Balance of trade, Balance of payment

 Balance of trade

The balance of trade is the distinction between the value of a nation’s imports and exports for a given time frame. The BoT is the largest constituent of a nation’s balance of payments. Economists utilize the BoT to compute the associative potency of a nation’s economy. The BoT is also known as the trade balance or the international trade balance.

Balance of payment

The balance of payment is a statement of all the transactions that are made between entities in one nation and the rest of the world over a particular time frame, such as a quarter or a year. To put it in other words, the BoP is a set of accounts that identifies all the commercial transactions operated by the nation in a specific period with the remaining nations of the world. It documents a record of all the monetary transactions performed globally by the nation on goods, services, and income during the year.

 

Difference between the balance of trade and balance of payments.

Balance of trade	Balance of payments
Definition
Balance of trade or BoT is a financial statement that captures the nation’s import and export of commodities with the rest of the world.	Balance of payment or BoP is a financial statement that keeps track of all the economic transactions by the nation with the rest of the world.
What does it deal with?
It deals with the net profit or loss that a country incurs from the import and export of goods.	It deals with the proper accounting of the transactions conducted by the nation.
Fundamental Difference
Balance of trade (BoT) is the difference that is obtained from the export and import of goods.	Balance of payments (BoP) is the difference between the inflow and outflow of foreign exchange.
Type of transactions included
Transactions related to goods are included in BoT.	Transactions related to transfers, goods, and services are included in BoP.
Are capital transfers included?
No	Yes
What is its net effect?
The net effect of BoT can be either positive, negative, or zero.	The net effect of BoP is always zero.

Liquidity Trap

 Liquidity Trap with Causes, Signs, and Cures

A liquidity trap is an economic situation where everyone hoards money instead of investing or spending it. It occurs when interest rates are zero or during a recession. People are too afraid to spend so they just hold onto the cash. As a result, central banks use of expansionary monetary policy doesn't boost the economy.

Causes

Central banks are in charge of managing liquidity with monetary policy. Their primary tool is to lower interest rates to encourage borrowing. That makes loans inexpensive, encouraging businesses and families to borrow to invest and spend. It's like stepping on the gas to increase the engine's speed. When you push the gas pedal, the car goes.

A liquidity trap often occurs after a severe recession. Families and businesses are afraid to spend no matter how much credit is available. It's like a flooded car engine. You've released so much gas into the engine that it crowds out the oxygen. Pumping the gas pedal doesn't help.

That's what happens in a liquidity trap. The Fed's gas is credit and the pedal is lower interest rates. When the Fed pushes the gas pedal, it doesn't rev up the economic engine. Instead, businesses and families hoard their cash. They don't have the confidence to spend it, so they do nothing. The economic engine is flooded.

There are five signs that you're in a liquidity trap. All of them show that the central banks efforts to boost the economy are not working.

Low-Interest Rates

For a liquidity trap to occur, interest rates must near or at zero. If it's been there for a while, people believe that interest rates have nowhere to go but up. When that happens, no one wants to own bonds. A bond bought today that pays low rates won't be as valuable after interest rates rise. Everyone will want the bonds issued then because it pays a higher return. The low-rate bond will be worth less in comparison.2

Prices Remain Low

Consumer prices remain low. Typically, when the central bank adds to the money supply, it creates inflation. During normal times, for each 1% increase in the growth of money, inflation increases by 0.54%.1

In a liquidity trap, it's more likely there will be deflation or falling prices. People put off buying things because they believe prices will be lower in the future. 

Businesses Don't Spend the Extra Cash

Businesses don't take advantage of low-interest rates to invest in expansion. Instead, they use it to buy back shares and artificially boost stock prices. They don't use it to buy new capital equipment, they make do with the old. They might also purchase new companies in mergers and acquisitions or leveraged buy-outs. These activities boost the stock market but not the economy.1

Wage Remain Stagnant

Companies are also reluctant to use the extra funds to hire new workers. As a result, wages remain stagnant. Without rising incomes, families only buy what they need and save the rest. This further contributes to the lack of demand.1

Lower Interest Rates Don't Translate to Increased Lending

Banks are supposed to take the extra money the Fed pumps into the economy and lend it out in mortgages, small business loans, and credit cards. During a recession, people aren't confident, so they won't borrow. Banks use the extra cash to write down bad debt or increase their capital to protect against future bad debt. They might raise their lending requirements, as well.

 Five Solutions

Five things can get the economy out of a liquidity trap by stimulating demand.

Raise Interest Rates

First, the Fed raises interest rates. An increase in short-term rates encourages people to invest and save their cash, instead of hoarding it. Higher long-term rates encourage banks to lend since they'll get a higher return. That increases the velocity of money.

Price Fall Enough

The economy could get going again once prices fall to such a low point that people just can't resist shopping. It can happen with consumer goods or assets like stocks. Investors start buying again because they know they can hold onto the asset long enough to outlast the slump. The future reward has become greater than the risk.

Expansionary Fiscal Policy

The government can end a liquidity trap through expansionary fiscal policy. That's either a tax cut or an increase in government spending, or both. That creates confidence that the nation's leaders will support economic growth. It also directly creates jobs, reducing unemployment and the need for hoarding.1

Financial Innovation

Fourth, financial innovation creates an entirely new market. That makes financial assets, like stocks, bonds, or derivatives, more attractive than holding cash.1

Global Rebalancing

If some countries are experiencing a liquidity trap, and others are not, then governments could end the trap by coordinating global rebalancing. That's when countries that have too much of one thing trade to those that have too little.

For example, China and the eurozone have too much cash tied up in savings. That's a result of consumer spending in the United States on Chinese exports. China must invest more in the United States to get that money back into circulation.

Problems of Calculating GDP in a country

1. The Bargaining Power and Value Added

The strongest defect of the GDP interpretation is related to the idea that the value added is distributed among agents who create the final product in accordance with objective characteristics of their activities. It means that everyone obtains a share proportionally to his contribution to the creation of value. Such distribution can indeed take place under conditions of perfect competition (allocative efficiency), when all economic agents have equal bargaining power and absolute freedom to choose counterparties. In the real life it is all quite different. There is inequality in the parties’ bargaining power, which can be caused by a considerable number of reasons. The main ones include a monopoly, including that for intellectual property, market entry barriers, technological backwardness that limit the choice of the dependent party, etc.

2. Problem with Measuring Value of the Product

Another key problem of assessing the level of GDP is related to the base for calculating it – the value of the produced (consumed) products. Prices are an excellent instrument for measurement in the market economy when the value of any product is limited to two borders – the upper one that reflects the utility of goods (the possibility to substitute one good for another), and the lower one that reflects the level of socially required costs for its reproduction. In other words, buyers will not demand this product if it can be substituted for another one, more efficient in terms of the price-quality ratio, and suppliers will not supply this product if the revenue they get does not cover the costs incurred. That is why under the conditions of market pricing, the value measurement allows to adequately compare various sets of products. The situation is completely different when the state acts as a buyer of a certain product (or as an entity that finances the production of relevant goods and services). Is it possible to consider that the money spent by the state to finance the construction of super-stadiums, new R&D, purchase of equipment the lion’s share of which includes logistic and transaction costs, purchase of monopolists’ products for state needs, etc. reflects socially required costs for production of relevant products? Even if these goods really meet current or future public needs (that, unfortunately, does not always happen), it is necessary to take into account that when there is no competition, any seller’s aim is to justify the need for increase in the amount of money invested in the project. Of course, there are many methods of justifying the value of production costs approved by the state. However, under conditions of asymmetry of information, the probability of irrational spending of state resources is quite high. In other words, under conditions of a considerable share of state expenses GDP will be higher if costs for the production of goods ordered by the state are higher. At the same time, such costs are likely to include costs of creating unnecessary goods and costs of obtaining administrative rent.

3. Imposed consumption

Limited resources are often spent on imaginary rather than real needs of the society. Using the monkey on our shoulder method , manufacturers impose on consumers the products and services that they absolutely do not need and that sometimes are even harmful for them. The flourishing of the consumer society where the status of a thing means much more than its functionality questions the ability of the market to ensure allocative efficiency. The main task of the manufacturer is to constantly update the existing products, to create a little meaningful difference in the models and characteristics of products of the same type. Even in such areas as pharmacology that is far from conspicuous consumption, great funds are spent on developing  Main Problems with Calculating GDP as an Indicator of Economic Health of the Country.

Another problem is the exaggeration of GDP by so-called “imposed” services that citizens of the country do not actually need. For example, additional medical services imposed on the patient are widely spread. Similar examples can be found in insurance and legal area.

4. Not taking into Account the Value of Products Created by Households

GDP does not take into account products created within households. In developed countries, a household can choose the way to meet its needs: to do some work on its own or to seek the assistance of others in exchange for money. If a work is done “for personal needs”, it is not taken into account when calculating the GDP. It turns out that the value of the vegetables grown in the kitchen garden is not included when calculating GDP, while in case of those bought in the supermarket it is included. Under conditions when production of most consumer goods and services returns to the households (food production in home appliances, apartment cleaning by vacuum cleaners robots, washing and cleaning clothes in washing machines, etc.), ignoring the results of households’ production activities can cause a serious underestimation of the actual volume of production in the country. This problem will be further deepened as the prices of 3D printers that make it possible to produce many items of clothing, shoes etc. at home become lower.

5. Underestimation of Turnover within Sharing-Economy

The GDP includes neither households’ production nor works and services provided by households to one another with no charge. Meanwhile, today we are witnessing the emergence of a new type of economy – the sharing economy that involves not only the joint use of property, but also the inclusion of many households in the networks of mutual services. In this case, households can act in two different roles – as providers of commercial services and as participants in reciprocal transactions. The most important difference between the reciprocal transaction and the bargaining transaction is the lack of a goal to obtain income as the leitmotif of interaction among the participants. In the case when a car owner pick his friend up, and the latter pays for the gasoline, we deal with mutual assistance rather than with market exchange. Even now it is possible to single out the following types of sharing economy related to the interaction of households: increase in the volume, capacity and speed of using private resources by combining them (Skype, Torrent, libraries and film libraries), joint use of a resource owned by one person; creation of a network where households exchange baby clothes, books, records, information, the right to use temporarily available real estate, exchange of services – creation of networks of mutual assistance (doctors, teachers, drivers, and repairmen). It is also possible to exchange services in the form of knowledge, information etc. At the moment most of the relevant transactions are not taken into account when calculating GDP.

6. Using Base Prices When Calculating the Real GDP

The nominal value of GDP is greatly influenced by inflation. Therefore, the value of the real GDP cleared from the influence of price changes is usually taken as the main indicator. When calculating the real GDP, the value of final goods and services is measured in base prices, i.e. the prices that have been formed in the markets of goods and services during the period taken as the base. However, the structure of output does not remain unchanged: the ratio of certain goods and services in the total volume of output changes, new goods and services appear, and their quality Victor is being improved. For example, in high-tech industries, technical characteristics of new products can be considerably higher than those of their analogues of the base period, but this will not be reflected when calculating the real GDP. Likewise, improvement in the quality of services provided this year (for example, more efficient diagnostic procedures) will not be taken into account.

Finally, the appearance of fundamentally new goods is not adequately reflected in the real

GDP indicator because there are problems with determining prices of the base period.

7. Measuring GDP using Purchasing Power Parity (PPP)

For international comparisons, GDP (PPP) is often used. To calculate it, the nominal GDP calculated in a national currency is adjusted according to the purchasing power parity (PPP). However, when calculating the purchasing power parity, several problems arise. Firstly, the standard consumer baskets in different countries cannot be absolutely the same, because consumer habits and preferences differ from country to country. Secondly, goods and services that have the same name can vary considerably by their quality. Thirdly, statistical sources of information are not always uniform, and the number of observations is not always sufficient to adequately assess price differences.

Perfect Competition

Perfect Competition is a type of market structure where many firms sell similar products and profits are virtually non-existent due to fierce competition. With that said, it is important to realize that perfect competition is an abstract term used to compare against real life markets.

Perfect competition has 5 key characteristics:

·    Many Competing Firms

·   Similar Products Sold

·   Equal Market Share

·   Buyers have full information

·   Ease of Entry and Exit

When these characteristics are seen in the market, we can consider it perfectly competitive. Let us look at them in more detail below.

1. Many Competing Firms

A perfectly competitive market has many buyers and sellers. This means that firms are known as ‘price takers’. In other words, the firm must sell at the ‘equilibrium’ price – this is where the firm sells when supply and demand align. If not, they will go out of business, as there are many other firms that sell the same good at a lower price. As a result, customers have little cost of switching to a substitute good.

The number of competitors in the market means that each company is prevented from raising prices. If they do, then they will be forced out of the market as consumers are able to switch to cheaper alternatives.

2. Similar Products Sold

In perfect competition, competitors sell similar products. This is otherwise known as ‘homogenous’ – in economic jargon. In simple terms, it means the products are similar.

Individual businesses may be indistinguishable to the average customer. As a result, the ability and willingness to switch is easy and costless.

Dairy is a notable example. For instance, many farmers sell milk to supermarkets, but the product is very similar. In fact, supermarkets change contracts with dairy producers without customers even noticing.

3. Equal Market Share

Competitors all have a similar market share because firms are unable to compete on price. As firms produce where Marginal Revenue = Marginal Cost, there is no room to reduce prices.

If a firm was to reduce prices, it would start making a loss – because it costs more to make than sell, meaning it would go out of business. At the same time, if any firm increases prices, there is enough competition to attract customers from that store and put them out of business. In turn, this puts a restriction on a firm’s ability to gain market share.

4. Buyers have full information

In economic jargon, we call this ‘Perfect Information’. This is where the customer knows that the business down the road sells the same product at a lower price. As a result, businesses are reluctant to raise prices ahead of a competitor.

Furthermore, customers are also aware of the quality of a product. For instance, one firm may reduce costs to provide a lower quality product and make more profit. Since customers have perfect information, they will know the product is inferior. In turn, they will switch to competitors – putting the original firm out of business.

5. Ease of Entry and Exit

Firms can enter and exit the market with little cost. This can come in the form of financial, time, or information. For instance, the oil and gas industry requires a high level of up-front investment. As such, this is a barrier to entry for competitors. Under perfect competition, these costs do not exist or are in fact insignificant.

Additionally, firms are able to exit the market with ease under perfect competition. For example, a firm may have a long-term contract. But they are unable to leave the market without significant costs.

Quantity Theory of Money

  The quantity theory of money (QTM) also assumes that the quantity of money in an economy has a large influence on its level of economic activity. So, a change in the money supply results in either a change in the price levels or a change in the supply of goods and services, or both. In addition, the theory assumes that changes in the money supply are the primary reason for changes in spending.

 One implication of these assumptions is that the value of money is determined by the amount of money available in an economy. An increase in the money supply results in a decrease in the value of money because an increase in the money supply also causes the rate of inflation to increase. As inflation rises, purchasing power decreases. Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of currency can buy. When the purchasing power of a unit of currency decreases, it requires more units of currency to buy the same quantity of goods or services.

 Throughout the 1970s and 1980s, the quantity theory of money became more relevant as a result of the rise of monetarism. In monetary economics, the chief method of achieving economic stability is through controlling the supply of money. According to monetarism and monetary theory, changes in the money supply are the main forces underpinning all economic activity, so governments should implement policies that influence the money supply as a way of fostering economic growth. Because of its emphasis on the quantity of money determining the value of money, the quantity theory of money is central to the concept of monetarism.

 Calculating QTM

The quantity theory of money proposes that the exchange value of money is determined like any other good, with supply and demand. The basic equation for the quantity theory is called The Fisher Equation because it was developed by American economist Irving Fisher. In it's simplest form, it looks like this:​

 (M)(V)=(P)(T)

where:

M=Money Supply

V=Velocity of circulation (the number of times money changes hands)

P=Average Price Level

T=Volume of transactions of goods and services

Some variants of the quantity theory propose that inflation and deflation occur proportionately to increases or decreases in the supply of money. Empirical evidence has not demonstrated this, and most economists do not hold this view.

A more nuanced version of the quantity theory adds two caveats:

New money has to actually circulate in the economy to cause inflation.

Inflation is relative—not absolute.

In other words, prices tend to be higher than they otherwise would have been if more dollar bills are involved in economic transactions.

Monetarism

According to monetarists, a rapid increase in the money supply can lead to a rapid increase in inflation. This is because when money growth surpasses the growth of economic output, there is too much money backing too little production of goods and services. In order to curb a rapid rise in the inflation level, it is imperative that growth in the money supply falls below the growth in economic output.

When monetarists are considering solutions for a staggering economy in need of an increased level of production, some monetarists may recommend an increase in the money supply as a short-term boost. However, the long-term effects of monetary policy are not as predictable, so many monetarists believe that the money supply should be kept within an acceptable bandwidth so that levels of inflation can be controlled.

Instead of governments continually adjusting economic policies through government spending and taxation levels, monetarists recommend letting non-inflationary policies–like a gradual reduction of the money supply–lead an economy to full employment.

Keynesianism

Many Keynesian economists remain critical of the basic tenets of the quantity theory of money and monetarism, and challenge the assertion that economic policies that attempt to influence the money supply are the best way to address economic growth.

Keynesian economics is a theory of economics that is primarily used to refer to the belief that the government should use activist stabilization and economic intervention policies in order to influence aggregate demand and achieve optimal economic performance. John Maynard Keynes was a British economist who developed this theory in the 1930s as part of his research trying to understand, first and foremost, the causes of the Great Depression. At the time, Keynes advocated for a government response to the global depression that would involve the government increasing their spending and lowering their taxes in order to stimulate demand and pull the global economy out of the depression.

In the 1930s, Keynes also challenged the quantity theory of money, saying that increases in the money supply actually lead to a decrease in the velocity of money in circulation and that real income–the flow of money to the factors of production–increased. Therefore, the velocity of money could change in response to changes in the money supply. In the years since Keynes' made this argument, other economists have proved that Keynes' contention with the quantity theory of money is, in fact, accurate.

Some of the tenets of monetarism became very popular in the 1980s in both the U.S. and the U.K. Leaders in both of these countries, such as Margaret Thatcher and Ronald Reagan, tried to apply the principles of the theory in order to achieve money growth targets for their countries' economies. However, it was revealed over time that strict adherence to a controlled money supply did not provide a solution for economic slowdowns

Definition of 'Quantity Theory Of Money'

 Definition: Quantity theory of money states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa.

It is supported and calculated by using the Fisher Equation on Quantity Theory of Money.

M*V= P*T

where,

M = Money supply

V = Velocity of money

P = Price level

T = volume of the transactions

Description: The theory is accepted by most economists per se. However, Keynesian economists and economists from the Monetarist School of Economics have criticized the theory.

According to them, the theory fails in the short run when the prices are sticky. Moreover, it has been proved that velocity of money doesn't remain constant over time. Despite all this, the theory is very well respected and is heavily used to control inflation in the market.

Is higher per capita income the only measure of economic development/Measurement of Economic Development

GDP is the final value of the final goods and services produced within the geographic boundaries of a country during a specified period of time, normally a year.

It counts the goods and services produced within the country and hence does not consider the products that the country imports from another country.

GDP Growth Rate

·         GDP growth rate is an important indicator of the economic performance of a country. It is the percentage increase in GDP from year to year.

·         It tells us exactly whether the economy is growing quicker or slower than the preceding year. Most countries use real GDP to remove the effect of inflation.

·         If the economy produces less than the preceding year, it contracts and the growth rate is negative. This signals a recession. If it stays negative long enough, the recession turns into a depression.

Significance of GDP

·         GDP is a broad measure of a country’s economic activity, used to estimate the size of an economy and growth rate. Because GDP provides a direct indication of the health and growth of the economy, businesses can use GDP as a guide to their business strategy. Investors also watch GDP since it provides a framework for investment decision-making.

·         The “corporate profits” and “inventory” data in the GDP report are a great resource for equity investors, as both categories show total growth during the period. Corporate profits data also displays pre-tax profits, operating cash flows and breakdowns for all major sectors of the economy.

Methods of Gross Domestic Product (GDP) Calculation

Gross Domestic Product (GDP) can be measured by 3 methods:

1. Income Approach:

• The income approach starts with the income earned from the production of goods and services. Under income approach we calculate the income earned by all the factors of production in an economy.
• Factors of production are the inputs which goes into producing final product or service. Thus, the factors of production for a business are – Land, Labor, Capital and Management within the domestic boundaries of a country. 
• In this approach, we calculate income from each of these Factor of production which includes the wages got by labor, the rent earned by land, the return on capital in the form of interest, as well as business profits earned by management. Sum of All these incomes constitutes national income and is a way to calculate GDP.

• Formula : Net National Income = Wages + Rent + Interest + Profits

2. Expenditure Approach :

• Second approach is converse of Income approach as rather than Income, it begins with money spent on goods & services. This measures the total expenditure incurred by all entities on goods and services within the domestic boundaries of a country.
• Mathematically, GDP (as per expenditure method) = C + I + G + (EX-IM)

Where,

1. C: Consumption Expenditure, i.e. when consumers spend money to buy various goods and services. For example – food, gas bill, car etc.
2. I: Investment Expenditure, i.e. When businesses spend money as they invest in their business activities. For example, buying land, machinery etc.
3. G: Government Expenditure, i.e. when government spends money on various development activities and
4. (EX-IM): Exports minus Imports, that is, Net Exports. I.e. we include the exports to other countries in calculation of GDP and subtract the imports from other countries to our country.

• The calculation of GDP from the above methods gives us the nominal GDP of the country. We will consider the difference between the Nominal and Real GDP in the coming article.
• Mostly GDP is calculated with both approaches and calculations are done in such a way that the values from both approaches should come almost equivalent.

3. Output (Production) Approach:

• This measures the monetary or market value of all the goods and services produced within the borders of the country.
• In order to avoid a distorted measure of GDP due to price level changes, GDP at constant prices or Real GDP is computed.
• GDP (as per output method) = Real GDP (GDP at constant prices) – Taxes + Subsidies.

• To make it gross, we need to do two adjustments – Add depreciation of capital & Add Net Foreign Factor Income. NFFI is (income earned by the rest of the world in the country – income earned by the country from the rest of the world)
• GDP (Factor Cost) = Wages + Rent + Interest + Profits+ Depreciation + Net Foreign Factor Income
• This basically is the sum of final income of all factors of production contributing to a business in a country before tax.
• Now if we add taxes and deduct subsidies, then it become GDP at Market cost.
• GDP (Market Cost) = GDP (Factor Cost)+ (Indirect Taxes – Subsidies)
•  

Is higher per capita income the only measure of economic development?

Generally, economic development is a process of change over a long period of time.

Though there are several criteria or principles to measure the economic development, yet none provides a satisfactory and universally acceptable index of economic development.

Hence, it is a complex problem to answer about the measuring of economic development.

R.G. Lipsey maintains that there are many possible measures of a country’s degree of development, income per head, the percentage of resources unexploited, capital per head, saving per head and amount of social capital. But more commonly used criteria of economic development are increase in national income, per capita real income, comparative concept, standard of living and economic welfare of the community etc.

1. National Income as an Index of Development:

There is a group of certain economists which maintains the growth of national income should be considered most suitable index of economic development. They are Simon Kuznets, Meier and Baldwin, Hicks D. Samuelson, Pigon and Kuznets who favored this method as a basis for measuring economic development. For this purpose, net national product (NNP) is preferred to gross national product (GNP) as it gives a better idea about the progress of a nation.

According to Prof. Meier and Baldwin, “If an increase in per capita income is taken as the measure of economic development, we would be in the awkward position of having to say that a country had not developed if its real national income, had risen but population had also risen at the same rate.”

Similarly, Prof. Me de maintains that, “Total income is a more appropriate concept to measure welfare than income per capita.” Therefore, in measurable economic development, the most appropriate measure will be to include final goods and services produced but we must allow for the wastage of machinery and other capital goods during the process of production.

Arguments in Favor of National Income:

There are certain arguments for stressing real national income as a measurement of economic development.

They are:

(i) A larger real national income is normally a pre-requisite for an increase in real per capita income and hence, a rising national income can be taken as a token of economic development.

(ii) If per capita income is used for measuring economic development, the population problem may be concealed, since population has already been divided out. In this context, Prof. Simon Kuznets writes, “The choice of per capita, per unit or any similar measure to gauge the rate of economic growth carried with it danger of neglecting the denominator of the ratio.”

(iii) If an increase in per capita income is taken as the measure of economic development, we are likely to be put in an awkward situation of saying that a country has not developed if its real national income has increased but its population has also increased at the same rate.

Arguments against National Income:

Despite the favourable arguments, national income as a measure of economic development suffers from certain shortcomings:

(i) It cannot definitely be said that economic welfare has increased if the national and even the per capita income may be rising unless the distribution of income is equitable.

(ii) Expansion of national and per capita income cannot be identified with enrichment because the composition of the total output is also important. For example, an expansion of total output could be accompanied by a depletion of natural resources or it could compose of only armaments or could consist of merely a greater output of capital goods.

(iii) It must not only consider what is produced but also how it is produced. It is possible that when real national output grows, the real costs i.e., ‘pain and sacrifice’ of the society may also grow.

(iv) It is difficult to determine proper deflators to eliminate the effects of price changes in an underdeveloped countries.

(v) It is also complicated when average income is rising but unemployment exists due to the rapid growth of population, thus, such a situation is not consistent with the development.

2. Per Capita Real Income:

Some economists believe that economic growth is meaningless if it does not improve the standard of living of the common masses. Thus, they say that the meaning of economic development is to increase aggregate output. Such a view holds that economic development be defined as a process by which the real per capita income increases over a long period time. Harvey Leibenstein, Rostow, Baran, Buchanan and many others favor the use of per capita output as an index of economic development.

The UNO experts in their report on ‘Measures of Economic Development of Under-developed Countries’ have also accepted this measurement of development. Charles P. Kindleberger also suggested the same method with proper precautions in computing the national income data.

Arguments in favor of per Capita Real Income:

The aim of economic development is to raise the living standard of the people and through this to raise consumption level. This can be, estimated through per capita income rather than national income. If national income of a country goes up but the per capita income is not increasing, that will not raise the living standard of the people. That way, per capita income is a better measure of economic development than the national income.

Increase in per capita income can be better index of an increase in the welfare of the people. In advanced countries, national income has increased much faster than the growth rate of population. It means the per capita real income has been constantly increasing and this has led to the increase in welfare of the people. That way, per capita income can be considered a better index of the welfare of the people.

Arguments against Per Capita Real Income:

The real per capita income, a measure of economic development has been severely criticized by Jacob Viner, Kuznet etc.

(a) According to Meier and Baldwin, “If an increase in per capita income were taken as the measure of development, we would be in the awkward position of having to say that a country had not developed if its real national income had risen, but population has also risen at the same time.”

If in a country an increase in national income is offset by the increase in population, then we would be bound to say that no economic development has taken place. Similarly, if national income in a country has not gone up but population has reduced due to epidemic or war, in that case we would be bound to conclude that economic development is taking place.

(b) When we divide national income by population, the problem of population in that case is ignored. It confines the scope of the study.

The increase in per capita income is a good measure of economic development. In the advanced countries, per capita income has been on continuous increases because the growth rate of national income is greater than the growth rate of population. This has raised the economic lot of the people. In underdeveloped countries, there is very less capacity to produce per head. So, as the capacity to produce goes up these economies proceed towards economic development.

c) In this measure, distributive aspect has been ignored. If national income goes up but there is unequal distribution of income among different sections of the society, in that case rise in national income will be meaningless.

(d) In the underdeveloped countries where per capita income is regarded as a measure of economic development, with the increase in per capita income of these countries, there is also increase in unemployment, poverty and income inequalities. This cannot be regarded as development.

(e) Economic growth is multi-dimensional concept which involves not only increase in money income but also improvement in social activities like education, public health, greater leisure etc. Such improvements cannot be measured by changes in per capita real income.

(f) The data of per capita national income are often inaccurate misleading and unreliable because of imperfections in national income data, and its computation. That way, per capita real income cannot be free from weaknesses. Despite these drawbacks in the measure of real per capita income, many countries have adopted this measure as an indicator of economic development.

3. Economic Welfare as an Index of Economic Development:

Keeping in view the drawbacks of real national income and real per capita measures of economic development, some economists like Coline Clark, Kindleberger, D. Bright Singh, Hersick etc. suggested economic welfare as the measure of economic development.

The term economic welfare can be understood in two ways:

(a) When there is equal distribution of national income among all the sections of the society. It raises economic welfare.

(b) When the purchasing power of money goes up, even then there is an increase in the level of economic welfare. The purchasing power of money can go up when with the increase in national income there is also increase in the prices of goods. That means economic welfare can increase if price stability is ensured.

Thus economic welfare can boost with equal distribution of income and price stability. Higher the level of economic welfare, higher will be extent of economic development and vice-versa.

Arguments against Welfare Index:

In order to assess economic welfare, it is essential to know the nature of national income and the social cost of production. We face lot a practical difficulties while estimating these economic factors. It is on account of this reason that many economists do not consider economic welfare as a good measure of economic development. Also the concept of welfare is subjective in nature which cannot be measured. Also welfare is a relative term which differs from person to person.

4. Comparative Concept:

Economic development is a comparative concept and it can easily be understood and measured. In a simple way, from comparative concept, we can ascertain how much the economic development has been attained in a country.

The comparison can be made by two methods over time period:

(а) Comparison within the country.

(b) Comparison with other countries.

(a) Comparison within the Country:

5. Measurement through Occupational Pattern:

The distribution of working population in different occupations is also regarded as a criteria for the measurement of economic development. Some economists regard the changes in the occupational structure as a source for measuring the nature of economic development. According to Colin Clark there is deep relation between the occupational structure and economic development. He has divided the occupational structure in three sectors.

(1) Primary Sector:

It includes agriculture, fisheries, forestry, mining etc.

(2) Secondary Sector:

It consists of manufacturing, trade, construction etc.

(3) Tertiary Sector:

Here we should note that the measurement of economic development through occupational patterns is not considered as satisfactory on following grounds:

(i) It is not possible to clearly classify the occupations in an underdeveloped economy in three distinct categories

(ii) Secondly, in the early stages of development, the activities of tertiary sector like transport, communications, trade etc. are inadequate and insufficient. Consequently the chances of employment in these activities are very restricted.

6. Standard of Living Criterion:

Another method to measure economic development is the standard of living. According to this view, standard of living and not rise in per capita income or national income should be considered an indicator of economic development. The very objective of development is to provide better life to its people through improvement or upliftment of the standard of living. In other words, it refers to increase in average consumption level of the individual. But, this criteria is not practicably true.

Let us suppose, national income and per capita both increase but the government mops up this income with the way of heavy dose of taxation or compulsory deposit scheme or any other method, in such a situation, there is no possibility to raise to average consumption level i.e., standard of living.

Moreover, in poor countries, propensity to consume is already high and stern efforts are made to reduce superfluous consumption in order to encourage savings and capital formation. Again ‘standard of living’ is also subjective which cannot be determined with objective criterion.

Which is the Best Measure of Economic Development?

After studying all the above methods of measurement of economic development we are likely to be confused and the question might arise as to which of the above measures of economic development is the best. Answer depends on the objective of measuring economic development. However, after considering form different point of view it may be concluded that GNP or per capita is the best method of measuring economic development.

In the words of Prof. R.G. Lipsey, “Whatsoever changes there may be in future in the measurement of economic development they cannot fully replace gross national product (GNP).” Economists and U.N. Organisations use GNP per capita as the measurement of economic development.