Measuring Economic Performance

Readings Lequiller François and Derek Blades, 2006, Under standing NATIONAL ACCOUNTS, Organization for Economic Cooperation and Development, Chapter 1 and 2. LinkLink Bureau of Economic Analysis “Introduction to the National Income and Product Accounts” LinkLink

Economic Growth Rate of Increase of Production. If Q t is a measure of production, the simple net growth rate is Implying

What is Economic Growth in a world of many goods? We need to combine the many goods produced or consumed in an economy into one measure =?

(Simple) Average Growth If there are K goods then we could calculate the average growth rate of each type of good. Problem: Taking the simple average of the growth of different types of goods may give a distorted picture of average growth, since different goods are of different importance in the economy.

Weighted Average Growth Instead we could construct a weighted average where the weights add to 1. An even weight is w k =1/K but we could adjust the weights to be indicate the importance of each good in the economy.

Measuring the Economy National accounts are the core statistical measure of the economy. Accounts cover many features of the economy but organizing concept is Gross Domestic Product (GDP)

“GDP combines in a single figure, and with no double counting, all the output (or production) carried out by all the firms, non-profit institutions, government bodies and households in a given country during a given period, regardless of the type of goods and services produced, provided that the production takes place within the country’s economic territory.” L & B p. 15 All goods sold in an economy share a common unit of measure: the price at which they are sold. Sum up the value of goods

GDP is a measure of production Value added at production establishment i GDP is the sum of VA across establishments.

Economic Concept Value Added is production at firm level due to the combination of capital equipment and workers. Value added is not equal to profits because the costs of worker and capital are not deducted.

Accounts are created by national statistical agencies UN System of National Accounts is the “internationally agreed standard set of recommendations” used by most countries. Annual data for many countries available at the UN Link

Production Approach Sub-aggregates Divide production establishments into sectors usually along the line of – Primary: Natural Resources (Agriculture, Forestry, Fishing, Mining, Quarrying) – Secondary: Goods production (Manufacturing, Construction, Utilities) – Tertiary: Intangibles Production

Hong Kong: Value Added by Sector Hong Kong Census and Statistics

Table 035

Demand If we add up the value added at all stages of production we derive the value to the end user. Sum of Final Demand Aggregates equals Sum of Value Added

Expenditure Approach Purchase of Final goods by end users are divided into two categories: 1.Consumption: Household expenditure (durables, nondurables & services); government (nondurables & services) expenditure; nonprofit expenditures 2.Investment: Inventories, Fixed Investment (equipment, structures)

Some Asian Expenditure Shares: 2010 Source: United Nations Main Aggregates DatabaseUnited Nations Main Aggregates DatabaseSource: United Nations Main Aggregates DatabaseUnited Nations Main Aggregates Database People’s Republic of China

Reconciliation Some demand for domestically produced value added comes from abroad, some domestic demand is satisfied by overseas goods. GDP = Consumption + Investment + Exports – Imports Exports – Imports = External Balance = Trade Balance = Net Exports <> 0

Value Added and Income Production establishments are where income is generated. Funds raised can be paid for labor and finance costs, left over money is profit income. Sum of domestic value added (GDP) is equal to wage payments plus financial and profit income referred to as “operating surplus and mixed income.”

GDP Equivalence

Using GDP to Measure Economic Performance

Measuring stick of value is prices of goods in terms of money, but arbitrary changes in the stock of money arbitrarily change prices/the measure of value over time. Comparing value across time requires abstracting from those arbitrary changes in value.

Value vs. Volume Consider the sales of a hypothetical single good k (for example, k = apples). Dollar Value of sales (called v k ) is the product of the volume of goods sold (called q k ) measured in the goods natural units (i.e. bushels of apples) and the dollar price per good (called p k ) v k = p k *q k Growth of value can be decomposed into growth of volume and growth in prices.

Aggregate Growth Growth of volume measures true/real growth in the production of goods as opposed the change in the arbitrary measure of value. To measure economy wide growth we could average the growth of production across all the different goods produced.

Growth Rates of Products and Ratios

Share of Value We could measure total value for the economy. Divide our economy into K categories of goods indexed by k = 1,…, K. Value of sales of good k, v k. GDP is represented as the sum of value across goods The weight of k in the economy could be defined aswhich add up to 1 across sectors.

Aggregate Growth Macroeconomic aggregates such as GDP and its sub-totals are the sum of values of sales (or purchases) from different firms. We also decompose the growth of the aggregates into growth in prices (inflation) and growth in volume (output).

How statistical agencies calculate volume growth. 1.Construct representative market basket of each category of goods, k. For example, if k were apples, the market basket could consist of a certain number of Red apples, Green apples, Fuji apples depending on how many of each of these are purchased. 2.Sample goods of type k at time t and at time t-1 to assess the price level of the market basket at each time period.

Example If for category k = the typical family purchases 2 bushels of red apples, 1 bushel of green apples and 1.5 bushels of Fuji apples in a given year, the statistical agency could price this market basket Price/Bushel: Red Apples Price/Bushel: Green Apples Price/Bushel: Fuji Apples t t

Building Blocks for Volume Growth Value and Inflation Vectors 3.For every type of good at time t, measure and construct an inflation vector representing the growth rate of prices. 4.Convert the dollars spent on good k into their purchasing power measured at time t-1 prices.

Conceptually, if we think of value of good k as the product of price and quantity v k = p k *q k we can think of value divided by the inflation vector as the quantity of goods produced at time t measured at the value in terms of the previous period prices.

5.Sum the inflation adjusted values across the types of goods and divide by value in previous period

Volume Growth cont. Conceptually, the numerator of volume growth is the sum of goods produced at time t valued at the price prevailing at time t-1 while the denominator is the sum of goods produced at time t-1 valued at the price prevailing at time t- 1. The yardstick of value, dollar prices in time t-1 prices, are the same in the numerator and denominator.

Volume Growth cont. Conceptually, we can also think net volume growth as a weighted average of the growth rate of quantities of each type of good.

We can rewrite the numerator as Collect terms Rewrite

Note that and divide through by V t-1. Define as a weight By construction, the weights add up to one, so volume growth is a weighted average of the growth of production of each type of good

Notes on Price Indices: New Goods Weights change as production structure of the economy changes Market baskets used to construct don’t need to stay the same over long-periods. K categories of goods don’t need to stay the same over long periods. New goods can be introduced as long as matched goods are compared in every t and t-1 period.

Notes on Price Indices: Quality Some categories of goods (computers, cars) observe marked changes in quality over time. Price growth rates for these components often reflect the price growth for certain characteristics (e.g. MHz,GB HD, etc.). These are referred to as hedonic price indices.

Candyland vkvk pkpk qkqk vkvk pkpk qkqk KitKat M&M Inflation vectorVolume GrowthWeight KitKat 1⅓.6 M&M 2.5.4

Contribution to Growth Each sub-component contribution to the growth rate is the product of its importance in expenditure at time t-1 and the size of its own growth rate For each component k, this contribution can be calculated as:

Volume Levels To compare the level of aggregate quantities at different points in time, total up the growth that appears in between periods. 1.Calculate the growth rate for all periods using the prices from the immediately previous periods to adjust current values. 2.Choose a reference period, ref, preferably in a recent period and set a constant price series equal to value in that period

Chained Index 3.Define the constant price series recursively in all periods using the equation The relationship between the levels of the chain volume index at any two points t and t+T is the product of the growth between the two points.

Implicit Price Deflator An estimate of the price level is the ratio of the value to the quantity in chained dollars.

GDP per Capita Population changes over time To assess income levels over time, we divide by population Link

Comparing GDP across Countries We want to compare output in two countries though those are measured in different currencies.

Exchange Rate: S - # of domestic currency units purchased for 1 US$. An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation. Exchange Rates

Convert sums into another economy’s currency N j is a number measured in country j’s currency (e.g. GDP) that you want to convert it into the reference country’s currency. Exchange Rate Conversion Link

Exchange Rate Method Exchange Rate Method can be a useful measure if you are going to convert income in one area and spend it in another. – Ex. Your Swiss food company projects that it can at most get a 20% share of the market for Mexican processed foodstuffs. Converting the size of Mexico’s processed food expenditures from Pesos to Swiss Francs is useful info for estimating profits.. But macro aggregates are often used to give an idea of living standards, here exchange rates are not as useful because they are highly variable and not so representative..

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Big Mac Index Economist magazine reports big differences in the x-rate converted prices of McDonalds in different countries. Big Mac is a bundle of different goods and services which can be a reasonable sample. Economist Magazine

PPP: Purchasing Power Parities PPP is the relative price of goods in one country measured in its own currency compared to the price of a reference country. Example: If Big Macs were only good and cost HK$18.90 in HK and US$3.71 in USA, then PPP HK =5.0943HK$/US$ Problem: Many goods

Market Basket Index? Construct an international market basket of goods produced and purchased around the world. For country j, PPP j could be the relative price of the market basket relative to price of the market basket in US$. Problem: Judging the cost of living by the cost of the international market basket may not be fair if customers in the local market can buy the types of goods which are cheaper at home.

Major project to compare prices internationally implemented by the World Bank with the help of UN and national statistical agencies. ICP has been implemented by UN Statistical Office since Link

PPP’s 1.Divide expenditures into k = 1,..,K (in 2005, K = 155) “basic heading” categories of goods. 2.All j = 1,..J countries (in 2005, J = 146) report total expenditure in domestic currency of all categories. ICP Handbook

PPP’s cont. 3.Sample prices of representative goods from each category in each country. 4.Construct average of those prices (relative to “anchor” economy) for each country j basic heading type of good k. Note: Measured in # of j country Currency units per anchor country currency units. Example. If Japan = j and anchor is USA, and 1 kg. rice is 400 yen in Japan and $2 in USA :

PPP in Anchor Currency. 4.Define quantity of good of type k valued 5.Calculate price of j’s market basket in j’s prices relative to price of j’s market basket in anchor country prices. Numerator in j currency, denominator in

Conceptually PPP is the cost of the goods purchased by consumers in their country relative to the cost of those same goods in anchor country terms.

Hong Kong PPP per Category WDI provides PPP data for many countries using US$ as anchor currency

Constructing accurate PPP’s takes a long time. Last completed project from Link

GDP in Intl$ PPP’s are used to construct comparable measures of GDP for multiple countries by converting them into international dollars. Per capita GDP in international dollars is headline way of comparing living standards.

Developing countries tend to be relatively cheap with PPP’s being lower than exchange rates. OECD countries tend to have more similar price structures, though they tend to be relatively more expensive. High income, non-OECD countries tend to be relatively cheap. Compare values measured in different currencies using the PPP and exchange rate method.

PPP 2010

PPP vs. Exchange Rate Conversion Exchange rates are easily available so exchange rate is a “quick and dirty” comparison. – Measures how many US dollars someone could buy with average income. However, money goes farther in some countries as many types of goods are relatively cheap (especially in developing countries). – PPP conversion measures how much the goods purchased by the average person would cost in the US. Better measure of living standards.

GDP in US$ by Conversion Method

Is China the Biggest Economy in the World? Discuss Subramanian LinkLink