Of what use is per capita nominal GDP which includes inflation?

Chandra Jayarane has urged professional economists to respond to a statement by S.B Dissanayake in a Sunday paper that in 10 years the per capita income under President Mahinda Rajapaksa would top US$ 10,000.

Here is what he said: “This story noted below appearing in the Front Page of the Sunday Observer today, meant to fool us and all along with all the citizens of Sri Lanka and make us venerate with ‘Sadhu Sadhu’ and hands above our heads, the Development Strategy that unfolds in the horizon.”

Economists have pointed out that the per capita money income includes inflation and when converted at a prevailing over-valued nominal rate of exchange instead of at the purchasing power parity rate of exchange represents nothing. It is not a measure of the standard of living. Per capita real income is the relevant measure but even that is not a measure of personal incomes but of economic activity.

In my opinion there is a total misunderstanding of development theory by the authorities. There is a short term theory of economic growth and a long term theory which are different. If we want to talk about 10 years, then what is relevant is the long term growth and not an extrapolation of the short term growth theory. What determines the long term growth rate are the real variables.

Generally, economists attribute the ups and downs in the short term to fluctuations in aggregate demand with no changes in aggregate supply. The theory of long run growth is different and is based on real variables like the amount of labour and human capital, the stock of physical capital in the form of machinery and equipment, buildings, infrastructure of roads, power plants, the availability of land and natural resources and entrepreneurship; while the short run growth is based on nominal variables like the rate of inflation, the rate of interest and the exchange rate.

These real factors of production determine what economists call the ‘potential output,’ which involves the full employment of all f actors of production, particularly labour. Our unemployment rate is 3-4% and would constitute full employment since economists consider what is called the natural rate of unemployment is about this level since  workers are all the time leaving one job for another and  this level of unemployment is the minimum required for labour mobility to respond to wage incentives.

As regards the other factors of production like capital (machinery and equipment, tools, etc.) or entrepreneurship, these cannot be increased in the short run. So they are already fully employed.

So when an increase in aggregate demand due to say higher Government expenditure takes place and the actual price level is higher than the expected price level, the response of the producers is to run down their stocks, causing GDP to increase. So GDP fluctuates according to the inventory cycle if the actual price level in the economy is higher than the price level expected by the producers.

We are still an agricultural economy and any fluctuation in GDP in response to higher aggregate demand is not possible for it depends on the weather. So any increase in aggregate demand produces a higher price level along with a higher nominal GDP. It may also produce more imports and cause a current account deficit.

The topic of economic growth is concerned with the long-run trend in production due to structural causes such as technological growth and factor accumulation. The short term cycle moves up and down, creating fluctuations around the long-run trend in economic growth.

In this regard, it is vital to understand the forces that determine potential GDP. We produce the goods and services that make up real GDP by using factors of production as follows:

labour and human capital;

physical capital (equipment, machinery, tools, buildings, infrastructure, etc.);

land and natural resources

entrepreneurship.

In the short run the changes in GDP are primarily caused by changes in aggregate demand. Economists draw aggregate supply and aggregate demand curves. The aggregate demand curve is like the normal demand curve for a single product sloping downwards in relation to price level – the higher the price level, the lower the aggregate demand. But the curve can shift to the right meaning that at each price level the amount demanded will be more than earlier.

Short run economic growth theory explains both GDP increase as well as price level changes and changes in the current account of the balance of payments. In the short term what the authorities have to do is to manage aggregate demand to control inflation and ensure there is no balance of payments crisis. So the growth rate projected by the Central Bank of 7.5% is possible but is it desirable for it risks a larger current account deficit which if there are not adequate foreign capital inflows could cause a serious balance of payments crisis.