You will no doubt come across the 3 methods of calculating GDP that is in the macro syllabus of most courses. Here are the main features of each.
National Income measures the value of output produced within the economy over a period of time. One of the key economic objectives of government is to increase the level, and rate of growth, of national income. Before we start to analyse why economic growth is so important, it is important to be able to define the key concepts.
GROSS DOMESTIC PRODUCT (GDP)
Under new definitions introduced in the late 1990s, Gross Domestic Product is also known as Gross Value Added. It is defined as the value of output produced within the domestic boundaries of the NZ over a given period of time, usually a year. It includes the output of foreign owned firms that are located in NZ, such as the majority of Trading Banks in the market – ASB, National, ANZ etc. It does not include output of NZ firms that are located abroad. There are three ways of calculating the value of GDP all of which should sum to the same amount since by identity:
NATIONAL OUTPUT = NATIONAL INCOME = NATIONAL EXPENDITURE
1. THE EXPENDITURE METHOD
This is the sum of the final expenditure on NZ produced goods and services measured at current market prices (not adjusted for inflation). The full equation for calculating GDP using this approach is:
GDP = Consumer expenditure (C) + Investment (I) + Government expenditure (G) + (Exports (X) – Imports (M))
GDP = C + I + G + (X-M)
2. THE INCOME METHOD
This is the sum of total incomes earned from the production of goods and services. By adding together the rewards to the factors of production (land, labour, capital and enterprise), we can see how the flow of income in the economy is distributed. The rewards to the factors of production can be loosely summarised in the following table:
Land - Rent
Labour - Wages and Salaries
Capital - Interest
Enterprise – Profit
Only those incomes generated through the production of a marketed output are included in the calculation of GDP by the income approach. Therefore we exclude from the accounts items such as transfer payments (e.g. government benefits for jobseekers allowance and pensions where no output is produced) and private transfers of money.
The income method tends to underestimate the true value of output in the economy, as incomes earned through the black economy are not recorded.
3. THE OUTPUT MEASURE OF GDP
This measures the value of output produced by each of the productive sectors in the economy (primary, secondary and tertiary) using the concept of value added.
Value added is the increase in the value of a product at each successive stage of the production process. For example, if the raw materials and components used to make a car cost $16,000 and the final selling price of the car is $20,000, then the value added from the production process is $4,000. We use this approach to avoid the problems of double-counting the value of intermediate inputs. GDP will, therefore, be equal to the sum of each individual producer’s value added.
Problems of accuracy:
Officially data on a nation’s GDP tends to understate the true growth of real national income per capita over time e.g. due to the expansion of the shadow economy and the value of unpaid work done by millions of volunteers and people caring for their family members. There may also be errors in calculating the cost of living
The scale of the informal “shadow economy” varies widely across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the leading industrialised countries of the OECD, the shadow economy may be in the region of 15% of GDP.
It is believed that in 2009 Indians held more money is Swiss banks than people from all other countries combined.
- A 2010 study by the World Bank has suggested that India’s shadow economy is equivalent to 20% of GDP.
- Research indicates that 85% of jobs in India are typically cash orientated.
- Only 42,800 people declare income of over 10m rupees a year – only 2.5% of Indians pay income tax.
Mumbai has a huge stock of empty apartments held as investments, their owners unwilling to to sell for fear that the proceeds might enter the formal economy and be taxed.
Source: The Economist. March 23rd 2013
The Economist recently did a Special Report on India and one of the problems that it mentioned was the lack of a manufacturing sector. Unfortunately unlike the rest of South-East Asian economies over 50% of the workforce are still involved in the agricultural sector. However it is interesting to see the breakdown of GDP per sector:
Service sector makes up 59% of GDP and is still expanding,
Agriculture 19% and
The Economist suggests that more factories could provide jobs that would ease the pressure of 13m people that join the Indian workforce every year. What are the issues regarding its expansion:
* Bureaucracy and a poor infrastructure
* Labour costs are relatively high compared to other East Asian countries
* High cost of credit
* Weaker ruppee makes it advantageous for overseas companies to base their production
But there seems no prospect of a big leap in Indian manufacturing in the near future. And if services are to keep expanding, the country needs huge quantities of skilled labour that will not be easy to come by.
Source: The Economist – September 29th 2012
With the CIE A2 Paper 4 exam approaching I thought it would be useful to update what is happening in the BRIC countries – remember developing countries is a popular area that is examined. I was very fortunate to attend the Tutor2u 10th Anniversary Conference in June this year where one of the keynote speakers was Jim O’Neill of Goldman Sachs who coined the acronym in a 2001 paper entitled “Building Better Global Economic BRICs”.
The BRIC’s are struggling hard to ease policies and maintain economic growth in the face of a slowing global economy not of their own making. Although you might think that these rates are high in a developed nation for these 4 developing countries growth rates need to be maintained at much higher levels in order to keep apace with the factors of production that are coming on stream.
One of the reasons for the slowdown is the economic situation in Europe and the downturn on the USA followed by their own uncertainty associated with the coming fiscal cliff. There are also consequences of the BRIC slowdown are on the commodity market. BRIC countries were the reason behind the economic growth in the past decade, which meant they had a great affect on commodity prices. As economic growth decelerates rapidly in these countries, so does energy and commodity demand. Downward pressure on oil prices and other key commodities, such as copper, are likely to continue until one can be sure that the growth trend in the emerging market countries is moving higher again. We are not at that stage yet. BRIC nations, in their own
Other reasons for the growth slowdown is the ever worsening economic situation in Europe, followed closely by the general lack of economic leadership and market confidence coming from the aging industrial countries. One cannot, however, lay all of the economic challenges in the BRIC countries at the doorstep of Europe’s debt crisis and the massive policy uncertainty associated with the coming fiscal cliff in the US.
BRIC currencies represent high-risk, high- return carry trades, due to the near-zero level of interest rates in the U.S., Europe and Japan compared to the much high rates in the emerging market world. When BRIC currencies start to appreciate it will be a sign of confirmation of two important new trends.
1. A necessary, but not sufficient, condition for BRIC currency appreciation is that the global deleveraging process is abating.
2. To complete the scenario, economic growth and the ability to attract capital needs to return to the BRICs.
Source CME Group Market Insights – 25th July 2012
BRIC’s in 2011 – Source: The Economist – 29th Sept 2012
The Chinese authorities have cut interest rates for the time since the Global Financial Crisis (GFC). One year lending and deposit rates were cut by 0.25%.
Lending rate – 6.31%
Deposit rate – 3.25%
Although this should encourage spending with an increase in the money velocity in the circular flow some commentators are concerned that the Chinese authorities know something about their economy that the rest of world is in the dark about.
It is interesting to see the reaction of main central banks in the aftermath of the GFC and how aggressive they were in cutting rates – US, EU, UK – relative to the other countries on the graph, namely China, India and Australia. Furthermore notice that some economies seem to have been at a different part of the economic cycle namely Australia, India, and the EU as their central bank rates have risen in order to slow the economy down. This is especially in India as they have had strong contractionary measures in place but have now started to ease off on the cost of borrowing.
Indian growth has slowed to 5.3% this year and although this seems very healthy it is the lowest level in 7 years. A developing nation like this needs higher levels of growth to create the jobs for their vast working age population and without employment there could be a situation not unliike that of Spain where over 50% of those under 25 don’t have a job. The main cause of the slowdown seems to be from a lack of private investment.
Also look how low rates are in the US, UK, and EU. With little growth in these economies the policy instrument of lower interest rates has been ineffective and they are in a liquidity trap. Increases or decreases in the supply of money do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.
According to the International Energy Agency (IEA) coal accounts for 20% of the primary energy supply in OECD countries. If you consider world consumption, coal accounts for 50% of the increase in energy use between 2000-2010. Not surprisingly 66% of the growth in demand for energy has come from Asia with China leading the world in coal production and consumption – some interesting facts:
1. China mines over 3 billion tonnes of coal per year – that is x3 when compared to USA
2. 80% of China’s electricity comes from coal-fired power plants
3. Burning coal is the biggest cause of air pollution.
4. By 2030 China is likely to consume 4.4 billion tonnes of coal.
5. From 2005 – 2030 – Carbon emissions are expected to increase from 6.8bn – 15bn tonnes
India also uses significant amounts of coal – 70% of its electricity comes form coal. It has 5th largest coal reserves globally but cannot extract it quick enough to satisfy the demand. However its emissions will increase by 250% by 2030.
In the emerging Asian economies the drive for more coal-fired power continues to steam ahead. Unfortunately alternative forms of energy don’t offer affordable electricity on a large enough scale to satisfy the Asian economies insatiable demand for energy. Natural gas which emits less carbon could be an option, but it will not take over from coal. Look out for those negative externalities – see graph below from Tutor2u.net.
With the stagnating growth levels in the developed world – USA, Europe, etc – the emerging economies are not immune from this environment. Lower export demand for goods and services impacts on average growth levels in those emerging countries. In order to get out this sluggish condition economies can employ both monetary and fiscal policy. However richer nations have tended to exhaust both these policy options by dropping interest rates to exteremely low levels (see interest rates below) and in their inability to exapand their borrowing because of the size of governmets deficits. Emerging economies average budget deficit 2% of GDP, against 8% in the G7 economies. And their general-government debt amounts on average to only 36% of GDP, compared with 119% of GDP in the rich world.
The Economist ranked 27 emerging economies according to their ability to utilise expansionary fiscal and monetary policy. They used 6 indicators to assess a country’s ability to use these policies. The first 1-5 focus on the ease of which countries can manipulate monetary policy interest rates. 6 concerns Fiscal Policy flexibility
1. Inflation – 2% in Taiwan to 20% or more in Argentina and Venezuela.
2. Excess Credit – measures the gap growth rate in bank credit and nominal GDP. Argentina, Brazil, Hong Kong and Turkey have seen credit grow vastly beyond GDP whilst Chinese bank lending is now rising mor slowly than GDP.
3. Real Interest Rates (interest rate – CPI) – tends to be negative in most economies. Over 2% in Brazil and China
4. Currency Movements (against US$ since mid-2011) – Nine countries, including Brazil, Hungary, India and Poland, have seen double-digit depreciations, with the risk that higher import prices could push up inflation.
5. Current-Account Balance – If global financial conditions tighten, it would be harder to finance a large current-account deficit, and so harder to cut interest rates.
6. Fiscal-Flexibility Index – combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.
From The Economist
The average of these monetary and fiscal measures produces our overall “wiggle-room index”. Countries are coloured in the chart according to our assessment of their ability to ease: “green” means it is safe to let out the throttle; “red” means the brakes need to stay on. The index offers a rough ranking of which economies are best placed to withstand another global downturn. It suggests that China, Indonesia and Saudi Arabia have the greatest capacity to use monetary and fiscal policies to support growth. Chile, Peru, Russia, Singapore and South Korea also get the green light.
At the other extreme, Egypt, India and Poland have the least room for a stimulus. Argentina, Brazil, Hungary, Turkey, Pakistan and Vietnam are also in the red zone. Unfortunately, this suggests a mismatch. Some of the really big economies where growth has slowed quite sharply, such as Brazil and India, have less monetary and fiscal firepower than China, say, which has less urgent need to bolster growth. India’s Achilles heel is an overly lax fiscal policy and an uncomfortably high rate of inflation. The Reserve Bank of India has sensibly not yet reduced interest rates despite a weakening economy. In contrast, Brazil’s central bank has ignored the red light and reduced interest rates four times since last August. In its latest move on January 18th, the bank signalled more cuts ahead. That will support growth this year but at the risk of reigniting inflation in 2013. Desirable as it is to keep moving, ignoring red lights is risky.
Still on the inequality theme – here is a very worthwhile chart that looks at World Income Inequality. It is from the publication entitled “The Haves and the Have-Nots,” a new book by the World Bank economist Branko Milanovic about inequality around the world which was recently reviewed by New York Times columnist Catherine Rampbell. The graph below shows how inequality in Brazil, USA, China, and India ranks on a global scale. On the x axis the population of each country is divided into 20 equally-sized income groups, which is ranked by each country’s household income per person. These are referred to as ventiles and 1 ventile = 5% of the population. So that we are looking at purchasing power parity (PPP) the data is adjusted for the variance in the cost of living in different countries.
Now on the vertical axis, you can see where any given ventile from any country falls when compared to the entire population of the world.
- poorest 5% are amongst the poorest in the world
- richest 5% are amongst the richest in the world
- the bottom 5% are richer than 68% of the world’s population
- the bottom 5% = 4th poorest percentile worlwide.
- the richest 5% = 68th percentile worldwide which means that USA’s poorest = India’s richest.
Now you might be wondering: How can there be so many people in the world who make less than America’s poorest, many of whom make nothing each year? Remember that were looking at the entire bottom chunk of Americans, some of whom make as much as $6,700; that may be extremely poor by American standards, but that amounts to a relatively good standard of living in India, where about a quarter of the population lives on $1 a day.