L-3 Analyzing Aggregate Demand IMF Singapore Regional Training Institute OT 18.52 Macroeconomic Diagnostics February 26 March 2, 2018 Presenter Natan Epstein Deputy Director, STI This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF courses. Any reuse requires the permission of the IMF.
Lecture Objectives/Outline Review why domestic demand is important to analyzing the macroeconomy Examine the contributions to GDP growth of individual components of aggregate demand Discuss the determinants of the major components of aggregate demand Explore tools to analyze business cycles, including nowcasting
What will we cover in the workshop? We will: Examine the contributions from individual components of aggregate demand to GDP growth Analyze fluctuations in GDP and detect business cycles Evaluate the usefulness of leading indicators
Why do we analyze domestic demand? Fluctuations in domestic demand (DD) play an important role in economic cycles DD impacts inflation, fiscal, and monetary policy And is affected by these factors Domestic demand relative to national income determines the external current account and the exchange rate Consumption/saving and investment have important implications for current and future economic welfare and macro stability Investment -> Capital accumulation -> future production capacity
Aggregate Demand and Aggregate Supply P AS AD illustrates the relationship between prices and output demanded P2 P1 Many factors can cause demand to shift such as increase in money supply, investment, government consumption or decrease in taxes AD2 Y1 AD1 Y2 Real GDP When aggregate demand increases there is a movement along the supply curve.
I. Short-term analysis of AD
The expenditure approach to GDP GDP = Final Consumption (C p + C g ) + Investment (I p + I g + DS) + exports (X) imports (M) of goods & services = Domestic absorption (A) + Net Exports (X-M) Note that domestic absorption includes both public and private consumption (C p and C g ) and investment (I p and I g ), and the change in inventory investment (DS). Understanding the behavior of these key components is important to understanding the behavior of the economy.
What are the sources of growth? GDP ( C I ( X M )) GDP GDP C I ( X M ) GDP GDP GDP C C I I ( X M ) ( X M ) C GDP I GDP ( X M ) GDP
Indonesia: Shares in GDP 70 GDP Component Shares (% of Real GDP) 60 50 40 30 20 10 0-10 Private Consumption Government Consumption Gross Fixed Capital Formation Changes in Inventory Net Exports 2003-2005 2006-2008 2009-2011 2012-2017
Example of contribution calculation Consumption (private and public) Investment (private and public) (Shares in GDP ) t-1 Yoy % t Contribution to Growth 0.62 7 4.3 0.18-3 -0.5 Net exports 0.15 2 0.3 Change in inventories 0.05 0 0 4.1 GDP Growth
Indonesia: Sources of Growth (Contributions to Real GDP Growth YoY) 14 12 10 8 6 4 2 0-2 -4-6 -8 Private Consumption Public Consumption Public Investment Private Investment Change In Inventory Net Exports Statistical Discrepencies Real GDP Growth %Δ Year-over-Year Q1-2008 Q1-2010 Q1-2012 Q1-2014 Q1-2016
Key national account aggregates GDP C I X M Domestic Absorption is A = C P + C G + I P + I G + DS Gross National Income: add net transfers and net factor income to GDP GNDI = GDP + Y f + TR f = C P + C G + I P + I G + DS +(X-M) + Y f + TR f A CAB GNDI A = CAB
Two key relationships 1. The current account (CAB) is the gap between income and domestic absorption CAB = GNDI A 2. CAB is the gap between saving and investment CAB = S-I If A > GNDI => S < I (CA deficit) If A < GNDI => S > I (CA surplus) If A = GNDI => S = I closed economy
II. Analysis of the key components: Consumption
Why analyze spending components? By far, C and I are the most important components of GDP The behavior of C and I have significant implications for current and future economic growth Fluctuations in domestic demand (household consumption, government consumption, private investment and public investment) play important role in economic cycles The behavior of domestic demand (domestic absorption) relative to national income determines the external current account, which is important for assessing external sustainability.
What are the key components of consumption? Durables Examples: motor vehicles, furniture and household equipment Tend to be highly cyclical Non-durables Examples: food, clothing and shoes, fuel Not very cyclical because they are necessities for the most part; these purchases generally track population growth Services Examples: housing services, transportation May include imputed items Not very cyclical because they are necessities for the most part; these purchases generally track population growth Fast growing countries relatively ask for more services
Analyzing Consumption Consumers distribute consumption throughout their lives so as to maximize lifetime utility, taking account of: Current disposable income Higher current income higher current consumption, higher saving Expected future income Higher future income higher current consumption, lower saving Uncertainty Increased uncertainty about future income higher saving (in the face of risk aversion and imperfect financial markets) Wealth Higher wealth higher current consumption, lower saving Expected real interest rate Higher real interest rate saving could go up or down
Other determinants of consumption Government borrowing may constrain private consumption through Ricardian equivalence: If the government has a large debt, consumers would expect an increase in taxes down the road even if they reduce taxes now Consumers would then consume less today and save more to smooth consumption over their lifecycle (significant offset of private and public saving).
III. Analysis of the key components: Investment
What are the key components of investment? Private fixed investment Nonresidential structures, e.g., commercial buildings, industrial plants, farm buildings Producers durable equipment, e.g., ICT equipment, transportation equipment Residential structures, i.e., housing Inventory investment Change in inventories from the previous period Not level of inventories Government investment
Analyzing Private Investment Private investment (I P ) includes spending by businesses and households on fixed assets. I P is much more volatile than consumption substantially contributes to fluctuations in GDP. Driving factors: Rate of return Expected future income Cost of finance Access to financing Uncertainty
What is the right level of investment? Investment (In percent of GDP, 2004 08 average Source: Asia and Pacific REO (April 2010, Ch. 3)
III. Business cycles, indicators, and nowcasting
What is a business cycle? Business cycle: Repeated sequence of economic expansion followed by temporary decline, then recovery. Temporary deviation from the economy s normal growth path. Part of the output losses and gains that occur during a business cycle may become permanent. No two business cycles are alike but they often have common features These features can be very helpful in understanding and diagnosing the state of the economy.
Illustration of a Business Cycle Business cycle -- fluctuations of aggregate demand and supply over time resulting in changes in economic growth Output Boom Recession Trough Recovery Potential output Time
How can we use the direction and timing of variables over the cycle? Direction Move the same direction (procyclical) Move the opposite direction (countercyclical) No clear movement (acyclical) Timing Move (peaks and troughs) in advance of aggregate economic activity (leading) Move at the same time (coincident) Move later (lagging)
Cyclical Behavior of Key Variables Variable Direction Timing Production Industrial Production Procyclical Coincident Expenditure Consumption Procyclical Coincident Business Fixed Investment Procyclical Leading Labor Market Unemployment Countercyclical Not classified by NBER Financial Stock prices Procyclical Leading
Cyclical Behavior of Key Variables 9 Indonesia: Real GDP Growth and Unemployment Rate (%, YoY) 12 8 11 7 6 5 4 10 9 8 7 6 3 5 Q1-2004 Q3-2005 Q1-2007 Q3-2008 Q1-2010 Q3-2011 Q1-2013 Q3-2014 Q1-2016 Q3-2017 Source: Haver Analytics Real GDP Growth Unemployment Rate (Right Axis)
Cyclical Behavior of Key Variables 20 Indonesia: IP, Retail Sales and GDP Growth in % (SA, 2010=100) 7 15 10 6 5 5 0 Q1-2011 Q1-2012 Q1-2013 Q1-2014 Q1-2015 Q1-2016 -5 Source: Haver Analytics IP Growth Retail Sales Growth Real GDP Growth (Right Axis) 4
Beware of Seasonality Many data series exhibit intra-year seasonal patterns. To understand what the data is really saying about economic growth, we need to remove such seasonality from the data (SAAR, Y/Y). 3.000.000 2.500.000 2.000.000 1.500.000 1.000.000 500.000 Q4-2005 Q2-2007 Q4-2008 Q2-2010 Q4-2011 Q2-2013 Q4-2014 Q2-2016 Q4-2017 Source: Haver Analytics Indonesia: Evolution of GDP (IDR Billions) Quarterly Real GDP NSA Quarterly Real GDP SA
Business Cycle Indicators and Nowcasting Some of the economic indicators which co-move with GDP happen to be available at higher frequency than GDP IP, retail sales, electricity High frequency indicators can be used to now-cast GDP (Stock and Watson (1991)). The Federal Reserve Bank of New York (FRBNY) updates a nowcast of GDP growth by weighing in news releases relative to employment, international trade, retail and consumption, etc.
Nowcasting: An Example from the FRBNY
https://www.frbatlanta.org/cqer/research/gdpnow.aspx?pa nel=fa9ccf1bede04c3b8a3ac751883e58a91
Business cycle analysis Familiarity with cyclical patterns of key macro variables can help detect when the economy may be off track Very helpful in pinning down the causes Provide insights into what is going on during the current quarter / year Standard measures to assess the current state of the economy are often available with lags and revisions
Do all economic variables move together? 80 60 Indonesia Good & Service Imports and the Business Cycle (T=Q4-1998: Cycle 1) 10 5 40 0 20 0-20 T-8 T-7 T-6 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8-5 -10-40 -15-60 Imports of G&S Growth Cycle 1 Real GDP Growth Cycle 1 (Right Axis) -20
Do all economic variables move together? 40 Indonesia Good & Service Imports and the Business Cycle (T=Q2-2009: Cycle 2) 8 20 7 0 T-8 T-7 T-6 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8 6-20 5-40 Imports of G&S Growth Cycle 2 Real GDP Growth Cycle 2 (Right Axis) 4
What does IP say about GDP growth? 14 Indonesia IP and the Business Cycle (T=Q2-2009: Cycle 2) 8 12 10 7 8 6 4 6 5 2 0-2 -4 T-8 T-7 T-6 T-5 T-4 T-3 T-2 T-1 T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8 4 3-6 IP Growth Real GDP Growth (Right Axis) 2
Key takeaways Potential output estimation tools include time series filters and theory based-methods (production function approach), all have limits and should be used complementarily Analysis of domestic demand requires high quality data on GDP and its components, especially consumption and investment Understanding the underlying drivers of consumption and investment is key to diagnosing the state of the economy Business cycle provides information on the current state of the economy and the short run direction it might be moving in
Thank You
Appendix
Investment and the Capital Stock Demand for capital is derived from the production function: Y f A, L, K Technical progress Labor supply Capital stock Optimal capital stock (K*) equates marginal product of capital to the marginal (user) cost of capital. Investment relates to the change in capital stock: I K K K t t t 1 t 1 Gross investment Net investment Depreciation