National Income and Inflation

A government wants to know whether its people produce more than they did five years ago. It cannot add tonnes of wheat to haircuts and mobile phones. It needs one number, in rupees, that counts each thing once.

Final, not intermediate. A final good is bought for use, not to be processed or resold. An intermediate good is used up in making something else. Counting only final output avoids double counting. Follow a loaf of bread, as an illustration, and assume the farmer buys no inputs:

Adding all the sales gives ₹47,000, which counts the wheat three times. Adding the value added at each stage gives ₹22,000, exactly the value of the final bread.

Three methods. In principle all three give the same answer: output (value added) = income = expenditure.

• Product or value-added method: the value of output minus intermediate consumption, summed over every stage of production, as in the table.
• Income method: NI = W + R + I + P (wages, rent, interest, profit). Indian textbooks group these as compensation of employees, operating surplus (rent, interest and profit) and mixed income of the self-employed.
• Expenditure method: C + I + G + (X − M): consumption, investment, government spending and net exports. This gives GDP at market prices; the next concept shows how to get from there to national income.

Why they agree: the ₹22,000 the bread chain adds is paid out as wages, rent, interest and profit. And it is the amount buyers spend on the bread. One flow of value is measured at three points.

What is left out. Transfer payments, such as pensions and scholarships, are not payment for anything produced. A second-hand sale is not new output; only the dealer's commission counts. Buying shares or bonds moves money between owners and produces nothing.

Don't confuse final with intermediate goods by the product's name. What matters is the use. Flour bought by a bakery is intermediate. The same flour bought by a household for its kitchen is final.

Where it breaks. National income leaves out unpaid work at home, such as cooking and caring for children. Output in the informal sector has to be estimated. Damage to the environment is not subtracted. In practice the three methods never match exactly, and statisticians report the difference as a discrepancy.

For exams. Know the three methods and their formulas, why only final goods count, and what is excluded: transfer payments, second-hand sales and financial transactions.

In one country much of the profit made inside its borders goes to foreign owners. In another, residents earn a lot from investments abroad. Output inside the borders alone cannot show whose residents are better off.

Three switches. Every aggregate is one setting of three switches:

• Domestic or national: add net factor income from abroad (NFIA). NFIA is what residents earn abroad, such as interest and profits on investments, minus what non-residents earn here.
• Gross or net: subtract depreciation, the wear and tear of machines and buildings during the year.
• Market price or factor cost: subtract indirect taxes and add subsidies. Factor cost is what the factors of production (labour, land, capital and enterprise) actually receive.

A worked example. Take a small, hypothetical economy, with figures in ₹ crore and a population of 10 lakh.

Per capita income is ₹800 crore ÷ 10 lakh people = ₹8,000 a person. The domestic route reaches the same national income: GDP 1,000 − depreciation 80 = NDP 920; minus net indirect taxes 100 gives NDP at factor cost, 820; plus NFIA (−20) gives 800.

The flow runs GDP → GNP → NNP → national income → personal income → disposable income.

Don't confuse GDP with GNP. GDP asks where: everything produced inside the borders, whoever owns it. GNP asks who: everything the country's residents earn, wherever they earn it. A foreign-owned factory in Pune adds to India's GDP; the profit it earns for its foreign owners is subtracted to reach GNP.

Where it breaks. Per capita income is an average. It says nothing about how income is shared, so a few very rich people can lift it while most people see no change. GDP also counts spending to repair damage, such as rebuilding after a flood, as output. That is one reason for wider measures such as the Human Development Index.

For exams. Learn the order of the flow and each step's formula. Remember the three switches: NFIA (domestic to national), depreciation (gross to net), net indirect taxes (market price to factor cost). Some textbooks also subtract social security contributions on the way to personal income.

Where it is made, who earns it, what wears out, what the state takes.

A family's monthly basket of groceries, rent and bus fares cost ₹20,000 last year and costs ₹21,200 today. Its income must rise 6% just to buy the same things.

Purchasing power. If prices rise 25%, ₹100 buys what ₹80 bought before, since 100 ÷ 1.25 = 80. Purchasing power falls by 20%, not 25%.

Three causes.

• Demand-pull: aggregate demand, the total spending in the economy, exceeds what the economy can supply, so prices rise. Cheap credit or heavy government spending can start it.
• Cost-push: production costs rise and firms pass them on. A rise in crude oil prices raises transport and production costs; a poor monsoon raises food prices.
• Built-in: a wage-price spiral driven by expectations. Workers expect prices to rise 6% and ask for 6% more pay. Firms then raise prices to cover the higher wages, and the expectation comes true.

The 50%-a-month mark for hyperinflation comes from Phillip Cagan's study of hyperinflations (1956). Cost-push is the usual route to stagflation, as the right-hand panel shows: prices rise while output falls. The oil price shocks of the 1970s brought stagflation to many countries.

Don't confuse disinflation with deflation. If inflation falls from 8% to 4%, prices are still rising, only more slowly: that is disinflation. Deflation means the price level itself falls. Cut-offs for walking and running inflation differ between textbooks; learn the order and treat the ranges as rough.

Where it breaks. Real inflation rarely has a single cause. A cost shock can start a wage-price spiral, and a spiral can only continue if spending keeps growing. Milton Friedman argued that "inflation is always and everywhere a monetary phenomenon": without more money, prices cannot keep rising for long. Many economists accept this for the long run, but not as a full account of short-run price changes.

For exams. Know the three causes, the AD and AS shifts behind demand-pull and cost-push, the kinds of inflation in order, and the difference between disinflation, deflation and stagflation.

Demand pulls, costs push, expectations build it in.

Vegetable prices jump, and a household feels inflation sharply. A factory owner watching the prices of steel and cement may see almost none. Both are right: they are watching different baskets.

From index to inflation rate. Suppose, as an illustration, a household basket cost ₹10,000 in the base year, ₹12,000 last year and ₹12,600 this year. The CPI is 100, 120 and 126. This year's inflation rate is the change in the index, as a share of last year's:

India's inflation target, which guides the Reserve Bank of India's monetary policy, is set in terms of CPI inflation, because CPI tracks what households actually pay.

The GDP deflator, worked. Nominal GDP values output at this year's prices; real GDP values it at base-year prices. Take a toy economy that makes only rice and cloth (an illustration):

• Base year: 100 kg of rice at ₹40 and 50 m of cloth at ₹100. GDP = ₹4,000 + ₹5,000 = ₹9,000.
• This year: 110 kg at ₹44 and 50 m at ₹110. Nominal GDP = ₹4,840 + ₹5,500 = ₹10,340.
• Real GDP, at base-year prices: 110 × ₹40 + 50 × ₹100 = ₹9,400.
• Deflator = 10,340 ÷ 9,400 × 100 = 110. Prices rose 10%; real output grew 9,400 ÷ 9,000, about 4.4%.

Don't confuse index points with per cent. An index that moves from 120 to 126 has risen 6 points, but only 5%. The two match only when the starting index is 100.

Where it breaks. A fixed basket ages. People switch to cheaper goods when prices rise, quality improves, and new products appear. So a fixed-basket index tends to overstate the rise in the cost of living. Each index also answers only its own question: WPI says little about the price of a haircut or a school fee.

For exams. Match each formula to its index. CPI includes services; WPI excludes them; the deflator covers the whole economy with a changing basket. Inflation is the percentage change in the index.

A retired teacher lives on the interest from a ₹10 lakh fixed deposit paying 7% a year. If prices rise 9% a year, her ₹70,000 of interest buys less each year, and so does the ₹10 lakh itself.

Effects. Moderate inflation can lift spending, investment, production and employment, since firms see rising prices and expand. High inflation cuts purchasing power and savings, deepens inequality and raises uncertainty. It does not hit everyone alike:

The real interest rate. The real return on saving is roughly the interest rate minus inflation. For the teacher: 7% − 9% = about −2% a year. The nominal rate is the rate on paper; the real rate is what it buys.

Four sets of tools.

• Monetary policy: the central bank raises interest rates and reserve ratios, and sells government securities in open market operations to absorb money. In India the RBI's Monetary Policy Committee sets the repo rate, the rate at which the RBI lends to banks. Other tools include the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).
• Fiscal policy: the government lowers spending and raises taxes, which reduces demand.
• Price control measures: price ceilings, subsidies, rationing through the public distribution system, and release of buffer stocks.
• Supply-side measures: raise production, remove supply bottlenecks, improve efficiency and logistics.

Don't confuse monetary with fiscal policy. Monetary policy is the central bank's: interest rates, reserve ratios and money. Fiscal policy is the government's: taxes and public spending. Both can cool demand, but different bodies decide them.

Where it breaks. Raising interest rates works on demand. It cannot bring rain after a poor monsoon or lower world oil prices, so it is weak against cost-push inflation. It also slows growth. Price ceilings that are held below the market price create shortages and black markets. Supply-side measures attack the cause of cost-push inflation, but take longest.

For exams. Match each tool to who uses it. Monetary tools are often split into quantitative ones (repo rate, CRR, SLR, open market operations), which change the overall amount of credit, and qualitative ones (selective credit controls, moral suasion), which steer credit to or from particular uses.