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Understanding the basics of Indian economy - Arushi Jamar, IIM A

Arushi Jamar is a final year student at Shaheed Sukhdev College of Business Studies, University of Delhi. She is pursuing a bachelors in Financial and Investment Analysis. Arushi cracked CAT 2014 with 99.78 percentile and  converted IIM A, B and C and is joining IIMA batch 2015-2017. She occasionally writes on Quora on finance and related topics.

Hello fellow MBA Aspirants!

Here I am writing an article on some very basic facts about the Indian economy that I thought you must know before you go and face your MBA interviews. I’ll try to keep the article brief and informative.

Let’s first talk about how big the Indian economy is.

Big ? How can I use words like big or small for something that doesn’t physically exist? How do we measure the size of an economy?

Here comes the measure called ‘Gross Domestic Product’ or ‘GDP’ to our rescue. GDP is the MONETARY VALUE of ALL the finished goods and services PRODUCED within a country's borders in a specific time period, usually a year. You can think of it as the sum of all the income generated within the country during a particular year.

In India, GDP is calculated using 2 methods, Production or Value Added Method and Expenditure Method.

In the first method, the economy is divided in 8 sectors and then value added in each of these is calculated and added together to get the GDP at factor cost. Whereas the second method uses the following formula to arrive at GDP at Market Prices:
 GDP = consumption + investment + (government spending) + (exports-imports)

The GDP so calculated is the ‘Nominal GDP’.

India ranks 10th in the world with a GDP of $2.047 trillion

 

This conversion from Rupee to Dollar uses the Nominal exchange rate.

But wait. A loaf of bread produced in India will be valued at say Rs 20 or $0.33 (roughly). In USA it will be valued at something like $2. So is the comparison fair?

To solve this problem we introduce a concept called Purchasing Power Parity.

PPP rates are calculated by comparing the purchasing power of currencies in their home countries.

If we use PPP rates to convert Rupee to Dollars, India ranks 3rd in the world in terms of GDP.

 

The growth rate of this GDP is a very important indicator of an economy’s performance. While China maintained over 10% per annum growth for three straight decades, India could achieve a growth rate of only 4.7% in the fiscal year 2013-14, in contrast to higher economic growth rates in 2000s.

The Indian Finance Ministry expects the GDP growth for the fiscal year 2014-15 to be 5.5%, while the IMF expects it to be 5.6%.

Note that while calculating the GDP growth rate, we use ‘Real GDP’, which is Nominal GDP adjusted for inflation.

Why do we do that? What is inflation?

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every rupee you own buys a smaller amount of a good or a service.

The Ministry of Statistics and Programme Implementation (MoSPI) calculates the YoY inflation on a monthly basis. Historically, the wholesale price index (WPI) has been the main measure of inflation in India. But in April 2014 India shifted to Consumer Price Index (CPI) for measuring inflation.

A rise in prices would mean that GDP will rise even when production in the country remains stagnant. To remove the effect of rising prices on GDP, we adjust the GDP for inflation to calculate the ‘Real GDP’. The growth rate is always calculated on this Real GDP.

Here’s a graph showing the inflation trend in India.

In recent years, India has seen very high inflation, but it has stabilised in the last few months. October’14 CPI was as low as 5.52% followed by 0% November’14 CPI.

Now you might think that inflation reduces your real income and it should be zero, or maybe even negative. But a little inflation is actually required in an economy. Zero inflation means that the economy is not growing. (India being an exception here. Prices in India have risen so much already that low or negative figures for some time will be a welcome relief)

Also, historically, we have seen an inverse relationship between inflation and unemployment. In times of low inflation, unemployment has usually risen.

So how much inflation is ideal?

We can’t decide on any one figure, but usually economists believe inflation should be something between 2-4%. But high growth in an economy would mean a rise in people’s incomes and may lead to more inflation. On the other hand, absence of such growth will lead to unemployment.

It is the policy makers’ job to balance the two.

There are two powerful tools the government and the RBI use for this balancing act and to steer our economy in the right direction: fiscal and monetary policy. When used correctly, they can have similar results in both stimulating our economy and slowing it down when it heats up.

Fiscal policy is how the government receives its revenue and how it utilises it. What I am talking about is the Finance Act passed every year, or what we usually call, the budget (Watch out for this year’s budget on February 28th). If the government plans to spend more money than what it is receiving through taxes and other sources, it resorts to borrowing money. The difference between the government’s revenue and expenditures is called the Fiscal Deficit. It is the amount government has to borrow to meet its requirements. It is measured as a percentage of GDP. India’s fiscal deficit for the year 2013-14 was 4.6% and has remained somewhere near 5% in the 3 preceding years.

Monetary policy, on the other hand, is controlled by the Reserve Bank of India. RBI uses various tools such as Repo rate, CRR & SLR requirements to control the money supply in the economy. By decreasing these rates, RBI increases the amount of money available with banks to lend and hence gives a boost to economic activity and growth. On the other hand, increased supply of money may also lead to inflation in the economy.

Now you know why Mr Rajan was reluctant to reduce rates till inflation stabilised.

Hope that helped!

Feel free to leave a comment if you have any doubts, or simply Google it :-)

Recommended Read: Concepts of Currency, Inflation, Deflation and Exchange Rate

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