Our economy works much like the game of passing the parcel, a favourite party game of children in which a gift wrapped in covers passes through different hands to the tune of music. In our economy also, money passes from one hand to another just like a parcel to the tune of demand and supply. So, the next time you take out your wallet, just keep in mind that you are playing a game of penny. This game can continue only if one person passes his penny to the next person. What goes out of your pocket as expenditure for using the laundry service ultimately becomes the income of the person providing that service. In this manner, the game of penny leads to the growth of gross domestic product or GDP in our economy.
Johnny: Last week, you had told me that in addition to the output method we can also measure GDP growth by using the income or expenditure methods. I hope you will now take our discussion further.
Jinny: Output of goods and services that have value in terms of money results in income for the producer and expenditure for the consumer.
So, instead of measuring the value of output, we can also measure GDP by measuring either the income or expenditure of people.
The figures arrived at by any of the three methods must be the same. But in reality, the figures may vary due to counting errors and omissions.
Johnny: Yes, Jinny, errors and omissions are bound to occur when you are counting the income and expenditure of all the people in the country. But tell me how these income and expenditure methods work.
Jinny: Let’s talk about the expenditure method first. For measuring total expenditure, we divide the final users of goods and services into four groups: households, firms, government and foreign consumers.
The expenditure method works on the presumption that whatever goods and services a country is generating ultimately get consumed by these four groups. So if you add up their total expenditure on various goods and services, you can very well know the value of GDP. Households spend their money in private consumption on a variety of goods and services such as foods, clothes, car, toothpaste, haircuts, laundry service and many other things.
Likewise, our government also spends money on a variety of goods and services. It makes hospitals, builds schools and dams, and does many other things. Similarly, firms spend their money in investments for purchasing new machines, factories, office buildings, things that increase their productive capacity.
In addition, unsold goods in the inventory of firms are also treated as their expenditure. This ensures that unsold goods are not left uncounted in the expenditure method.
Finally, we count the money spent by foreign consumers on the goods and services produced within our country. We do this by calculating the value of net exports (by subtracting the value of imports from the value of exports of goods and services).
Once we have the final figures of all the items—private consumption, firms’ investments, government spending and net exports—we can add them to arrive at the final value of GDP through the expenditure method.
Johnny: How do we use the income method to calculate GDP?
Jinny: For calculating GDP by the income method, we can broadly divide our economy into two groups: those who contribute their labour and those who contribute their capital. The cost of production of goods and services leads to income for both these two groups of people. A mechanic engaged in the production of cars earns his income in the form of a monthly salary.
The shareholders of the car company earn money in the form of dividends. The lenders of the company take away interest and the owners of the land take away lease rent.
One activity can generate income for so many different people. We have numerous incorporated and unincorporated firms, enterprises and individuals in our country that are engaged in the production of a variety of goods and services. If we add the income of all the firms and individuals, we arrive at the value of GDP at factor cost. This value of GDP at factor cost does not include the taxes and subsidies on final goods and services paid by the final consumer. It only shows the production cost of goods and services.
So, this figure will not match with the figure of GDP calculated by us through the expenditure method, which takes into account the actual price paid by the consumer after taxes and subsidies.
In order to remove this discrepancy, we add the value of taxes and subtract subsidies from the value of GDP at factor cost. This will give you the final figure of the value of GDP calculated through the income method. This should be equal to the value of GDP calculated through the expenditure method.
If it does, then you have completed a feat that is as difficult as counting the number of hair on your head.
Johnny: That’s true, Jinny. The next time I go for a haircut, I will challenge my barber to take stock of the number of hair on my head.
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 both of them at firstname.lastname@example.org
Making sense of GDP
What: Measurement of GDP requires collection of data from a variety of sources.
How: Expenditure method uses expenditure figures of consumers whereas income method uses income figures of producers for measuring GDP.
Who: The task of measuring GDP is done by the Central Statistical Organization in our country.