DEV 300: Economics and Development

Lecture 7

GDP Growth Rate at Current and Constant Prices

GDP Growth Rate

Structural Change of GDP

Investment as percent of GDP

What is money?

Money is the stock of assets that can be readily used to make transactions. Functions of money:

Store of value A unit of account A medium of exchange

The quantity of money is called the money supply and the control over the money supply is called the monetary policy.
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Quantity Theory of Money

MXV=PXY Where, P = Price of one unit of output Y = the amount of output V = Income velocity of money M = Quantity of money

Quantity Theory of Money

if velocity (V) is fixed, than a change in the quantity of money (M) must cause a proportional change in nominal GDP (PY). Factors of production and the production function determined real GDP Price level is proportional to money supply. In percentage form, % change in M + % change in V = % change in P + % change in Y. where, % change in the price level is the inflation rate.

Inflation and Interest rate

r=i Real interest rate is the difference between the nominal interest rate and the rate of inflation The Fisher Effect According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% increase in the rate of inflation. According to the Fisher equation, a 1% increase in the rate of inflation causes a 1% increase in the nominal interest rate

National Inflation Rate

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Defining Inflation
A continuing increase in an economys overall price level is called inflation. Inflation is measured by the change in the consumer price index (CPI). The CPI is used to measure changes in the cost of living over time.

Point-to-point inflation:
It refers to the change in the CPI in a period (month/quarter/year) over the corresponding period of the previous year.
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Causes of inflation
There are two main theories about the causes of inflation i. Demand-pull inflation and ii. Cost-push inflation.

The reality is probably a blending of the two. Demand-Pull Inflation: Prices are pulled up by an increase in aggregate demand. Fiscal and monetary policies lead to monetary expansion, which in turn causes inflation. Cost-Push Inflation: As a result of cost-push factors such as increase in wages, world market prices of imported inputs, government-administered prices, the general price level is pushed up.

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Measuring Inflation
Three different price indices are published by Bangladesh Bureau of Statistics --i. The consumer price index (CPI) with 1995/96 as the base, ii. The index of wholesale prices of agricultural and industrial products (WPI) with 1969/70 as the base, and iii. The GDP deflator (GDPD, which is the ratio of nominal GDP to real GDP times 100) with 1995/96 as the base.

The CPI measures the prices of a representative basket of domestic and imported final goods and services purchased by an average consumer.
The WPI measures price movements of selected agricultural (41) and industrial products (45) at the wholesale market and thereby provides some advance information on prospective CPI movements. The GDPD is a price index of all domestically produced goods and services and reflects the overall trend of sectoral price changes.
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Measuring Inflation, contd

The reasons for adopting CPI for assessing inflationary trends are given below :

The CPI measures the cost of living of an average consumer and is therefore the most appropriate in terms of the welfare of individuals in the economy.
An increase in the price of an imported good, such as oil shows up in CPI.

Time-series data on monthly basis are available for CPI.

CPI remains important because it is used for indexation purposes for many wage and salary earners (including government employees).

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Currently, Bangladesh Bureau of Statistics (BBS) is compiling consumer price indices with 1995/96 as the base year for general, food and non-food at national, rural and urban levels. The Household Expenditure Survey of 1995-96 has provided weights for the consumption basket for the base year 1995/96. The following eight groups of consumption items are included in the CPI commodity basket (Table 1):
Table 1: Groups of Consumption Items included in CPI Groups 1 2 3 Food, beverage and tobacco Clothing and footwear Gross rent, fuel and lighting
Weights in CPI (%)

62.32 6.88 14.69

4
5 6 7 8

Furniture furnishing, household equipment and operation

Medical care and health expense Transport and communications Recreation, entertainment, education and cultural services Miscellaneous goods and services Total

2.70
2.79 2.98 3.20 3.80 99.36
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Source: BBS

Determinants of Inflation
Theoretical Framework for Analyzing the Determinants of Inflation The Monetarist Approach The two approaches namely, the monetarist and the structuralist approaches explain the inflationary pressure in a developing country. According to monetarists, a rate of growth of money supply over and above the rate of growth of output will exert an upward pressure on prices. "Inflation is always and everywhere a monetary phenomenon." So wrote Milton Friedman (1956). Monetarists argue that maintaining a stable price level through the control of money supply would take care of economic imbalances and rigidities in the country. Harberger (1963) and Vogel (1974) modeled the monetary version of the inflationary process.

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Determinants of Inflation,

contd

Operationalizing the Monetarist Approach

Growth Rate of Broad Money (M2): Narrow money (M1) comprises currency outside banks plus demand deposits. Broad money equals the sum of narrow money and time deposits. An increase in money supply (M2) is expected to result in higher prices. Real GDP Growth Rate: An increase in real income is expected to lead to a decline in prices. As real output increases, the aggregate supply curve shifts to the right resulting in a decline in the aggregate price level and hence lowering inflation. Nominal Wage Rate: The wage rate with the base of 1969/70 is intended to measure the movement of nominal wages of skilled and unskilled labor over time in different sectors of the economy. In computing this index, sub-sectors namely, (1) manufacturing industry (large scale and small scale separately), (2) agriculture, (3) fishery and (4) construction are included. An increase in money wage adds to the inflationary pressure of the economy.
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The Structuralist Approach

On the other hand, structuralists (Maynard, 1962; Edel, 1968; Hirschman, 1961, Myrdal, 1968) argue that inflation is inevitable in a developing country that is attempting to achieve rapid economic growth in the presence of structural constraints. Argy (1970) and Hagger (1977) developed models, which capture the arguments of structuralists. Structuralists identify the three principal structural elements contributing to inflation: (1) supply bottlenecks in the case of both agricultural and industrial output, (2) fiscal bottlenecks and (3) foreign exchange bottlenecks.

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Measures of Supply Bottlenecks

Food import as percentage of food availability Changes in food price (%) Capacity utilization in industry

Measures of Fiscal Bottlenecks

Budget deficit (as % of GDP) Gap in revenue target and collection

Measures of Foreign Exchange Bottlenecks

Exchange rate depreciation (%) Terms of Trade

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