Understanding National Economy

Indrajith Aponsu
Department of Economics
University of Colombo
 Economics In global context

Asia poised to faster economic growth @ 7%+

Current account surplus to continue
Inflation remain well contained
Prospects for capital flows look good
Risk due to a more than expected slowdown in US
Higher oil prices can hamper growth prospects
Inflation will result due to high costs and financial
volatility
Rapid growth in China, later India, provide mixed
blessings for the region
Regional Economic Outlook, IMF
More specifically,
Why economics information?
Commonly,

For better returns on investment

Making decisions on capital and financial outlays
Get to know the economy and its functioning
Reduce inherent risks
To be ahead of the rest

Or simply,

almost all our decisions are inescapably tied to

economics, and every human being (almost) is a
practicing economist
Economic performance is measured
Economic indicators are used

Economic indicators are statistics that Tell

about the health of an economy
Direction of change
Likely pitfalls Implications
of policy Development
prospects Impact of rest of
the world

Macroeconomics tell us about the economic

envrioment and how each parameter realtes and
interacts with each other
 Broad Economic Growth Equation
Primary Inputs Intermediate Inputs Output

Productive capital Mobilisation of Accelerated Real

stock financial capital GDP growth
A sound financial Growth in capital Reduced
system stock unemployment
Sound Growth in productivity Higher standard of
infrastructure New technology living
Disciplined means of production Greater social
workforce Learning by doing welfare
Appropriate policy More savings for Economic strength
and strategies investment Political stability
Visionary political Growth in human
leadership capital
 Development process and outcome
both desirables and undesirables
Countrys output/ income growth
Financial system
in a year measured by
Capital Stock Gross Domestic Product / Income
(Mach.+Tech+Land+)
Inflation

BOP status
Labour exchange rate
(Knowledge+Skills+Knowhow+)

Demand stability

Fiscal measures
and income gaps

Public debt

Rising per capita

Reduction of employment
Closing income gaps
Economic parameter /indicators
come under several braod headings:
Production, income and unemployment
Price levels and inflation
Fiscal policy also referred to as budget policy
Demand management policies also referred to as
monetary policy
Trade and industry policy framework for creating
growth, and business with other countries
Balance of payment foreign exchange flows and
rates
International wealth and liabilities
Economic factors relate to each other and to the
business cycle, economy, and decision making as

Leading-
Indicates before hand likely changes-
Stock market with growth
Stock indices falter when GDP growth begins to decline
Falling reserves indicates X rate under pressure

Lagged
Happens with a delay
Unemployment improves only sometime after a recovery
Rising interest rates chokes growth
Selected Economic parameters
The rate of growth of GDP
The rate of growth of per capita GDP
The rate of unemployment
The sectoral economic growth
The rate of domestic savings
The rate of national investment
Change in the structure of the economy
The capital output ratio
 Economic Indicators
The Budget surplus/ deficit current account and
overall
Revenue as a percentage of GDP
The growth of public debt

Balance of Payments Current Balance / Overall

Balance as a percentage of GDP
The terms of trade
The level of external reserves
 Social Indicators
Life Expectancy at Birth
Male
Female
Infant Mortality rate
Maternal Mortality rate
Crude Birth rate
Crude Death rate
Total Fertility Rate
Literacy level
Male
Female
School enrolment rate
Primary
Secondary
Prevalence of under 5 child malnutrition
Poverty Head Count
 Political Indicators
Regularity of Elections
Freedom and Fairness of Elections
Sharing of Power
Devolution of Power
Multi- party system
Freedom of Speech
Freedom of Association
Freedom of the media
Incidence of political violence
Incidence of grave crime
Violations of Human Rights
Governance
Transparency
Independence of Judiciary

Corruption
 Have a look at
Happiness Index

Life Expectancy

Life Satisfaction

Ecological Footprint.
 Selected Qualitative Indicators

Process Indicators
Indicators of good governance
Transparency
Accountability
Non- Discrimination
Equity
Inclusivity
Participation
Gross Domestic Product or GDP
GDP is the key measure of any economy

the value of the output generated within the country in

one year
However, this distorts value due to changes in price
Hence, we create two measures, nominal GDP vs. Real
GDP
Nominal GDP = prevailing price x quantity
Real GDP = some specific price ( base price) x quantity
( for the whole series of GDP only one set of prices used)
The economic activity centers on pushing GDP ; it creates
wealth; jobs; enhances income;
Needs to understand that its the monetary value of one years
output in a country. Hence, it brings both price (P) and
output(Q). We wish to have more Q and not more P
 Real GDP is what we look for
Hence take GDP = PQ where P
is fixed value from one year
Real GDP eliminates value illusion caused by price
changes
Measures the actual output generation in value
terms
In practice, only real GDP is relevant for the
assessment of countrys economic health
Also referred to as GDP at constant prices
Gives a measure of relative size of the economy
Also, provides a yardstick for domestic market
size
Real Growth (also called Growth) main economic objective
Most vital is the Rate of Growth in GDP. If growth slows
down it affects all sectors of the economy
It reflects the vitality of the GDP
US grew @ nearly 5% during 1990-2000 ( exceptional)
Developing countries should achieve faster growth (used to be

over 5%, now over 7% is the bottom point)

Typically, rich countries grow slower (below 5%);

East Asia grew in excess of 7-8 percent, for a long-period. China

is galloping @ 10%+ , for over a decade

SL hit 7%+ in 2006 while India notches 8%+

Also growth is the immediate economic target

Most economic policies are targeted at Real Growth.
Sustained high growth makes the economy looks attractive
Growth is the main driver of prosperity
It creates jobs
Enhances income
Gives rise to more businesses
Makes people welfare to go up
Attracts more investment local and foreign

Growth could result from expansion of business activities

Growth may result from more foreign trade
Growth could result from increased government expenditure
Growth could result from increased public investments
GDP per Capita Income A medium term main
economic target- sustained growth increases per
capita Either in real terms or commonly on
Income each citizen gets if GDP distributed evenly
A crude, yet the most common, measure of Standard of living
Indicator of the overall economic well-being
For businesses, a barometer of purchasing power
For Foreign businesses, how attractive economy looks (especially
for smaller economies)
(Real GDP/ Mid-year Population)
Sri Lanka US $ 1000+
took 50 years to get to Low Middle income range ($800+ -3400+)
require another 25 years to Upper-Middle range (3400+ -10,000+) if we grow at 7%+
( Nicholas)
Malaysia US $ 4,900+
achieved within 50 years
Other products of GDP
(long term indicators)

GDP per capita growth

How fast the country is getting richer
Superior measure of economic development
Increasingly used as a measure of wealth creation
2000-4
SL 4%; China 9%; India 7.%; Malaysia 3% (WDR 2007)
Other products of GDP
(long term indicators)..

Structure of the economy

Each major sectors contribution (%) to the GDP
Reflects fundamental character of the economy
Poor Agriculture dominates ( South Asia)
Fast growing Industry dominates ( Asia pacific)
Highly advanced Services dominate (US)
 Other products of GDP..
Gross Domestic Savings Ratio Savings/GDP
Portion of investment financed by GDP

Corporate savings by firms+ household savings+

public savings
Reflects what has not been consumed from the
domestic production ( but, does not reflect what is
available)
National Savings ratio Savings adjusted for net
inflows/ GDP
what is available within the economy
Asians command high levels of savings
 Finance related indicators
Narrow Money supply- M1
Cash and demand deposits in circulation

Most liquid form of money

Broad Money supply M2

Time deposits +M1
Above money stock values are used for
monetary targets for control of inflation by the
Central bank
 What makes the GDP click?
Rate of Investment - Investment /GDP
Main measure of capacity and future production
potential
A higher value indicate greater growth potential ahead

Poor ratio indicate a fundamental bottleneck to

growth
Raising investment is a relaible forecast for faster

growth
Very cyclical in nature ,a dn quite sensitive to growth

expectations ( profit expaecations)

 What makes the
Productivity GDP/ (Labour+ Capital)
A combine measure of how efficiently labour and
capital are used
Countries thrive to enhance productivity
It leaves more savings for further capacity creation
Developing countries with low productivity are
poor economic performers
SL and similar countries pay less attention to this
aspect
No direct measures of productivity are in use in SL
Spoilers of the GDP party
Inflation
An unwelcome, yet inevitable by product of growth
Bad, because,
it blurs the market signals and affects efficiency
Notoriously unpredictable, hence, creates uncertainty
Affects income distribution

Originate from two fronts:

Demand-pull created due to rising budget deficit, credit
expansion, wage rise due to labour shortages, tax cuts
Cost-push is caused by import prices, exchange rates,
commodity price volatility,
Poor Double digit inflation is worrisome
Rich More tight margin for inflation
Modest inflation is inevitable: excessive control harmful
 Measuring inflation
Control on inflation affects growth prospects
Too much inflation affects competitiveness
Attracts tight fiscal and monetary policy

CPI is the inflation index

most common and most timely
Reflects only consumer prices

WPI is the lead indicator of inflation producer index

Most critical to competitiveness
Affects exchange rate via the trade balance - negative
High inflation makes imports good and exports bad
Rising WPI indicates CPI inflation to come and vice
versa
 Relatively High inflation
Puts interest rates under pressure
Exchange rates under pressure
Budget deficit under pressure

It is also true that,

High interest rates pushes inflation up
Also, Currency deprecation and
High budget deficit
SL : over 10% , India below 5%; Japan below 0%
Budget policies governments impact on finances
Problematic Yet cant be without-
Government expenditure / deficit
As share of GDP high in LDCs
Influences imports
Pressures costs up and hence inflation
Foreign borrowings backed expenses boosts forex

Government revenue
higher revenue gives more flexibility
more tax on the private sector
Deficit
The means of financing has implications
Size of it too
Reduction of defcit too have implications
Finance with the rest of the world
Terms of trade
Price of imports in terms of that of locally produced
Deteriorating TOT is a sign of exchange trouble and
Sign that Foreign exchange is leaking out
Trade balance as % of GDP
Exports minus imports
Usually, as a proportion of GDP
Widening trade balance is bad as country is
overspending
 Assets and liabilities to the rest of
the world
Capital account balance as % of GDP
current account deficit is financed from
surplus in capital account
More capital inflows means rising liabilities
Nevertheless, we borrow and invite FDIs

Overall balance as % of GDP

Requires to be positive
If negative, BOP support from the IMF is the only way
out
 Countrys financial credibility
hinges upon:
Balance of payments
Composite statement of all currency
transactions
Degree of liberalisation directly correlate to
the Forex
Degree of Capital controls
( SL, China, India still have capital controls,
Malaysia has not. All Rich countries have liberal
capital accounts)
 Countrys financial credibility..
Reserves in months of imports
shows the Health of the BOP in the short term
Falling reserves means Foreign Exchange
situation is turning to be precarious
Foreign debt outstanding
Short-term debt attracts speculative attacks (
Thailand in 1998)
Long-term normally from multilateral
lending
International value of the Currency - Exchange rate
Nominal rate ( either spot or forward)
The actual price of currency either current, end period, or
sometimes, period average
Useful for making comparisons/ correlations with other
real time data
Commonly, used as a weighted average of major trading
currencies

Real exchange rate

Incorporates exchange rate fluctuations and inflation
differentials simultaneously
Calculated to reflect trade competitiveness
The rate used in economic analysis to determine how badly
real economic situation dislodged from currency
Currency fluctuations
Appreciate - when local currency is more priced
Happens when either exports, capital flows (loans, FDI,
portfolio, etc.) surges
Speculative demand for the domestic currency surges hoping
an interest rate rise
Transaction demand picks up, rather slowly, with enhanced
economic activity
Depreciates when local currency looses international value
Caused by a widening trade deficit and hence, BOP
Rising prices of essential commodities, like oil
Short fall in export proceeds
Capital flight
Rising budgetary excesses
 Currency value for trade
Over valued currency
Currency fixed over and above the market rate
Maintains a policy to counter domestic inflation
Bad for exports and economic growth
SL adopts a de-facto overvaluation due to its
preoccupation with inflation fears
Undervalued currency
Currency is under priced or made to remain so
A deliberate policy to make exports competitive
Pro-growth, pro-export regimes use this effectively
East-Asians used this policy very effectively
Chinese Renminbi under valuationhas become
major thaw in the eyes of US policy makers
Currency regimes.

Pegged floats ( semi-fixed and floating )

Currency pegged to value or band, either fixed or adjusted
periodically
SL Rupee since late 1970s
Common intermediate stage from fixed to floating

Linked rates
Currency rate is fixed , but market operates freely
Currency Board for the HKD
Sri Lankas Place in the International Indexes

The Human Development Index 99 out of 174 countries

The Quality of Life Index Economic Intelligence Unit - 43 out of 111

countries

The Happiness Index - 22 out of 179 countries

The Fredom House Index - partly free

The Integrity Index. Overall rating Very Weak 58 out of 100

Thats it