Session 1

Paradox of Thrift

People generally believe that saving is good and more saving is better. However, if every family
increased its saving, the result could be less income for the economy as a whole. In fact,
increased saving could actually lower savings for all households.
The paradox of thrift states that if everyone tries to save more money, then aggregate demand
will fall and will in turn lower total savings in the population because of the decrease in
consumption and economic growth. This is a paradox because seemingly virtuous behavior
(i.e., preparing for hard times by saving more) ends up harming everyone.

The paradox of thrift, in many circumstances, is a short-run phenomenon. Over the long-term,
a bigger stock of savings can increase growth. If increased saving is used to fund investment
expenditures, the economy should grow over time to higher and higher levels of income. More
savings lowers interest rates and provides more capital. That enables firms to undertake more
capital investment, feeding growth and increasing income.
In the long run, the accumulated money from individuals’ saving (This, obviously, doesn’t
include the guy with hundreds of rupees in his mattress or in his safe) is available for capital
investment, a situation where businesses/firms borrow to purchase capital (e.g., machinery and
technology). Thus, an increase in the saving rate increases capital investment (e.g., investment
in machinery for production). Such increases in capital stock ultimately lead to higher levels
of business productivity and growth.
Moreover, the paradox assumes a closed economy in which savings are not invested abroad.

Because economists are largely concerned with long-run growth and economic theory notes
the positive aspects of increased saving, the paradox of thrift remains a controversial concept.

Session 2
Incremental Capital Output Ratio
Incremental Capital Output Ratio (ICOR) is the additional capital required to increase one unit
of output. It is the ratio of annual investment and output growth (ICOR= Investment rate/GDP
growth). For instance, with the savings rate (which gives the size of investment) of 36% (of
GDP) and the ICOR of 4, one can estimate the potential output growth rate of 9%. This ratio
is used to measure the efficiency of an industrial unit or country as an economic unit.
ICOR reflects how efficiently capital is being utilized to generate additional output. The lesser
the ICOR, more efficient the organization/firm or economy. For example, an economy with
ICOR of 4 is better than an economy with ICOR of 6. ICOR is best estimated over long periods
of time to eliminate business cycle influences; it is more informative then.
ICOR is determined by a variety of factors including technology, skill of manpower,
managerial competence and also macroeconomic policies. Thus delays in the completion of
projects, lack of complementary investments in related sectors and the non-availability of
critical inputs can all lead to a rise in ICOR. The nature of investments matters too. For instance,
heavy capital investments, such as in energy sector, take longer to produce and breakeven.
ICOR in underdeveloped and developing countries is generally higher, i.e., the capital is less
productive in them than in developed countries.

Business Cycle

A business cycle is a short run, upward or downward movement of economic activity (output
or real GDP) that occurs around the growth trend. It is divided into two main phases:
contraction and expansion. Peaks (the top of a cycle) and troughs (low point) mark the turning
points of the cycle. The contraction phase represents a decline in Real GDP. The expansion
phase refers to increases in Real GDP.

Potential GDP represents the level of real GDP attained when all firms are producing at
capacity.

A recession is a decline in real output that persists for more than two consecutive quarters of a
year. A recession that is large in both scale and duration (generally lasting for a period more
than two years) is called a depression (a deep and prolonged recession).

A recovery occurs when the economy begins to pick up and starts to grow (after a ‘trough’). A
boom occurs when an economy is growing at a fast rate.
Business cycles are fluctuations of “aggregate economic activity”, not a specific variable.
Although real GDP may be the single variable that most closely measures aggregate economic
activity.
There are expansions and contractions. The sequence from one peak to the next, or from one
trough to the next, is a business cycle.
Economic variables show comovement. Business cycles do not occur in just a few sectors or
in just a few economic variables. Although some industries are more sensitive to the business
cycle than others, output and employment in most industries tend to fall in recessions and rise
in expansions.
The business cycle is recurrent, but not periodic. Recurrent means the pattern of contraction–
trough–expansion–peak occurs again and again. Not being periodic means that it doesn't occur
at regular, predictable intervals (e.g., the Great Depression of 1930s, the recessions of 1991
and 2001 in the United States).
The business cycle is persistent. The duration of a complete business cycle can vary greatly,
from about a year to more than a decade, and predicting it is extremely difficult. Declines are
followed by further declines; growth is followed by more growth.

An economic variable that moves in the same direction as aggregate economic activity (up in
expansions, down in contractions) is pro-cyclical (e.g., Employment, Inflation, Real wage).
A variable that moves in the opposite direction to aggregate economic activity (up in
contractions, down in expansions) is countercyclical (e.g., Unemployment).

While individual business cycles are not identical, they often share many similarities. The
following are some usual characteristics of a recession:
The effect of recessions on the inflation rate and unemployment: During recessions, demand
for products is low relative to supply, resulting in prices increasing more slowly or even
decreasing—low inflation or deflation. As firms see their sales start to fall in a recession, they
generally reduce production and lay off workers. (During expansions, demand for products is
high relative to supply, resulting in prices increasing—high inflation). Steel industry example!
Investment usually falls sharply in recessions.
Consumer purchases often decline sharply as well.
The demand for crude materials declines.
Firms selling durable goods (e.g., automobile firms) are more likely to be hit hard by a
recession.
Session 4

GDP

Gross domestic product (GDP) is the market value of all final goods and services produced in
a country during a period of time, typically one year. GDP measures total production of an
economy.

A final good (or service) is an item that is bought by its final user during a specified time
period. Some goods can be an intermediate good in some situations and a final good in other
situations. (Tire example)
Financial assets- stocks and bonds are not part of GDP. Transfer payments by governments are
not included in GDP.
A secondhand good was part of GDP in the year in which it was produced, but not in GDP this
year.
Only goods and services that are produced within a country count as part of that country’s
GDP.

Real and Nominal GDP

If GDP rises in the next year, it could be due to two reasons: (i) economy’s production has
increased; and (ii) prices of the goods and services being produced have increased.
Nominal GDP: The value of final output produced in a given period, measured in the prices of
that period (current prices).
Real GDP: The value of final output produced in a given period, adjusted for changing prices
(constant prices). It rises only when production rises.
GDP deflator: It is defined as the ratio of nominal GDP to real GDP in year t.
GDP Deflator = (Nominal GDP/Real GDP)*100

GDP Measurement
Three ways to measure GDP are the expenditure approach, the value-added approach, and the
income approach. Understanding these approaches tells us much about the structure of our
economy.
Expenditure approach: In the expenditure approach to measuring GDP, we add up the value of
the goods and services purchased by each type of final user: households, businesses,
government, and foreigners.
Y = C + I + G + X- M

When measuring private investment spending, it is important to include changes in business

inventories, in order to adjust GDP for output sold this year that was produced in previous
years, and to adjust GDP for output produced this year but not sold during the year.

Session 5
GDP Measurement
Gross domestic product (GDP) is the market value of all final goods and services produced in
a country during a period of time, typically one year. GDP measures total production of an
economy.

A final good (or service) is an item that is bought by its final user during a specified time
period. Some goods can be an intermediate good in some situations and a final good in other
situations. (Tire example)
Financial assets- stocks and bonds are not part of GDP. Transfer payments by governments are
not included in GDP.
A second-hand good was part of GDP in the year in which it was produced, but not in GDP
this year.
Only goods and services that are produced within a country count as part of that country’s
GDP.

Real and Nominal GDP

If GDP rises in the next year, it could be due to two reasons: (i) economy’s production has
increased; and (ii) prices of the goods and services being produced have increased.
Nominal GDP: The value of final output produced in a given period, measured in the prices of
that period (current prices).
Real GDP: The value of final output produced in a given period, adjusted for changing prices
(constant prices). It rises only when production rises.
GDP deflator: It is defined as the ratio of nominal GDP to real GDP in year t.
GDP Deflator = (Nominal GDP/Real GDP)*100

Three ways to measure GDP are the expenditure approach, the value-added approach, and the
income approach. Understanding these approaches tells us much about the structure of our
economy.

Expenditure approach: In the expenditure approach to measuring GDP, we add up the value of
the goods and services purchased by each type of final user: households, businesses,
government, and foreigners.
Y = C + I + G + X- M

When measuring private investment spending, it is important to include changes in business

inventories, in order to adjust GDP for output sold this year that was produced in previous
years, and to adjust GDP for output produced this year but not sold during the year.

Transfer payments: Governments also make transfer payments to households; any payment
that is not compensation for supplying goods or services (e.g., unemployment allowance).
These payments are not included in GDP because they are not received in exchange for
production of a new good or service. (There is difference between government spending in the
national accounts and the official government budget).

We subtract imports from total expenditures because when we measure consumption spending,
we include the value of imports in the goods that consumers buy. The same is true when we
measure private investment and government purchases: the value of any imported goods or
imported components is included.

Value added (output) approach: Output is calculated by summing the value added at each stage
of production. Value added at each stage of production is the revenue a firm receives minus
the cost of intermediate inputs it uses.

Income approach: GDP is measured by adding up all of the income components: compensation
(wages and salaries, fringe benefits), rent, interest, and profit.
All three approaches give identical measurements (except for problems such as incomplete or
misreported data or measurement errors).

GDP at Market Prices = GDP at Factor Cost + Indirect Taxes - Subsidies

There have been two (major) changes to the GDP calculations in India. One was a change in
the base year for the calculation which is done routinely every five years or so. The other was
to adopt a new method to measure output. The Central Statistics Office (CSO) now measures
the country's economic growth by gross value-added (GVA) at basic prices, replacing the
practice of measuring it by GDP at factor cost. (Basic prices include production taxes and [-]
production subsidies and do not consider product taxes and product subsidies). GVA captures
what accrues to the producer, before a product is sold. The industry-wise estimates are
presented as GVA at basic prices while GDP at market prices is referred to as (simply)
GDP. The current base year for calculating national accounts is 2011-12.

Session 6
GDP Family
Gross National Product (GNP) is the value of final goods and services produced by residents
of a country, even if the production takes place outside the country. For example, income of an
IIMU graduate working in the US.

GNP= GDP + Net factor payments from abroad (NFIA)

NFIA = Factor incomes earned by residents from the rest of the world – Factor incomes earned
by non-residents from our country.

Depreciation is the value of the capital that wears out during the period over which economic
activity is being measured.

Net Domestic Product (NDP) is the total value of production minus the value of the amount of
capital used up in producing that output.
NDP = GDP – depreciation
NNP = GNP – depreciation
National Income (NI) is the total income received by factor of payments (Factor incomes
accrued to the residents of a country). NI is NNP at Factor Cost.
GDP (or GNP) at factor cost= GDP (or GNP) at market price - Indirect taxes + Subsidies

Personal Income: All earned income is not received by the factors of production in the same
year. Personal Income (PI) = National Income - Income earned but not received + Income
received but not earned.
Income earned but not received: Corporate taxes, undistributed profits
Income received but not earned: Welfare payments, pensions

Private Disposable Income (DI) is what remains of personal income after (personal) taxes are
paid (DI= PI-Personal Taxes). We can do two things with our disposable income: spending or
saving.

Session 7
Interpreting GDP data
In today's session while understanding the US recession example (using quarterly figures),
many of you got different numbers of 'final domestic private sales'. One of the reasons was the
computing error. Another reason was because of 'Residual' component. The residual
component was relatively a very small component and one may ignore it. One can estimate the
final domestic private sales either by [i] summing total consumption and total fixed investment,
or [ii] by subtracting inventories, government expenditure and net exports from total output.
My numbers were based using G, NX and inventory (that is using [ii]). Since the residual
component was (relatively) very small, the figures arrived from either [i] or [ii] are very much
comparable. The key point is that whenever examining the overall GDP figures, it is useful to
look at this measure of economic activity (domestic private final sales) as well.

We discussed the following broad points:

1. The change in inventory investment vis-à-vis the change in all other components of GDP: If
most of the gain in last year’s GDP was caused by unintended inventory stockpiling. The last
year’s GDP include all inventories accumulated that year. One may look at the change in final
domestic private sales (which is equivalent to total consumption plus total fixed investment),
or final sales (total output - total inventories)
2. Consumption (private) expenditure may increase if people consume more of imported items
(relative to domestically produced items); their increased spending on imported items will be
reflected in an increase consumption expenditure.
3. Government purchases (census and election years)
4. The gain or loss in net exports: If real growth is strong because imports did not rise very
much, that may mean firms expect slower growth ahead, so they have cut back on their imports.

Session 8
General Price Level Measurement

A price index (P) measures the average level of prices.

Inflation rate: [(Pt - Pt-1)/ Pt-1] *100

There are three price indices more often used to measure the price level: (i) GDP deflator, (ii)
Consumer Price Index (CPI), and (iii) Producer Price Index (PPI)/ Wholesale Price Index
(WPI) in India.

The GDP deflator covers all output including consumer goods, investment goods and
government services. It is defined as the ratio of nominal GDP to real GDP in year t. 1 It is not
based on a fixed basket of goods and services.

The CPI tracks the prices paid by the typical consumer. CPI measures the cost of a given basket
of goods/services, which is the same from year to year (fixed weights).2 It includes the
purchases of some things, like imported goods, that are not included in GDP.

WPI considers only goods and all services are excluded. It takes wholesale prices into
consideration (not retail prices). The quantity weights are constant as in the CPI.

The set of goods produced in the economy is not the same as the set of goods purchased by
consumers. For instance, some of the goods are sold to firms, to government, or to foreigners
(captured in the GDP Deflator). Similarly, some of the goods are not produced domestically
but are imported from abroad (CPI).
Food has a larger weight in the CPI, and therefore the CPI is more sensitive to changes in prices
of food items. The fuel group has a much higher weight in the WPI than in the CPI.

1
GDP Deflator = (Nominal GDP/Real GDP) *100
2
Computing CPI/WPI: (i) Choose a base year, (ii) Compute the basket’s cost for the base year,
(iii) Compute the base year weights, (iv) Compute the relative price for the current year, and
(v) Use the base year weights for the current year and compute the basket cost (by multiplying
the relative price of each item with its weight in the basket, and add it for all the items). Note
that the CPI/WPI for the base year is 100.

Item Base Year Current Year

Quantity Price Weights Relative Price Relative Price * Base year weight
1
2