Macroeconomic Policy Analysis

in Low Income Countries

Lecture 2:
Real Sector:
Ouput and Prices

By Dr. Mark Ellyne

 OUTPUT EXTERNAL
REAL ABSORBTION Foreign Inflows
Trade Flows
Output
Foreign Reserves
Prices PRICES Foreign Prices

DEMAND -NCP NFA

MONETARY EXCHANGE RATE

Credit to Government PPP
Credit to Economy Critical Flows
NFA Interest Rates

DEMAND IMPORTS + DONOR

NCG AID

FISCAL
Tax Revenue &Grants Expenditure
Foreign Financing Domestic Financing (T-Bills)

2
 Goals of the Lecture

 Understand the National Accounts and its

various measures
 Be able to project real GDP and the GDP
price deflator using alternative
methodologies, including:
 Trends
 Filters
 Production function
In order to estimate nominal GDP
Dr. M Ellyne – Macro Policy Analysis 4
 Key Elements of the
Real Sector?
Output: GDP and national income
accounts
 Prices: CPI and GDP deflator
Important but needs to be examined
separately:
Income distribution
Employment
Market structure

Dr. M Ellyne – Macro Policy Analysis 5

1 - National Accounts by Activity
Nominal & Real

Value added by:

Primary sector (Agriculture)
+ Secondary sector (Industry)
+ Tertiary sector (Services)
= GDP at basic prices (factor costs)
+ Taxes less subsidies on products
= GDP at market prices (purchasers
prices)

6
2 - National Accounts by Expenditure
Nominal and Real
+Consumption expenditure
government
private
+ Investment expenditure
government
private
+ Exports of goods and nonfactor services
+ Imports of goods and nonfactor services
+ indirect taxes - subsidies
= Gross Domestic Product at market prices
7
 National Income

GDP = C + I + (X-IM)gnfs
+ Factor Income (FI)
= Gross National Income
+ Transfers from ROW (Tr)
= Gross National Disposable Income

Y = C + I + CAB

9
 Absorption Approach

Absorption (A) = C + I
Production = Y
Y – A = CAB
• Can absorption be greater than
production?
• Is this bad?

Dr. M Ellyne – Macro Policy Analysis 10

 Is Internal Balance Separate from
External Balance?
Y = (C + I) + (X-IM)
(Y - C – I) = (X-IM)

(Y - C – I) = (S – I)
=Internal balance
= (X-IM) = CAB
= External balance
 Savings = Y-C
 External current account balance (CAB) reflects the internal
saving-investment gap. External balance must be consistent
with internal conditions.
Dr. M Ellyne – Macro Policy Analysis 11
Dividing Internal Balance Between
Government and Private Sector
Y = (C + I) + (X-M)
(Y - C – I) = (X-M)
Y = (Cg+Cp) + (Ig +Ip) + CAB
(T- Cg- Ig)+[(Y-T) - Cp- Ip)] = CAB
Fiscal Bal + Pvt Bal = CAB

BOP: CAB + CFA = ΔNFA = 0

The current account balance must financed
by capital flows

Dr. M Ellyne – Macro Policy Analysis 12

3 - National Accounts by Income
Nominal
GDP =
+ Compensation of employees (Wages)
+ Return on Capital, including:
Operating Surplus of enterprises (Profits)+
Rents + Interest income
+ Taxes less Subsidies on Products
= Gross Domestic Product at market prices

= Labour income + Capital profit

13
 National Output and Productivity

National Income (P*Y) =

labour income (W*L)+capital profits (R*K)
PY=WL+RK
1 = WL/PY + RK/PY
= labour share + profit share
If the wage share of total income rises,
then the profit share must fall.
Given: Prices, Y real output, Wage rate, Labour force, amount of
Capital, and Rental rate of capital (interest rate)
14
The Battle Between Wages and Profits

1 = WL/PY + RK/PY
= (W/P)/(Y/L)+ RK/PY
Y/L = Productivity
W/P = real wage
1. If productivity growth is greater than wage
growth, what happens to profits and prices?
2. If wage growth is greater than productivity
growth, what happens to profits and prices?
15
 Economic Growth Theory:
The (Exogenous) Supply Side
Y = TFP KαL (1-α)

Y = Real GDP (Output)

 K = Capital stock (∑Inv-depr)
 L = Labour force,
 TFP = Total factor productivity
 Education and skills-Labour
 Technological progress-Capital
04/22/2023 Africa and the IMF – Mark Ellyne 16
 What is TFP

K is quantity of undifferentiated capital

L is quantity of labourers
TFP captures quality issues of quality of capital
and labour:
 Skilled labour
 Technological progress
There may be other factors at work
 Governance
 Institutions
…
04/22/2023 Africa and the IMF – Mark Ellyne 17
 Solow Growth Model

• “Sources of growth” analysis

• Using Cobb-Douglas production function
Y = TFP Kα L (1-α)
Ln(Y) = ln(TFP)+αln(K)+(1-α)ln(L)

%∆Y= %∆TFP+ α %∆K + (1- α)%∆L

where:
TFP is generally thought of as constant and affects long-run
growth;
α= share of growth due to K (.33 to.5)
(1- α)= share of growth due to Labour (.67 to .5)
18 18
 Growth Accounting

Based on the estimated average Capital

(α) and Labor (1-α) shares, we can identify
the historical TFP from the estimated
equation.
Typically, α is between .33 and .5

Dr. M Ellyne – Macro Policy Analysis 19

 How to Calculate TFP

%∆Y= %∆TFP+ α %∆K + (1- α)%∆L

TFP is the Solow residual:
%∆TFP = %∆Y – (α %∆K + (1- α) %∆L)
Assume for 2010-2014:
• economy grows at 5%;
• Capital share = α=.5 = labour share;
• labour (population) growth of 3%; and
• capital growth rate of 3.0%.

04/22/2023 Africa and the IMF – Mark Ellyne 20

 How to Calculate TFP

%∆TFP = %∆Y – (α %∆K + (1- α) %∆L)

On average:
%∆TFP=.05-(.5*.03+.5*.03) = .02 = 2.0%

This could be done on year-by-year basis to look for

shifts in TFP
%∆TFP = %∆Y - α %∆K - (1- α) %∆L

04/22/2023 Africa and the IMF – Mark Ellyne 21

How to Calculate the Capital Stock

Kt = Kt-1 (1- d) + It
Capital stock = old stock – depreciation + new
capital (investment)
At steady state, K grows by g
K(t-1)(1+g) = K(t-1) – d K(t-1) + I
I = K(t-1)(g+d)
I/K = g+d
Need K0 ≈ beginning stock
K0 ≈ I0/(d+g)
22
 Endogenous Growth Theory

The Solow growth model tends to depend on

exogenous factors of production (K & L) and
some constant level of technological
progress, resulting in constant returns to scale
The new growth theory views technological
progress as endogenous, dependent on
knowledge, and creating increasing returns to
scale.
TFP = F{knowledge}
23
How to Identify The Business Cycle

Unobserved Components
Most variables can be decomposed into 3
components:
Y = Ytrend + Ycyle + Ynoise
Cyles may be short-term (seasonal
factors) and/or long-term (business cycle)
 To separate the cycle from the trend and
identify both, use the HP filter

Dr. M Ellyne – Macro Policy Analysis 28

 The Output Gap

ygap = [y – ypotenital]
The output gap is intended to be a pressure
gauge. The problem is that we don’t know
the correct ypotential, so we use some
measure of an output trend.
The best strategy for capturing ytrend is a
moving average or frequency filter.

Dr. M Ellyne – Macro Policy Analysis 29

 Hodrick-Prescott (HP) Filter

The HP filter is a 2-sided moving average

filter that smoothes series S around trend
Y by minimizing the variance of the
difference (Y-S) subject to a penalty that
constrains the second difference of S. The
penalty parameter (λ) controls the
smoothness of the series.

Dr. M Ellyne – Macro Policy Analysis 30

 How the HP Filter Works

The HP filter creates a smoothed series S

from original series Y, by minimizing the
formula:
∑(Y-S)2 + λ∑[(St+1-St)-(St-St-1)]2
The first term keeps S close to Y; the
second term is the penalty for abrupt
movements in S; thus λ can be thought of
as a smoothing coefficient.
As λ approaches infinity, S →linear trend.
Dr. M Ellyne – Macro Policy Analysis 31
 Estimating the Output Gap for
SA GDPR
Hodrick-Prescott Filter (lambda=1600)
180,000

160,000
Smoothed output = Trend cycle 140,000

120,000
6,000
100,000
4,000
80,000
2,000
60,000
0 40,000

-2,000

-4,000 Cycle = Actual-trend

-6,000
1980 1985 1990 1995 2000 2005 2010 2015

KBP6647D Trend Cycle

32
OutputGap = HP_cycle/HP_Trend*100
GDP_GAP
4

-1

-2

-3

-4

-5
1980 1985 1990 1995 2000 2005 2010 2015

Dr. M J Ellyne 33
 Useful to know where you are in the
business cycle, as it can assist you in
making projections view of economic
developments

Dr. M Ellyne – Macro Policy Analysis 34

 Projecting the Trend:
Which One?
Madagascar Real GDP (level) and Growth Rate
600 Trend 2 15

550 10

500 Growth 5
rate
1984 Ar bn

%
450 0
Trend 1

400 -5

350 -10
Real

300
GDP -15
1990
1986

1987

1988

1989

1991

1992

1993

1994

1996

1997

1998

1999

2001

2002

2003

2004

2005

2006
1984

1985

1995

2000

2007
Dr. M Ellyne – Macro Policy Analysis 35
 Constant Growth Trend

Log(Y) = a + b time
Yt = e(b*Time+a)
Yt = e(b*Time) e(a)
b = average growth rate (decimal)
then
Yt+1 = Yt (1+b)
[In Excel]

36
What is the Average Annual
Growth Rate 1980-2015q1?
Dependent Variable: LOG(GDPR_TREND)
Method: Least Squares (Gauss-Newton / Marquardt steps)
Date: 07/23/15 Time: 16:08
Sample: 1980Q1 2015Q1
Included observations: 141
LOG(GDPR_TREND) = C(1) +C(2)*@TREND(1950)

Coefficient Std. Error t-Statistic Prob.

C(1) 10.11235 0.010215 989.9670 0.0000

C(2) 0.007432 5.26E-05 141.3809 0.0000

R-squared 0.993094 Mean dependent var 11.52449

Adjusted R-squared 0.993044 S.D. dependent var 0.304644
S.E. of regression 0.025407 Akaike info criterion -4.493464
Sum squared resid 0.089730 Schwarz criterion -4.451637
Log likelihood 318.7892 Hannan-Quinn criter. -4.476467
F-statistic 19988.55 Durbin-Watson stat 0.009589
Prob(F-statistic) 0.000000

37
 But Yearly Growth Has Varied
GROWTH
8

4
2.8%
2

-2

-4

-6
1980 1985 1990 1995 2000 2005 2010 2015
38
 More Recent Growth Trend
May Be Appropriate for Near Term
Dependent Variable: LOG(GDPR_TREND)
Method: Least Squares (Gauss-Newton / Marquardt steps)
Date: 07/23/15 Time: 16:15
Sample: 2009Q1 2015Q1
Included observations: 25
LOG(GDPR_TREND) = C(1) +C(2)*@TREND(1950)

Coefficient Std. Error t-Statistic Prob.

C(1) 10.97986 0.002904 3780.687 0.0000

C(2) 0.003904 1.17E-05 333.4956 0.0000

R-squared 0.999793 Mean dependent var 11.94799

Adjusted R-squared 0.999784 S.D. dependent var 0.028734
S.E. of regression 0.000422 Akaike info criterion -12.62628
Sum squared resid 4.10E-06 Schwarz criterion -12.52877
Log likelihood 159.8285 Hannan-Quinn criter. -12.59924
F-statistic 111219.3 Durbin-Watson stat 0.260079
Prob(F-statistic) 0.000000

39
 Autoregressive Growth Equation

Dependent Variable: @PCY(GNI_R)

Method: Least Squares (Gauss-Newton / Marquardt steps)
Date: 07/26/16 Time: 12:19
Sample (adjusted): 1982Q1 2015Q1
Included observations: 133 after adjustments
@PCY(GNI_R) = C(1)+C(2)*@PCY(GNI_R(-1))+C(3)*@PCY(GNI_R(-4))

Coefficient Std. Error t-Statistic Prob.

C(1) 0.627800 0.200116 3.137182 0.0021

C(2) 0.847825 0.057202 14.82151 0.0000
C(3) -0.111204 0.057377 -1.938125 0.0548

R-squared 0.652549 Mean dependent var 2.334995

Adjusted R-squared 0.647203 S.D. dependent var 2.719321
S.E. of regression 1.615186 Akaike info criterion 3.819076
Sum squared resid 339.1474 Schwarz criterion 3.884272
Log likelihood -250.9685 Hannan-Quinn criter. 3.845569
Durbin-Watson stat 1.897439

@PCY(GNI_R) = 0.627 + 0.848*@PCY(GNI_R(-1)) - 0.111*@PCY(GNI_R(-4))

40
Fit always lags behind actual

0
6

4 -4

2
-8
0

-2

-4

-6
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Residual Actual Fitted

41
Forecast goes to Trend after lags

-1
00 02 04 06 08 10 12 14 16 18 20

@PCY(GNI_R_F1) @PCY(GNI_R)

42
Growth and the Harrod-Domar Model
Y = F(K)
Growth is determined by the Savings or
Investment rate, divided by the Kapital/Output
(K/Y) ratio.
 dy/Y=g=(S/Y)/(K/Y)
If I=S
dY/Y = I/K = dK/K
Because marginal productivity of Kapital is
constant: dK/dY = K/Y

43
 World Bank Shortcut:
Incremental Capital Output Ratio
ICOR = dK/dY
A long run relationship between real
investment and growth can be summarized in
the ICOR
ICOR = ΔKt-1/ΔGDPt-1 = Constant
If the ICOR is constant or can be projected,
then:
ΔKt+1 = It+1 = ICOR*ΔGDPt+2

44
Incremental Capital Output Ratio

ICOR = ΔKt-1/ΔGDPt
Can be transformed to
ICOR t =(I/GDP)t-1/(ΔGDPt/GDPt-1)
= (I/GDP)t-1/%ΔGDPt
Although the ICOR is often
very volatile, use the average ICOR over
past several year as
the future ICOR
Dr. M Ellyne – Macro Policy Analysis 45
 ICOR - Madagascar
'Incremental Capital Output Ratio'

15.0

[Average (1985-2007) = 3.6 (excl. 1994)]

10.0

5.0
%

0.0
1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007
-5.0

[Average (1999-2007) = 2.4]

-10.0
-280

-15.0
46
 Use the ICOR
to Calculate Investment
For Madagascar, 1998 – 2008:
Average ICOR = 3.6
For Future Growth of 5.6% pa
(I/GDP)t+1=%GDP*ICORavg
= 5.6%*3.6 = 20.1
An investment ratio of 20.1% is needed to
sustain expected growth of 5.6, assuming
an ICOR of 3.6

Dr. M Ellyne – Macro Policy Analysis 47

 ICORs, Investment and Growth

ICOR = (I/GDP)t-1/%ΔGDPt

Required Investment/GDP Ratios

I/GDP Ratios Growth

Lo Mid Hi
ICOR 2.5% 4.0% 7.0%
Efficient 3.0 7.5 12 21
ICOR
Mid 4.0 10 16 28

Inefficient 6.0 15 24 42

48
 Where are we going?

Project Nominal GDP projection from real

GDP and GDP price deflator:
GDP = GDP_R*P_GDP
Project investment from ICOR
Project consumption from GDP
Assess standard of living as Consumption/Pop
Use nominal GDP to drive fiscal revenues, and
the demand for money.

Dr. M Ellyne – Macro Policy Analysis 49

 Key Prices

Consumer price index

GDP Deflator
Export and import unit prices
Nominal Interest rate
Nominal exchange rate
Average wage rate

Dr. M Ellyne – Macro Policy Analysis 50

 The Role of Price
Real vs Nominal
Real = nominal value adjusted for price effect
Real factors drive the economy
Value = Quantity x Price
Nominal = Real x Price
(1+%Δvalue) = (1+%Δquantity)(1+%Δprice)
Individuals operate on nominal values

Real = Nominal adjusted for Price

 Real Money Supply: Ms/P
 Real interest rate: r = i – E{π}
 Real Exchange Rate: NER*Pf/Pd
Dr. M Ellyne – Macro Policy Analysis 51
 Projecting Prices:
Start with CPI
Use the high frequency data to make the
projection for current year. Use annual
projections thereafter.
Check data for Seasonality
Remove seasonality or project monthly CPI
on a year over year basis
Make a long-term annual forecast based on
trends or simple macro variables

Dr. M Ellyne – Macro Policy Analysis 52

 Seasonality is an Annual Cycle

Many cycles:
Multiplicative: Actual =
Trend*SeasonalFactor*Random
[Additive: Actual = Trend+Seasonal+Random]

Long cycles – use HP filter

Annual cycle – use Seasonal Adjustment

55
 Seasonal Adjustment

If there is a strong seasonal pattern, it is

more effective to project the underlying
trend-cycle and then add back the
seasonality, or
Project monthly values with year-over-year
growth rate to impose same seasonality in
the future.

Dr. M Ellyne – Macro Policy Analysis 56

 Seasonal Adjustment
(X-13 Model Eviews)
The multiplicative model:
Actual CPI = (Trend cycle)
*(Seasonal factor)
*(Random factor)

 Seasonally Adjusted = (Actual)/(Seasonal

factor)

A monthly season factor of 1.05 means that the actual

value tends to be 5% above the average/trend value.
Dr. M Ellyne – Macro Policy Analysis 57
 Test for Seasonality
Madagascar CPI
STABLE SEASONALITY TEST [among months]
HO: The monthly seasonal factors are not different
SUM OF DGRS.OF MEAN
SQUARES FREEDOM SQUARE F
BETWEEN MONTHS 90.611 11 8.237 23.414
RESIDUAL 16.887 48 0.352
TOTAL 107.498 59
F is significant, therefore reject HO
==> IDENTIFIABLE SEASONALITY PRESENT

Dr. M Ellyne – Macro Policy Analysis 58

 Testing for Seasonality
Madagascar CPI
MOVING SEASONALITY TEST over time
HO: The seasonal factors are shifting over time
SUM OF DGRS.OF MEAN
SQUARES FREEDOM SQUARE F
BETWEEN YEARS 7501.3954 4 1875.34 0.624
ERROR 132334.082 44 3007.59

The F test is not significant enough to reject H0.

==> There may be some movement in the seasonal factors
over time

Dr. M Ellyne – Macro Policy Analysis 59

 Seasonal Factors
Madagascar CPI
102.5

102.0

Seas factor 101.5

101.0

100.5
32
100.0

28
99.5

24 99.0

98.5
20
98.0
16

12 Inflation SA
8

4
2005M01 2005M07 2006M01 2006M07 2007M01 2007M07 2008M01 2008M07

CPI_SF2 INFLATION_SA

60
 Projecting Monthly CPI
and Inflation

For the remaining months of the years

project the monthly CPI by using the recent
trend annual inflation rate.
CPIt+1= (1+ π*t+1/100) CPIt+1-12

π*t+1 = trend annual inflation rate

Dr. M Ellyne – Macro Policy Analysis 61

 Date CPI_ZAM (IFS) Inflation Annual Avg CPI

2016 Jul 169.57 20.2%

2016 Aug 170.16 19.6%

2016 Sep 170.30 18.9%

2016 Oct 171.17 12.5%

2016 Nov 173.79 8.8%

2016 Dec 175.31 7.5% 169.7823

2017 Jan 176.82 7.0%

2017 Feb 178.53 6.8%

2017 Mar 179.14 6.7%

2017 Apr 179.78 6.7%

2017 May 179.91 6.5%
2017 Jun 181.02 6.8%

2017 Jul 180.97 6.7% =181.1

2017 Aug 181.43 6.6% Avg
2017 Sep 181.41 6.5%
projections
2017 Oct 182.33 6.5%
2017 Nov 185.13 6.5%
2017 Dec 186.75 6.5% 181.10
62
 Econometric Inflation Forecasts

Inflation is based on a pass-through of supply

prices and demand pressures.
Supply side:
Food and Energy prices in local currency
Wages (momentum)
Demand side:
Output gap
Money growth

Dr. M Ellyne – Macro Policy Analysis 63

 Phillips Curve

πt = α +
+ β1*E{πt} Expected
inflation/Supply
+ β2*%GDPR Demand pressure
+ єt

Dr. M Ellyne – Macro Policy Analysis 64

 A Basic Equation to Try

πt = α + β1πt-1 + β2*%GDPRt + Trend+ єt

πt = α + β1πt-1 + β3*%Poilt + β2*%GDPRt + єt

Domestic External
Domestic demand
supply Supply

65
 Note shape of Trend
Infl = C(1)/@trend + C(2)
.5

.4

.3
.15
.2
.10
.1
.05
.0
.00

-.05

-.10

-.15
96 98 00 02 04 06 08 10 12 14 16

Residual Actual Fitted

66
Then Add Variable to Trend Line
Dependent Variable: INFL
Method: Least Squares (Gauss-Newton / Marquardt steps)
Date: 08/21/17 Time: 20:36
Sample (adjusted): 1996 2016
Included observations: 21 after adjustments
INFL = C(1)/@TREND +C(2) + C(3)*INFL(-1) + C(4)*@PCH(GDPR)

Coefficient Std. Error t-Statistic Prob.

C(1) 0.469955 0.165542 2.838891 0.0113

C(2) 0.078219 0.036801 2.125421 0.0485
C(3) 0.292053 0.185534 1.574121 0.1339
C(4) -0.354097 0.431296 -0.821005 0.4230

R-squared 0.803814 Mean dependent var 0.169466

Adjusted R-squared 0.769193 S.D. dependent var 0.092196
S.E. of regression 0.044293 Akaike info criterion -3.226335
Sum squared resid 0.033352 Schwarz criterion -3.027378
Log likelihood 37.87652 Hannan-Quinn criter. -3.183156
F-statistic 23.21750 Durbin-Watson stat 1.542818
Prob(F-statistic) 0.000003

67
 Capturing Past Momentum

Using a lagged dependent variable on the left hand

side of the equation, imposes an exponential
weighted average on all of the right-hand-side
variables
Yt = bo Xt + α Yt-1
Yt = ∑bo(1-α)(i) Xt-i

Short run response of X = bo

Long run response of X = bo/(1-α)
68
 Projecting Nominal GDP

PGDP = GDP/GDP_R

[log(GDP) = log(PGDP)+log(GDP_R)]

(1+%GDP) = (1+%PGDP)*(1+
%GDP_R)

%GDP ≈ %GDPR + %PGDP

Dr. M Ellyne – Macro Policy Analysis 71
 Components of GDP Deflator

 GDP = C + I + (X – IM) Nominal

 GDP_R = C_R + I_R + X_R + IM_R Real
 PGDP = GDP*GDP_R Deflator
Deflators:
 GDP = PC*C_R+PI*I_R+PX*X_R+PIM*IM_R
 The weighted average of the sector deflators must
equal the overall average:
 PGDP = wcPC + wIPI + wxPX – wIMPIM

 Sum(wi) = 1, GDP shares

Dr. M Ellyne – Macro Policy Analysis 72
 If Insufficient Information For
Individual Deflators - Use CPI Inflation
%PGDP = 1.475*%PC + .27*%PI + .575*%PX – 1.32*%PIM
Simplest assumption:
%GDP = %CPI

because
CPI ≈ Consumption deflator
Investment inflation = average of domestic inflation
+ imported inflation
Export inflation ≈ domestic inflation

Dr. M Ellyne – Macro Policy Analysis 76

 The Nominal Interest Rate

Use the Fischer Relationship

Nominal rate = inflation + real rate
i=π+r
Hold r constant from previous period
(no-policy-change)

77
 The Real Exchange Rate

Nominal exchange rate adjusted for relative

price differential
RER = NER Pf/Pd
NER in dom/for currency (R/$), so increase
= depreciation

78
 What you should know:

Understand the national accounts

identities and internal-external balance.
Be able to project real GDP by one or
more methods.
Understand the sources of growth
methodology.
Be able to project CPI inflation.
Project nominal GDP from price and real
GDP projections
Dr. M Ellyne – Macro Policy Analysis 79