Gross Domestic Product – Dutch Uncles

Here is How Lockdowns Have Hit India’s GDP Growth

Aakash Sharma — Sun, 25 Apr 2021 07:35:04 +0000

The Indian economy shrank by a whopping 23.9% in 2020 due to COVID-19 induced lockdowns. The contraction did not surprise many as the Indian economy was already dramatically slowed down way before the pandemic hit.

Regardless, the sharp decline in the GDP has been disastrous for small businesses and the large segment of Indian MSMEs, who continue to suffer doubly – on health emergency and economic deprivation fronts.

2020 and Lockdown – A Disaster for India’s GDP

Since the first quarterly data was released in 1996, India had the lowest record for the April-June quarter in 2020 for the first time. It was worse than the 21.7% drop in Britain’s economy, the worst among the 20 largest economies in the world.

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By and large, the average annual growth of the Indian economy and GDP has been around 7% since the economic liberalisation of the 1990s.

The GDP growth rate in April-September 2020 contracted by 15.7 per cent compared with a 4.8 per cent growth in the same period of 2019. In 2020, the state of millions of excluded migrant workers made it clear that the COVID induced lockdowns had the worst impact on the MSME sector and small business in India. That is why the government established the Atmanirhbar Package for aiding MSMEs and India’s vulnerable. But the scheme fell short of its objectives and widely focused on loan guarantees than actual cash relief.

With a Lockdown in View, 2021 Also Looks Bleak

In the second week of April, India’s business activity has started to drop dramatically, and the economic situation could deteriorate further as COVID cases are skyrocketing. The Nomura India Business Resumption Index, which tracks high-frequency economic indicators like financial mobility, is about 16 percentage points below the normal levels.

Although India has not yet declared a national lockdown, severe national bottlenecks to curb the cases severely impact businesses, especially small, medium and micro-companies. Economic activities are getting affected across the country due to curbs imposed by states amid a surge in COVID-19 cases.

The Nomura Care ranking has also reduced the estimated GDP growth value of the GDP for the 2021-22 fiscal year to 10.2% from the previous estimate of 10.9. As India has no choice but to tighten restrictions due to deaths and accidents, more businesses may be affected in the coming months. Economists indicate that the economic impact of the second wave could intensify in the next few weeks due to lower mobility.

However, energy demand and occupancy rates remained essentially unchanged. Companies in the aviation, automotive, tourism, hospitality, restaurants and other sectors are likely to be subjected to new government restrictions to contain the disease. But one sure thing is that the Indian economy, and indeed India’s small businesses, cannot bear another nationwide lockdown.

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Understanding External Debt: All you need to know

Aakash Sharma — Fri, 26 Feb 2021 04:35:04 +0000

External debt is a national debt borrowed from foreign lenders, including commercial institutions, banks, governmental or global financial entities. The loan has to be repaid with interest applied on it over time. To even out the loaned capital, a borrower nation can adopt various repayment methods, including trade and export options for the lending country.

If a country fails to repay its external debt, it spirals down the vicious debt trap. If the state does not repay its external debt, it is declared as a defaulter on the global financial institution’s books. External loans can take the form of supplementary loans, where the borrower has to use the lender’s financing costs in the state.

How can an external debt crisis occur?

A debt crisis can arise when a country with a weak economy cannot pay off its external debt because of its incapacity to produce, sell and profit from its assets. The International Monetary Fund (IMF) is a critical organisation that supervises countries’ external debt. The World Bank issues a quarterly bulletin on external debt statistics.

If a country is incapable or unwilling to pay its external debt, it is considered bankrupt. This can lead lenders to reject future asset sales required by the foreign country. Failing to repay the loan threatens the borrower’s currency with the collapse and stagnation of its macroeconomic growth.

Source: International Monetary Fund

How do borrowers use external debt?

In addition to governments, corporations can also borrow external loans. In many cases, the external debt is tied up in fixed loans, which means that the money secured by the funding must be used in the country providing the financing. For example, a loan can allow a country to purchase its resources from the loan sanctioning country.

Foreign loans, especially this bond sort of loaning system, can be taken for specific purposes. Borrowers can use this financial support to respond to human needs or disasters. For example, if there is a drought in a country and the affected nation cannot provide emergency aid with its own funds, it can ask for the foreign debt to buy essentials from a foreign donor country. Or, when a country needs to build energy infrastructure, it can use its external debt by acquiring resources such as materials designed to produce energy in, say, an unoccupied area.

The debtor, or the entity that owes money, can be a government, business, or citizen of that country. Debt includes amounts owed by private commercial banks, foreign governments, or international financial institutions such as the International Monetary Fund (IMF) and the World Bank.

Role of principal and interest in external debt

If borrowed charges are paid regularly, as is often the case, they are called interest payments. All other expenses of financial value from the lender to the borrower that reduce the principal amount are called costs.

However, the interpretation of external debt does not differentiate between the initial payment and the payment of interest or the cost of both. Besides, the description does not indicate that involved parties must know the principal and/or interest’s future price for the obligation to be classified as debt.

Vital elements of external debt

The IMF defines the main components of external debt as the following:

Residency Clause

To be considered an external loan, the loan must be sanctioned by a non-resident to a country’s resident. Place of residence is determined by whether the centres of economic interest of creditors and borrowers are common- and not necessarily by nationality.

Current and not contingent

The definition of foreign debt does not include contingent responsibility. These are defined as contracts in which one or more conditions must be met before a financial transaction can occur. But from a weak perspective, there is analytical interest in the potential consequences of contingent liabilities in the economy, especially in institutional sectors such as government.

Generally, external debt is divided into four heads:

Guaranteed Government and State Debt: Guaranteed government and state debt encompass the long-term external responsibilities of the public sector, including the national government, state-owned companies, development banks, and other related industries.

Unsecured Personal Loans: The servicing of unsecured personal loans is the external responsibility of a private lender, which is not guaranteed by any public body.

Deposits with the Central Bank: For deposits with the central bank, commercial banks are usually required to deposit money into a central bank account. This amount is usually part of a bank’s reserve.

IMF Loans: The purpose of IMF loans is to repay member countries’ debts, stabilise their economies, and achieve sustainable economic growth. The role of solving debt crisis is at the heart of the IMF fund.

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If a country fails to repay its external debt, it spirals down the vicious debt trap. If the state does not repay its external debt, it is declared as a defaulter on the global financial institution's books.

External debt stability

Sustainable debt is the level at which the recipient can meet current and future obligations and accept redistribution or repayment to avoid arrears by allowing proper economic growth. The stability of external debt is generally analysed over the medium term.

These terms are statistical evaluations that properly consider economic variables, debt, and other indicators to determine the economy’s appropriate risk and policy adjustment requirements. In these analyses, macroeconomic uncertainties, such as the current account’s opportunity, and policy ambivalence, like fiscal policy, tend to dominate the medium-term outlook.

External debt sustainability indicators

Many indicators determine the stability and sustainability of external debt. The angles abound among economists don’t specify a single predictor for estimating the sustainability of a loan. These indicators are primarily like ratios—i.e., comparing two heads and the relation thereon and facilitating the policymakers in their external debt administration exercise.

These indicators can be thought of as dimensions of the country’s “solvency”. They consider the stock of debt at a specific time concerning the country’s ability to generate resources to repay the outstanding balance.

Examples of debt burden indicators include:

Debt to GDP Ratio: The debt to GDP ratio is an easy way to compare a country’s economic performance (measured in terms of gross domestic product) with its debt.

External Debt-to-exports Ratio: It is defined as the total outstanding debt ratio at the end of the year to the economy’s exports of goods and services for that year.

Risks associated with external debt

Foreign loans carry two main types of risks. First, as with mortgages, unexpected changes in mortgage rates can occur. This can lead to widespread insolvency if interest rates rise, for example, because debtors may not pay higher interest rates, increasing the risk of a systemic crisis.

An unexpected devaluation of the rupee could pose severe problems for Indian companies repaying loans in dollars. They would have to spend more rupees than expected to buy the currencies they need. Lenders usually take possible currency fluctuations into account when determining the interest rates for a loan. However, these predictions are not always perfect. Unexpected changes in exchange rates can still bring you incredible gains or losses.

Since the COVID-19 pandemic began, several emerging market currencies have depreciated sharply against the US dollar. The rupee, in particular, has fallen by around 7% since 2020. The devaluation of emerging market currencies is due to increased demand for dollars by investors who yearn to sell their assets in rising markets and invest in the United States, where earnings are proliferating.

Latest Data as of 2019 (Source: Govt. of India)

External debt and India

Rising interest rates could lead to larger capital outflows from emerging markets, causing unexpected changes in interest rates and rupee prices. Therefore, both the government and non-government borrowers in India are open to foreign debt and are consequently more susceptible to losses.

The Reserve Bank of India (RBI) held foreign exchange reserves as of January 2021 amounted to approximately $584 billion. This power of the central bank’s fire makes it possible to take advantage of the RBI and save troubled debtors.

We cannot conclusively state whether external debts are good or bad for a country. Taking loans from international forums and partners is a good and reliable way to raise money in emergency times. But, failing to repay those loans can prove to be fatal for countries, as is the case in many modern-day economies, like Pakistan in South Asia and Nigeria in Africa, to name a few.

Nevertheless, a well-formed national policy, leadership and international commitment are necessary to help nations and their people in need.

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Fiscal Deficit: An Important Component of Gross Domestic Product

Smruthi Krishnan — Wed, 17 Feb 2021 04:35:04 +0000

You must have heard in the recent Union Budget allocation the mention of Fiscal Deficit or the financing of fiscal deficit and wondered what it means or how changes in fiscal deficit affect you as an entrepreneur or your company in an economy. Before we dig deeper into Fiscal Deficit, let’s understand what is a government deficit and how fiscal deficit forms a part of it.

Fiscal deficit as a way of measuring government deficit

Deficit is always defined as the amount by which the spending exceeds the earnings in a budget. The Government Deficit is the amount by which the government spending exceeds government revenue according to the budget set by the government. It shows the financial status of the economy. Government deficit can be measured via Revenue Deficit, Fiscal Deficit or Primary Deficit.

The revenue deficit is the surplus of government’s revenue expenditure over its revenue receipts. It reflects only current income and current expenses. Usually, governments resort to disinvestments as a corrective measure to reduce revenue deficit.

Fiscal deficit on the other hand is the difference between the government’s total expenditure and its total receipts excluding borrowing. The fiscal deficit is always financed by borrowing. Thus, it reflects the total borrowing necessities of the government whether it is from the public, RBI or foreign aids.

And primary deficit is the amount of money the government needs to borrow other than the interest payments on the formerly borrowed loans. It is the difference between fiscal deficit and the interest liabilities.

Difference Between Fiscal Deficit and Revenue Deficit

The fiscal deficit is the excess of Budget Expenditure over Budget Receipt other than borrowings while on the other hand, Revenue deficit is the surplus of Revenue Expenditure over Revenue Receipts. Fiscal Deficit reflects the total government borrowings during a fiscal year while Revenue deficit highlights the inefficiency of the government to reach its regular or recurring expenditure. Fiscal deficit is calculated as the difference between Budgetary deficit and borrowings while revenue deficit is measured by the difference between revenue expenditure and revenue receipts.

How is the fiscal deficit calculated?

An Economy’s fiscal balance is measured by the difference between government’s revenue and its expenditure in a given financial year. Fiscal deficit occurs when expenditure of the government exceeds its revenue in a year. It can be calculated both in absolute terms and as a percentage of the country’s gross domestic product (GDP). However, it includes only taxes and other revenues and excludes all kinds of borrowings used to counter the shortfall.

The mathematical formula is:

Total revenue generated – Total expenditure

Where the total revenue is = Revenue receipts + recovery of loans + other receipts of the government.

Revenue receipts of the government include Corporation Tax, Income Tax, Custom Duties, Union Excise Duties, GST and taxes of Union territories and Non-tax revenues like Interest Receipts, Dividends and Profits, External Grants, Other non-tax revenues and Receipts of union territories. On the other hand, expenditures of the government include Revenue Expenditure, Capital Expenditure, Interest Payments, Grants-in-aid for creation of capital assets. The Budget allocates funds for payments of salaries, pensions, infrastructure, development, health and education, science and technology, etc.

High deficits often occur when the government spends a lot on developmental works like construction of highways, ports, roads, airports that generate revenue for the government in future time periods. Fiscal debts occur when there are persistent large fiscal deficits over the years.

What causes Fiscal Deficit?

Governments spend their revenue for various handouts like infrastructural development, assistance to the vulnerable sections of the society, research and development, health and education extra. Excess spending on these as compared to revenue inflow leads to fiscal deficits. High fiscal deficits are beneficial for the economy if the borrowed money is used for the creation of productive assets like highways, roads, ports and airports which will help boost economic growth and result in a rise in employment.

What are the Implications of Fiscal Deficit?

Increased foreign dependence: Government borrowings include borrowings from foreign countries. This often leads to increased economic and political interference from these countries.
Debt trap: The first and foremost issues that Fiscal deficits create are debt traps. As we know, fiscal deficits lead to borrowing which causes problems like repayment of loans and payment of interest on these loans. With increase in government borrowing, the liability of repaying loans in future with added interest rises. Interest payments increase revenue expenditure which results in increased revenue deficits. This in turn, pushes the government to borrow more, again increasing the interest payments. This leads to a vicious circle and the economy ends up in a debt trap.
Inflation: To finance fiscal deficits, governments mainly borrow from the central bank which lends money by printing more currency-notes (called deficit financing). This results in increased money circulation which often leads to inflation as prices and incomes hike.
Expenditure wastage: High fiscal deficit results in the government undertaking unnecessary expenses which often go waste.
Slows down future growth: The borrowings for fiscal deficit cannot entirely be used for growth and development as that part is used for payment of interests. This means that borrowings for fiscal deficit end up becoming a burden in the future in terms of repayment of the loan and interest rates. This slows down growth in the future periods.

Financing a Deficit:

Fiscal debts are usually financed using two sources that have been mentioned above:

Borrowings

Governments finance fiscal deficit by borrowing from commercial banks, internal sources like the public, from external governments, and other external financial institutions or International Agencies like the International Monetary Fund or the World Bank.

Deficit Financing or Printing New Currency

Governments also borrow funds from their central bank against their securities to meet the fiscal deficit. For this, the central banks issue new currency. This process is known as Deficit Financing.

Government securities for example, treasury bonds are put on sale. When governments issue bonds, they sell them through banks. This usually reduces funds that can be lent or be invested in other businesses. This often reduces the capital stock in the economy and also affects interest rates. Government bonds are extremely safe investments. The interest rate paid on loans to the government therefore and risk-averse investments. This pushes other financial assets to increase the interest rates they pay to shift purchasers from investing in government bonds. This is often used by federal banks in open market operations to control interest rates in the economy while keeping their monetary policy constant.

India’s Union Budget analysis: Fiscal Deficit

The budget estimated a central fiscal deficit of 9.5 per cent (10.2 including off-budget borrowing) of GDP in 2020-21, and 6.8 per cent (7 including off-budget) for 2021-22. The nominal deficit includes two components namely structural and cyclical deficit. The structural deficit is the amount that remains once we remove the revenue shortfall and expenditure increase due to sharp deviations in trend growth. During booms, the cyclical deficit is lower than the structural whereas during a slump, it is vice versa.

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The fiscal deficit is always financed by borrowing. Thus, it reflects the total borrowing necessities of the government whether it is from the public, RBI or foreign aids.

Disadvantages of Deficits

Budget deficits are always or mostly seen in a negative light. Several economists are of the view that deficits lead to crowding out of private borrowing, distort interest rates, scale non-competitive firms, and expand effects of people who do not participate directly in the market. But governments end up using deficits to expand on infrastructural development especially in the short run.

Deficits were originally meant to be run during recessions. And these deficits were to be corrected after the economy recovered from the recession. However, in reality, this is not the case. Increasing taxes and reducing government programs is not welcomed by the public even during booms. This often forces governments to run deficits persistently after each year without any attempt to correct it which finally leads to large public debts.

As governments increase borrowings to meet deficits, their liability of repaying loans in future with added interest spikes. Interest payments hike revenue expenditure further increasing revenue deficits. The government is forced to borrow more and the cycle leads to the economy ending up in a debt trap.

Deficits also lead to wastage of resources and funds. Deficit financing through money circulation also leads to inflation as the government mainly borrows from the central bank which prints more money. Borrowing for the fiscal deficit becomes a burden in the future in terms of repayment slowing down growth in the future and often increases foreign dependence which may lead to socio-economic interference.

Benefits of Fiscal Deficits

Many people do not view large government debt as something that negatively affects the economy. Leaders from both conservative and liberal administrations end up running large deficits in order to create tax cuts, stimulate spending for welfare, public goods, infrastructure, to finance wars and other public benefits. The public and businesses also end up believing that fiscal deficits are beneficial as they avail lower taxes as well as more government services.

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Trade Deficit – A Blessing or A Curse

Smruthi Krishnan — Fri, 05 Feb 2021 04:35:02 +0000

We keep coming across articles that talk about reduction or surge in a country’s trade deficit and how it impacts us across the globe. But what is Trade Deficit? How does our country’s deficit impact us? How does the United States trade deficit affect us

First, let’s begin by understanding what is a Balance of Trades. Balance of trade (BOT) is defined as the difference between the value of a country’s exports and the value of its imports for a given period. It is simply the total value of exports minus the total value of imports. BOT is used to measure a country’s relative economic strength. Countries that import more than what they export in terms of value have a Trade Deficit while on the other hand, countries that export more than what they import have a trade surplus. Usually, countries with trade deficits borrow money to pay for their goods and services while those with surpluses lend money to countries with deficits. As trade balances give an indirect measure of foreign investment in a country, it also reflects the country’s economic stability.

When Does a Trade Deficit Occur?

Trade deficits usually occur when a state does not produce everything and borrows from foreign states to pay for its imports. It can also occur if domestic companies produce goods overseas as the raw material used for production acts as exports and finished goods end up being imports. These imports are excluded while calculating an economy’s GDP even if the company is domestic.

Countries that experience a deficit are those that lack efficiency and capacity to produce their products due to lack of skill or resources or because they wish to practice specialization of goods. Trade balances indicate the exposure of the economy to the rest of the world.

To calculate the balance of trade, take an example of the United States. Suppose their total import value is $200 billion in goods and services during a given period and their export value is $160 billion. Then their trade balance during that period is – $40 billion or they have a trade deficit of $40 billion.

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Countries that experience a deficit are those that lack efficiency and capacity to produce their products due to lack of skill or resources or because they wish to practice specialization of goods.

What Does a Trade Deficit Signify?

Usually, economists subtract debit items (imports, foreign aid, domestic spending and investments abroad) from credit items (export, foreign spending and investments in the domestic country) to calculate trade deficit or surplus for a given period. According to the Reserve Bank of India, Indian Trade Balance recorded a deficit of 15.4 USD bn in Dec 2020 and a deficit of 9.9 USD bn in Nov 2020. The average deficit value is – 377.7 USD mn for India with an all-time high of 652.0 USD mn in Jun 2020 and an all-time low of – 20.2 USD bn in Oct 2012.

Around the world, the scenario is different for different countries. For instance, the United States has had a persistent trade deficit since the 1970s. While China’s trade surplus has spiked despite the pandemic reducing global trade. In 2019, Germany had the largest trade surplus followed by Japan and China. The United States had the largest trade deficit with the United Kingdom and Brazil right behind.

Trade Deficit and Economic Stability

A trade deficit is not necessarily a practical indicator of any economy’s stability. It should be observed relative to the business cycle and other indicators. During recessions, countries try to increase exports to induce jobs and demand while during booms, they import more to encourage price competition to control inflation.

Deficits can initially raise an economy’s standard of living as residents have access to a larger range of goods and services at more competitive prices. With lower prices, it keeps inflation in control. However, at later stages, it can lead to the outsourcing of jobs to foreign countries creating fewer jobs at home due to an increase in imports. At the same time, foreign companies increase hires to keep up with increased export demand. A trade deficit often makes domestic currency cheaper in a floating exchange rate system. This makes imports more expensive, pushing consumers to reduce consumption of imports while shifting to less expensive domestic goods. This increases the competition of exports in global markets and reduces the deficit by itself. However, deficits are also problematic in the long run. If a country persistently runs deficits, citizens of other countries acquire funds to buy capital in that nation.

Trade Deficit and Inflation

International trade is measured in U.S. dollars (United States of America). When a country runs a deficit, the demand for dollars to pay for imports is more than the supply of dollars for exports. This leads to a rise in the value of the dollar against domestic currency. This reduction in value pushes importers to increase the market price of products they produce as the cost of imported material increases. Due to the increase in the price of goods, workers demand an increase in wages and so on. The domino effect creates cascading triggers in all markets which leads to inflation in the economy.

Clearing a Trade Deficit

As we have already seen the disadvantages of a deficit, countries always try to reduce the deficit. One way to do so is by using deflationary policies like raising direct taxes or increasing monetary policy interest rates. Deflationary policies via a rise in taxes slow down consumption growth by reducing disposable income. This reduces demand for imports and also helps to lower inflation which then improves the price competitiveness of export industries. However, such policies contract planned capital investment which damages productivity and has the potential to worsen the trade deficit.

Another way to go about it is for the central bank to change monetary policy. It can also intervene in the currency markets to depreciate the exchange rate against major trade partners to make exports more competitive in foreign currencies.

A country can also use supply-side policies to increase productivity and make exports more competitive at the same time reducing dependency on imports. Supply-side policies theoretically have the best prospect of achieving a sustainable reduction of the deficit.

Trade Deficit and Exchange Rate

When imports exceed exports, a country’s currency demand in terms of international trade is lower. This makes the currency less valuable in international markets during deficits. Trade balances affect currency fluctuations in most cases. However, countries can try to make trade balances less influential by managing a portfolio of investments in foreign accounts. This controls the volatility and movement of the currency. Economies can also agree on a pegged currency rate to keep the exchange rate of their currency constant at a fixed rate.

As currency depreciates, exports from the country become more attractive as they become less expensive. The domestic country might start buying fewer dollars as imports become more expensive and foreigners buy more domestic goods as they are now cheaper. This gradually affects the balance of trade. The domestic country would then start exporting more and importing less, reducing the trade deficit.

Trade deficits become more dangerous with fixed exchange rates. As devaluation of the currency is impossible, trade deficits continue increasing unemployment significantly. A partial reason behind the European debt crisis was that some EU members were running persistent trade deficits with Germany. Exchange rates could no longer be adjusted between countries in the Euro zone leading to serious trade deficit problems.

Trade Deficit, Interest Rates and Investments

Higher interest rates potentially lead to a reduction in net exports. And negative net exports lead to a trade deficit. A higher interest rate means foreign investors induce more money into our domestic economy as it results in higher returns. They exchange their foreign currency for our domestic currency increasing demand for domestic currency. This raises the domestic currency’s value against foreign currency. This makes it cheaper for us to buy foreign goods and more expensive for foreigners to buy our goods. This means our imports go up and exports go down reducing net exports.

Deficits also occur if a country is a desirable destination for foreign investment. The U.S. dollar’s image as the world’s reserve currency induces a strong demand for U.S. dollars for which foreigners sell goods to Americans to obtain dollars. Several nations run cumulative trade surpluses with the U.S.

Conclusion:

Trade deficits are not that uncommon and many times not so dangerous. However, large trade deficits should always be avoided as they can lead to foreign dependency in terms of lending and borrowing. The final question remains whether a deficit is a blessing or a curse. Deficits can raise an economy’s standard of living with a larger range of goods and services at more competitive prices while keeping inflation in control. But it can also lead to outsourcing of jobs to foreign countries creating fewer jobs at home due increased imports. Trade deficits can thus be both a blessing and a curse, it depends on the business cycle, the country’s economic landscape and global markets

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Trade deficits are not that uncommon and many times not so dangerous. However, large trade deficits should always be avoided as they can lead to foreign dependency in terms of lending and borrowing.

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Disposable Income 101: All You Need to Know

Smruthi Krishnan — Mon, 01 Feb 2021 06:25:45 +0000

Whether you are an established entrepreneur, small scale businessman, a recent start-up founder or a consumer in the market, what you earn and what you spend is defined by your disposable income. But most of us aren’t aware of the term ‘Disposable Income’ and often confuse it with personal income. Personal and Disposable income are different and are not interchangeable. Disposable income is very simple language is the amount of money that an individual or household has with them to spend or save after income taxes have been deducted. In other words, it is the income you have in hand that can be disposed off (spent or saved) after paying your taxes.

For instance, let’s assume that a household has an income of Rs 3,00,000, and it pays a 35% tax rate. The disposable income of the household will be Rs 1,05,000—that is, Rs 3,00,000 – (Rs 3,00,000 x 0.35). Thus, the household has Rs 1,05,000 to spend on investments, savings, luxuries and necessities.

Though it seems like a simple concept, disposable income is one of the key economic indicators when it comes to analysing a country’s overall economy. Economists use disposable income as the foundational base to calculate other indicators like discretionary income, personal income, marginal propensity to consume or save, savings rates, etc. Disposable income is one amongst the three metrics of income, the other two being National Income and Personal Income, measured and recorded by the National Income and Product Accounts which is maintained by the Bureau of Economic Analysis.

As an entrepreneur, learning about disposable income helps you understand the consumer market better as it determines the aggregate demand and corresponding consumption spending patterns. Following DI statistics helps you decide portfolios, investments and supply chain of production that lead to profit-maximisation. Let’s dig a little deeper into the relationship between Disposable Income and other economic indicators.

Difference between Disposable Income and Discretionary Income

Discretionary income is the measure of income a household has to spend, invest, and save after paying for taxes and necessities. Necessities include student loans, mortgage payments, credit card debts, etc. Discretionary income is obtained from disposable income which is also why the two-income types are very similar and often confused.

Discretionary income subtracts all payments for necessities from DI like rent payment, health insurance, food, and transportation. It is that portion of disposable income that can be spent the way you want to spend it. It is usually the first thing that reduces when you lose a job, face a loss or pay reduction. During recessions, discretionary income becomes tight and ventures that sell discretionary goods, such as jewellery or vacation packages, suffer the most during recessions like the recent COVID-19 pandemic. Economists observe the sales of discretionary goods to analyse recessions and recoveries. Disposable income includes both necessity spending and luxury spending post taxes. Often people with low discretionary income have lower standards of living than people with higher ones even if they have the same disposable income.

To calculate discretionary income, let’s assume a household has an income of Rs 2,00,000 and pays an income tax rate of 25%. The household will have transportation, rent, insurance, food and other necessities adding up to 40,000 a year. Their discretionary income is 19,00,000 or the amount left after subtracting taxes and necessities. This is calculated as Rs 2,00,000 – (Rs 2,00,000 x 0.25) – Rs 40,000 for the year.

When we calculate discretionary income, we initially calculate our disposable income by subtracting taxes from personal income. Then we tally up our necessity expenditures like rent, utilities, mortgages, food, clothing, etc.

Disposable versus Personal Income

By definition, disposable income is calculated as the difference between personal income and personal tax and nontax payments. Usually, in numerical terms, personal tax and non-tax payments form around 15 per cent of personal income. Thus, DI comes to be about 85 per cent of your personal income. The equation below shows how we derive DI from PI by subtracting personal tax (PT) –

DI = PI – PT

Often people question the logic behind using disposable income in place of personal income when it comes to studying Macroeconomics. However, as mentioned before, it is not only about earning and receiving wages and payments. A key portion of your earnings is directly and indirectly paid to the government via taxes. This amount is not available for spending or saving, so your consumption patterns depend solely on your disposable income.

Consequently, your savings patterns also depend on DI. The main two purposes of studying DI are consumption expenditure (C) and saving (S)

DI = C + S

The consumption expenditure mentioned here put together with investments, government expenditure and net exports sums up to the Gross Domestic Product. The savings enter financial markets where they are borrowed by entrepreneurs and governments for investment purposes. Thus, disposable income is an indispensable component of Macro-economic studies.

Most of the time, consumption expenditure forms around 97 to 98 per cent DI while savings form around 2 to 3 per cent of DI. This division often fluctuates but remains more or less the same.

How Disposable Income affects Consumer Spending

John Maynard Keynes developed the theory of consumption which was based mainly on DI or income after paying taxes. To understand this, we need to define MPC or Marginal Propensity to Consume which is the change in the amount a consumer spends due to a change in their DI. For instance, let’s say your disposable income increases by Rs. 5000, you choose to spend Rs. 4000 of this on certain goods or services, then your MPC will be 4000/5000 = 0.8.

Similarly Marginal Propensity to save will be 1000/5000 = 0.2. The sum of MPC and MPS is always equal to 1. People with lower incomes usually have a higher propensity to spend with a change in their DI. If the government changes taxation, it directly affects disposable income and hence spending and levels of welfare. As an entrepreneur, you must be aware of how changes in DI affect consumer spending as the amount consumers spend will affect your earnings. An increase in DI increases spending which will in turn create more demand in the market and vice versa. Keep track of changes in taxes, MPC levels and demand to predict decisions for your ventures.

Effect of DI on the stock market

A surge in disposable income theoretically leads to a rise in stock valuations which correspondingly increases the overall stock market value. As we saw earlier, the increase in DI leads to households having more money to save or spend. This results in consumption growth. Consumer spending then creates the demand which is what helps keep companies profitable and pushes them to hire more workers as manufacturers raise their production to meet increased demand. This leads to a rise in wages which again creates more spending. Thus, a rise in consumption increases corporate sales and earnings, which raises the value of individual stocks. This turns into a market-wide rise in value with the potential to create an economic boom or inflation.

Disposable Income and Recession

Continuing from the above-mentioned points, the opposite also holds true. Assuming that disposable income decreases, households will have less amounts of money to spend and save. This forces them to consume less than what they did before. The decrease in consumption then reduces corporate sales and earnings, reducing the value of individual stocks. This in turn leads to a market-wide reduction in value with the potential to create a depression or recession.

However, increases in disposable income don’t always create a rise in the value of the stock market, and vice versa. For instance, during the wake of a recession or recovery period, even though DI increases, most consumers tend to not utilise their increased DI to raise consumption. In such situations, even an increase in disposable income results in a recession. So a rise in DI doesn’t necessarily lead to economic expansion.

Disposable income and Aggregate Demand

Aggregate demand is the total quantity of goods and services demanded in an economy at a given price level. An important component of the AD equation is C(Y-T) which shows consumption as a function of DI. The function of consumption is aggregated across all consumers. Therefore it can be applied for all incomes and tax brackets. As consumption forms a very necessary metric for calculating AD, disposable income is also an important metric for AD, an increase in DI increases consumption which increases AD. Aggregate Demand is an important metric for any venture to operate in a market as it decides how much to produce, how often to produce and most importantly how to produce.

Now that you know everything there is to know about disposable income, make sure you observe the trends and apply them in your ventures whilst making key decisions. To learn about Exchange Rate, check out Dutch Uncles Article on All you need to know about Exchange Rate.

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Gross Domestic Product (GDP): All You Need to Know

Aakash Sharma — Sat, 19 Dec 2020 12:02:56 +0000

Understand the concept and grow your business.

While starting a new business, it is extremely important to understand the state of economy. And for understanding and assessing economic conditions, the best tool at your disposal is the Gross Domestic Product (GDP). It is the by far the most effective measure available for calculating a country’s overall economic strength and capacity. It is closely connected with the size of a country’s economy – Nominal GDP, and the purchasing power of a country’s consumers- GDP per capita.

So, before starting your business, get your concepts clear about the economy and GDP.

What is GDP?

By definition, gross domestic product, commonly abbreviated as GDP, is the monetary or market value of all finished goods and services produced in a country over a particular period. This monetary value is then used to analyse and inspect a country’s economic condition. Following parameters are taken into account for calculating the GDP of any nation:

Personal Consumption (Expenditure): Personal consumption is indicative of all the goods and services that are purchased by individual consumers of a country. This parameter is essential for calculating as it is the indicator of the purchasing power of any given economy.

Government Consumption (Expenditure): Government spending means the amount of money spent by the government in any given year. This expenditure does not include transfer payments by the government, i.e., charges for social security or unemployment benefits.

Investment: Investment represents the valuation of capital goods added by a country to its assets in a given year. Capital Goods are the physical assets used for production processes and manufacturing of goods and services. Infrastructure, buildings, machinery, equipment, vehicles, tools, etc. are some of the examples of capital goods and investment.

Net Exports: Total value of goods and services that are sold to a foreign market- to consumers, businesses, or governments in another country accounts for the net exports of a country. These exports bring money into the country, increasing the GDP of exporting nations.

Foreign Direct Investment (FDI): Suppose an American multinational company produces and manufactures goods, and generates physical capital like cash, real estate, equipment, etc. in India. This adds to the Indian economy and therefore, is taken into account while calculating.

GDP Growth Rate

GDP is calculated to track the size and direction of any country’s economy. GDP Growth Rate is calculated quarterly and used to compare a country’s economic growth or decline with previous quarters. By comparing the one-quarter of a country’s GDP to the last quarter, the economic growth (or decline) is measured. For example, India’s growth rate for the first quarter of 2020 was 3.1 per cent, and for the second quarter it fell to 23 per cent (according to data by the Government of India) this means that the economy not only slowed down but contracted significantly too.

High Growth Rate – Economy is growing fast

Low Growth Rate – Economy is growing slow

Negative Growth Rate – Economy is contracting

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GDP is the by far the most effective measure available for calculating a country’s overall economic strength and capacity.

How is the GDP of India calculated?

GDP calculation includes the summation of the total value of all goods and services produced over a particular period. This calculation includes goods and services that are produced by domestic businesses and companies, as well as the physical capital goods created by foreign companies in India. Generally, two simple methods are used to calculate the GDP, which are:

Income Method: This method adds up the total income generated within a year by businesses, workers and asset owning entities, and

Expenditure Method: This method adds up consumer spending, investment, government expenditure, and net exports.

India’s GDP over the years

Industry sectors contributing to India’s GDP calculation

The following sectors are taken into account:

Agriculture, Forestry and Fishing

Mining and Quarrying

Manufacturing

Electricity, Gas and Water Supply

Construction

Trade, Hotels, Transport and Communication

Financing, Insurance, Real Estate and Business Services

Community, Social and Personal Service

Different types of GDP

GDP is broadly classified into four types based on the methods used for its measurements. These types are:

Nominal GDP: This is calculated by evaluating the current market prices of goods and services. Nominal GDP estimates are commonly used to determine the economic performance of a whole country or region, and to make international comparisons. This method of measurement fails to take into account the differences in the cost of living in different countries.

Purchasing Power Parity (PPP) GDP: This is calculated by comparing economic growth and standards of living among different countries. This comparison is more accurate as it tells the exchange rate at which the currency of one country is converted to that of another country while purchasing the same amount of goods and services.

Real GDP: It is an ‘inflation-adjusted’ method of calculating the GDP of a country. By ‘inflation-adjusted’, it is meant that this calculates the real value of all goods and services produced in a country in a given year while comparing and adjusting the value of said goods and services from previous years’ prices called base-year prices.

GDP per Capita: It is calculated by dividing the GDP of a country by its population. It is calculated to determine a country’s economic output per person. It is a useful way to compare data of various countries.

Why does it matter for your business?

GDP matters for your business because it tells you if the economy is under stress, contracting, growing fast, etc. It is undoubtedly an essential tool for analysing a country’s economy. For businesses, investors and economists, GDP is the representation of economic production and growth. And economic output and growth significantly impact your business- be it a large company or a start-up.

Positive growth is indicative of the growth of the economy, which means that the necessary resources are available to people in the country, due to which goods and services, wages and profits increase. In a healthy economy, there is lower unemployment, and wages tend to increase as businesses hire more labour to meet the growing demand of the economy.

With the growth of economic activity in the country, the spending capacity of consumers increases more. And if you are a consumer-facing business, this gives a boost to your business as more sales take place.

One of the significant benefits of positive growth is that it boosts the small business and start-up industry. Investors rely on GDP growth while formulating an investment strategy. Big enterprises make a higher investment into expanding their assets as well as in new ventures. This gets the economic growth moving faster, and more increase triggers even more significant investments by investors into start-ups and new businesses.

Investments are closely associated with the GDP because a significant change in the GDP- either up or down– primarily impacts the stock market. A good economy, indicated by high growth, translates into higher earnings for companies and the stock value goes up. The reverse is also true, and a reduction in GDP ultimately translates into lower stock prices and loss of investors.

What happens when the economy underperforms? GDP Dips

An upward economic growth means a higher GDP and downward financial curve results in the dipping of GDP figures. When a country’s GDP is calculated to be negative, or when a decline is recorded for two quarters in a row, these are seen as the signs of an economic slowdown.

Remember, GDP is a tool, not something tangible like economic assets and capital goods. When economic activities start to go on a downward scale- a sharp fall in growth, employment, production and businesses- the economy is said to be underperforming. The economic slowdown is further identified when bankruptcies, reduced trade and crippling commerce become apparent; these are the confirmatory points of an economic downturn. This economic downturn is captured in the sharply falling GDP figures and negative growth rates.

An anomaly of economic slowdown or depression is that some businesses start to pick up in the slow economy. Factors like cheap labour and business’s cost positivity, as the bi-products of an economic downturn, are taken advantage of by some entrepreneurs.

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Small businesses’ share in the GDP is indispensable. They play a significant role in most economies, particularly in India.

GDP & Small Businesses – A Symbiotic Relationship

Association between small enterprises and the economy is unique. Where small businesses provide the much-needed impetus at the grass-root level, the economy protects them, fulfils their needs and provides extra care at the time of crisis in the form of loans.

Small businesses’ share in the GDP is indispensable. They play a significant role in most economies, particularly in India. They are essential contributors to job creation and production & manufacturing processes. Small businesses (MSMEs and SMEs) represent about 90% of companies and more than 50% of employment in India (source: Press Information Bureau, Government of India). These businesses create job opportunities and drive the country’s economic growth in smaller geographic areas. They make the market more competitive and productive.

GDP, therefore, is a critical topic for anyone who wants to have a detailed understanding of the economy before setting up a business. While starting a business, the ultimate goal is to attain financial gains. And for that, a thorough understanding of the economy and tools that help understand the economy, particularly GDP, is essential.

Read about GST, EPFO and other financial topics on our website.

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