ECONOMIC DEVELOPMENT for Beginners

Extracted from CHAPTER ONE of THE GENERAL THEORY OF RAPID ECONOMIC DEVELOPMENT, this section will help you develop a learning curve on the subject matter and become confident before you purchase the book.

Concepts & terminology of Macroeconomics

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Economic Development --- Output, Savings, and Investment

 

To better understand the underpinnings of the macroeconomic backdrop of the theory of rapid economic development, which runs through Chapters Three and Four, it is helpful to get familiar with certain basic accounting notions and clarified on few already familiar concepts. Gross Domestic Product of a country is the aggregate monetary value of all final goods and services in market prices produced during a period (usually, quarter or annual) within the physical boundaries of the country. Let’s go with ‘annual’ as the period here. This aggregate value of annual production of all final goods and services include consumer goods and services and capital goods and is the gross output of the country.

Capital depreciates over time, and it needs to be replaced at the end of its life, or else capital is lost. Therefore, a certain portion of the gross output every year goes to replacing the worn and torn portion of the national capital stock. Typically depreciation expenditure in monetary value falls anywhere between 2%-20% of total output depending on the size of capital a country has accumulated. That value may be understood to be the cost of servicing the existing capital through its lifespan to be used to replace it at the end of its life.

 

Depreciation expenditure is the total of all monies set aside as deduction for capital depreciation by all businesses each year from their gross income and accounted on their income statements; and that sum, therefore, is nobody’s income. The output we get after deducting depreciation expenditure from gross domestic product is called domestic product, or net domestic output. As follows,

 

Net Domestic Output = Gross Domestic Output – Depreciation

 

Every country makes new capital investments each year. The sum of investments made by a country, either within the country or abroad, in the provision and acquisition of new capital constitutes ‘New Savings’ (or simply, Net Savings) of that country. Whereas depreciation expenditure funds the replacement of worn-and-torn capital, Net Savings of a country represent brand new wealth accumulated by the country. Together depreciation expenditure and Net Savings constitutes ‘Gross savings’ of a country.

 

Gross Savings = Net Savings + Depreciation

 

We will come back to net savings in a moment. For now, let’s get back to Net domestic output. In a closed economy, it is net domestic output that is the source of all income earned by the residents of the country. In the inter-connected world, besides the income generated from domestic output, residents earn income from abroad in the form of dividends from ownership of shares of foreign firms and repatriation of a portion of the earnings of family members working abroad. That inflow of purchasing power adds to the income earned from domestic output. Similarly, there’s also an outflow. The income earned by residents of foreign countries in the form of profits and dividends and some of the income earned by foreigners working in the country is repatriated.

 

Thus the sum of income from domestic output and the net income earned from abroad constitute the net national income of a country. The value of net income from abroad can be positive or negative and varies widely across countries, but typically it is not greater than 10% of gross domestic product.  As follows,

 

Net National Income (or simply, National Income) = Net Domestic Output + Net income earned from abroad

 

During a year, all income earned by the residents of a country is either consumed or saved. Income is a flow and therefore all savings must either be invested in the domestic economy or invested abroad. National income can be simply stated below as:

 

National income = Consumption + Net Savings  

 

And;

 

Net Savings = Net Domestic Investment + Net Foreign Investment

 

Just as national income noted above is income net of depreciation, national spending is also spending net of depreciation.  Also, all spending by the residents of the country is either consumed or invested. Therefore,

 

National Spending = Consumption + Net Domestic Investment

 

All income that remains after spending on consumption and domestic investment has to be invested abroad. That means the difference between national income and national spending is net foreign investment. We arrive at the following equation:

 

National income – National spending  = Saving – Net Domestic Investment = net foreign investment   

 

Let’s now return to GDP and its composition. See Fig 1.1 that shows China’s GDP composition in current trillion US dollars from 1981 to 2015. We see GDP is composed of consumption plus net domestic investment plus consumption of fixed capital (depreciation) plus change in inventories plus trade balance. Trade balance is exports minus imports. As follows:

 

Gross Domestic Product (GDP) = Consumption + Net Domestic Investment + Depreciation + Change in Inventories + Exports – Imports

 

The sum of net domestic investment, consumption of fixed capital and change in inventories is called Gross Capital Formation. The sum of just the first two is called Gross Fixed Capital Formation.

 

The accounts that are relevant when it comes to a country’s dealings with the rest of the world are these two: Capital Account and Current Account. Capital account is nothing but net foreign investment. That is, it is the difference between income invested abroad by a country’s residents and income invested by people of other countries at home. And current account is the sum of trade balance (exports-imports) and net income from abroad. The sum of Capital account and Current account, which is the Balance of Payments, must come to zero. That is because a country’s income flowing abroad is out either to purchase a product from abroad or to make a new investment abroad. The same stands true for income of the rest of the world dealing with the country in question. All purchasing power flowing in must match power flowing out. Thus,   

 

Net foreign investment = exports – imports + net income from abroad

 

The above equation tells us that whatever a country manages to export more than it imports and whatever its net earnings from abroad amount can be directed to make new foreign investments. Vice-versa also stands true. That is a country with a negative current account will see a net capital inflow.

 

Using the above equations, we will arrive at the following:

 

Savings – Net Domestic Investment = exports – imports + net income from abroad

 

The above equation comes handy in Chapter Four and parameters used as they are (such as net savings, national income, national spending, etc.) should always be thought of as net of depreciation. Therefore savings throughout the book should be assumed as ‘net savings’ and domestic investment as 'net domestic investment', and national income as ‘net national income’.

 

 

 

Economic Development --- Notations of Macroeconomics

 

Throughout the book, we shall come across some standard terms that allow for easy discussion and presentation, and whose definitions are set forth herein. The definition of every term remains standard and unchanged throughout the book. The terms employed here are based on standard terminologies such as the term ‘exports of goods and services’. Exports rate refers to exports of good and services as percent of GDP; imports rate refers to imports of good and services as percent of GDP; investment rate refers to net domestic investment (gross fixed capital formation less of depreciation) as percent of GDP; savings rate refers to net savings (s) (gross savings less of depreciation) as percent of national income. National income (net national income) is gross national income less of depreciation. Growth rate (g) refers to growth of national income in real terms and GDP growth rate refers to the real growth of gross domestic product. In short, each term is defined as the share of the numerator in the denominator, as given below:

 

Savings rate = net savings / net national income

 

Investment rate = net domestic investment / GDP

 

Exports rate = exports of goods and services / GDP

 

Imports rate = imports of goods and services / GDP

Nowhere do I mean gross savings, or gross investment, or gross national income when reference is made to savings, investment, and national income respectively in the book. The reader should be mindful as to the nature of usage of those terms throughout because those terms are and can be used differently in other publications and literature.  

 

There is another important note to be made. Unless explicitly mentioned, all data sets presented as graphs in the book correspond to current market prices. As an example, aggregating the net income of all residents of a country in 2015 adds up to, say, that of India’s national income, USD 2 trillion. That figure relates to USD in current market prices of 2015 as earned by individuals during that year. Also, all numbers related to income, savings, wealth, trade data, product price, etc. are in market prices throughout the book, except in few cases where it is explicitly noted as such. So all the US dollar figures quoted in the book are of prices or derived from prices that are market prices in that specific year. For example, Chinese exports of titanium ores in 2012 were USD 36 million, and in 2015, about USD 16 million.

Both figures are quoted in the purchasing price or market price of the commodity in that year. In monetary terms, China sold less titanium ore to rest of the world in 2015 than it did in 2012.     

 

It is useful if the reader is taken through a sample calculation of various macroeconomic parameters and its rates using the above equations. We will pursue the case of China here. In 2014, China’s output surpassed 10 trillion for the first time in current US dollars. Its gross domestic product was USD 10,350 billion exactly.

For the same year, China’s gross fixed capital investment came at 4,720 billion, of which 1,330 billion was accounted for depreciation and the rest of 3,390 billion (4,720 – 1,330) for net domestic investment. The figure 3,390 billion constitutes new investment undertaken in the country during the year 2014.

 

 

 

 

 

Source: Author's calculations based on World Bank data. The World Bank, World Development Indicators 2017, data retrieved from <https://data.worldbank.org>

By disaggregating gross fixed capital formation into net domestic investment and consumption of fixed capital (depreciation), we now have the following GDP components, as is shown in Fig. 1.1: consumption, net domestic investment, consumption of fixed capital (depreciation), change in inventories, trade balance of China in 2014.

 

National income derives from two sources: GDP and abroad, net of sum owed to people abroad. First, income earned from gross output of 10,350 billion can be calculated simply by deducting depreciation expenditure from GDP. Income from GDP comes to 9,020 billion (10,350 – 1,330). Now China has to pay a tiny portion of this income from GDP (9,020 billion) to people abroad in the form of profits and dividends due to their claim of ownership of a small portion of capital stock in China, remittance of foreign workers in China to their home country, etc. In the same vein, China also receives this type of income (factor income) from the rest of the world. The difference between them is net income received from abroad. In 2014, China posted a net receipt of 13.3 billion of income from abroad, and by summing up this figure with China’s income from GDP, a national income of almost 9,034 billion (13.3 + 9,020) is arrived.  

 

Next, the sum of China’s trade surplus (exports – imports) and net income received from abroad gives China’s net foreign investment for 2014. China’s trade surplus was 260 billion (2,492 – 2,232) and net income received from abroad was 13.3 billion in 2014; and that results in net foreign investment of 274 billion during the year.

 

Net savings, or new savings, or simply, savings is the total new capital investment undertaken, and it is the sum of net domestic investment and net foreign investment, which gives a Chinese net savings figure of 3,664 billion (3,390 + 274) for 2014. 

From 9,034 billion of national income flow, China saved a whopping 3,664 billion—that is, 40.5% of national income. China’s savings rate in 2014 is, therefore, 40.5% [(savings/national income) x 100].

 

Similarly, China’s net domestic investment rate is 32.8% [(net domestic investment /GDP) x 100]. China’s exports rate comes at 24% [(exports /GDP) x 100] & China’s imports rate at 21.5% [(imports /GDP) x 100].

 

An important note, with some relevance to the discussion in Chapter Four, is that the rates that involve GDP as denominator, such as ‘exports rate,’ show what may be called ‘Composition Effect’ when observing the trend for a given period. GDP (denominator) is the sum of some inter-linked components (consumption, net domestic investment, etc.). Whenever there arises a significant change from the previous year’s numbers with respect to the aggregate factor that is GDP, that change if big enough can dominate in the annual ratios of concepts such as exports rate ([exports/GDP]*100), even if the numerator (exports)—here, it is one of the components making up the denominator (GDP)—also undergoes significant change from the previous year’s number. That is, any big change in the denominator compared to last year can dominate the change in the numerator (exports) especially if the numerator is part of a positive makeup of the denominator (GDP) itself.

 

That kind of variation distorts the overall rate trajectory, misguiding the less-probing analyst. This effect is increasingly likely to be seen during or in the aftermath of a crisis or depression since GDP composition can get disoriented (due to shocks or counter shocks) when compared to the figures of the immediate pre-crisis year. This effect can somewhat disorient the savings rate as well. We will learn more about this part as we deal with such instances in Chapter Four.

 
China GDP.png