Macroeconomic Analysis and Policy

National Income Measurement

(Part-2)
Session 4

Ranjan Kumar Mohanty

Real versus Nominal GDP
▪ Inflation can distort economic variables like GDP, so
we have two versions of GDP:
▪ Nominal GDP
▪ values output using current prices
▪ not corrected for inflation
▪ Real GDP
▪ values output using the prices of a base year
▪ is corrected for inflation
EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200

Compute nominal GDP in each year:

Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
37.5%
2012: $11 x 500 + $2.50 x 1100 = $8,250
30.9%
2013: $12 x 600 + $3 x 1200 = $10,800
EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200

Compute real GDP in each year,

using 2011 as the base year: Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
20.0%
2012: $10 x 500 + $2 x 1100 = $7,200
16.7%
2013: $10 x 600 + $2 x 1200 = $8,400
EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
2012 $8250 $7200
2013 $10,800 $8400

In each year,
▪ nominal GDP is measured using the (then)
current prices.
▪ real GDP is measured using constant prices from
the base year (2011 in this example).
EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
37.5% 20.0%
2012 $8250 $7200
2013 $10,800 30.9% $8400 16.7%

▪ The change in nominal GDP reflects both prices

and quantities.
▪ The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
 Nominal and Real GDP in India
Nominal
(Base year 2011) GDP
25000000

20000000
Nominal GDP Real GDP
15000000
Rs. Crore

10000000
Real GDP
5000000

1988 [YR1988]
1972 [YR1972]
1974 [YR1974]
1976 [YR1976]
1978 [YR1978]
1980 [YR1980]
1982 [YR1982]
1984 [YR1984]
1986 [YR1986]

1990 [YR1990]
1992 [YR1992]
1994 [YR1994]
1996 [YR1996]
1998 [YR1998]
2000 [YR2000]
2002 [YR2002]
2004 [YR2004]
2006 [YR2006]
2008 [YR2008]
2010 [YR2010]
2012 [YR2012]
2014 [YR2014]
2016 [YR2016]
2018 [YR2018]
2020 [YR2020]
Year
➢ Before the base year, real GDP > nominal GDP. Prices were much higher.

➢ After base year, nominal GDP rises faster than real GDP. This should make sense, because growth in nominal GDP is
driven by growth in output AND by inflation. Growth in real GDP is driven only by growth in output.
The GDP Deflator
▪ The GDP deflator is a measure of the overall level of prices.
▪ Definition:

nominal GDP
GDP deflator = 100 x
real GDP

▪ One way to measure the economy’s inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.
EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2011 $6000 $6000 100.0
14.6%
2012 $8250 $7200 114.6
2013 $10,800 $8400 128.6
12.2%

Compute the GDP deflator in each year:

2011: 100 x (6000/6000) = 100.0

2012: 100 x (8250/7200) = 114.6

2013: 100 x (10,800/8400) = 128.6

ACTIVE LEARNING 2
Computing GDP
2011 (base yr) 2012 2013
P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2011.
B. Compute real GDP in 2012.
C. Compute the GDP deflator in 2013.
ACTIVE LEARNING 2

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

A. Compute nominal GDP in 2011.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2012.

$30 x 1000 + $100 x 200 = $50,000
ACTIVE LEARNING 2 Continued..

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

C. Compute the GDP deflator in 2013.

Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
 How to Measure GDP? (NIA)
• Three alternative methods/approaches are used, all give same
measurement
• The Product Method/ The Value Added Method
• The Income Method
• The Expenditure Method
• The Value Added Method
• The contribution of all sectors to the value of the final goods.
• value added = value of output minus value of inputs purchased from other producers.

N
GDP   GVAi
i =1
• GVA: Gross value added at each production unit “i”.
 The Value Added Method continued…
Example: 1 kg wheat is sold at Rs. 20, initial value addition by the farmer
is 20, then the same is used in bake shop & bread is sold of Rs.50, so
value added by the bread maker is 50-20= Rs. 30. Total value added =
30+20=50.

It considers all sectors of an economy (Three Sectors)

Primary:
Agriculture, Forestry and Fishing,
Secondary:
Mining and Quarrying, Manufacturing, Electricity, Gas and water supply, and construction.
Tertiary:
All items under services like i) trade, hotel and restaurants, ii) Transport, storage and communication, iii)
Banking and Insurance, iv) Real Estate, dwellings and business services, v) Public administration and defense
and vi) others.
 The Income Method
• It looks at GDP in terms of who receives the income for the product
exchanged. It is the owned by a country’s citizen. total income
earned by factors of production
• It corresponds to the sum of the rewards to the owners of the factor
of production (LAND, LABOUR,CAPITAL, ENTERPRENEURSHIP).
• GDP= σ 𝑅𝐸𝑁𝑇+ σ 𝑊𝐴𝐺𝐸+ σ 𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇+ σ 𝑃𝑅𝑂𝐹𝐼𝑇+
σ 𝐷𝐸𝑃𝑅𝐸𝐶𝐼𝐴𝑇𝐼𝑂𝑁

The Expenditure method (already discussed as component of GDP)

Y = C + I + G + NX
Interrelationship between three approaches
Why are the three approaches equivalent?
They must be, by definition
• Any output produced (product approach) is purchased by
someone (expenditure approach) and results in income to
someone (income approach)
• The fundamental identity of national incomeaccounting:
➢ total production = total income = total expenditure
 Understanding the Three methods of NIA
The Income method; (Before Tax)
Dhirendra Transactions Rs.(Lakh)
Total Wage= (20000+15000) = Rs. 35000
Wages paid to workers 20000
Tax paid to Government 10000
Dhirendra profit= ( 45000-20000)= Rs.25000 (B-TAX)
Revenue received from sale of Apples 45000 Jugal Profit= (50000-(30000+15000)= Rs. 5000 (B-TAX)
▪ Apples sold to public 15000
▪ Apple sold to Tropicana factory owner 30000 Thus, Total Income= Rs. 65000

Jugal Transactions (the Tropicana factory owner)

Wages paid to workers 15000 The Income method; (after tax)
Tax paid to Government 2000 Total Wage= (20000+15000) = Rs. 35000
Apples purchased from Dhirendra 30000 Dhirendra profit= Rs.15000 (A-TAX)
Revenue received from sale of Juice 50000 Jugal Profit= Rs. 3000 (B-TAX)
Tax received by Govt= Rs. 12000
The Value-added method;
Dhirendra Value added= Rs.45000 Thus, Total Income= Rs. 65000
Jugal Value added= (50000-30000)= Rs. 20000

Thus, Total Value added= Rs. 65000 The Expenditure method;

Ultimate users= 50000+15000= Rs.65000
The product approach, income approach, and expenditure approach are three different ways of arriving the
same GDP calculations
Is GDP a good measure of Economic Well-Being?
▪ Real GDP per capita is the main indicator of the average
person’s standard of living.
▪ But GDP is not a perfect measure of well-being.
▪ Robert Kennedy issued a very eloquent yet harsh criticism of
GDP:
Gross Domestic Product…
“… does not allow for the health of our
children, the quality of their education,
or the joy of their play. It does not
include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968
GDP Does Not Value:
▪ the quality of the environment
▪ leisure time
▪ non-market activity, such as the child care
a parent provides at home
▪ an equitable distribution of income
Then Why Do We Care About GDP?
▪ Having a large GDP enables a country to afford better schools, a
cleaner environment, health care, etc.
▪ Many indicators of the quality of life are positively correlated with
GDP. For example…
 GDP and Life Expectancy in 12 countries
90

Bangladesh China Japan

Life expectancy (years)

80 U.S.
Mexico
Brazil Germany
70 Russia
Indonesia
India
60
Pakistan

50 Nigeria

40
$0 $10,000 $20,000 $30,000 $40,000 $50,000
Source: Human Development Report 2011, United Nations
Real GDP per person
22
 GDP and Average Schooling in 12 countries
14
Germany
Japan
12 U.S.
Average years of school
Russia
10 China
Mexico
8
Brazil
6 Indonesia

4
India

2
$0 $10,000 $20,000 $30,000 $40,000 $50,000
Real GDP per person 23
Source: Human Development Report 2011, United Nations
 GDP and Water Quality in 12 countries
100%
Indonesia Germany

Satisfaction with water quality

90% Bangladesh U.S.
Japan
(% of population) Brazil
80%

China
70%
Mexico
India
60%
Pakistan Russia
50%
Nigeria

40%
$0 $10,000 $20,000 $30,000 $40,000 $50,000
Real GDP per person 24
Source: Human Development Report 2011, United Nations
Summary about GDP
• Gross Domestic Product (GDP) measures a
country’s total income and expenditure.
• The four spending components of GDP include:
Consumption, Investment, Government
Purchases, and Net Exports.
• Nominal GDP is measured using current prices.
Real GDP is measured using the prices of a
constant base year and is corrected for inflation.
• GDP is the main indicator of a country’s
economic well-being, even though it is not
perfect.
Thank You