1

Introduction to the Introduction to the Real SectorReal Sector

OverviewJan Gottschalk

TAOLAM

This training material is the property of the IMF – Singapore Regional Training Institute (STI) and is intended for the use in STI courses. Any reuse requires the permission of the STI. This training activity is funded with grants from Japan.

I. GDP

OverviewOverview

II. InflationIII. Nominal vs. RealIV. Forecasting GDP

1. Forecasting Real GDP2. Forecasting Inflation3 GDP D fl t3. GDP Deflator4. Putting It Together: Nominal GDP Forecasts

2

I. GDP I. GDP

Measure of output

Why Is GDP so Important?

• Measure of output• Approximation of welfare• Many other variables are moving broadly

proportional to GDP (e.g., revenues) GDP ratios GDP forecast is basis for revenue forecasts etc.M i k i GDP hl• Macroeconomic management: keeping GDP roughly in line with its potential

3

Gross output: value of all goods produced in the economy (double counting; example of wheat used in

What is GDP and How Do We Measure It?

economy (double counting; example of wheat used in production of bread)

Value added (VA): gross output minus intermediate consumption (eliminates double counting)

Gross Domestic Product (GDP): sum of value added across all sectors of the economy. Measures the value of final goods and services

Consumption: can be intermediate (inputs into production) and final (goods and services used byproduction) and final (goods and services used by households and government sector)

Gross investment (also called gross capital formation): additions to the physical stock of capital in the economy, such as building of machinery, facilities

Goods and services (real flo

Estimate of GDP

Production ApproachMoney (financial flow) ( sectoral "value added") Money (financial flow) ( sectoral value added )

"Goods Market" Expenditure Approach ( Y = C + I + X - M )

HOUSEHOLDS PRODUCERS

"Factors Market"

NON-RESIDENTS

Income Approach (Y = wages + OS+TSP)

Wages (financial flow)

OS=gross operating surpluses of enterprises (including profits, rents, interests)

Labor (real flow) TSP=taxes less subsidies

4

Production Approach: GDP SharesProduction Approach: GDP SharesComposition of GDP in Lao PDR (% of GDP, Constant 2002 Prices)

10%15%20%25%30%35%40%45%

AgricultureIndustryServicesNet taxes

0%5%

10%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Net taxes

Evolution of Value-Added in Industry SectorComposition of Industry Value-Added (% of GDP, 2002 Prices)

15%20%25%30%35%40%45%50%

ConstructionGas, electricity, waterMining and quarrying

0%5%

10%15%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Manufacturing

5

GDP Growth Rates – Production Approach60.0%

20.0%

30.0%

40.0%

50.0% Agriculture

Industry (excl. mining & gas, elec, water)

Mining & gas, electricity, water

Services

0.0%

10.0%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Net taxes

GDP

GDP Growth Contributions – Production Approach

9 0%

10.0%

3 0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

Mining & gas, electricity, waterNet taxes

Agriculture

Industry (excl mining &

0.0%

1.0%

2.0%

3.0%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Industry (excl. mining & gas, elec, water)Services

6

Absorption (A) Final Consumption (C) +

GDP from the Expenditure Side

Absorption (A) = Final Consumption (C) + Investment (I): A = C + I

Net Exports (X-M)X = Exports of goods and servicesM = Imports of goods and servicespo ts o goods a d se ces

GDP = A + X – MDomestic Demand Foreign Demand

Final consumption (C)Households: food, electricity, cars, mobile phones,

GDP from the Expenditure Side—Examples:

, y, , p ,etc.Government: ‘goods & services’ in recurrent budget both imported & locally produced goods Investment (I)

Machines, equipment both imported & locally produced goods

Exports (X)electricity mineral commodities (gold copper)electricity, mineral commodities (gold, copper), garments, wood products etc. Imports (M)

Cars, mobile phones, machines, equipment (see above)

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Expenditure Approach: GDP SharesExpenditure Approach: GDP SharesComposition of GDP in Lao PDR (% of GDP, Constant 2002 Prices)

30%40%50%60%70%80%90%

-5%0%5%

10%15%20%25%30%

Public consumption

Private investment

Public investment

Resource balance (X-M)

0%10%20%

-20%-15%-10%

20022003200420052006200720082009201020112012

Resource balance (X-M)

Private consumption (right axis)

GDP Growth Rates – Expenditure Approach200%

60%

70%

P i i

0%

50%

100%

150%

0%

10%

20%

30%

40%

50%Private consumption

Public consumption

Private investment

Public investment

-100%

-50%

-30%

-20%

-10%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Resource balance (X-M) [right axis]

GDP

8

GDP Growth Contributions – Expenditure Approach20.0%

R b l (X M)

5 0%

0.0%

5.0%

10.0%

15.0% Resource balance (X-M) [right axis]Public investment

Private investment

Public consumption

-15.0%

-10.0%

-5.0%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Private consumption

GDP

Inflation is a sustained increase in the overalli l l

III. InflationIII. Inflation

price level◦ Increase in average prices of all goods and services vs.

change in relative prices of individual goods and services◦ One-time increase in the price level vs. underlying inflation

Commonly used measures include changes in:y g− The consumer price index (CPI)− Wholesale (WPI) oror Producer Price Index (PPI)− The GDP deflator (PGDP)

9

Reasonably low inflation is equivalent to price stability

Why Do We Care About Inflation?

y key element of macroeconomic stability low inflation important for markets to function effectively, thereby supporting economic development high inflation has adverse social impact, especially on poor

Many macroeconomic variables have a price component e gcomponent, e.g.Nominal GDP = Real GDP * GDP Deflator Inflation helps understanding the price component

Inflation DeterminantsInflation Determinants

Π (Price Inflation)

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Inflation in Lao PDR: The Long RunInflation in Lao PDR: The Long Run

Annual inflation (year on year eop)

0 0%

50.0%

100.0%

150.0%

200.0%Annual inflation (year-on-year, eop)

-50.0%

0.0%

Jan-91M

ar-92M

ay-93Jul-94Sep-95Nov-96Jan-98M

ar-99M

ay-00Jul-01Sep-02Nov-03Jan-05M

ar-06M

ay-07Jul-08Sep-09Nov-10Jan-12M

ar-13

Inflation in Lao PDR: Recent YearsInflation in Lao PDR: Recent Years

Annual inflation (year on year eop)

2.0%4.0%6.0%8.0%

10.0%12.0%

Annual inflation (year-on-year, eop)

-4.0%-2.0%0.0%

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

Jan-13

Jul-13

11

Nominal GDP: measures the value of output of the economy at current prices

IV. Nominal IV. Nominal vs. Realvs. Real

of the economy at current prices Real GDP: measures the value of output of

the economy -- changes in an economy’s physical output -- using prices of a fixed base year Changes in nominal GDP over time reflect

changes in both prices and physical output

Distinction Between Nominal & Real Is Useful For (1) Purchasing Power

If inflation was 10%,Real buying power grew

BUT

If inflation was 30%,Real buying power shrank

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Distinction Between Nominal & Real Is Useful For (2) Accounting for Different Determinants

Fundamental relation to be used over & over !

Approximation: ∆%V ≈ ∆%P + ∆%Q

Nominal GDP (V) = GDP Deflator (P) * Real GDP (Q)

Exact relationship:(1+ ∆%V/100) =(1+∆%P/100)*(1+∆%Q/100)

V. Forecasting GDPV. Forecasting GDPWhy does forecasting GDPWhy does forecasting GDPmatter?• GDP forecast is the starting point for many other forecasts, e.g., revenues or imports• Similarly, GDP forecasts are

f j i GDPnecessary for projecting GDP ratios• GDP forecasts are central for macroeconomic management

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It’s difficult …It’s difficult …• It’s very rare that the f hi l hforecast hits exactly the mark (if so, it’s just luck!)• The forecast ‘number’ is important (e.g., for the budget), but …• … the ‘story’ behind the forecast is often as important

General Procedure• Start with analyzing the

h kpast what were key developments and how are they going to affect the present and future?• What do we know about the present (nowcast)?• Forecast is an extrapolation of past and present, taking policy (changes) into account

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Forecasting Real GDP (volume)

Specific Procedure

◦ Potential output and output gap◦ Supply: Production function Sectoral forecasts◦ Demand: expenditures (C + I + X - M)◦ Reconciliation of Supply & Demand Forecasting Inflation (prices) Obtaining Nominal GDP Forecast

V.1 Forecasting Real GDPPotential Output & Output Gap

• Potential GDP is the level of output that can be sustainably produced without adding or subtracting inflation pressures. That is, demand and supply are broadly in balance.

• Output gap: The difference between actual and potential GDP.

• Output gap may be positive or negative. − A positive output gap would signify an expansion that could

place excessive pressure on resources.− A negative output gap signifies idle resources—low capacity

utilization of capital stock and higher unemployment—that is likely to lead to declining rates of inflation or deflation.

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Output Gaps

Positive output gap:demand > supply

Negative output gap:d d ldemand < supply

NonNon--Resource Real GDP and Trend in Lao PDRResource Real GDP and Trend in Lao PDR

10.4

10.6

9 4

9.6

9.8

10

10.2

10.4

Real GDP excl. Resource Sector in natural logarithmTrend output

9

9.2

9.4

199019921994199619982000200220042006200820102012

16

Corresponding Output Gap in Lao PDRCorresponding Output Gap in Lao PDR6.0%

4 0%

-2.0%

0.0%

2.0%

4.0%

-8.0%

-6.0%

-4.0%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Actual and Trend NonActual and Trend Non--Resource Real GDP GrowthResource Real GDP Growth12.0%

4.0%

6.0%

8.0%

10.0%

Change in %Average

0.0%

2.0%

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

17

Q = f (K L A)

Supply Side: Production Function Approach for Forecasting Potential Growth

Q = f (K, L, A)where K = Capital

L = LaborA = Technology, Institutions

In the long run, increasing supply requires increasing A (through structural policies)

Production Approach to GDP:

Forecast production in each sector separately as they

Supply Side: Sectoral Forecasts

Forecast production in each sector separately as they may have different determinants, then add up the individual forecasts to obtain the total:

...,

1,

,

1,

,

1,1

tser

tserser

tman

tmanman

tagr

tagragr

t

t

GDP

GDPw

GDP

GDPw

GDP

GDPw

GDP

GDP

18

GDP = (CP + CG) + (IP + IG) + (X – M)Demand Side: Forecasting Expenditure

Fiscal sector BOP

We should be able to forecast public consumption and investment (CG & IG) using information from the budget. We might be able to construct forecast equations for exports and imports (X – M) [External sector]

Fiscal sector BOP

Private consumption (CP) is often fairly steady and not that difficult to forecastLeaves private investment (IP) as a very difficult element to forecast because this tends to be fairly volatile

V.2 Forecasting Inflation

Why does forecasting inflationWhy does forecasting inflationmatter?• Inflation forecast is the starting point for the price component of many other forecasts, e.g., GDP deflator

K i i fl i d l• Keeping inflation under control is central macroeconomic objective, which requires inflation forecast

19

Simple Inflation Forecasts—Based on CPI Data OnlySimplest inflation forecast assumes return of

inflation to its historical average:Ad t

0 0%2.0%4.0%6.0%8.0%

10.0%12.0%

Annual Inflation in Lao PDR (Year-on-Year, End-of-Period)Advantage: Simple Surprisingly hard

to beat with respect to forecast error

Disadvantage: Doesn’t help

with monetary

-4.0%-2.0%0.0%

Jan-05Jul-05Jan-06Jul-06Jan-07Jul-07Jan-08Jul-08Jan-09Jul-09Jan-10Jul-10Jan-11Jul-11Jan-12Jul-12Jan-13Jul-13Jan-14Jul-14

Average 2005-13 Annual inflation (year-on-year, eop)

with monetary policy formulation

Structural breaks are major problem—i.e., what average to choose?

Identifying Role of Individual Inflation ComponentsIdentifying Role of Individual Inflation ComponentsContribution to Headline Inflation 1/(In percentage points)

4

6

8

10

12Core (2010 weight 0.63) Raw food (2010 weight 0.28)Energy (2010 weight 0.08) Others (2010 weight 0.01)Headline

p g p

-2

0

2

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13

1/ Core inflation exclues raw food, fuel, gold, electricity tariffs.

20

Core vs non-core inflation

Adding Content to the Inflation Analysis—General Considerations

(e.g., non-food vs food inflation) Overall demand conditions Exchange rates Imported prices Expectations

Exchange Rate Changes and InflationExchange Rate Changes and Inflation

50 0%0.0%

50.0%100.0%150.0%200.0%250.0%

-50.0% Jan-91Sep-91M

ay-92Jan-93Sep-93M

ay-94Jan-95Sep-95M

ay-96Jan-97Sep-97M

ay-98Jan-99Sep-99M

ay-00Jan-01Sep-01

Annual inflation rate (eop)Annual change in exchange rate (+ devaluation, eop)

21

… But Often in Opposite Directions Since the Late 2000s. 20.0%

-15.0%-10.0%

-5.0%0.0%5.0%

10.0%15.0%

Jan

Oc Jul

Ap Jan

Oc Jul

A p Jan

Oc Jul

A p Jan

Oc Jul

Apn-02

ct-02

-03

pr-04

n-05

ct-05

-06

pr-07

n-08

ct-08

-09

pr-10

n-11

ct-11

-12

pr-13

Annual inflation rate (eop)Annual change in exchange rate (+ devaluation, eop)

Any Ideas Why the Relationship Between Exchange Rates and Inflation Might Have Changed?

22

Could the Commodity Price Boom Have Something to Do With This?

International Commodity Price Indices (in US$)

100 00

150.00

200.00

250.00International Commodity Price Indices (in US$)

Fuell

0.00

50.00

100.00

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

Metals

Output Gap and InflationOutput Gap and Inflation

101 2

Output Gap and Inflation(In percent of potential GDP)

0

2

4

6

8

10

0

0.2

0.4

0.6

0.8

1

1.2Output gap - Band-pass filter Output gap - HP

Inflation (y/y percent change, RHS) Core inflation (y/y percent change, RHS)

Proj.

-4

-2

-0.4

-0.2

2006 2007 2008 2009 2010 2011 2012 2013

Sources: Country authorities; and IMF staff estimates.

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Inflation Forecast: Practical ApproachWhen data is not extensively available --Inertial Approach (with judgmental adjustment): 1t t tX

• How and why would inflation rate be different from the previous year?

X: judgmental adjustment

Expected cost pressures:W ld d i h h i diWorld trade prices, exchange rate changes, wages, indirect taxes

Expected policy and other demand changes:Changes in fiscal or monetary policy stance, slowdown in consumption due to rising unemployment, negative expectations

V.3 GDP Deflator

Real

Consumption =

Nominal Consumption Deflator

=Consumption

Real Investment

Investment Deflator

= Nominal

Investment

Real Exports

Export Deflator

= Nominal

Exports

Real Imports

Import Deflator

= Nominal

Imports

Real GDP Nominal GDP

Nominal GDPGDP Deflator 100

Real GDP

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Decomposing GDP deflator into its components

Forecasting GDP Deflator

%∆PGDP = WC %∆PC + WI %∆PI

+ WX %∆PX - WM %∆PM

WC = consumption share in GDP

WI = investment share in GDP

WX = export share in GDP

WM = import share in GDP

Consumption: %∆ PC = %∆ CPI Investment: %∆ PI = (1-a) %∆ CPI + a %∆ PM

Forecasting Component Deflators

Investment: %∆ PI (1 a) %∆ CPI + a %∆ PM

(a = share of imported investment goods)

Export:%∆ PX = ((1+%∆ Export price in US$/100) *(1+%∆ Exchange rate/100) –1) *100

Import:Import:%∆ PM = ((1+%∆ Import price in US$/100) *(1+%∆ Exchange rate/100) –1) *100

25

Forecast real GDP growth Forecast prices

V.4 Putting It Together: Nominal GDP Forecast

p◦ CPI◦ Sub-components of GDP deflators (CG, IP , IG)◦ GDP deflator

Compute nominal GDP growth, using

Value = Value (1+%P) (1+%Q)Valuet+1 = Valuet (1+%P) (1+%Q)

CONGRATULATIONS!

You are now well on your way to forecasting GDP and Inflation on

your OWN!

Thank you!