Last year methodology of calculating India’s GDP was revised along with base year revision. It produced surprising results revising growth rate for 2013-14 to 6.9% from 5% (38% jump) as per old methodology. Not many were convinced then and most are still unconvinced.

In this article, we discuss various changes brought about by the recent revision but before we go there, let’s have a look at basics of GDP.

What is GDP and how is it calculated?

GDP or gross domestic product is nothing but money value of all the final goods and services produced in the domestic economy in a given time period.

Let’s break GDP down-

It’s gross because it does not account for depreciation.

What is depreciation-

A part of capital is lost every year due to wear and tear. Suppose life cycle of a machine which makes toys is 20 years, after 20 years we will have to replace it or we can say that every year 1/20th portion has to be replaced. This replacement cost is called depreciation.

When we subtract depreciation, we get net product.

Net Domestic Product = GDP – Depreciation

It’s domestic because production happening in domestic economy is considered. It does not matter if it’s produced in India by Indians or Americans.

On the other hand national product takes into account production by nationals. It does not matter whether they produce in India or US.

Let’s understand this with an example –

Priyanka Chopra charges some (hefty) fee for acting in Quantico in US. Her fee will be counted in domestic product of USA and national product of India.

By this very same token, McDonald american manager’s salary who is working in India will be counted in US National product and Indian Domestic product .You get the point, right ?

National product = domestic product +income of nationals in abroad – income of foreigners in the country

Or

Domestic product – net factor income from abroad.

Okay so now that we understand the basic definitions, let’s understand how GDP is calculated.

There are only 3 methods of GDP calculation

1. Income method i.e. add income of all the individuals of the economy
2. Expenditure (consumption) method i.e. add all the expenditure incurred by all the individuals
3. Production or value added method i.e. add value addition at each stage of production or as we say in definition Final value of all goods and services produced.

Note here that I mention final value which implies if we count value of a Maruti, we shall ignore value of component parts of Maruti such as steel used or rubber etc. Or we can ignore the final value of Maruti but add value addition at every stage. Point here is to avoid double counting.

All 3 methods shall give the same result due to circular flow of money.

What is this circular flow of income?

A theory that states that money flows to workers in the form of wages, they buy goods and services from it ( expenditure) and money flows back to firms in exchange for products.

What’s the concept of GDP at Factor cost and GDP at market price?

Factor cost is cost incurred in paying factors of production i.e. land (rent), labour (wages), Capital (interest,dividend), entrepreneur (profits). Essentially cost of production.

Market price of a good = Factor cost + Indirect taxes – subsidies

GDP at market price = GDP at factor cost + Indirect Taxes – Subsidies

What’s this GDP at current market price and GDP at fixed price?

Because of inflation, money value of output may increase without any commensurate increase in actual real production.

For instance, if last year we produced 100 kg of pulses whose cost was 100 rs per kg, our GDP would be 100*100.

This year due to some reason price has risen to 200 per kg. We produce only 100 kg this year but GDP at current market price would be 100*200 i.e. double of last year even though there’s no real increase in output. 

Hence, when we calculate real GDP growth, we compare the real GDP i.e. inflation adjusted GDP with some base year. That inflation adjuster is known as GDP deflator.

Real GDP = Nominal GDP at current market prices/ GDP deflator.

The base year has to be revised periodically as structure of economy changes. Some goods become obsolete with time (audio cassettes) while new goods come into the market and base year has to reflect those changes.

It was to reflect these changes that the base year was revised but other changes were also incorporated in the methodology of GDP calculation.

Let’s analyse these change in brief –

1. Base Year was revised from 2004-05 to 2011-12
2. GDP calculation at constant market prices instead of at factor cost.
3. Sector wise estimation of gross value added (GVA) at basic prices instead of factor cost.
4. Comprehensive coverage of corporate sector using MCA21 software.
5. Comprehensive coverage of financial sector
6. Improved coverage of activities of local bodies and autonomous institutions.

All these changes were made to align Indian accounts as per IMF approved methodology.

But as mentioned earlier, revision dramatically increased our growth rate but high growth rate numbers don’t correspond with the high frequency macro-economic indicators in the economy, such as bank credit growth, corporate performance, auto sales, factory output etc.

What needs to be done?

Central Statistical Organization (CSO) will have to create a back series so that analysts are able to make sense of the GDP data. Otherwise credibility of our numbers will be questioned which would be a very bad news for investor confidence.