Pakistan Economic Policy

Basic Concepts Gross Domestic Product (GDP) at Market Prices GDP is the market value (at retail prices) of all final goods and services newly produced during a specified period (Normally one year) within the borders of a country by whoever. Gross Domestic Product at Factor Cost Gross domestic product at factor cost is the value at factor cost of the product, before deduction of provisions for the consumption of fixed capital, attributable to factor services rendered by the various factors of production (land, capital, labor and entrepreneur). Gross domestic product at market prices is calculated by adding indirect taxes to GDP at factor cost and deducting subsidies provided. Alternatively, GDP at market prices less indirect taxes plus subsidies equals GDP at factor cost. Gross National Product (GNP) GNP measures the value of all final goods and services newly produced by a countrys factors of production wherever i.e. both within the country and outside the country and sold on the market in a given period. GNP = GDP + net receipts of factor income from the rest of the world (incomes of factors of production of countrys origin, but operating abroad; the best example of this is net home remittances of Pakistani workers abroad). Net National Product (NNP) = GNP minus depreciation National Income = GNP Minus depreciation Plus net unilateral transfers from abroad Less indirect business taxes and non-tax liability plus subsidies. Here Unilateral Transfers = income from abroad that is not produced (like gifts). Indirect business taxes include sale, excise, and business property taxes. Non-tax liabilities include inspection fees, special assessments, and various fines and penalties. (Data on GNP, GDP, Net factor income from abroad, NNP, Nation Income are given in Appendix A) Monetary Policy The regulation of the volume of money supply/monetary assets (M2) by a central bank, such as State Bank of Pakistan, in order to achieve/maintain relative price stability. If the economy is heating up, the SBP can withdraw money from the banking system, raise the cash reserve requirement (CRR) or raise the discount rate. If there is fear of recession or otherwise there is inadequate liquidity in the economy, the SBP can reverse the process increase the money supply by lowering the reserve requirement and /or decreasing the discount rate. There are several other instruments of monetary management.

Quantitative Methods of Monetary Management 1. 2. 3. 4. 5. Changes in bank rate/discount rate/repo rate Open market operations Changes in cash reserve ratio (CRR) Changes in liquidity ratio Credit rationing: crediting ceilings regime or credit deposit ratio

Qualitative Methods 1. Changes in margin requirements etc. 2. Moral suasion Objectives 1. Price stability 2. Promote savings, investment and hence economic growth 3. Keep the countrys exchange rate competitive Some Basic Concepts of Monetary Policy M0 or Reserve Money: Currency in circulation + schedule banks reserves with SBP + selected deposits with SBP + cash in the tills of scheduled banks (which is not included in money supply, M1, M2) M1= Currency in circulation + demand deposit with schedule banks + some deposits with SBP M2 = M1 + time deposits with the schedule banks. Technically, M 2 is called Monetary Assets & M1 is called Money Supply. Money Multiplier: this is a ratio between the reserve money (M0) and stock monetary assets (M2). Discount Rate: It is the rate at which the SBP lends to scheduled banks / discounts the Government or other first class securities offered by scheduled banks to borrow against. Repo: Repurchase Option. The rate at which the SBP lends for short term (usually three day) against securities, which a scheduled bank buys back after the stipulated time. Fiscal Policy The use of the governments tax and spending policies in an effort to influence the behavior of such macro variables as GDP, National Savings, Investment, Employment etc. These reserves are a part of government budget central and provincial. According to Paul A. Samuelson, Fiscal policy is concerned with all those arrangements which are adopted by government to collect the revenue and make the expenditures so that economic stability could be attain/maintained without inflation and deflation

According to Lee, fiscal policy considers: 1. 2. 3. 4. Imposition of taxes Government expenditures Public debt Management of Public debt

A prudent fiscal policy is the foundation of a stable macroeconomic environment as it affects private sector savings and investment and therefore the private sectors contribution to growth. Fiscal variables affect private economic decisions both directly through taxation and public spending and indirectly by affecting other macroeconomic variables. Depending on how deficits are financed, they can lead to inflation, the crowding out of private investment, the worsening of the current account balance, or problems of external credit-worthiness. Instrument of Fiscal Policy 1. Taxes (both direct and indirect taxes, direct tax: impact and incidence is on same person, indirect tax means the impact and incidence on different person). Impact means (initial) burden on the one who first pays a Tax. Incidence means the burden on the one who finally pays and cannot pass on burden of a tax to someone else. 2. Government expenditure 3. Subsidies 4. Transfer payments like unemployment allowances, stipends and scholarships 5. Deficit financing, i.e., government borrowing from various sources including central and commercial banks; government borrowing form State Bank leads to printing of additional currency. 6. Management of public debt

Objectives
1. 2. 3. 4. 5. Price Stability Influence the consumption pattern To raise the level of employment Redistribution of income Promote saving, investment and hence economic growth

Budget Deficit The amount by which a government, a company, or individual's spending exceeds its income over a particular period of time, also called deficit or deficit spending Budget deficit = Excess of total expenditure over total revenue Budget Surplus The amount by which a government's, company's, or individual's income exceeds its spending over a particular period of time

Budget Surplus = Excess of total revenue over total expenditure Total Revenue Revenue Receipts (net) = Total tax revenue plus Non-tax revenue minus transfers to provinces Here transfers to provinces include taxes on income, sales tax, excise duty and royalty on nature gas and crude oil, surcharges on gas, wealth tax, custom duties, capital value tax, federal excise (net of gas), and General Sales Tax (provincial) Total Expenditure Total expenditure = Current expenditure + Development expenditure Financing of Budget Deficit 1. Internal Resources i. ii. Borrowing from banking system a. Central Bank (SBP) b. Schedule banks Non-banking borrowing i.e., national saving schemes etc.

2. External Resources i. ii. iii. Loans Grants Debt Rescheduling

2. Change in Provincial Cash Balance 3. Privatization Proceeds Inflation Inflation is a situation of persistent increase in prices in an economy. To measure the inflation rate, we calculate the annual percentage change in price level Inflation rate = 100 * (price index of current year minus price index of previous year divided by price index of previous year) Price Index Price index is a measure of the average level of prices for a specified set of goods and services, relative to the price in specified base period.

Consumer Price Index (CPI) CPI is average level of prices of the goods and services that a typical urban Pakistani family consumes. The CPI covers the retail prices of 375 items in 35 major cities. Wholesale Price Index (WPI) It is calculated by using wholesale prices. It covers the wholesale prices of 97 major items prevailing in the city of origin of commodities. Sensitive Price Index (SPI) The SPI covers prices of 53 essential items accounting for 51.6 percent of the expenditure of those households whose monthly income ranges from Rs.3000 to Rs.12000 per month. In Pakistan, the main focus is on the CPI as a measure of inflation, because it is more representative relative to other price indices. Price Stability Price stability, a situation neither inflationary nor deflationary, can be conceptually defined as an environment where economic agents including households and firms can make decisions regarding such economic activity as consumption and investment without being much concerned about the fluctuation of the general price level. Following points show the importance of price stability. (1) (2) Price stability provides the essential foundation for sustainable longrun economic and employment growth. Price stability enables the price system (the information or signaling mechanism of market economies) to function most effectively by directing resources to their most beneficial use. Price stability provides a reliable anchor for the price system so that comparative values can be established and accurately measured. Price stability works to lower interest rates and stabilize financial markets. Price stability serves to promote transparency, accountability, and credibility in monetary policy.

(3) (4) (5)

Exchange Rate Exchange rate is the price of one currency in terms of other currency/currencies.

Fixed exchange rate In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must also commit to defend that parity by being willing to sell (buy) foreign reserves whenever the market demand for foreign currency is greater (smaller) than the supply of foreign currency. Flexible exchange rates system allows the demand and supply of foreign currency in the exchange rate market to determine the equilibrium value of the exchange rate. So the exchange rate is market determined and its value changes at every moment in time depending on the demand and supply of currency in the market. Balance of Payments Balance of payments of a country is the records of all transactions between the residents of that country and the rest of the world during a certain period of time, generally a year. Classification of the Balance of Payments Accounts 1. Current Account 2. Capital Account Current Account All those transactions with the non residents which are settled immediately and do not create any future liability are included in current accounts. The current account balance includes international purchases and sales of goods and services, cross-border interest and dividend payments, and cross-border gifts to and from both private individuals and governments. The current account is divided into three separate components i. ii. Net export of goods (value of exports minus value of imports). It is also called visible balance. Net receipts on account of services/invisible account. It is also known as the invisible balance. Investment income received from assets abroad includes interest payments, dividends, royalties and other returns that residents of a country receive from assets (such as bonds, stocks, or patents) that they own outside their own country. Payments of investment income to foreign owners of assets in country and debit items because they represent funds that flow out of the country. Net investment income from assets abroad equals investment income received from assets abroad minus investment income paid to foreign owners of domestic assets. Net Unilateral Transfers. Unilateral transfers are payments from one country to another that do not correspond to the purchase of any good, service, or asset. Examples are official foreign aid or a gift of money from a resident of one

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country to family members living in another country. A countrys net unilateral transfers equal unilateral transfers received by the country minus unilateral transfers flowing out of the country. Adding all the credit items and subtracting all the debit items in the current account yields a number called the current account balance. If the current account balance is positive, the country has a current account surplus. If the balance is negative, the country has a current account deficit. Capital Account This mainly consists of changes in the financing of current account deficit / surplus. Capital account is a record of all international transactions for assets. Assets include bonds, treasury bills, bank deposits, stocks, currency, real estate, etc. The current account includes only the trade of currently produced goods or service. The transaction of the existing assets is not part of the current account. Trade between countries in existing assets, either real or financial, is recorded in the capital account. When the home country sells an asset (existing) to another country, the transaction is recorded as a capital inflow for the home country and as a credit item in the capital account. When the home country buys an asset (existing) from abroad, the transaction is a capital outflow from the home country. The capital account balance equals the value of capital inflows (credit items) minus the value of capital outflow (debit items). When residents of a country sell more assets to foreigners than they buy from foreigners, the capital account balance is positive, creating a capital account surplus. When residents of the home country purchase more assets from foreigners than they sell, the capital account balance is negative, creating a capital account deficit. A country that increases its net holdings of reserve assets during a year has a balance of payments surplus, and a country that reduces its net holdings of reserve assets has a balance of payments deficit. The Relationship between the Current Account and the Capital Account Current account Capital account = 0 Suppose that a Pakistani buys an imported British sweater, paying Rs.500 for it. This transaction is an import of goods to the Pakistan and thus reduces the Pakistan current account balance by Rs.500. However, the U.S exporter who sold the sweater now holds Rs.500. What will he do with it? There are following three possibilities, any one of which will offset the effect of the purchase of the sweater on the sum of the current and capital account balance. Case I: Pakistan imports sweater at the worth of Rs.500 from British, British imports wheat at the worth of Rs.500 from Pakistan Current Account Exports + Rs.500

Imports
Current Account Balance = 0 Capital Account No transaction Capital Account Balance = 0

- Rs.500

Sum of Current and capital account balance = 0 Case 2: Pakistan imports sweater at the worth of Rs.500 from British, British buys bonds worth Rs.500 from Pakistan

Current Account Exports

Imports
Capital Account

- Rs.500

Current Account Balance = - Rs.500

Capital inflow

+ Rs.500

Capital Account Balance = + Rs.500 Sum of Current and capital account balance = 0 Case 3: Pakistan imports sweater at the worth of Rs.500 from British, State Bank of Pakistan sells British pounds at the worth of Rs.500 to British Bank

Current Account Exports

Imports
Capital Account

- Rs.500

Current Account Balance = - Rs.500

Capital inflow (reduction in official reserve assets)

Capital Account Balance

+ Rs.500
= + Rs.500

Sum of Current and capital account balance = 0 Development Economics Capital Formation or Investment This is the part of countrys wealth which is used for the production of more wealth. Capital formation or investment is financed by savings. Savings have following components: Suppose total investment during a year is 20% of GDP. National savings are 15% of GDP; the remaining 5% will be financed by borrowing, investment etc. from abroad; this will be countrys external liabilities; these are also called foreign savings and are equal to current account deficit of countrys balance of payments. National savings comprise of two components: domestic savings (savings by factors of production working / operating within the territorial boundary of the country) and net factor income from abroad (income from the factors of production of Pakistans origin operating and working abroad); technically these are residents (like senders of home remittances. Do not confuse net factor income from abroad with foreign savings. Foreign savings as explained above are the countrys liabilities. But net factor income from abroad is not the countrys liability but are savings of Pakistani factors of production working abroad. These do not create any foreign liability of the country. Capital Output Ratio: is the ratio between the investment and its output / income. For instance to create a capacity to produce income (net value added) of Rs.1 million we need investment of Rs.3 million. This capacity will continue to produce the income over several years. Capital output ratio varies from sector to sector of the economy: it is low in agriculture but very high in case of capital intensive projects and social and physical infrastructure.