PFTAC GDP Compilation and Forecasting Workshop GDP and economic policy Suva, Fiji October 19, 2016

Economic management GDP estimates and forecasts are important for sound macroeconomic management and monetary and fiscal policy. Having timely and accurate GDP estimates and forecasts is crucial for empirical based policy (advice).

Economic activity A useful concept to analyze economic activity is to decompose GDP into: Temporary business cycle effects and Long-run, full capacity, potential output Output gap = 0: supply = demand, no inflationary pressures Output gap > 0: supply < demand, inflationary pressures Output gap < 0: supply > demand, downward pressure on prices

Factors influencing potential output Capital stock Population growth rate Natural disasters External linkages Financial development, financial stability Property rights, legal system, political stability Taxation Government expenditure …

Factors influencing the business cycle External shocks (e.g. global financial crisis, world food prices, oil prices) Weather Interest rates Exchange rate Fiscal policy Consumer and business confidence …

Economic management As economists our advice to policy makers is guided by improving welfare and wellbeing. The aim is to improve ‘economic efficiency’, i.e. produce more with less resources. Economic policies, regulation, institutions, public spending can increase economic efficiency and hence productive capacity. Some government spending has been found to be productive, e.g. on basic education and health, infrastructure.

Economic management Government spending can increase productive capacity if it is in areas that: the private sector does not invest in because other people cannot be excluded from benefitting from the spending (e.g. street lights, roads) people and businesses invest less in than what is socially optimal (e.g. education, people around us benefit from our education but we did not take this into account when deciding how much or how hard to study)

GDP, potential output and fiscal policy Knowing where we are in the business cycle is important for fiscal forecasting. For example, if the economy is recovering from a severe slowdown it might take some time before corporate income tax collection picks up … … if businesses can carry forward losses, which they can in most countries.

Cyclically adjusted fiscal balance We don’t want fiscal policy to contribute to the business cycle, e.g. increase spending when the economy already is operating above capacity. We want our governments to set aside some money during boom times because we know that they will be followed by an economic slowdown. We want governments to only commit to quality spending that it can afford now and in the future.

Exchange rate The exchange rate is the price of the domestic currency in terms of foreign currency. If demand for a currency goes up, the price of the currency goes up, i.e. it appreciates. If demand for a currency goes down, the price of the currency goes down, i.e. it depreciates. E.g. when imports go up, more USDs are needed to pay for imports, i.e. the demand for domestic currency relative to USDs declines (depreciation). If tourist arrivals increase, the demand for domestic currency increases (appreciation).

GDP and monetary policy Central banks in open economies face a trilemma. They can only pursue two of the following three policies simultaneously: A fixed foreign exchange rate Free capital movement An independent monetary policy Countries in the region have a fixed exchange rate. The nominal exchange rate against other currencies or a basket of currencies is not freely floating but set and maintained by the central bank.

GDP and monetary policy With a fixed foreign exchange rate and free capital movement, a country cannot have independent monetary policy. If the US Federal Reserve increase interest rates, to maintain the exchange rate the central bank also needs to raise the interest rate. Otherwise money would flow out of the country to earn a higher rate of return in the United States. This would lower the demand for and price of the domestic currency.

GDP and monetary policy With a fixed exchange rate and capital controls, the country can have independent monetary policy, i.e. set interest rates. The exchange rate is controlled by controlling how much the country transacts with the rest of the world.

GDP and monetary policy With a fixed exchange rate foreign reserves become important … … to maintain the level of the domestic currency by buying or selling foreign currencies … to ensure sufficient foreign currencies are available to pay for imports. Changes in foreign reserves result from transactions between the domestic country and the rest of the world.

GDP and monetary policy These transactions, i.e. trade in goods and services, financial transactions including foreign investment and remittances, are captured in the balance of payments. To forecast foreign reserves requires forecasts of the balance of payments which require GDP forecasts. For example, a lot of machinery and equipment is imported. An increase in investment will increase imports and all else equal reduce foreign reserves to pay for the imports.

GDP and monetary policy In most countries the nominal exchange rate is not fixed indefinitely but adjusted from time to time. And it should be adjusted if it is causing imbalances in the economy, i.e. excess demand or supply. Excess demand and supply can be measured with the output gap.

In summary GDP is important. It is probably the most important macroeconomic variable. To give empirical based policy advice we need accurate estimates of GDP … … and we need time series data. More accurate estimate will give better forecasts. The impact of policy changes often only become apparent with a lag. We need to take a medium-term outlook.

Pleas To the statistics offices Given limited resources it may not be feasible to produce ‘official’ historical data, e.g. with rebasing or changes in methodology. Unofficial data would help! It could be produced by the statistics office or some reputable data user. Maybe it could be published on the statistics office’s website with an appropriate disclaimer regarding quality? The statistics office website is where most users look / should look first for data.

Pleas To the statistics offices If historical series (official or unofficial) cannot be constructed, please provide on your website all data published in the past … … in Excel and unrounded. To the ministries of finance Please fund your statistics offices!

Pleas To the tax administrations Please share taxpayer data! It will immensely improve the accuracy and quality of GDP estimates. The statistics office is subject to the same confidentiality rules as you are sometimes even stricter. To the central banks You probably use the data the most. Share the knowledge you gain from using the data.