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Introduction to Economics ECO401

Lesson 11.5

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED.......)

Determinants of Capital Account:

Although the focus of discussion above has been the current account, it is useful to briefly look

at the determinants of the capital account, and the factors which increase the ability of a

country to attract capital account inflows:

a. The attractiveness of the macroeconomic environment, the law and order situation etc.

is an important determinant of foreign investment inflows into the country. The better

the situation, the more inflows can be expected by way of direct investment by foreign

firms.

b. The more favourable are international conditions to borrowing (foreign lenders' attitude

towards, and perception of, the borrowing country; foreign interest rates), the more

easily can a country raise foreign debt.

c. If foreign interest rates are lower than domestic interest rates (the latter adjusted

downwards for any expected exchanger ate depreciation), then foreign portfolio

investors will want to invest in the domestic country's stocks, bonds and other interest

bearing assets. The underlying relationship being referred to here is that of interest

parity which says: id - ΔEe should approximately equal if if private portfolio flows are to

balance. Here id stands for domestic interest rate, ΔEe is the expected depreciation

adjustment, and if is the foreign interest rate.

If it is not already clear, the costs of running a high BOPs or current account deficit (high is

usually defined as over 5% of GNP) for a long time can be fairly severe. The country risks

losing precious foreign exchange reserves if the exchange rate is fixed.1 In this case, a

monetary contraction, and hence AD contraction, follows the loss in reserves with obvious

social costs. Alternatively, if the country completely runs out of reserves, a BOPs crisis can

occur which can be very costly both in terms of the image of the country internationally as well

as its ability to borrow and attract investment from abroad.

GROWTH

The Concept of Growth and Growth Rate:

Economic growth is increase in an economy's level of production, output or income. We can

talk about production or output in two broad definitional contexts. One, we can compare real

GDP with some other measure of welfare (for e.g., one which adjusts for externalities, social

indicators, the black market, purchasing power parity, income inequality etc.). Two, we can talk

about potential vs. actual output. Potential output is the aggregate capacity output of a nation;

the maximum quantity of goods and services that can be produced with available resources

and a given state of technology.2 In our discussion here, we will abstract from such

complexities and take output to simply mean real GDP.

The growth rate of a country's real GDP can be negative, positive or zero. A growth rate of

between 2-3% is considered normal for mature developed countries; for LICs, 5-7% is

considered healthy and 7%+ excellent.

Per Capita Real GDP:

When studying growth, it is always instructive to analyse changes in per capita real GDP along

with changes in real GDP. Per capita real GDP growth adjusts GDP growth downwards by the

population growth rate and gives a more accurate indication of improvements in living

Note that serious BOPs problems or crises are unlikely under floating exchange rates.

Thus, when the production possibilities frontier of a country shifts out, that represents an increase in potential

GDP. Actual GDP can be less than or equal to potential GDP, and is usually less. The difference between potential

and actual GDP is sometimes referred to as the output gap.

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Introduction to Economics ECO401

standards in a country. For mature HICs, Real GDP growth rate = per capita real GDP growth

rate, since the population size in these countries is quite stable.

It is also important to note that even a small per capital real GDP growth rate (say around 2%

p.a.), if sustained for a very long very of time (say 100 years) can deliver huge improvements

in living standards. The U.S. and Japan in the 19th and 20th centuries and East Asian tiger

economies in the last four decades are a neat example of this.

Why Growth is an Important Macroeconomic Issue:

It is obvious why growth is an important macroeconomic issue. Every government aspires to

deliver a higher growth rate for the country. High growth rates means higher national income

which means better living standards on average, which in democracies, means happier

electorates and therefore increased chances of re-election for another term in office. However,

while all countries might wish to achieve high growth rates, in practice, only a handful have

been able to convert the wish into reality.

Traditional Thinking about Growth:

Traditional thinking on growth was that it can be driven either by an increase in factor

resources (land, natural resources, labour, capital), i.e. an increase in potential GDP, or by

more efficient use of the factors, i.e. a move from inside the PPF to the PPF. The policy

implication attached to this line of thinking was simple. Countries must either accumulate

factors of production (esp. capital), or develop more cost-efficient technologies and methods of

production to utilize those resources better. In any event, factors of production were at the

heart of growth theory.

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