 last class I ended up stressing on the importance of national output because it is the volumes of output that is more important than the quantities of money that is being circulated you might print a lot of currency but collectively it might be burst off if the national output declines. So we need to understand that it is the national output that is more important and it is important because that characterizes a nation's strength. So how do we measure the national output is a question we need to understand what constitutes output now let us for example take a nation's economy in a year and let us say throughout this year it produced 10 pig farms, 4 holidays and 20 pairs of jeans pant and this is the economic activity of a given nation in a given year. So does it mean that at the end of the year that the economy produced 34 pigs in pants no it is not, it is not just a mere collation of all the economic activities into one big sum that signifies the nation's output. So what do we do next how do we still find the nation's output in an accepted quantifiable form then we need to add monetary value to it. Now let us say these 10 pig farms valued was valued at 500,000 these 4 holidays in for 2 million and the jeans spent for 25,000 so the total market value is 25.25 million now whether it is the total market value or whether it is the value add that happens in the intermediate goods and services again is a question that needs to be answered. So to understand the intricacies of calculating the monetary value of the goods and services that are being produced the most widely accepted measure of a national output is its gross domestic product. Fundamentally the definition for GDP is the monetary value of all the final goods and services that are produced within the boundaries of a country in a one single year constitutes the GDP of a country. Now when we calculate the GDP of a country there are different things that we should have in mind what actually constitutes the GDP. We need to remove the intermediate goods because intermediate goods are the ones that become part of the final good that is being sold. So we need not take into account the monetary value of intermediate goods because anyway that is going to get factored in the final goods of which the intermediate goods is a part. By doing this we are eliminating the double accounting for the monetary value which we otherwise would have done if we had taken the value of intermediate goods also and then again taking the value of the final good. Let me just give a small example for you to understand this. Suppose let us say I am a company that is engaged in let us say I am a forestry company. So I just fell wood cut trees and give wood to somebody who finishes it in the form of a furniture and that company again gives it to a retailer who sells this furniture to a end user. So suppose I sell the wood to the company B for 1000 rupees and then company B makes fine additions converts it into a table or a chair and then sells it to a retailer company C for 2500 rupees and then that company C also makes some value adds and then finally sends it sells it to a end user for 3000. So in calculating the total output if we just add the sales of every transaction in this case it is 1000 plus 2500 plus 3000 the result would be 6500 and this would overstate the amount of the output because of the simple reason that it would have calculated the value of the lumber three times because in all three transactions have happened and the value of the carpentry twice because it has happened in two transactions. So a good way to avoid this over counting is to just focus on the value add now let us see how we do this I will just give you a small example so that you will understand what I am trying to explain now suppose the same transaction we are just going to concentrate only on the value add because company A sold the raw wood it had cut for 1000 rupees and had purchased no material input so whatever it has added is just the 1000 of the value that it has sold to company B and then company B adds value to the extent of 1500 and sells it to company C which adds another 500 rupees value before it sends sells it for rupees 300 to a end user so suppose we calculate the total output suppose we take this example to calculate the total output we know that there is a company A let us in this case it is the forestry company company B which is the furniture company and company C just retail outlet that sells it and then you have a sales price cost of material input and the difference between these is the value add on the first case there was no cost of material input so the difference is 1000 but furniture company B sells it to C for 2500 by buying this for 1000 from company A and the resultant value add that it has created is 1500 and company C sells it after buying it for 2500 from company B it sells it for 3000 because it creates a value add of 3000 of 500 so the total value add that is created is 3000 while the total transaction value is 6500 as I told you before this 6500 captures the intermediate goods for more than one time as a result of which there is double counting to eliminate this if you are just capturing the value add at each stage then we are doing a correct estimate of calculating the actual output which in this case is 3000 so a good way of estimating the output and let us say a nations economy it is an aggregation of such output from different industries from different sectors of the economy services or agriculture and each of them calculated in this way and if we just calculate the value add this 3000 in this case let us say this represents a nations economy then this 3000 is the value of the national output but it is extremely difficult to calculate the value add at each stage because the nations economy as is not as simple as this so the best way to estimate that is to calculate the value of the end use product that is getting sold so the end product that is getting sold is for a particular value and if that value is captured now that represents the correct value of the nations output we will discuss different ways of calculating the GDP in the subsequent slides now it is very important for you to understand that the example that I gave you just now it is just for you to understand that intermediate goods should not be included in calculating the GDP of a country second hand sales should also not be included because there is no value add in this and not to be actually explicitly told it is a good understanding that the black market economy never constitutes an integral part of a nations output a voluntary work or own work then inside the house let us say you are moving your garden in the process you are not creating any economic value so that does not constitute a nations output or does not constitute a part of the nations output or pure financial transactions like buying bonds or stocks because this is just a mere transfer of ownership without creating any economic value that also does not constitute a part of a nations output and transfer payments like the social security scheme or the welfare schemes which just transfer of money from the government to the other end user so they and they do not result in any final production so that is also not included in calculating a country's GDP now how do we calculate in that case the GDP of a country now typically there are the first method is the expenditure method which as I said before it just calculates the end value of the goods or services that is being delivered instead of calculating the value addition at each stages and this is popularly called the expenditure method in this expenditure method it divides expenditure on final goods and services into five groups and it combines these five groups in calculating the GDP these five groups include C which is the conception by households that is the consumer spending I which is the investment in productive assets and this investment is done by business spending for productive assets G is the government spending on goods and services the net of exports and imports now these form the five important the export and imports is the net of exports and imports plus the consumer spending plus the investment in productive assets by businesses and the government expenditure this constitutes the GDP calculated based on an expenditure method the important thing that we have to remember is that all of these categories are designed to avoid the double counting although we conception includes almost all spending by households business investments does not include all spending by households sorry business it does not include all the spending by the firms if it includes then it would end up in double counting because many of the things that the firms buy such as raw materials are ultimately sold to the consumers so we are just interested in capturing the investments done by businesses in creating productive assets that are more long term not short term for example if a business as a carpenter I buy an electric saw then it is a business investment for me but the wood and other raw materials that I buy is not a business investment because anyway that is going to get sold later which is captured in the consumer spending so we are interested in only capturing the business spending in productive assets the exports and imports are also calculated in calculating the GDP the reason that we are eliminating imports in the process let us for example say an Indian consumer he buys television from Japan now we should be very careful in not counting this because this expenditure is purchased in a foreign soil and does it create any domestic value so we need to actually detect the imports from this and likewise add exports suppose our goods and services are purchased by somebody outside the country that needs to be added and the net of exports and imports together with consumer spending investment and government spending actually constitutes the GDP and government spending will include the expenditure on final goods like the government spending on defense or infrastructure salary to its public servants these all constitute the government expenditure before that another method that is also used to measure the total output is to focus on income what do I mean by income now this income method assumes that income is the amount that is paid to the factors of production for the services that they have rented factors of production here I mean it is the capital and labor typically the services comes in the form of the wages is repaid in the form of wages interest dividends rent royalties now these are all the income that is paid to the factors of production now since income is just payment for the production of output it does definitely make sense to assume that the total income should ultimately equal the total output because the proceeds of production ultimately have to end up somewhere either in my pocket or in somebody else's pocket but it is very safe to assume that the total income should be equal to the total output but by and large the most popular method the convenient method that is used to calculate the GDP of a country is the method that I explained before which is the expenditure method which just captures the conception driven expenditure which is the household expenses the investment which is driven by businesses for the purpose of long-term and not short-term garment expenditure plus the exports minus the imports this constitutes the GDP of a country now while calculating the GDP of a country we need to have in mind there are different terminologies that you will encounter you would see a newspaper reporting the nominal GDP real GDP we need to understand the difference between the nominal GDP and real GDP a nominal GDP is one that does not adjust for inflation which just measures the at a certain price level now let us say in 1990 the nominal GDP uses 1990 prices in 2000 the nominal GDP uses 2000 prices so it does not adjust for inflation whereas in a real GDP the adjustment for inflation is also made it is using some constant base price now let me just give you an example for you to understand this now let us say the economy of a country is just in its producing cars now let us say at a given year 2000 that it produced 100 cars and the cost of the production was 50 per car the nominal GDP is 5000 so the at the end of year 2000 the nominal GDP is 5000 now let us say in 2001 the quantity of car produced did not change it is the same 100 but the cost of producing that car increased to 75 the nominal GDP in this case is 7500 now we would tend to assume that the country the GDP has increased as a result of which the output has increased there is increase in the economic value but on the contrary although the country produce the same amount it will it actually looks as though more was produced on the contrary it is because that the cost of production has increased and it is that increase in the cost of production that has actually caused the increase in the value so we need to remove this effect of inflation to calculate the real growth in the economy and that is why a real GDP is essential as for the basis of understanding the real growth of an economy vis-a-vis a nominal GDP because in a nominal GDP even if the same number of goods are produced higher prices will just cause an artificial increase in the GDP whereas in a real GDP the effect of inflation is removed from the real GDP only an increase in production which means an increase in the real output will actually cause a real increase in GDP so we need to actually understand the difference between a nominal GDP and a real GDP now there is also another terminology that you need to understand this is called the gross national produce a little different from GDP GDP includes all production within a given country let us for example take India now whether it is a foreign firm or an Indian firm the monetary value of all goods and services produced by anybody within the country constitutes GDP whereas GNP is the monetary value of all Indian production that is made worldwide so if we need to understand it from a different perspective GNP is GDP minus foreign investments in India plus Indian investment overseas for example if Ford is producing cars in India it is counted in India's GDP but not counted in India's GNP because Ford is not Indian likewise if Maruti is engaged in producing cars in Europe it is not counted in India's GDP because the production doesn't happen inside India but it is counted in India's GNP because it is India's production happening outside India so you need to understand the difference between GDP and GNP GNP is also an important economic indicator but usually we measure the strength of a country's economy by measuring its GDP and not GNP but it is essential that you understand what GNP is all about. Now I will just give you a small economic flow for you to understand what happens within a nation's economy now if you look at this this animation illustrates a country's internal economic flows it shows the relationship between the various elements in the economic value addition process and the expenditure components that come in the form of conception investments and government spending so I will just trace the path of this economic flow for you to understand this better the value add that you see here it is the sales minus the purchase of intermediate goods because that is the real value add that is being created as we saw in the previous example. Now the value add is constituted before that if you just calculate the total income minus the total value add the sales revenue minus the value add it is given in the form of these wage interest rent the profit the depreciation the rent the indirect business taxes. Now actually what we are doing is the total value added the GNP here in this case is the total value added which is the which actually removes the purchases of intermediate goods to avoid double counting as they represent sales of one business entity to another now the total income minus the total value add which is represented by the the resultant is the depreciation the wages interest rent business profits all of this constitute the value add. Now if you closely look what happens here the value add depreciation the wage rent the profit the indirect business tax now the wage rent all this gets into the personal income or also gets into RE here which is the retained earnings and the profit that the firm gets distributed you have to pay the firm pays income tax for that and after that gets into the retained earnings other indirect business tax indirect business tax income tax and then the personal income tax gets into the government's revenue after which the consumer has disposable income and then some government transfers enhances the disposable income of the consumer in consumer spending and the remaining goes to banks in the form of savings and it is from this bank that borrowings are done for investments. So business investments comes from borrowings from these investments consumers pending business investments come from borrowing from these investments the retained earnings the depreciation that constitutes I the C comes from the consumer spending the G is the government's expenditure so this I plus C plus G plus the export minus import constitutes the GDP. So this economic flow just gives you an illustration of how various variables flow within the economic system and how at different points of time it reaches different places and all of them again aggregate together in different forms either in the form of an investment which is driven by borrowings from banks or the internal surplus that is generated through retained earnings or depreciation which is added back these are investments from businesses or consumer spending which is that part of the spending that a consumer does and then the government expenditure plus exports minus imports. So this is how the economic flow works in any nation's economy now after understanding what constitutes an economy and how it is been measured we need to understand what actually fuels the economic growth there are three important factors that actually fuel the growth of an economy labor capital and efficiency. Now labor can result in economic growth if we are able to add more into the labor workforce or widen the employment workforce or the same workforce working for longer work covers capital can enhance the economic activity if we are enhancing productive capacity through investments and thirdly efficiency without enhancing labor or capital if more output we are able to generate through organizational innovation then we are increasing the economic growth and this we usually call it as the total factor productivity. I will just give you an example for you to understand this better let us say there is a textile unit and there are 10 employees and 10 sewing machines and each employee can make you know one shirt per day so at the end of the day we are able to produce 100 shirts using the 10 machines and 10 employees and let us say this constitutes the national output this is the economy of a nation now how do we increase the economy of this nation one we increase the labor by either adding more or asking them to work for more hours or we increase the capital by purchasing more sewing machines or let us say we do both we add 10 more people into the workforce and by 10 more sewing machines as a result of which the economic growth happens to the extent of 200 shirts per day as against 100 shirts before in this case we just increased the number of people available and the number of machines available an alternate option is to increase the efficiency by just changing the process of making these shirts by doing some study that can optimize the manufacturing process as a result of which more number of shirts could be made by the same number of employees using the same number of sewing machines in the process we have just increased the efficiency and this way we are also increasing the nation's output so we need to understand that either by increasing labor or by increasing the productive assets through addition of capital or by doing both or by increasing the efficiency we are able to create more economic value and create economic growth now just as economic growth is possible there is also times where there are economic downturns and just as labor capital and efficiency cause increase in economic activity it is the same labor capital and efficiency that causes output to reduce or the rate of economic growth to reduce the lack of labor the drop in efficiency or the lack of access to capital will cause an economy to contract and economic downturn is characterized usually by words like recession or depression and there is an old joke to differentiate between recession and depression I am sorry yeah recession and depression a recession is when your neighbor loses his job a depression is when you lose your job a recession in an economic definition means that there is a contraction in the economic activity there is a general slowdown in the economic activity if the if the growth in GDP was 6% in the previous quarter and if it has fallen down there is a general contraction in the economic activity then there is recession the one that differentiates depression from recession is the period of recession long periods of recession let us say the contraction in economic activity happens for a longer period 2 to 3 years then we are in a state of depression or if the real GDP has dropped by over 10% then we say that the economy is in a state of depression so whether it is recession or depression the understanding is that the economy is contracting now such economic downfall downturns can happen because of a number of reasons one could be because of natural calamities like war or earthquake or or epidemics which can create a total fall in the economic growth or a general fall in the demand for goods and services in the US after the war the great depression in the US in the 1930s witnessed the economic output falling by 30% and during times of economic distress which is not because of natural disasters or epidemics the tendency is to save more and spend less because once we realize that there is an economic distress we are a little insecure about our future so we tend to save more and spend less and when we spend less the incentive to invest and produce more is also missing so investment by businesses is also on hold and when you consume less there is lower production there is layoffs which again causes lower income levels distribution again lower consumption and this spiral keeps repeating itself but mind you that this economic contraction has not happened because the capacity to produce more is missing this is despite the fact that there is capacity the actual output fall is because there is a short fall in demand and when such short fall in demand occurs and the pricing mechanism do not adjust quickly then there is this economic downturn which is not again because of the supply side because the capacity to produce is always there but it is from the demand side that has caused the short fall in the demand so we should understand that the economic growth is just not the supply side we also need to understand that the demand is also essential and at times of great depression it becomes the government's job to sustain this demand through its fiscal or monetary policy and this forms the basis of the famous kinesian theory which says it is the government that has to create a demand by investing during times of great recession or depression so we need to understand that there are two sides to the economic theory the supply side and the demand side the actual output will actually fall short of the potential output when the demand falters there is capacity to produce but if the potential to consume the capacity reduces because of changing demands then we need to know how the supply and demand need to be adjusted and there are good theories the law of supply and demand which ensures that there is a balance between the supply and demand when the supply side and the demand side are balanced to the optimum extent then we have a good economic architecture in place but it is not as easy as it is said there are various variables that change the relationship between the supply and demand and the characteristics of demand and supply also varies across different types of goods and services that are being used some services are very critical that whatever be the price people need it so the classic theory of the classic law of demand and supply will not hold good for critical services so we need to understand what are these types of services how the demand and supply all things being equal change with variations in price and are there goods and services that have a constant demand or remain unaffected even if prices changes why is that so and how other economic variables change the behavior of the quantity supplied and quantity demand demanded vis-à-vis the price of these are things that we will understand we will try to understand in next class when I just bring in the concept of the supply demand characteristics and to understand how the supply or the demand of a particular product keeps changing with the price of the product or the service that is being delivered and how later we will see how various policies of the government be it the monetary or the fiscal policy actually tries to control regulate the supply and also stimulate the demand before I end this class I will also show you a small video that gives you a quick capsule of the economics understood at a very broad level what is economics and what is GDP so all this all of that that I told you in the last two sessions I will try to capture that in a small video of 5 to 6 minutes so that you will better understand and appreciate what economics is and how that a nation's output which is actually calculated by way of GDP and how GDP is being calculated and what constitutes GDP so next class I will get into the characteristics of supply and demand and its behavior with price thank you