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(The Indian Express has launched a new series of articles for UPSC aspirants written by seasoned writers and scholars on issues and concepts spanning History, Polity, International Relations, Art, Culture and Heritage, Environment, Geography, Science and Technology, and so on. Read and reflect with subject experts and boost your chance of cracking the much-coveted UPSC CSE. In the following article, Meera Malhan and Aruna Rao, Professors in economics, analyse alternative ways of measuring GDP.)
Retail inflation, based on the Consumer Price Index (CPI), fell to a five-month low of 4.31 per cent in January, mainly due to a decline in prices of key food items such as vegetables. Since inflation influences consumer spending, production costs, and overall economic growth, it plays a crucial role in Gross domestic product (GDP) calculations. But what are the possible ways of measuring GDP?
GDP is the sum of the market value of all the final goods and services produced within the geographical boundaries of a country each year. The value of GDP measured in current prices is called Nominal GDP but it might not be a good measure of production because the increase in value may result from an increase in prices and not output. Nominal GDP, adjusted for price changes, is called Real GDP.
Nominal GDP per capita = Nominal GDP/total population
Real GDP per capita = Real GDP/total population
Furthermore, economists rely on three approaches to accurately measure GDP: Expenditure, Income, and Product. GDP calculated from all these approaches should give the same value. However, GDP measurement also depends on the structure of the economy. In a four-sector open economy, economic activities involve interactions among four key sectors:
1. The consumers
2. The producers
3. The government sector
4. The rest of the world sector (ROW)
Each sector has a significant role in determining GDP, and their combined contributions are reflected in the three GDP measurement approaches.
Expenditure approach
The expenditure approach is a sum of four key components – personal consumption expenditure (C), investment expenditure (I), government expenditure (G), and net exports (X-M) by the ROW sector.
Personal consumption expenditure is the sum of expenditure on consumer durables, non-durable goods, and services. Gross private domestic investment is the total of business fixed investment (non-residential structure, equipment, and software), residential investment and inventory investment.
Government purchases are calculated both at the federal level and state and local levels and consist of both defense and non-defense expenditures. Net exports are calculated as the value of exports to the ROW minus the value of imports from the ROW. Thus, this approach captures the total spending within an economy.
Income approach
The income approach is very simply calculated as income earned from all sources and includes wages and salaries, proprietors’ income (earnings from self-employment and unincorporated businesses), rental income, corporate profits, and net interest earned (interest earned minus interest paid). Additionally, the concept of GDP also includes net indirect taxes, statistical discrepancy, depreciation, and net payments made to the ROW.
Product approach
The product approach, also known as the output method or value-added method, adds up the market value of all goods and services produced, excluding the goods used in the intermediate stages of production.
The three GDP measurement approaches must always give the same total due to the following relationships:
Equivalence of production and expenditure: The market value of goods and services produced in each period is, by definition, equal to the amount that buyers must spend to purchase them.
Thus, Value of Product Approach = Total Obtained by Expenditure Approach (Equation 1).
Equivalence of expenditure and income: What sellers receive must be equal to what buyers spend. In other words, sellers’ receipts represent the income generated from economic activity, including income paid to workers and suppliers, and taxes paid to the government, and profits.
Therefore, Total Expenditure = Total Income (Equation 2)
Because of (1) and (2) , Total product = Total income
The Total Product = Total Income = Total Expenditure is called the fundamental identity of national income accounting.
India’s GDP is estimated by the Central Statistical Office (CSO) using two methods. One is based on economic activity (at factor cost, this does not include taxes), and the second is on expenditure (at market prices, this includes taxes).
Economic activity-based method (at factor cost): This measures GDP based on the cost of production, excluding taxes but including subsidies.
Expenditure-based method (at market prices): This calculates GDP based on total spending in the economy, including taxes but excluding subsidies.
Sectors using factor cost method
The factor cost method is calculated by collecting data for each sector during a particular time-period. Due to the lack of reliable data for the other two methods, GDP is primarily measured using the factor cost method across the following sectors:
1. Agriculture, forestry, and fishing
2. Mining and quarrying
3. Manufacturing
4. Electricity, gas, water supply, and other utility services
5. Construction
6. Trade, hotels, transport, communication, and broadcasting
7. Financial, real estate, and professional services
8. Public administration, defense, and other services.
Sectors using expenditure method
The expenditure method involves summing the domestic expenditure on final goods and services across various streams during a particular time-period. It includes consideration of expenses towards household consumption, net investments (capital formation), government costs, and net trade (exports minus imports).
The GDP figures derived from the two methods may not match precisely due to differences in the database and methods of data collection. This difference is termed statistical discrepancy.
The expenditure approach offers good insights into the most important contributors to India’s GDP. For example, domestic household consumption forms 60.34% of the economy’s GDP, which is why India remains unaffected to a good extent by economic slowdowns in other parts of the world.
In comparison, an economy with a high concentration on exports will be more susceptible to the effects of global recessions.
The largest contributor to India’s GDP is the services sector, which accounts for 61.5% of GDP. The next largest contributor is the industrial sector at 23%, followed by the agricultural sector at 15.4%.
GDP is a statistical indicator that defines the economic progress and development of a country. The percentage growth in GDP during a quarter is considered the standard measure of economic growth. However, there are limitations of GDP as a measure of economic growth, which are:
— It excludes non-market transactions
— It doesn’t account for the standard of living (Per capita income is a better measure of that)
— It doesn’t account for externalities
— It doesn’t account for income inequalities or the distribution of income
Therefore, while GDP growth is an important metric, it should be analysed alongside other welfare indicators for a more comprehensive assessment of economic development.
What is retail inflation, and how is it measured in India?
Define potential GDP and explain its determinants. What are the factors that have been inhibiting India from realizing its potential GDP?
Explain the three primary ways of measuring GDP?
Why might GDP figures obtained from the factor cost and expenditure methods differ?
What is a statistical discrepancy in GDP measurement?
(Meera Malhan and Aruna Rao are Professors in economics at Delhi University.)
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