Our friend Jinny thinks that the growth of hair on our heads also contributes to the growth of our gross domestic product (GDP). There is a long list of people—right from the barber in our neighbourhood to the shampoo and hair oil makers located far off—who depend on the growth of our hair for the growth of their businesses. Imagine what would happen if the entire country were to go bald. How would that affect our GDP growth? Would there be a recession in the economy? If the barber had no money, how would he buy the baker’s cakes? We will ponder over some of these interesting issues. But let us first understand the basics.
Johnny: I keep hearing that the economists are concerned about the growth of GDP. But I don’t understand what exactly we mean by GDP.
JAYACHANDRAN / MINT
Jinny: GDP is short for gross domestic product. It is measured in terms of the monetary value of all goods and services produced withinthe borders of a countryduring a year.
A country can produce a variety of goods—from soaps to jumbo jets—and services, such as a barber cutting your hair or a chartered accountant taking care of your taxes. But, how can we measure the value of all these goods and services being produced in every nook and corner of our country?
Well, we can measure GDP by using any of the three methods—the output method, income method or expenditure method. Output of goods and services leads to income for those who are producing and expenditure for those who are consuming the items. So, the value of GDP measured by any of the three methods must give the same figure. But, in reality, that is hardly so due to errors and omissions incounting.
Johnny: How do these three methods work?
Jinny: Let us talk about the output method first. In this method, we calculate GDP by adding the market value of all goods and services produced during a year. If the current market value is taken without making any adjustment for inflation, then we arrive at what is known as nominal GDP. However, if we adjust the current market price by taking inflation into account, we arrive at real GDP.
Nominal GDP may not give you the true picture. Suppose last year you produced 10 bars of soap at the price of Rs10 each. Then the total value of your output is Rs100. But suppose the price this year has increased to Rs12 due to inflation and you have produced only nine bars of soap. The total value of your output at the current price is Rs108, which is still 8% higher than the value of your output last year. The price rise due to inflation makes it look as if your output has increased by 8%, whereas in reality your output has decreased by 10%. To know the real GDP, you have to ignore the increase in price due to inflation and measure the value of your output at a constant price.
How do you do that? We first choose what we call the base year, which serves as the starting point of our comparison. The price of the product in the base year is taken as the constant price. Suppose, in the present example, last year is our base year. You ignore the Rs2 increase in price and take Rs10 as the constant price of soap. At this price, the value of output is Rs90, which actually shows a 10% decline in output. So, real GDP gives us the picture of real growth.
Johnny: Yes, Jinny! Inflation really makes a lemon look like a watermelon.
Jinny: But, inflation is not the only culprit. Taxes and subsidies also distort the value of GDP. The market value of goods and services may increase due to taxes and decrease due to subsidy. So we can know the actual cost of producing goods and services by adding subsidies in the cost and by reducing taxes. The value of GDP measured at the actual cost, without taxes or subsidies, is known as GDP at factor cost.
Johnny: What could be the pitfalls of measuring GDP by the output method?
Jinny: You should not count the value of the same good twice. If you are counting the value of tyres produced separately, then you should deduct this while counting the value of cars that use tyres as inputs.
Similarly, while counting the value of services, you should have the data for all the services that are worth something in terms of money. Helping someone cross the road may not be quantifiable in terms of money, even though you may be doing a great service. But, what if the person you help gives you a tip? Will that be counted as part of GDP? How are we going to get the data for all the individuals getting tips for their services?
Johnny: Let me think before we meet next week to continue our chat.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at email@example.com