods; this will lead to marginal revenue > marginal cost of production) and circular flow of income. As the former can lead to incentives and bonuses.  

Note: The production approach to calculating NI will be increased with increased output. Hence, MC=MR or MC<MR is either ways fine as this is usually a product selling price sensitivity issue where the results may vary.

 

National Income: Production Approach

NI = P₁Q₁ + P₂Q₂ + P₃Q₃ + …. + P_nQ_n

Or

NI = Σ P_iQ_i

Q₁, Q₂, Q₃ = Quantities of annual goods and services; P₁, P₂, P₃ = Correlating prices.

 

National Income: Income Approach

This is mathematically expressed as

PiQi = W_i + I_i + R_i + P_i

W_i = Wages; I_i = Interest; R_i = Rent; and P_i = Profits respectively.

 

National Income: Expenditure Approach

Mathematically expressed as

Y = H_e + B_e + G_e

H_e = Annual household expenditure; B_e = Annual business expenditure; and G_e = Annual government expenditure respectively.

Note: The above three approaches are used to find sectoral based NI e.g. Railways; Airways; Road transport; Retail sector; Financial Sector; and Goods and Services markets.

 

Aggregate Income concepts

Gross aggregate value = No provision for depreciation is created on capital consumption. (Machinery Etc.)

Net aggregate value = Provision for depreciation is created on capital consumption.

The difference between these two aggregate values give

Gross capital investment consumption – Net capital investment consumption = Aggregate Depreciation.

Gross National Product = Of Indians or its diaspora abroad, the income accrued as salary/profits payable or paid to employees and owners when they participated in the current year’s production.

Gross Domestic Product = It is the value of total output or income generated within a territory of a country (E.g. states). The aggregate income generated from both residents and non-residents is included into GDP.  

There is not much difference between NNP and GDP values apart from a residual balance, Net Factor Income.

Net Factor Income/Output = Factor income inflow from foreign – Corresponding outflow

Or

(Wages + Interest + Profits + Dividends received by Indians from overseas assets they own) – (Wages + Interest + Profits + Dividends earned by foreigners from Indian assets they own).

Market Prices = Value of factors of production + Indirect taxes (Sales taxes, Duties Etc.) - Subsidies.

GDP or GNP at market prices = GDP or GNP at factor cost of production + Indirect taxes – Subsidies.

GDP and GNP are calculations at Market price and Factor cost:

GDP Market Price = C + I + G + (X – M)

C= Consumption expenditure on goods and services; I = Value of capital goods or gross investments output; G = Government expenditure; and X – M = Exports – Imports called as ‘Balance of trade’.

GDP Factor Cost = GDP Market Price – Indirect taxes + Subsidies.

 GNP Factor Cost = GDP Factor cost +/- Net factor income.

NNP Factor Cost = GNP Factor cost – Aggregate Depreciation.

 

Nominal GDP Vs. Real GDP

There is a shortfall in understanding the real economic growth because of inflation. Nominal GDP rises when inflation increases prices. Hence, Real GDP helps to adjust for that inflation.

Example: 

In 2010 – 200 Television @ 500 INR; 400 Radios @ 300 INR and so on products were manufactured and sold. 

In 2020- 500 Televisions @ 300 INR; 500 Radios @ 200 INR and so on products were manufactured and sold.

From the above example:

Nominal GDP 2010 = 200 x 500 + 400 x 300 +….. = 220,000 INR

Nominal GDP 2020 = 500 x 300 + 500 x 200 +…. = 250,000 INR

Real GDP 2010 = 200 x 500 + 400 x 300 +….. = 220,000 INR

Real GDP 2020 = 500 x 500 + 500 x 300 + …..= 400,000 INR

From the above it must be clear to everyone that Real GDP uses historic or benchmarked year’s prices to calculate current year’s GDP.

GDP Deflator = Nominal GDP / Real GDP  

                                                 

Personal Income vs. Disposable income

Personal Income = NNP Factor Cost – Corporate taxes – Undistributed profits + Transfer payments

Disposable Income = Personal Income – Personal taxes

Economic Growth = (1 + GDP Growth / 1 + Population Growth) - 1.

Please write a comment if you find this useful or if you need any changes to be made. 

Happy New Year 2022