CHAPTER 1 – INTRODUCTION (FREE)

 

INTRODUCTION

 

 

ECONOMICS VS ECONOMY

 

Before we start studying about Indian Economy, it is very important to understand the difference between Economics and Economy. It is a common misperception to think of both as one and the same thing, when in reality they are different from each other. 

Economics is the science and art of how the societies use resources to produce valuable commodities and distribute them among different people. In other words, Economics is a subject concerned with the optimisation of available resources, in an efficient manner.  Economics is theoretical, as it contains theories, models and principles.There are two branches of economics:

  • Micro Economics: The arm of economics which studies the behaviour and actions of individual economic agents, such as a person, a household, a firm, or an industry. In short, it studies selected small parts of the economy.
  • Macro Economics: The arm of economics in which broad issues of the economy are studied, such as economic growth, unemployment, trade balance, poverty, the standard of living, inflation, etc. It studies the economy as a whole.

Economy is economics at play in a certain region. When a country or a geographical region is defined in the context of its economic activities, it is known as economy or economic system. Economy is the practical application of Economics. In an economy, the supply-demand cycle might be managed by the government (State), market or both, giving rise to various type of economies. Therefore, we have Chinese Economy (State driven), US Economy (market driven or capitalist), and Indian Economy (mixed economy).

 

 

TYPES OF ECONOMIES

 

CAPITALIST ECONOMY

  1. Origins in the book Wealth of Nations (1776) by an American Economist Adam Smith.
  2. He raised his voice against the heavy handed government regulation of commerce and industry of the time which did not allow the economy to tap its full economic potential.
  3. He proposed an environment of ‘laissez faire’ i.e. non-interference by the government in market affairs of an economy.
  4. According to him market forces themselves bring a state of equilibrium in an economy.
  5. In such an economy, the decisions of what to produce, how much to produce, and at what price to produce are taken by the market, with state having no economic role. In a capitalist economy, the market determines prices through the laws of supply and demand. 
  6. For e.g. let say the market is left itself to determine the price of wheat, rather than government deciding the same. Let say the cost of production of wheat is INR 18 per kg. Now the farmers may think of selling it at INR 60 per kg thinking to reap big profits. However, at such high prices people will start consuming less of wheat to keep their expenditure constant. So the farmers get the same amount as before but now they are left with lot much unused wheat, which they either will have to store somewhere or try to dispose off at lesser price. The cycle will continue and ultimately the price of wheat will settle down at market driven price, let say INR 28 per kg.

 

STATE ECONOMY

  1. Origins in the work of German Philosopher Karl Marx (1818-1883).
  2. This type of economic system first came in erstwhile USSR after Bolshevik Revolution (1917) and got its ideal shape in China (1949)
  3. While USSR economy is socialistic economy, Chinese economy is known as communist economy. Both socialism and capitalism are left wing schools opposing capitalism. 
  4. In socialistic economy the state plans and the economy is carried out by the market forces strictly according to the state plan. Here everyone gets the equality of opportunity and one’s share is determined according to one’s contribution to the economy.
  5. In communist economy, the state plans and owns the resources, and distributes equally among all sections, irrespective of their contributions.
  6. In such an economy, the decisions of what to produce, how much to produce, and at what price to produce are taken solely by the state only.

 

MIXED ECONOMY

  1. Origins in the book General Theory of Employment, Interest and Money by British Economist John Maynard Keynes (1883-1946).
  2. Major setback to Capitalistic Economy in Great Depression of 1929.
  3. Keynes suggested strong government intervention in the economy.
  4. With Keynes policy, the concerned economies were successfully pulled out of the Great Depression.
  5. On similar lines, in state economies, Polish Philosopher Oscar Lange suggested inclusion of some of the good things of the capitalistic economies. He called it market socialism.
  6. China took first step towards limited market economy through it open door policy of 1985.
  7. However, the efforts towards market socialism by USSR led to its very disintegration, as the constituent states felt they could do better outside the regulatory control of USSR.
  8. The world by late 1980s was having neither a pure example of capitalistic economy nor of a state economy.
  9. After independence, India opted for mixed economy with balance more towards state. However, post 1991 reforms, the balance is shifting towards market.

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SECTORS OF AN ECONOMY

 

  1. PRIMARY SECTOR


    1. All those economic activities that involve direct use of natural resources. For e.g. agriculture, dairy, forestry, fishing, mines etc.
    2. An economy is called agrarian economy if primary sector contributes more than 50 percent in the total output of the economy.
    3. In case of India, it was so at the time of independence but now the share of primary sector is about 14 percent of India’s GDP. However, still more than 47 percent of the workforce is still dependent for livelihood on this sector.
  2. SECONDARY SECTOR


    1. All those economic activities that involve processing the produce of primary sector. This sector is also known as industrial sector. For e.g. food processing industry, bakeries, furniture, pharmaceutical industry, iron and steel plants etc.
    2. An economy is called industrial economy if secondary sector contributes more than 50 percent in the total output of the economy.
    3. This sector contributes to approximately 28 percent of India’s GDP. Out of this the contribution of manufacturing sector is approximately 15 percent of India’s GDP. This sector employs 22 percent of Indian workforce.
  3. TERTIARY SECTOR


    1. All those economic activities that involve production of various services such as education, banking, insurance, transportation, tourism etc. This sector is also known as service sector.
    2. An economy is called service economy if tertiary sector contributes more than 50 percent in the total output of the economy.
    3. This sector contributes to approximately 58 percent of India’s GDP. This sector employs 31 percent of Indian workforce.

Below is the tabular representation of various sectors and their share in percentage terms of GDP in Indian Economy.

SECTOR  FY 2019-20 FY 2018-19
Agriculture, Fisheries and Forestry 14 16
Industry 28.2 29.7
Mining 2.1 2.4
Manufacturing 15.4 16.4
Electricity 2.9 2.8
Construction 8 8
Services 57.8 54.3
Trade, Hotel, Transport, Storage, Communication and services related to broadcasting 18.1 18.3
Financial, Real estate & Professional services 24.5 21.3
Public Administration, Defence and other services 15.2 14.7

During the FY 2019-20 , the share of agriculture and allied sector (14 percent), along with that of mining, electricity and manufacturing (28.2 percent) got reduced in the Indian Economy, while the share of service sector (57.8 percent) has increased, as compared to the previous financial year. 

 

WAYS TO CALCULATE INCOME OF AN ECONOMY

 

GROSS DOMESTIC PRODUCT (GDP) 

  1. Gross Domestic Product is the value of all final goods produced and services provided within the boundaries of a country in one financial year.
  2. It is a quantitative concept and it’s volume/size indicates the internal strength of an economy. However, it doesn’t tell anything about the qualitative aspects of the goods and services produced.
  3. It is used by IMF/WB in their comparative analysis of its member nations.
  4. It is generally used to determine growth rate of an economy. So when we say the projected growth rate of India this year is 7 percent, we mean that our GDP is expected to grow at 7 percent over last year.

Normally, there are two types of GDP – Nominal and Real.

Real GDP is adjusted for inflation while nominal is not and therefore it always appears higher than the real GDP. However, it is real GDP which is used for calculating economic growth.

BASIS FOR COMPARISON

NOMINAL GDP

REAL GDP

Meaning

The GDP calculated at current market prices of goods and services produced.

The GDP calculated at market prices of goods and services produced, in the base year.

Expressed in

Current year prices

Base year prices or constant prices.

Value

Higher

Generally, lower.

Economic Growth

Not used to measure economic growth.

Good indicator of economic growth.

 

NET DOMESTIC PRODUCT (NDP)

  1. NDP=GDP-Depreciation on capital assets. Therefore NDP is always less than GDP for a country.
  2. Depreciation refers to decrease in value due to wear and tear.
  3. Capital assets refer to assets that are not part of the goods and services produced but are used to produce the same. For e.g. machinery, infrastructure, roads, etc.
  4. The governments of the economy decide the rates of depreciation of various assets. In India, this is done by Ministry of Commerce and Industry.
  5. For e.g. a residential house in India might have a rate of 1% depreciation per annum while an electric fan might have a rate of 10% depreciation per annum. In terms of currency, depreciation means fall in value with respect to foreign currency, usually US dollar.
  6. It is a qualitative concept. More is the NDP of a country, implies less depreciation of assets and hence more efficiency of an economy.
  7. NDP is not used in comparative economics i.e. to compare two economies. This is because rate of depreciation is subjective and often used to manipulate market behaviour. Where one nation may keep rate of depreciation of luxury vehicles at 20% per annum, other might keep it at 10% to boost sales of new vehicles. By reducing the rate of depreciation, people in this segment will be inclined to buy new vehicles due to less difference between price of new and old vehicles. Similarly, one nation may keep rate of depreciation of heavy vehicles at 10% per annum, other might keep it at 40% to boost sales of new vehicles. This is because heavy trucks are mostly employed for transportation business, where the businessman can claim tax reduction based on asset depreciation. More the depreciation, more is the tax reduction, and hence more is the profit. Hence in this case, with increase in depreciation rates, businesses will invest more in heavy vehicles.

 

GROSS NATIONAL PRODUCT (GNP)

  1. GNP=GDP+Income from abroad. 
  2. Income from abroad is sum total of:
    1. Private Remittances: Since India is the highest recipient of private remittances in the world with USD 80 billion in year 2018. Inward remittances are counted positive while outgoing remittances are counted negative. For India, the sum total of all remittances is positive i.e. we have more inward remittances than outgoing.
    2. Interest on external loans: Interests earned on loans given to external markets are counted positive while interests paid on loans borrowed from external markets are counted negative. Since India borrows more from external markets than it lends, this has been negative in case of India.
    3. External grants: Grants received are counted positive while grants given are counted negative. Since India gives more external grants than its gets, this is negative in case of India.
    4. Trade Balance=Net value of exports- Net value of imports. Exports are counted positive while imports are counted negative. In case of India, since total value of exports is less than total value of imports, it is negative.
  3. Income from abroad can be positive or negative. In case of India, it is negative, primarily due to negative trade balance and negative interest on external loans.
  4. Hence, in case of India, GNP is less than GDP.
  5. It is on the basis of GNP that IMF ranks the countries of the world in terms of volumes at Purchasing Power Parity (PPP). We will discuss PPP in later chapters but for the sake of clarity, PPP is relative value of currencies based on their purchasing capacities. 
  6. Although it is a quantitative concept, it is more exhaustive than concept of GDP since it’s volume/size indicates the internal as well as external strength of an economy.

 

NET NATIONAL PRODUCT (NNP)

  1. NNP = GNP – Depreciation = GDP + Income from abroad – Depreciation = National Income of an economy.
  2. Per Capita Income = NNP/Total Population = (GNP – Depreciation)/Total Population.
  3. A higher rate of depreciation leads to lower per capita income in an economy.

 

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COST AND PRICE OF NATIONAL INCOME

 

An economy needs to choose at which of the two costs and two prices it will calculate its national income. In India, this task is done by Central Statistical Organization (CSO).

COST: The value of goods can be determined at either of:

  1. Factor Cost: The input cost of producing goods and services. This is also termed as Factory Price.
  2. Market Cost: The wholesale market price of goods and services. This is arrived at by adding the indirect taxes to the factor cost of the product. This is also termed as Market Price.

India officially used to calculate its national income at factor cost. However, since 2015, the CSO has switched over to calculating India’s national income at market cost.

Thus, National Income at Factor Cost = National Income at Market Cost –  Indirect Taxes.

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PRICE: The value of money used to calculate value of goods can be determined at either of:

  1. Constant Price: The effect of inflation is removed to calculate the value of goods and services. For e.g  goods might be costing INR 100 in January 2018 and INR 150 in January 2019. Let say there was 10 percent inflation during this period. So actual value of the goods at constant price in 2019 with 2018 as base year would be [150/(100+10)]*100 which is nearly equal to INR 136.40.
  2. Current Price: The effect of inflation is included while calculating the value of goods and services. For e.g. in the above case, the value of goods at current prices would be INR 150 only.

India calculates its national income at constant prices. The base year has been revised from FY 2004-2005 to FY 2011-2012.

Headline Growth Rate = Growth in GDP at constant Market Prices with base year as FY 2011-2012 (FY11).

Certain developed nations calculate their national income at current prices since inflation in those nations is marginal and so by shifting to current prices, they reduce complexities involved in calculations based on constant prices. 

CONCEPT OF BASE YEAR IN PRICE

The base year is a reference year from which onwards the inflation is considered zero.

In the above example, let say the price of a good in year X is INR 100, and let’s assume that annual inflation is 10 percent. Therefore price of the good at current price in year X+1 would be (100 +10) percent of 100 i.e. INR 110. Similarly, the price of the good at current price in year X+2 would be (110 + 10) percent of 110 i.e. INR 121. Similarly, the price of the good at current price in year X+3 would be (121+10) percent of 121 i.e. INR 133.10. 

In all the scenarios up, if we exclude the effect of inflation, we get the price of the good at constant value. Therefore, the price of the good in year X+3 at constant value with base year X+2 would be INR 121. Similarly, the price of the good in year X+3 at constant value with base year X+1 would be INR 110. Similarly, the price of the good in year X+3 at constant value with base year X would be INR 100.

The price of the good in year X+2 at constant value with base year X+1 would be INR 110. Similarly, the price of the good in year X+2 at constant value with base year X would be INR 100.

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COMPONENTS OF NATIONAL INCOME

The national income (GDP/GVA) is usually measured as a sum total of the below components:

  1. PRIVATE CONSUMPTION EXPENDITURE (C) – This component measures the value of consumer goods and services purchased by households and non-profit institutions during a financial year. This forms the biggest component of India’s GVA and account’s for 50-60 percent of it.
  2. INVESTMENT EXPENDITURE (I) – This component measures the value of capital goods and infrastructure created in a given financial year.
  3. GOVERNMENT PURCHASE OF GOODS AND SERVICES (G) – This component measures government’s spending on goods and services in a given financial year. It basically measures the cost of government services.
  4. NET EXPORTS (X) – It measures the difference between value of export and import for a given financial year.

National Income = C + I + G + X

 

 

TYPES OF INCOME

 

Before we discuss this, let us first understand some basic concepts of mathematics.

Therefore, if there is inflation in an economy, the price of an item in previous year would always be lesser than price of the same item in current year.

  1. Nominal Income = The income that we get in our hand. Let say we get a salary of INR 100. This will be our nominal income.
  2. Real Income = Nominal Income minus the effect of inflation i.e. the value of nominal income in the base year. Let say the inflation has been 50 percent since FY 2018-2019 (FY18). Real Income = [Nominal Income/(100+50)]*100 = INR 66.7
  3. Disposable Income = Nominal Income- Direct Taxes.
  4. Real Disposable Income = Disposable Income minus the effect of inflation i.e. disposable income in the base year.

 

 

GROSS VALUE ADDED (GVA)

 

Subsidies reduce the price of products while indirect taxes increase the price of products. Hence, to get a more accurate picture of the growth rate, it was decided in FY 2011-12 to remove the effect of both these components from the market price of goods and services produced in a nation. This is because high taxation in an economy would show up as a higher growth rate, due to increased prices of goods and services. Similarly, high subsidies on goods and services would show up as lower growth rate, due to reduced prices of goods and services.

Therefore, since FY 2011-12, India measures its growth, also in terms of Gross Value Added (GVA), which is nothing but GDP calculated at market cost minus the effect of indirect taxes and subsidies. To understand the concept of GVA, please consider the below:

Market Price of a product = Factory Price of a product + [Indirect Taxes – Subsidies]

Therefore, Market Cost = Factor Cost + [Indirect Taxes – Subsidies]

or, Factor Cost = Market Cost – [Indirect Taxes – Subsidies]

or, Factor Cost = Market Cost –  Indirect Taxes + Subsidies

Therefore, 

National Income at Factor Cost = National Income at Market Cost – Indirect Taxes + Subsidies

This is also known as Gross Value Added (GVA) in an economy and is being increasingly used to determine actual value of goods and services produced in an economy.

Therefore, GVA = GDPMarket Cost – Indirect Taxes + Subsidies.

 

 

NOMINAL GDP 

 

In India, national income is measured in nominal terms, while the growth rate in measured in real terms. 

Thus, India’s GDP = Nominal GDP of India

India’s nominal GDP grew to approximately USD 2.9 trillion (i.e. USD 2900 billion or INR 205 Lakh Crores). According to the World Economic Forum, India’s economy has become the 5th largest in the world, as measured using GDP at current USD prices, moving past United Kingdom and France. India’s GDP at the end of FY2018-19 was USD 2.7 trillion. The Union Budget 2019- 20 articulated the vision to make India a USD 5 trillion economy by 2024-25. 

 

 

GROWTH RATE BASED ON REAL GDP

 

For India, the Growth Rate is measured in terms of real GDP i.e. after removing the effect of Inflation. Thus, to measure Growth Rate of an economy, we would need to know the real GDP of current year, as well as the previous year.

Real GDP  = Nominal GDP Constant Price w.r.t. Base Year.

i.e. Real GDP = Nominal GDP – Effects of Inflation w.r.t. Base Year

India’s growth rate was approximately 5 percent for FY 2019-20. This is much lower than India’s growth rate of 6.8 percent for the previous financial year i.e. FY 2018-19. On the supply side, the deceleration in growth rate has been contributed generally by all sectors except agriculture and allied sector, and public administration and defence sector, which grew at a higher rate as compared to the previous financial year. Nevertheless, India has been becoming an attractive destination for investment in the backdrop of a decline in the growth of major economies of the world.

The IMF in its January 2020 update of World Economic Outlook has projected India’s real GDP to grow at 5.8 percent in 2020-21. World Bank in its January 2020 issue of Global Economic Prospects also sees India’s real GDP growing at 5.8 per cent in 2020-21. According to the Economic Survey, India’s GDP growth is expected to grow in the range of 6.0 to 6.5 per cent in 2020-21.

 

 

COMPOUND ANNUAL GROWTH RATE – CAGR

 

Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance. It is assumed that the profits were reinvested at the end of each year of the investment’s lifespan.

To calculate the CAGR of an investment:

  1. Divide the value of an investment at the end of the period by its value at the beginning of that period.
  2. Raise the result to an exponent of one divided by the number of years.
  3. Subtract one from the subsequent result.

For e.g. Let say you invested INR 100 in a mutual fund. Please find below a table depicting the growth of the mutual fund and investors’ profit thereof.

Therefore,

Beginning Balance (BB) = INR 100. 

Ending Balance (EB) = INR 127.8

Number of years (N) = 5

Year Annual Profit or Loss Percentage Value of investment at the end of period ( in INR)
Year 1 +10% 100(1.1) = 110
Year 2 -20% 110(0.8) = 88
Year 3 +10% 88(1.1) = 96.8
Year 4 +20% 96.8(1.2) = 116.2
Year 5 +10% 116.16(1.1) = 127.8
(5 years)

CAGR = (127.8/100)(1/5)-1 = 0.05

ENDING BALANCE (EB) = INR 127.8

Therefore, in the above case, CAGR for the investment is 5 percent.

CAGR is one of the most accurate ways to calculate and determine returns for anything that can rise or fall in value over time. Since it shows only the overall performance, it does not reflect the investment risk.

 

 

KEY FACTS (FY2019-2020)

 

  1. India’s GDP in PPP (Purchasing Power Parity) is nearly USD 11.5 trillion. This makes India 3rd largest economy in terms of PPP. In PPP, the currencies are matched in terms of their purchasing capacity for a basket of selected goods. Thus, although in nominal terms, USD 1 might be equal to INR 75, but in PPP terms, USD 1 might be equal to INR 32, if USD 1 has the same purchasing capacity in USA as INR 32 would have in India.
  2. In India, beside the GDP based growth rate, GVA based growth rate is also calculated simultaneously. In inflation driven economies, GVA based growth rate comes out to be lower than GDP based growth rate.
  3. IMF estimated the global output to have grown at 2.9 per cent in 2019, declining from 3.6 per cent in 2018 and 3.8 per cent in 2017.  The global output growth in 2019 is estimated to be the slowest since the global financial crisis of 2009, arising from a geographically broad based decline in manufacturing activity and trade. 
  4. Maharashtra (USD 450 billion) has the highest GDP followed by Tamil Nadu and Uttar Pradesh.
  5. Among states, Goa has the highest per capita income followed by Delhi and Sikkim. Bihar has the lowest per capita income followed by Uttar Pradesh.
  6. Largest Trading Partners of India –
    1. China (Bilateral trade = USD 90 billion)
    2. USA (Bilateral trade = USD 75 billion)
    3. UAE (Bilateral trade = USD 50 billion)
  7. Total exports = 305 billion USD.
    1. USA (16 percent)
    2. UAE (9 percent)
    3. China (5.5 percent)
  8. Total Imports = 465 billion USD.
    1. China (17 percent)
    2. USA (7.5 percent)
    3. UAE (6.5 percent)
  9. Manufacturing sector constitutes the major part of both exports (70 percent) as well as imports (52 percent). Fuels form the next major part (Exports 14 percent, Imports 30 percent).
  10. Total Remittances = 79 billion USD.
  11. Total foreign reserves = 474 billion USD (As on April 2020).