Chapter 9

Measurement of Nation Income

Er. Shrutee Karna

Department of Civil Engineering

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 CONTENT

Measurement of Nation Income (5 hours)

9.1 Gross domestic product (Components, real and nominal gross domestic
product)
9.2 Unemployment (Measurement, job search, minimum wage law)
9.3 Inflation
9.3.1 Causes, effects and measurement of inflation
9.3.2 Constant and current cash flow
9.3.3 Equivalence calculation under inflation
9.3.4 Inflation controlling measures
9.4 Real and nominal exchange rates, fiscal budget and monetary policy
9.5 Financial statement

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 Gross domestic product (Components, real and nominal gross domestic product)
GDP is a broad monetary measure of a nation’s overall economic activity, valuing all the final
goods and services produced in a particular period of time, typically annually or quarterly,
within the country’s boundaries. Within each country, GDP is usually measured by a national
governmental agency.

GDP is considered to be one of the principal indicators in economics, allowing analysts to

build a better picture of a nation’s financial situation. A significant change in GDP, whether
negative or positive, usually reflects in the stock market.

When the economy is doing well, wages increase and a lower unemployment rate is indicated
as businesses demand more labor to meet the growing economic needs. Rising GDP signifies
that incomes within the country are increasing respectively as well as consumers purchasing
power, and vice-versa.

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 Gross domestic product (Components, real and nominal gross domestic product)

GDP has a large impact on nearly everyone within that economic environment. It can
affect everything from personal finances to investments to job growth.

Understanding the GDP of a given nation may be helpful for investors when making any
decisions in a particular region. It is also vital when comparing a country's growth rates
to find the best international opportunities. For example, an investor may choose to buy
shares in companies that are located in a rapidly growing economy in the hope of higher
returns.

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 Gross domestic product (Components, real and nominal gross domestic product)

1. Consumption (C)
Consumption means spending by households on goods and services.
Examples:
• Food
• Clothes
• Rent
• Transport
• Medical services
• Education fees
It is usually the largest component of GDP in many countries.

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 Gross domestic product (Components, real and nominal gross domestic product)

2. Investment (I)
Investment means spending on capital goods that help produce other goods and services
in the future.
Examples:
• Purchase of machinery
• Construction of factories
• Building houses
• Tools and equipment
• Business inventory
In GDP, Investment does not mean buying shares or bonds. It means spending on physical
productive assets.

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 Gross domestic product (Components, real and nominal gross domestic product)

3. Government Expenditure (G)

Government expenditure means spending by the government on public goods and services.
Examples:
• Roads and bridges
• Salaries of teachers and police
• Hospitals
• Defense services
• Public infrastructure

4. Net Exports (X−M)

Net exports are the difference between exports and imports.
Exports (X) = goods and services produced domestically and sold to other countries
Imports (M) = goods and services bought from other countries
So,
Net Export = X−M
If exports > imports, net exports are positive
If imports > exports, net exports are negative

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 Gross domestic product (Components, real and nominal gross domestic product)

Nominal GDP
Nominal GDP is the GDP measured at current market prices of the same year.
It includes changes caused by:
•change in output
•change in price level
So, if prices rise due to inflation, nominal GDP may rise even if production does not increase
much.

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 Gross domestic product (Components, real and nominal gross domestic product)

Real GDP is the GDP measured at constant prices of a base year. It shows the actual
change in production, excluding the effect of inflation. So, real GDP is a better measure of
economic growth.

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 Gross domestic product (Components, real and nominal gross domestic product)

Nominal GDP Real GDP

Nominal GDP is the total value of goods and Real GDP is the total value of goods and
services produced in a country measured using services produced measured using constant
current market prices. prices of a base year.

Uses current year prices of goods and services. Uses base year prices, so prices remain constant.

Includes the effect of inflation or deflation. If

Removes the effect of inflation, so it reflects only
prices rise, nominal GDP also increases even if
changes in production quantity.
production does not change.
Shows the total economic value in current Shows the actual growth in production of goods
money terms. and services.

Less accurate for measuring real economic More accurate for measuring economic growth
growth because price changes distort the value. because it isolates real output changes.

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 Gross domestic product (Components, real and nominal gross domestic product)

Prices are adjusted using a GDP deflator or

No adjustment is made for price changes.
base-year prices.

Difficult to compare economic growth over

Allows meaningful comparison of economic
different years because price changes affect
output across years.
values.

Not affected by inflation because price

Highly sensitive to inflation or deflation.
changes are removed.
May show increase even if production stays Shows increase only when actual production
the same but prices increase. increases.
Used to measure the current size of the Used to analyze real economic performance
economy in monetary terms. and growth rate.

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 Gross domestic product (Components, real and nominal gross domestic product)

Actual Dollars (Nominal/Current Dollars)

The actual amount of money physically spent, earned, or received at the time of a
transaction.
Impact of Inflation: They do not account for changes in the cost of living over time.
Usage: Used for straightforward cash flow tracking, such as knowing exactly how
many bills you need to pay a current bill or salary.

Example: If your salary is $100,000 this year and stays $100,000 next year, your
"actual dollars" remain the same even if prices for goods rise.

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 Gross domestic product (Components, real and nominal gross domestic product)

Constant Dollars (Real Dollars)

Dollar values adjusted to a "base year" to remove the effects of inflation.
Impact of Inflation: They reflect purchasing power, allowing you to compare the value of
money across different years as if prices hadn't changed.
Usage: Essential for analyzing economic trends like Real GDP or historical income
growth to see if you are actually getting "richer" or just keeping up with rising prices.

Calculation: They are calculated by dividing the actual (nominal) dollar amount by a
price index, such as the Consumer Price Index (CPI).

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 Unemployment (Measurement, job search, minimum wage law)
Unemployment occurs when people who are willing and able to work cannot find a job
at the prevailing wage rate.

Measurement of Unemployment
Unemployment is measured using the unemployment rate.

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 Unemployment (Measurement, job search, minimum wage law)

Labor Force
Labor force includes:
•Employed people (those who have jobs)
•Unemployed people (those actively looking for jobs)

It does not include:

•students not seeking work
•retired people
•people not willing to work

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 Unemployment (Measurement, job search, minimum wage law)

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 Unemployment (Measurement, job search, minimum wage law)
Job search refers to the process where workers spend time looking for suitable
employment.
Even in a healthy economy, unemployment exists because workers need time to find the
right job.
Reasons for Job Search
Workers may take time to search because:
•they want better salary
•they want better working conditions
•they want jobs matching their skills
•they need time to collect job information

A minimum wage law is a government regulation that sets the lowest legal wage
employers can pay workers.
It is designed to protect workers from very low wages.

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 Inflation : Causes, effects and measurement of inflation
Inflation is the sustained, broad-based increase in the general price level of goods and
services in an economy over time. It is not just a single price hike but an ongoing trend
where the purchasing power of money declines- meaning each unit of currency buys fewer
goods and services than before
Core Causes
Economists typically categorize the causes of inflation into three main types:
• Demand-Pull Inflation: Occurs when the demand for goods and services exceeds the
economy’s ability to produce them (often described as "too much money chasing too few
goods").
• Cost-Push Inflation: Happens when the cost of production (e.g., raw materials like oil or
labor wages) rises, forcing businesses to increase prices to maintain profit margins.
• Built-In Inflation: A "wage-price spiral" where workers demand higher wages to keep up
with rising costs, which then causes firms to raise prices further to cover those higher
labor costs.
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 Causes, effects and measurement of inflation
Measuring Inflation: Inflation is tracked using various indices that monitor price changes
for a "basket" of goods and services over time:
• Consumer Price Index (CPI): Measures the average change in prices paid by urban
consumers for a market basket of consumer goods and services.
• Producer Price Index (PPI): Tracks the average change in selling prices received by domestic
producers for their output.
• Core Inflation: A version of the CPI that excludes more volatile items like food and energy
to reveal underlying long-term trends.
• GDP Deflator: A broad measure that reflects price changes for everything produced in an
economy.
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 Causes, effects and measurement of inflation
Measuring Inflation: Inflation is tracked using various indices that monitor price changes
for a "basket" of goods and services over time:
• Consumer Price Index (CPI): Measures the average change in prices paid by urban
consumers for a market basket of consumer goods and services.
• Producer Price Index (PPI): Tracks the average change in selling prices received by domestic
producers for their output.
• Core Inflation: A version of the CPI that excludes more volatile items like food and energy
to reveal underlying long-term trends.
• GDP Deflator: A broad measure that reflects price changes for everything produced in an
economy.
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 Causes, effects and measurement of inflation
Inflation Intensity & Degrees
• Creeping Inflation (1–3%): Prices rise slowly at about 1–3% per year, which is considered
normal and healthy for economic growth. Purchasing power decreases slightly but remains
stable.

• Walking Inflation (3–10%): Prices increase moderately at around 3–10% per year, making the
cost of living noticeably higher. It can signal that the economy is overheating.

• Galloping Inflation (10–50%): Prices rise rapidly between 10–50% per year, significantly
reducing purchasing power. Savings and fixed incomes lose value quickly.

• Hyperinflation (more than 50% per month): Prices increase extremely fast, often exceeding
50% per month, causing money to lose value dramatically. It can lead to economic collapse
and loss of trust in the currency.

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 Measuring Inflation

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 Measuring Inflation

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 Equivalence Calculation Under Inflation

24
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 Equivalence Calculation Under Inflation

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 Equivalence Calculation Under Inflation

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 Questions

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 Questions
Calculate the average (compound) inflation rate when CPI has increased from 176 to 216 over the past 3
years.
Given: Initial CPI (P) = 176
Final CPI (F) = 216
Number of years (N) = 3
We know the compound inflation formula:

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 Questions
Convert an actual cash flow of Rs. 20,000 per year for 5 years into constant (real) cash flow when
inflation rate is 5%.
Also calculate the loss in purchasing power each year.

Loss in Purchasing
Year (EOY) Actual Cash Flow Conversion Factor Constant Cash Flow
Power
0 20,000 (1.05)⁰ 20,000 0%
1 20,000 (1.05)⁻¹ 19,048 4.76%
2 20,000 (1.05)⁻² 18,141 9.30%
3 20,000 (1.05)⁻³ 17,277 13.62%
4 20,000 (1.05)⁻⁴ 16,454 17.73%

Even though you receive Rs. 20,000 every year, its real value decreases because of inflation.
After 4 years, Rs. 20,000 feels like only Rs. 16,454 in today’s money.

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 Questions
Choose the best project from the following alternatives.

Project Machine X Machine Y

First cost 15,00,000 20,00,000
Life 7 years 7 years
Salvage Value 2,00,000 3,00,000

Annual operating and

3,00,000 2,50,000
maintenance cost

Assume an average inflation of 5% for the next five years and interest
rate is 15% per year.

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 Questions

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 Questions

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 Questions
You borrowed Rs. 1,20,000 and agreed to pay Rs. 6,000 per month for 2 years (24 months).
If average inflation is 0.75% per month, find the inflation-free (real) interest rate.

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 Questions

Convert Nominal Rate to Real (Inflation-Free) Rate

We use the standard relation:

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 Questions

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 Questions
Compute the equivalent present worth (PW) using the inflation method.
Given:
•Cash flows are in Actual Dollars
•Inflation rate f=5%
•Real interest rate i=10%

EOY Cash Outflow Cash Inflow Net Cash Flow

0 -10,00,000 – -10,00,000
1 1,00,000 5,00,000 4,00,000
2 2,00,000 5,60,000 3,60,000
3 3,00,000 6,20,000 3,20,000
4 4,00,000 6,80,000 2,80,000
5 5,00,000 7,40,000 2,40,000

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 Questions

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 Questions
Calculate IRR if:
•MARR = 12%
•Inflation rate (f) = 8%
•Cash flows are given in Constant Dollars

Year 0 1 2 3 4
Constant
-6,000 1,500 2,000 2,500 3,000
Dollar

Year Constant Conversion Factor Actual Dollar

0 -6,000 – -6,000
1 1,500 (1.08)¹ 1,620
2 2,000 (1.08)² 2,332.8
3 2,500 (1.08)³ 3,149.28
4 3,000 (1.08)⁴ 4,081.47
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 Questions

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 Inflation Controlling Measures
To control inflation, governments and central banks use a combination of monetary, fiscal, and
supply-side measures. The primary goal is typically to reduce aggregate demand or increase the
economy's productive capacity.
Monetary Measures
• Central banks primarily use monetary policy to manage the money supply and interest rates.
• Interest Rate Hikes: Raising policy rates (e.g., the repo rate or federal funds rate) makes
borrowing more expensive, which discourages consumer spending and business investment.
• Increasing Reserve Requirements: By raising the Cash Reserve Ratio (CRR) or Statutory
Liquidity Ratio (SLR), central banks force commercial banks to hold more cash, reducing the
amount available for lending.
• Open Market Operations (OMO): The central bank sells government securities to absorb
excess liquidity from the banking system.
• Quantitative Tightening: Stopping or reversing quantitative easing (buying bonds) reduces the
money supply in circulation.

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 Inflation Controlling Measures
Fiscal Measures
• Governments use fiscal policy to influence the economy through taxation and
spending.
• Reducing Government Expenditure: Cutting public spending on infrastructure, defense,
or subsidies directly reduces the total demand in the economy.
• Increasing Taxation: Raising direct taxes, such as personal income or corporate taxes,
reduces disposable income for households and profits for firms, leading to lower
consumption and investment.
• Deficit Reduction: Moving toward a budget surplus helps lower long-term interest
rates and reduces inflationary expectations.

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 Inflation Controlling Measures
Supply-Side Measures
These long-term strategies aim to increase the economy's productive capacity, allowing it
to meet demand without price hikes.
• Incentivizing Production: Providing subsidies or tax breaks for essential industries
(e.g., renewable energy or semiconductors) to lower production costs.
• Labor Market Reforms: Improving education and vocational training to increase
worker productivity and reduce labor shortages.
• Deregulation: Removing "red tape" to encourage competition and lower business
costs.
• Infrastructure Investment: Improving transport and energy networks to reduce
logistical costs and increase efficiency

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 Inflation Controlling Measures
Other Targeted Actions
• Exchange Rate Intervention: A central bank may target a higher exchange rate to make
imports cheaper, directly lowering the cost of foreign goods.
• Price Controls or Caps: In extreme cases, governments may impose price ceilings on
essential goods like energy or food to protect vulnerable citizens.
• Anti-Hoarding Laws: Restrictions on stockpiling essential commodities can prevent
artificial supply shortages.

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 Impact of Inflation on Economic Evaluation
In recent years, inflation remains a critical variable in economic evaluation, influencing how projects, investments,
and national growth are assessed. It primarily distorts the time value of money, requiring evaluators to
distinguish between nominal and real values to avoid overestimating or underestimating project returns by as
much as 50% or more. The evaluation of long-term projects is heavily influenced by how inflation interacts with
cash flows and discount rates:
Real vs. Nominal Analysis: Evaluations must use consistent data. If cash flows include expected inflation
(nominal), they must be discounted using a nominal interest rate. If they exclude inflation (real), a real discount
rate must be used.

Purchasing Power Erosion: Future cash receipts lose value over time. For example, at 5% annual inflation, a
$100 receipt in year three is worth only $86.40 in today's terms.

Cost Overruns: In sectors like construction, shifting inflation rates cause significant deviations in the price of
goods and services, necessitating frequent budget revisions and advanced forecasting models to avoid excessive
liability.
Distorted Price Signals: High inflation creates "inflationary noise," making it difficult for businesses to
distinguish between shifts in market demand and general price increases, often leading to inefficient resource
allocation.
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 Impact of Inflation on Economic Evaluation
Effects on Economic Growth & Stability
Economic evaluations often look for a "threshold" where inflation transitions from helpful
to harmful:
Growth Thresholds: Studies suggest an optimum inflation rate (e.g., around 6% for developing
economies like Nepal) supports growth, while exceeding this threshold can jeopardize
economic stability and increase poverty.

Investment and Savings: High inflation lowers the real value of savings, discouraging long-
term capital accumulation. Conversely, modest, predictable inflation can stimulate activity
by encouraging immediate spending and reducing the real burden of existing debt.

International Competitiveness: If a country's inflation significantly exceeds that of its trading

partners, its exports become less competitive, potentially worsening the current account
balance and slowing growth.
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 Impact of Inflation on Economic Evaluation
Global Outlook for 2026
Projections for 2026 indicate a global move toward stabilization, though risks remain:
Inflation Targets: Global headline inflation is projected to fall to 3.7%–3.8%.
Monetary Policy: Central banks, such as the RBA and the Fed, are expected to maintain
tighter policies through 2026 to ensure inflation returns to long-term targets (typically 2%).
Regional Trends:
United States: Inflation is expected to slow to 2.7% .
Euro Area: HICP inflation is projected to reach approximately 1.7% by early 2026.
Emerging Markets: Growth in low-income countries is projected to rise to 5.7% in 2026 as
inflationary pressures ease.
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 Real and nominal exchange rates, fiscal budget and monetary policy
An exchange rate is the price of one country’s currency in terms of another country’s
currency.
If 1 US dollar = NRs. 133, it means to buy 1 dollar, one need 133 Nepali rupees.
Exchange rates are very important in international trade, imports, exports, tourism, and
investment.
The nominal exchange rate is the actual market rate at which one currency can be
exchanged for another.
It tells us how many units of domestic currency are needed to buy one unit of foreign
currency, or vice versa. It only shows the money value of one currency against another.
It does not show the difference in purchasing power between countries.

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 Real and nominal exchange rates, fiscal budget and monetary policy
Real Exchange Rate: The real exchange rate measures the relative price of goods and
services between two countries after adjusting for price levels.
It tells us how many units of domestic goods must be given up to obtain foreign goods.
the real exchange rate shows whether foreign goods are cheap or expensive compared to
domestic goods.

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 Real and nominal exchange rates, fiscal budget and monetary policy
• If the real exchange rate rises, foreign goods become relatively more expensive, or domestic
goods become relatively cheaper.
• If the real exchange rate falls, foreign goods become relatively cheaper, or domestic goods
become relatively more expensive.

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 Real and nominal exchange rates, fiscal budget and monetary policy
o This means 1.33 units of Nepali goods are exchanged for 1 unit of American goods. So, US
goods are relatively more expensive compared to Nepalese goods.

A fiscal budget is the government’s annual financial plan showing:

• expected revenue
• expected expenditure
• borrowing and repayment plans
• It is usually prepared for one fiscal year.
It is the income and spending statement of the government.

Importance of Fiscal Budget

• helps allocate resources
• supports economic development
• funds infrastructure

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 Real and nominal exchange rates, fiscal budget and monetary policy
• reduces unemployment
• maintains stability
• supports social welfare
• encourages balanced growth

Monetary policy is the policy by which the central bank controls the money
supply, interest rate, and credit conditions to achieve macroeconomic goals. It
controls how much money and credit are available in the economy.
In Nepal, it is conducted by Nepal Rastra Bank.

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 Real and nominal exchange rates, fiscal budget and monetary policy

Objectives of Monetary Policy

•price stability
•control of inflation
•economic growth
•employment generation
•exchange rate stability
•financial stability
•balance of payments stability

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 Real and nominal exchange rates, fiscal budget and monetary policy
Basis Fiscal Policy Monetary Policy
Policy of government related to taxation and Policy of central bank to control money
Definition
public expenditure to influence the economy supply, credit, and interest rates
Authority / Control Government / Ministry of Finance Central Bank (e.g., Nepal Rastra Bank)
Economic growth, employment, income Price stability, inflation control, financial
Main Objective
redistribution, development stability
Focus Area Government revenue and spending Money supply and credit conditions
Taxation, public expenditure, subsidies, Bank rate, repo rate, CRR, SLR, Open Market
Key Instruments
borrowing, budget deficit/surplus Operations (OMO)
Nature of Control Direct (government directly spends or taxes) Indirect (influences banks and financial system)
Long (due to political approval and
Time Lag Short (central bank can act quickly)
implementation delay)
Flexibility Less flexible More flexible
Indirectly affects demand via interest rate and
Impact on Demand Directly affects aggregate demand (G + T)
credit
Controls inflation through taxation and
Impact on Inflation Controls inflation by reducing money supply
spending
Can directly create jobs (infrastructure
Impact on Employment Indirect effect through investment and growth
projects)
Increase spending, reduce taxes (Expansionary
Use in Recession Lower interest rates, increase money supply
Fiscal Policy)
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 Real and nominal exchange rates, fiscal budget and monetary policy
Reduce spending, increase taxes
Use in Inflation Increase interest rates, reduce money supply
(Contractionary Fiscal Policy)
Budget Involvement Yes (annual budget is core tool) No direct budget involvement

Political Influence High (depends on government decisions) Low (central bank often independent)

Public Debt Impact Can increase debt through deficit financing Does not directly create public debt

Can reduce inequality via progressive taxes

Effect on Income Distribution No direct role in income distribution
and subsidies

Example (Nepal) Government builds roads, reduces taxes Nepal Rastra Bank changes bank rate or CRR

May not work well if banks don’t lend

Risk / Limitation Political delays, budget deficits, inefficiency
(liquidity trap)
Broad (affects entire economy and Narrower (focus on financial system and
Scope
development) liquidity)
Type of Policy Expansionary / Contractionary Expansionary / Contractionary
Effect on Investment Direct via government projects Indirect via interest rate changes
Control over Economy Structural + developmental Stabilization + liquidity control
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 Financial Statement
A financial statement is a formal record that shows the financial performance and
financial position of a business or organization over a specific period of time.
It helps managers, investors, and stakeholders understand:
•how much the company earns
•how much it spends
•what it owns
•what it owes
Financial statements are usually prepared annually or quarterly.

Financial statements are classified into income statement, balance sheet, cash flow
statement, statement of owner’s equity, and statement of retained earnings. These
statements help evaluate profitability, financial position, and cash flow of a business.

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 Financial Statement
Type of Financial Statement Definition Main Components Purpose

A financial statement that shows

Revenue, Cost of goods sold, To determine whether the
Income Statement (Profit and the revenue, expenses, and profit
Operating expenses, Taxes, Net company is making profit or loss
Loss Statement) or loss of a business during a
profit during the accounting period.
specific period of time.

A financial statement that shows

To show what the company owns
Balance Sheet the financial position of a business Assets, Liabilities, Owner’s equity
and what it owes.
at a specific point in time.

A financial statement that records

Operating activities, Investing To evaluate the liquidity and cash
Cash Flow Statement the inflow and outflow of cash in a
activities, Financing activities availability of the business.
business during a given period.
A statement that shows changes in
Beginning capital, Additional To show how owner’s investment
the owner’s capital or
Statement of Owner’s Equity investment, Net income, and profits change the company’s
shareholders’ equity over a period
Withdrawals equity.
of time.
A financial statement showing how Beginning retained earnings, Net
Statement of Retained To show how profits are used
profits are retained or distributed income, Dividends, Ending retained
Earnings within the company.
as dividends in a company. earnings

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 Thank you for your attention!

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