Hello and welcome to the NPTEL MOOCs course
on Economic Growth and Development. Today
is the first lecture. In this lecture I will
take you through to the basic concepts of
economic growth which are important in understanding
the differences in the levels and rate of
growth between countries across the world.
We live in an unequal world. Inequality shows
up in differences in standards of living of
people within a country as well as across
countries.
Within the national boundaries of a country,
when we talk about inequality of incomes and
assets, as well as unequal access to opportunities
of gaining incomes and assets. Inequality
within a country may be estimated vertically
say in terms of levels of incomes of people
within a country or horizontally say in terms
of differences in different social groups
of population including caste, class and gender
and so on. But when we talk about inequality
across countries, we are usually measuring
inequality in terms of the level and the rate
of economic growth registered.
So, whether or not India is ahead of Sri Lanka
or Bangladesh or South Africa has strategic
importance for investment within a country,
and to be able to make sense of such differences,
we need to get introduced to certain basic
concepts of economic growth and one such is
a system of national income accounts.
Now, if you look at certain ways in which
economic growth has been defined, we see that
it has been variously defined. Some say it
is an increase in the production of goods
and services over a period of time, some others
define it as sustained annual increases in
an economy’s real national income over a
long period of time, while others will define
it as increases in real per capita income
of a country over a long period of time.
Now, note the usage of terms such as increase
in production of goods and services, annual
increases in an economy’s real national
income and annual increases in real per capita
income. What do all of these terms mean? All
of these terms basically say that economic
growth means raising the standards of living
of people. However, this rise in standards
of living of people must be a sustained increase,
it must be consistent, if it has to qualify
as economic growth. Also note the term ‘real’.
While the growth theory has to its credit
a vast literature focusing on all aspects
of it, including the desirability of it in
various country contexts, a definition of
growth points to its measurability.
So, when we are saying that country A is growing
at a faster rate than that of country B, we
are essentially referring to the estimate
of economic growth which is a calculation
and this calculation is usually made in real
terms.
Before I introduce you to some of the very
basic definitional issues with respect to
national income accounts, as we use in India,
and is generically used in various countries
across the world. Let me introduce you to
some general differences with respect to certain
terms, which are central to understanding
these issues. One such is nominal versus real,
second is gross versus net, and current versus
constant prices.
Now, in economics the nominal values of something
are its money values in different years. Real
values adjust for differences in the price
level in those years. What we are essentially
trying to talk about is whether or not values
are adjusted for inflation. Examples include
a bundle of commodities such as gross domestic
product and income. For a series of nominal
values in successive years, different values
could be because of differences in the price
level.
But nominal values do not specify how much
of the difference is from changes in the price
level. Real values remove this ambiguity.
Real values convert the nominal values as
if prices were constant in each year of the
series. Any differences in real values are
then attributed to differences in quantities
of the bundle or differences in the amount
of goods that the money incomes should buy
in each year. The term gross refers to the
total amount made as a result of some activity.
It can refer to things such as total income
or sales or profit. Net refers to the amount
left over after all deductions are made and
usually in terms of national income accounts
when we are referring to deductions we are
basically referring to depreciations.
Current prices measure income or asset prices
using the actual prices we notice in the economy.
In other words they make no adjustment for
inflation, which can very simplistically be
defined as the rise in the general level of
prices within the economy. Constant prices
adjust for inflation. Using constant prices
enables us to measure the actual change in
output and not just an increase due to the
effects of inflation.
Understanding the basics of the systems of
national accounts is crucial to delving into
the growth literature.
For that let me demonstrate how incomes and
output flows take place in an economy. In
standard economics literature we are introduced
to certain circular flow models. There are
two sector, three sector, four sector, multiple
sector models. It will suffice to introduce
you to a simple model: a closed economy where
there is no foreign trade and there are just
two sectors households and firms.
Let us assume that only two types of goods
are produced that is investment goods and
consumption goods. The resources such as land,
labor and capital are provided by the households
to the productive sector or the business sector
or the firms, they are also otherwise referred
to as the business sector. For these productive
services they receive rewards in the form
of rent, wages, interest and profits.
So, the households provide land, labor and
capital to the firms and in return the firms
provide rent, wages, interest and profit to
the households. Now households as a rule do
not spend all their incomes on consumption,
as they save some part of their income to
meet exigencies. So, part of their incomes
go into savings and part into expenditure
on goods and services. The firms for investment
purpose plough back some of its savings and
get the household savings which is funneled
through the money market.
In this model economy only two types of goods
are produced - consumption and investment
goods - and some of these goods may be purchased
and distributed by the government.
So, our national output, we generally refer
to national output as Y. This may mean output
or income. So, national output Y will have
three components: consumption goods, investment
goods and goods purchased or distributed by
the government.
Through this flowchart I also want to draw
your attention that typically national income
is measured in three ways. They are
First the expenditure method. It is basically
an aggregate of the value of all final sales
of what has been produced in the economy.
Second is the product method which is a sum
of value added by each type of industry in
the business sector.
And the third is an income method which is
an aggregate of factor earnings to the resources
supplied by the households.
Now, let me throw some light on each of these
methods of estimating national income as I
have discussed here, as it is important that
we get clear of concepts such as problems
of double counting.
.
Let me begin with the product method. The
product method of estimating national income
is also known as the output method or industry
origin method or commodity service method.
National product is arrived at by adding the
net output of each industry in this method.
The term net output means the value of final
product produced by an industry minus the
intermediate purchases made by it. Now consider
the following example. Say there are three
industries. Industry A B and C. Industries
A and B sell intermediate products and industry
C sells final products to consumers. Industry
A sells raw jute to industry B for rupees
10 crore, industry B sells jute fibre to industry
C for rupees 25 crore and industry C sells
canvas ropes to final consumers for rupees
50 crore. We have made certain assumptions
here.
It is assumed that industry A purchases no
intermediate products and therefore, rupees
10 crore is the final output. The net output
of B and C are rupees 15 crore and rupees
25 crore respectively. Since B purchases raw
jute from A for rupees 10 crore it adds only
rupees 15 crore and industry C adds only rupees
25 crore over the intermediate purchases of
rupees 25 crore from B. Therefore the total
output is rupees 10 plus rupees 15 plus rupees
25 that is rupees 50 crore. Since the intermediate
products are ignored there is no double counting
and this is extremely important in the system
of national accounts when we are trying to
estimate national income accounts by the product
method. If the final output of value of these
three industries is added the double counting
boosts up the national product to rupees 85
crore. Therefore, it is extremely important
that issues of double counting are avoided.
Let us now look at the income method of national
income accounting. The income method is also
referred to as factor earnings methods or
the cost approach. Estimating national income
through income method helps us understand
the distributive shares of different factors
of production in an economic. Therefore, this
method is also called factor earnings method
or cost approach. Let me demonstrate this
very simply. In the circular flow model we
have seen that households supply labor, capital
and other resources needed for producing the
product to the productive sector or the firms
and the forms in turn pay wages, salaries,
rent, interest and profit.
All these sources of income received by the
basic factors of production are added to get
the national product. Profit is treated as
an earning over cost item. So, according to
the income method 
the 
national income or Gross National Product
is an addition of wages + rent + interest
+ profits + indirect taxes + dividends + undistributed
corporate profits + corporate taxes + depreciation
– transfer payments.
I will presently get to giving you a short
definition of all of these components when
we are deriving national income through the
income method. But let me mention here that
transfer payments are deducted because they
are not paid for any productive activity.
Indirect taxes are the part of the prices
of commodities and therefore, they are included.
Depreciation and undistributed corporate profits
are not received by factors as income and
therefore, they are also added.
National product calculated by these two methods
product an income should be identical. This
is because product contribution is made equivalent
to earnings made out of the products. Therefore,
in terms of national income identities following
the circular flow of income and output in
the economy, national product is equal to
national income. Let me repeat this identity
once again going by the income method, national
income or GNP is calculated by adding the
factor payments - wages, rent, interest, profits,
indirect taxes, dividends, undistributed corporate
profits plus corporate taxes plus depreciation
minus transfer payments.
To give you a little more clarity about these
constituent elements of national income through
income method let me give you small definitions.
Wages are of course, the payment made to labor;
rent is the payment on land, interest on rate
of investments and profits. Indirect taxes
are basically a tax levied on goods and services
rather than on income and profits. Dividends
are a sum of money which is paid regularly
by a company to its shareholders out of its
profits or reserves.
Corporate tax is a levy placed on the profit
of a firm to raise taxes. In India a flat
rate of 25 percent corporate tax is levied
on the income earned by a domestic corporate.
A surcharge of 12 percent is levied in case
turnover of a company is more than rupees
one crore. Depreciation here refers to the
monetary value of an asset which decreases
over time due to use, wear and tear or obsolescence.
This decrease is measured as depreciation.
This decrease in an asset’s value may be
caused by a number of factors as well as unfavorable
market conditions. Machinery, equipment, currency
are some examples of assets that are likely
to depreciate over a specific period of time.
Opposite of depreciation is appreciation which
is increase in the value of asset over time.
It is important to understand the term transfer
payments. Transfer payments are basically
payments made or income received in which
no goods or services are being paid for such
as a benefit payment or a subsidy. So, basically
no productive activities are associated with
transfer payments. They are simply a transfer
from the government to the people mostly in
the form of subsidies or income support such
as old age pensions and so on and so forth.
Undistributed corporate profits are commonly
referred to as retained earnings. These are
corporate profits that are neither paid as
corporate profit taxes nor paid to shareholders
as dividends. So, UCP or an Undistributed
Corporate Profits are important for the derivation
of personal income from national income.
So, what we have looked at so far is the method
of national income estimation. The first method
is the product method in which we try to see
how double counting should be avoided by excluding
the value of intermediate products from the
final product. The income method, which is
basically the factor earnings method or the
distributive shares of factors of production
within an economy and lastly the expenditure
method.
According to the expenditure method, national
product is the sum value of sales to final
demand. This method is also known as consumption
saving method since the personal consumption
expenditure, net foreign investment expenditure
and the government expenditure on goods and
services are added to obtain the national
at income market prices. Note that I have
used the term gross national income unlike
gross national product in the earlier cases.
Since we are talking about national income
identities here, national product and national
income are substitutably used. The GNI here
is C + I + G plus X - M which is basically
the net of exports and in terms of a national
income identity based upon all of these methods
the GNI or the national income should be equal
when we are looking at all of these identities.
Moving on let us have a look at some of the
definitions of national income. One of the
most widely used terminology in national income
accounts, is what is referred to as the gross
national product. Gross national product is
defined as the sum of the money value of all
final goods and services, produced during
a particular time period usually one year
including earnings from abroad. Now GNP consists
of a variety of final goods and services like
manufacturing, services etc. These diverse
items cannot simply be added up to get GNP.
Therefore we add only the money value of these
final goods and services. Intermediate products
are excluded because they are a part of the
final product. Also note here that GNP includes
only productive activities related to the
current year. On these count sales of existing
shares, bonds, existing houses, cars and other
assets and the consumer durables purchased
previously are not included in GNP.
In case of the consumer durables, it is counted
in the year in which demand is made. The other
items listed in the identities that I have
just discussed involve only financial transfer
and do not result in associated productive
activity. The profit or loss due to changes
in the prices of capital assets, due to market
fluctuations, does not enter international
product, since they do not form part of any
productive activity. Only goods and services
passing through organized market are included
in GNP. Activities in parallel economy, personnel
services, goods and services made free or
free of charge or exchanges which involve
no money payment are not included in GNP.
One of the important limitations of the concept
of GNP is that since it takes into account
productive activities only in the organized
sector, the vast informal sector of developing
countries such as India have been left out
as far as national income accounts is concerned.
That brings us to the second concept which
is the net national product.
Now, NNP is considered a true measure of national
output and it is simply defined as GNP minus
depreciation. I have already discussed what
depreciation means. It is invariably also
referred to as capital consumption allowances
an NNP is simply GNP minus D which is depreciation.
So, depreciation is deducted from GNP to arrive
at NNP since capital stock wears out in the
process of production.
In other words the amount of capital equaling
depreciation goes out of the production process.
So far we have been talking about national
product. Note the difference in usage of the
term gross national product and gross domestic
product. However, estimating domestic product
is also extremely important for growth assessments.
Domestic product relates to the product of
factors of production employed within the
political boundaries of a country, that is
what is produced within the domestic territory.
On the other hand, national product is the
output produced by nationals of the country
including net return on assets owned abroad.
So, GDP is equal to GNP minus net income from
abroad. You must note here that net income
from abroad is the balance after deducting
the earnings of foreigner’s investment in
domestic territory from the nation’s investment
earning abroad. National income will be smaller
than domestic income when net income from
abroad is negative. A positive net income
from abroad makes the national income greater
than domestic income.
Now before we move ahead let me summarize
what we have discussed so far. I started giving
you a definition of economic growth. What
do we mean generally when we say economic
growth? It basically refers to a sustained
increase in standards of living of people
and when we are measuring a sustained increase
in standards of living, we are generally referring
to increase in incomes or the changes in levels
of incomes of individuals within a country.
To be able to understand this, I introduced
you to certain general concepts used in economics
and which is central to understanding the
system of national income accounts. Nominal
versus real, gross versus net, current versus
constant prices. Then we tried to look at
a very simple model of a closed economy where
there is no foreign trade and there are two
sectors household and the firms and how the
circular flow of income and output takes place
in such a simple economy.
Through the circular flow model we came across
the first national income identity which is
output or income comprises of hree elements
in terms of output, consumption goods, investment
goods and goods purchased and distributed
by the government. So, we have three methods
of national income estimation one is the expenditure
method secondly, the product method and the
income method.
I started explaining the product method first,
in which I took an example of three industries,
two industries producing intermediate goods
and one industry producing final good. So,
we looked at how the intermediate products
are ignored and there is no double counting.
So, we are basically adding up the final goods
and services and that is how national income
or GNP is estimated.
We also looked at the income method, which
shows us the distributive shares of different
factors of production within the economy.
Then we also looked at the expenditure method
which is basically the summation of all expenditures
– consumption, investment and government
expenditure including the net of exports minus
imports. After being introduced to three methods
of national income estimation or accounting,
I introduced you to some of the definitions
of the most important terms used in national
income – GNP, NNP, GDP and NDP.
Let us now move on to certain personal income
concepts that are important as far as household
flows are concerned.
Personal income is defined as the income received
by the households before the payment of personal
income taxes. From the national income undivided
corporate profits, corporate income taxes,
corporate savings and social security contributions
made by individuals are deducted and the transfer
payments are added since they increase the
income of individuals.
Let me remind you here that transfer payments
are those payments for which no productive
activity is made. They are merely transfer
of purchasing power from one group or persons
to others such as old age pensions, lottery,
gifts, gambling, unemployment allowance, widow
relief and pensions and other social security
contributions from the government. So, personal
income is important to be able to understand
the overall incomes within a country.
Relatedly an important concept is disposable
income which simply put means what gets into
the hands of public for consumption and savings.
So, it is personal income minus personal income
taxes. DI stands for disposable income which
is personal income minus personal income taxes.
Another important income estimate is that
of per capita income and this is something
that we generally use when we are referring
to the levels of income within a country,
if the per capita income of a country matches
international standards or not. It is simply
put it shows how the total national income
of a country is distributed across the population.
So, if a national income of a country in a
particular year is divided by the total population
in that year, we get the per capita national
income. So, per capita income of India for
year 2017 will be the national income or GNP
of India for 2017 divided by the population
of 2017. So, the population of 2017 is estimated
from the census of India population estimates
of 2011.
Now, in most empirical studies per capita
income is taken as a more reliable measure
of national income than GNP. This is because
per capita national income tells us how national
income is distributed across the population
in this country. However, you must also note
here that like GNP per capita national income
also does not reveal the existence of income
inequalities within a country and that is
a matter concerning growth and development
debate which we will see as the course progresses.
The per capita national income since the unorganized
sector or the informal sector is also not
accounted for as far as the national income
accounts is concerned. Therefore, per capita
national income mostly talks about distribution
of national income over the population in
the organized sector and does not say much
about the unorganized sector.
Now, I have made references to real income
in some of the previous slides, and it is
important that we spend a little time on GNP
at current and constant prices which will
bring us to this concept of real income.
Although I have already discussed the difference
between nominal and real, I would like to
specifically point out what real income here
means. In comparing economic growth through
any of these estimates it is important that
we adjust for changes in the general price
level in the economy. I hope you now understand
that in a country, in an economy in a particular
year, a great number of goods and services
are produced and all of these goods and services
have different valuations and to be able to
come up with a general level of price within
a country, Indices or price indices are constructed
and it helps us to understand how the general
price level in a country has moved in a particular
year or from one year to another.
And that brings us to the concept of GNP at
current and constant prices. GNP measured
at current market prices may overstate GNP
when there occur increases in price level.
Let me demonstrate this to you in terms of
an example. Assume that in a small community
only one product is produced. The price of
the product was rupees 10 per kg and the total
production was hundred kg in 1990. In 2000
the production remains at 100 kg, but the
price of the product rises to rupees 20 per
kg due to some external shocks. As a result
the money value of product rises from rupees
1000 to rupees 2000 though the real product
or quantity produced remains the same. This
effect of price rise or fall can be reduced
by deflating the GNP by a general price index.
As a result the real GNP may then be defined
as current year GNP over price index of the
current year multiplied by 100. And there
are various kinds of price indices that are
used in the country. Usually we use the consumer
price index or the wholesale price index.
The Labor Bureau, the Ministry of Labor has
a list of price indices. In India we have
consumer price index for agricultural laborers,
we have consumer price index for industrial
workers, we have wholesale price index and
any of these indices can be used to deflate
the current GNP at market prices to arrive
at real GNP.
So, essentially what we are trying to do when
we are calculating real GNP is adjust for
inflation within the economy. So, if we are
calculating real GNP for let us say the year
2000 and we are comparing it with the real
GNP of 1990, then we can conclusively tell
how much growth has taken place within a time
span of 10 years between 1990 and 2000.
.
Such a deflated income is called GNP at constant
prices, for which usually a particular year
is taken as base and the GNP measure at actual
market prices is called GNP at current prices.
In my lecture I have made frequent references
to GNP at market price. Let me point out what
it means and how it is differentiated with
respect to GNP at factor cost. National product
at market prices is the value of final goods
and services at prices paid actually on the
market including indirect taxes and subsidies.
The total payments to factors of production
are GNP at market prices minus the amount
of indirect taxes since they are paid to the
government.
But subsidies enter into cost of production.
Let us have a look at an example. A hand woven
cloth costs rupees 10 let us say and the government
gives rupees 2 as subsidy. So, the market
price will be rupees 8. the market price is
less because of subsidy and therefore, it
should be added to the factory receipts. The
market price is less because of the subsidy,
but it has entered into the cost production
and therefore, it should be added to the factory
receipts. So, GNP at market price minus indirect
taxes plus subsidies is defined as GNP at
factor cost.
It is important to look at GNP at market prices
and factor cost because it helps us to understand
as I have already pointed out the distributive
shares within the economy. It is important
to know what is the share of different factors
of production in the overall national income
of a country, which is why we tend to calculate
GNP at market prices and GNP at factor cost.
Another important concept income concept which
is used for international comparisons and
which you must all know is what is referred
to as the purchasing power parity. Often when
comparing economic growth across countries
we come across examples where you will see
the use of country A’s GDP estimate being
converted to an international currency usually
an US dollar in terms of purchasing power
parity.
I will end todays lecture with demonstration
of the PPP concept in the next slide. But
what is PPP? The Purchasing Power Parity?
You can think of PPP as a price index which
is very similar in content and estimation
to the consumer price index or the CPI. The
CPI will tell you the price changes over time
within a country whereas PPP or Purchasing
Power Parity will provide a measure of price
level differences across countries.
It is however, easier to understand consumer
price index because you are looking at price
index within a country, which means that you
are looking at a basket of goods and services
transacted within a country in a given year.
And it is based on one national currency which
remains same over time. However, PPP is slightly
complex because we are looking at basket of
goods and services and based on which international
comparisons are made possible. Usually conversions
are made to USD or US dollar in purchasing
power parity.
So, you would find reports for example, the
human development reports or world development
reports referring to GDP of India in terms
of USD at purchasing power parity.
If you look at this table, through this table
I will demonstrate why and how PPSs are used
to convert expenditures in national currencies
to a common currency. Column 2 in this table
shows the price of a Big Mac as reported on
the magazine economist website for five countries
for June 2011.
Big mac is basically a kind of a hamburger
which is sold through the McDonalds outlets
across countries in the world. The five countries
are Australia, Brazil, China, South Africa
and the United States. The Australian currency
is the Australian dollar, Brazil’s Real,
China’s Yuan, South Africa’s Rand and
United States’ Dollar. The PPP between Australia
and USA for a Big Mac is the price paid in
Australia in its national currency divided
by the price paid in USA.
So, it is 4.56 divided by 4.07 which is 1.12.
What does this mean? This means that a consumer
pays 1.12 Australian dollars to make a purchase
in Australia that would cost one dollar in
the United States. So, column three provides
the PPP for other countries to the USA. To
understand their full meaning these PPPs have
to be put into the context in which they are
used. Column 4 shows the exchange rate of
each country’s currency to the USA.
In Brazil for example, in June 2011, a US
dollar could be purchased for 1.5 Real which
is the Brazilian currency. When the cost of
a big mac in Brazil is divided by the exchange
rate, the result is how many US dollars are
needed to purchase a Big Mac in Brazil. 9.5
divided 
by 1.54 which is USD 6.17. So, what does this
mean? This means that big macs are more expensive
in Brazil than they are in the USA which is
USD 4.07.
The same column, column 5 shows, they are
much cheaper in China and South Africa than
they are in the USA. These price level differences
are measured by a price level index which
can be computed in two ways. One is simply
the ratio of PPP to the exchange rate which
for China is 3.61 divided by 6.45 which is
equal to 0.56. The other is the ratio of the
cost of USD of purchasing a big mac in China
to the cost in USA or 2.28 divided by 4.07
which is equal to 0.56.
So, what do we know then is that, Big Macs
are more expensive in Australia and Brazil
and cheaper in China and South Africa than
in the USA. Why do we carry out these calculations?
Purchasing power parity calculations are very
important in economic growth calculations,
because it helps us in understanding what
are the international differences in prices
across countries of the world.
So, for example, when we have rankings carried
out of countries based upon let us say the
human development index or some income, we
tend to convert the national currencies into
US dollars in terms of purchasing power parity
the price index so as to be able to tell us
what is the rank of country A, B and C with
respect to the USD.
I will now sum up todays discussion. In today’s
lecture, we tried to understand what does
economic growth mean, how is it defined, what
are the important concepts that are used.
I tried to give you a very brief introductory
overview of what are the basic concepts involved
in the system of national accounts. We understood
how circular flow of income and output takes
place within a country, within an economy.
We looked at a simple two sector economy,
a closed model where there is no foreign trade
and we saw how income and output flows take
place between the household and the business
sector or the firms. Through the two sector
model we also saw three methods of national
income accounting - the product method, the
income method and the expenditure method.
National income identities or national income
accounting are carried out in such a manner
that national income estimated whether through
the product method or the income method, or
the expenditure method are basically the same.
It gives a single estimate. We then also looked
at the definitions of gross national product,
net national product, gross domestic product
and net domestic product.
We also looked at some of the personal income
concepts, important among which was the disposable
income concept and the per capita national
income. We then also looked at the definitions
of some of the constituent elements of national
income such as what are indirect taxes, what
are undistributed corporate profits, what
are dividends, what are transfer payments
and finally, we also looked at the concept
of purchasing power parity with the help of
an example, which is basically to tell us
how income comparisons are made internationally.
I will now give you a snapshot of the next
lecture. In the next lecture we will look
at the structural characteristics of the developed
and underdeveloped countries. We will try
to understand why the first world, second
world and the third world have been named
so. we will also look at the basic features
or the characteristic features of industry
and agriculture in developed and underdeveloped
countries of the world. We will look into
the issues of demographic transitions that
have taken place in developed and underdeveloped
countries and finally, I will end the next
lecture with the social security arrangements
made in developed and underdeveloped countries.
To reiterate there are various measures of
income inequalities that have been carried
out. In this lecture I introduced you to certain
basic concepts and in the lectures to come
we will try to look at some of the growth
theories and the economic development theories,
for which these economic concepts are extremely
important. You may post your doubts, and confusions
if any, which I will try to solve through
the responses.
Thank you for your time.
PAGE \* MERGEFORMAT 22
