Prelims titbits: Basics of Economy

11th Aug, 2021

What is the economy?

  • An economy is an area of the production, distribution and trade, as well as consumption of goods and services by different agents.
  • It encompasses all activity related to production, consumption, and trade of goods and services in an area. It is the large set of inter-related production and consumption activities that aid in determining how scarce resources are allocated.
  • The production and consumption of goods and services are used to fulfill the needs of those living and operating within the economy, which is also referred to as an economic system.
  • The economy of a particular region or country is governed by its culture, laws, history, and geography, among other factors, and it evolves due to necessity.

Sectors in an economy

Generally, there are four sectors

  1. Household/Individual/Consumer
  2. Producer/Firms
  3. Government
  4. Rest of the world

Factors of production

Factors of production are the inputs needed for the creation of a good or service. There are four main factors of production:

  1. Land
  2. Labor: Labor refers to the effort expended by an individual to bring a product or service to the market. It covers both mental and physical efforts by an individual.
  3. Capital: Capital refers to all human-made productive assets used to further production. For example, a tractor purchased for farming is capital. Along the same lines, desks and chairs used in an office are also capital.
  4. Entrepreneurship: Entrepreneurship refers to the organization of all factors of production to profit. An entrepreneur take risks, conceive new ideas, new products and processes.

National Income Accounting

  • National income of a country means the sum total of incomes earned by the citizens of that country during a given period, say a year.
  • It refers to the practice of calculating the output of an economy. It helps in assessing how the economy is doing. 
  • The most basic measure of the size of economy is its volume of production. From this, the value of total goods and services produced in an economy is calculated.
  • There are four players in the economy, namely, Individuals or Households, Business Firms or investor, Government, and Foreign Nationals.
  • To understand the flow of goods and services, let’s consider only two players- Household and Business firm.

Gross Domestic Product (GDP)

  • GDP is the total value of goods and services produced within the country during a year.
  • This is calculated at market prices and is known as GDP at market prices (GDPMP). 
  • It is the market value of the output of final goods and services produced in the domestic territory of a country during an accounting year.
  • There are three different ways to measure GDP:
  • These three methods of calculating GDP yield the same result because;

National Product = National Income = National Expenditure

Gross National Product (GNP)

  • Gross National Product is defined as the total market value of all final goods and services produced in a year.
  • It is the market value of everything that is produced by Nationals of a country both inside and outside the country’s territory.

Net National Product (NNP) or National Income at Market Price

  • There is wear and tear during all these stages of production of goods. This wear and tear must be reduced from the Gross National products to know what net national product is.
  • NNP is also called National Income at Market price:

NNP or NI (market price) = GNP-depreciation

NNPFC= NNPMP  – taxes + subsidies

GDP Deflector

  • The GDP price deflator, also known as the GDP deflator or the implicit price deflator, measures the changes in prices for all of the goods and services produced in an economy.
  • The GDP price deflator measures the changes in prices for all of the goods and services produced in an economy.
  • Using the GDP price deflator helps economists compare the levels of real economic activity from one year to another.
  • The GDP price deflator is a more comprehensive inflation measure than the CPI index because it isn’t based on a fixed basket of goods.
  • We use the following formula to calculate the GDP price deflator:

GDP Deflator=(Nominal GDP ÷ Real GDP)×100

Difference between Economic Growth and Development

  ECONOMIC GROWTH  ECONOMIC DEVELOPMENT
Single dimension Concept- merely a quantitative conceptDouble / Multi dimension Concept- both quantitative and qualitative in nature
It is concerned with the rate of increase in national income.It is concerned with the welfare of people (a qualitative aspect) along with an increase in per capita income (a quantitative concept).
The distribution of income is ignored in the case of economic growth.The distribution of income is given due consideration. Reduction in inequality (of the income distribution) is one of the principal targets of economic development.
Economic growth may occur independently of any structural, institutional, and technical changes in the economy.Economic development is invariably associated with significant structural, institutional, and technical changes in the economy.

Human Development Index (HDI)

  • The human development index (HDI) report released by the United Nations Development Programme.
  • The HDI is the composite measure of every country’s attainment in three basic dimensions:
  1. Standard of living measured by the gross national income (GNI) per capita.
  2. Health measured by the life expectancy at birth.
  3. Education levels calculated by mean years of education among the adult population and the expected years of schooling for children.

Inclusive Development Index

  • The IDI has been developed by the World Economic Forum (WEF) as a new metric of national economic performance.
  • It is seen as an alternative to GDP.
  • The Index on inclusiveness reflects more closely the criteria by which the people evaluate their countries’ economic progress.
  • The index has three pillars of growth for global economies namely:
  1. growth and development
  2. inclusion
  3. intergenerational equity and sustainability

Fiscal Policy

  • Fiscal policy is the use of government spending and taxation to influence the economy.
  • Fiscal measures are frequently used in tandem with monetary policy to achieve certain goals.
  • The usual goals of both fiscal and monetary policy are to achieve or maintain full employment, to achieve or maintain a high rate of economic growth, and to stabilize prices and wages.
  • When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy.
  • Fiscal policy is based on the theories of British economist John Maynard Keynes, also known as Keynesian economics. This theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
  • Article 112 of the constitution mandates that expenditure to be shown in revenue and other categories.

Types of Fiscal Policy

  1. Neutral Fiscal Policy: This implies a balanced budget where (Government spending = Tax revenue). It further means that government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
  2. Expansionary Fiscal Policy: It is designed to stimulate the economy, is most often used during a recession, times of high unemployment or other low periods of the business cycle. It entails the government spending more money, lowering taxes or both. The goal is to put more money in the hands of consumers so they spend more and stimulate the economy.
  3. Contractionary fiscal policy: It is used to slow economic growth, such as when inflation is growing too rapidly. Too the opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes and cuts spending.

A break up of the finances into revenue and capital streams, in general, is as follows:

  1. Revenue receipts are recurrent receipts. Revenue account includes the following receipts:
    • Taxes- income tax, corporation tax, excise duty, customs duty etc;
    • Non-tax resources- user charges; interest receipts; dividends; profits etc
  2. Revenue account expenditure are essentially the non-plan expenditure that does not create assets i.e. interest payments, defense, subsidies and public administration. It is synonymous with maintenance and consumption expenditure as also welfare expenditure.
  3. Capital account receipts are recoveries of loans advances made by the Union Government to States, UTs and PSUs); fresh borrowings from inside the country and from abroad; disinvestment, proceeds etc. As is clear from above, some of them are debt and some are non-debt.
  4. Capital account expenditure is loans made to States, UTs and PSUs; expenditure for asset creation in infrastructure and social areas

REVENUE DEFICIT AND FISCAL DEFICIT

  • Revenue deficit is the difference between the revenue receipts on tax and non-tax sides and the revenue expenditure.
  • RD= Revenue Expenditure – Revenue Receipts
  •  It is targeted at 4% of GDP for 2010-11 which is rendered necessary because of the global recession and slowdown in Indian economy (FRBM Act says that RD should be zero by the end of 2008-09). The objective is to fund for consumption from government’s own resources and not borrowing.
  • The fiscal deficit is the difference between the government’s total expenditure and its total receipts (excluding borrowing). Fiscal deficit in layman’s terms corresponds to the borrowings and liabilities of the government.
  • In other words, it is the difference what is received by the government on revenue account and all the non-debt creating capital like recovered loans and disinvestment proceeds; and the total expenditure. It amounts to all borrowings of the government in a given period. It is targeted at 5.5% of GDP in 2010-11.
  • FD = (Total expenditure of the Government in a budget) – (Revenue receipts + non-debt creating capital receipts)
  • Fiscal Deficit mirrors the health of government finances most accurately unlike the budget deficit concept.
  • Primary deficit is the difference between the fiscal deficit and the interest payments. The concept helps in assessing the progress of the government in its fiscal control efforts.

DEFICIT FINANCING

  • Deficit Financing is the phrase used to describe the financing of gap between Government receipts and expenditure. It is financed by printing fresh money by the RBI and market borrowing.
  • The gap can be deliberate as the Government wants to spend on welfare and infrastructure for which it has no money and so borrows from the RBI; or due to bad finances of the government.
  •  But uncontrolled borrowing is not good for the economy, as a greater portion of the governments revenue will in future be used to pay back the interest of loans and the money available for social sector initiatives will reduce.
  • When the Government has to spend more than what it can raise through tax, non-tax, and other sources, it borrows from the market. It can’t borrow above a certain amount from the market, as it may be inflationary; drives up wasteful government expenditure; push up interest rates; increase government’s debt burden and thus divert resources from plan to non-plan; burden future generations with unduly high taxation and thus disrupt inter generational parity; and crowd out private investment.
  • The above point can be understood from following flowchart:
  • In other words, when the resources from taxes, user charges, public sector enterprises, public borrowings, small scale borrowings and others are not enough, RBI prints and gives to the Government. It is called deficit financing.
  • In fact, FRBM disallows RBI printing money to finance government deficit in normal conditions. But the economic conditions having become adverse since 2008-09, Government is forced to abandon the FRBM rules and is spending g well beyond the limits set by the Act.
  • On balance, it may be said that, if deficit financing is done prudently and the borrowed money is used well, it is healthy. However, if the borrowed money is wasted for consumption, is against good economics as it can negatively affect money supply and inflation; and also dampen growth. The desirability of deficit financing, in short, depends on-
    • Extent of borrowing
    • End use of the money borrowed.

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