pep definitionhandout

7/27/2019 PEP Definitionhandout

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Pakistan Economic PolicyBasic Concepts

Gross Domestic Product (GDP) at Market Prices

GDP is the market value (at retail prices) of all final goods and services newly produced during a

specified period (Normally one year) within the borders of a country by whoever.

Gross Domestic Product at Factor Cost

Gross domestic product at factor cost is the value at factor cost of the product, before deductionof provisions for the consumption of fixed capital, attributable to factor services rendered by

the various factors of production (land, capital, labor and entrepreneur). Gross domestic

product at market prices is calculated by adding indirect taxes to GDP at factor cost and

deducting subsidies provided. Alternatively, GDP at market prices less indirect taxes plus

subsidies equals GDP at factor cost.

Gross National Product (GNP)

GNPmeasures the value of all final goods and services newly produced by a countrys factors ofproduction wherever i.e. both within the country and outside the country and sold on the market

in a given period.

GNP = GDP + net receipts of factor income from the rest of the world (incomes of factors of

production of countrys origin, but operating abroad; the best example of this is net homeremittances of Pakistani workers abroad).

Net National Product (NNP) = GNP minus depreciation

National Income = GNP Minus depreciation Plus net unilateral transfers from abroad Less

indirect business taxes and non-tax liability plus subsidies. Here Unilateral Transfers = income

from abroad that is not produced (like gifts). Indirect business taxes include sale, excise, andbusiness property taxes. Non-tax liabilities include inspection fees, special assessments, and

various fines and penalties. (Data on GNP, GDP, Net factor income from abroad, NNP, Nation

Income are given in Appendix A)

Monetary Policy

The regulation of the volume of money supply/monetary assets (M2) by a central bank, such as

State Bank of Pakistan, in order to achieve/maintain relative price stability. If the economy isheating up, the SBP can withdraw money from the banking system, raise the cash reserve

requirement (CRR) or raise the discount rate. If there is fear of recession or otherwise there is

inadequate liquidity in the economy, the SBP can reverse the process increase the money

supply by lowering the reserve requirement and /or decreasing the discount rate. There areseveral other instruments of monetary management.


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Quantitative Methods of Monetary Management

1. Changes in bank rate/discount rate/repo rate2. Open market operations

3. Changes in cash reserve ratio (CRR)

4. Changes in liquidity ratio

5. Credit rationing: crediting ceilings regime or credit deposit ratio

Qualitative Methods

1. Changes in margin requirements etc.

2. Moral suasion

Objectives

1. Price stability

2. Promote savings, investment and hence economic growth3. Keep the countrys exchange rate competitive

Some Basic Concepts of Monetary Policy

M0 or Reserve Money: Currency in circulation + schedule banks reserves with SBP + selected

deposits with SBP + cash in the tills of scheduled banks (which is not included in money supply,M1, M2)

M1= Currency in circulation + demand deposit with schedule banks + some deposits with SBP

M2 = M1 + time deposits with the schedule banks. Technically, M2 is called Monetary Assets &

M1 is called Money Supply.

Money Multiplier: this is a ratio between the reserve money (M0) and stock monetary assets

(M2).

Discount Rate: It is the rate at which the SBP lends to scheduled banks / discounts the

Government or other first class securities offered by scheduled banks to borrow against.

Repo: Repurchase Option. The rate at which the SBP lends for short term (usually three day)against securities, which a scheduled bank buys back after the stipulated time.

Fiscal Policy

The use of the governments tax and spending policies in an effort to influence the behavior of

such macro variables as GDP, National Savings, Investment, Employment etc. These reserves

are a part of government budget central and provincial.

According to Paul A.Samuelson, Fiscal policy is concerned with all those arrangements which

are adopted by government to collect the revenue and make the expenditures so that economicstability could be attain/maintained without inflation and deflation


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According to Lee, fiscal policy considers:

1. Imposition of taxes

2. Government expenditures

3. Public debt

4. Management of Public debt

A prudent fiscal policy is the foundation of a stable macroeconomic environment as it affects

private sector savings and investment and therefore the private sectors contribution to growth.Fiscal variables affect private economic decisions both directly through taxation and public

spending and indirectly by affecting other macroeconomic variables. Depending on how deficits

are financed, they can lead to inflation, the crowding out of private investment, the worsening ofthe current account balance, or problems of external credit-worthiness.

Instrument of Fiscal Policy

1. Taxes (both direct and indirect taxes, direct tax: impact and incidence is on same person,indirect tax means the impact and incidence on different person). Impact means (initial)

burden on the one who first pays a Tax. Incidence means the burden on the one who finallypays and cannot pass on burden of a tax to someone else.

2. Government expenditure

3. Subsidies4. Transfer payments like unemployment allowances, stipends and scholarships

5. Deficit financing, i.e., government borrowing from various sources including central and

commercial banks; government borrowing form State Bank leads to printing of additional

currency.6. Management of public debt

Objectives

1. Price Stability2. Influence the consumption pattern

3. To raise the level of employment

4. Redistribution of income

5. Promote saving, investment and hence economic growth

Budget Deficit

The amount by which a government, a company, or individual's spending exceeds its income

over a particular period of time, also called deficit or deficit spending

Budget deficit = Excess of total expenditure over total revenue

Budget Surplus

The amount by which a government's, company's, or individual's income exceeds its spending

over a particular period of time


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Budget Surplus = Excess of total revenue over total expenditure

Total Revenue

Revenue Receipts (net) = Total tax revenue plus Non-tax revenue minus transfers to provinces

Here transfers to provinces include taxes on income, sales tax, excise duty and royalty on nature

gas and crude oil, surcharges on gas, wealth tax, custom duties, capital value tax, federal excise

(net of gas), and General Sales Tax (provincial)

Total Expenditure

Total expenditure = Current expenditure + Development expenditure

Financing of Budget Deficit1. Internal Resources

i. Borrowing from banking systema. Central Bank (SBP)

b. Schedule banks

ii. Non-banking borrowing i.e., national saving schemes etc.

2. External Resources

i. Loans

ii. Grantsiii. Debt Rescheduling

2. Change in Provincial Cash Balance

3. Privatization Proceeds

Inflation

Inflation is a situation of persistent increase in prices in an economy.

To measure the inflation rate, we calculate the annual percentage change in price level

Inflation rate = 100 * (price index of current year minus price index of previous year divided byprice index of previous year)

Price Index

Price index is a measure of the average level of prices for a specified set of goods and services,

relative to the price in specified base period.


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Consumer Price Index (CPI)

CPI is average level of prices of the goods and services that a typical urban Pakistani familyconsumes. The CPI covers the retail prices of 375 items in 35 major cities.

Wholesale Price Index (WPI)

It is calculated by using wholesale prices. It covers the wholesale prices of 97 major items

prevailing in the city of origin of commodities.

Sensitive Price Index (SPI)

The SPI covers prices of 53 essential items accounting for 51.6 percent of the expenditure of

those households whose monthly income ranges from Rs.3000 to Rs.12000 per month.

In Pakistan, the main focus is on the CPI as a measure of inflation, because it is more

representative relative to other price indices.

Price Stability

Price stability, a situation neither inflationary nor deflationary, can be conceptually defined as anenvironment where economic agents including households and firms can make decisions

regarding such economic activity as consumption and investment without being much concerned

about the fluctuation of the general price level. Following points show the importance of pricestability.

(1) Price stability provides the essential foundation for sustainable long-

run economic and employment growth.

(2) Price stability enables the price system (the information or signaling

mechanism of market economies) to function most effectively by directingresources to their most beneficial use.

(3) Price stability provides a reliable anchor for the price system so thatcomparative values can be established and accurately measured.

(4) Price stability works to lower interest rates and stabilize financial

markets.

(5) Price stability serves to promote transparency, accountability, and

credibility in monetary policy.

Exchange Rate

Exchange rate is the price of one currency in terms of other currency/currencies.


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Fixed exchange rate

In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must

also commit to defend that parity by being willing to sell (buy) foreign reserves whenever

the market demand for foreign currency is greater (smaller) than the supply of foreign

currency.

Flexible exchange rates system allows the demand and supply of foreign currency in the

exchange rate market to determine the equilibrium value of the exchange rate. So the exchangerate is market determined and its value changes at every moment in time depending on the

demand and supply of currency in the market.

Balance of Payments

Balance of payments of a country is the records of all transactions between the residents of that

country and the rest of the world during a certain period of time, generally a year.

Classification of the Balance of Payments Accounts

1. Current Account

2. Capital Account

Current Account

All those transactions with the non residents which are settled immediately and do not create anyfuture liability are included in current accounts.

The current account balance includes international purchases and sales of goods and services,cross-border interest and dividend payments, and cross-border gifts to and from both private

individuals and governments. The current account is divided into three separate components

i. Net export of goods (value of exports minus value of imports). It is also called

visible balance.

ii. Net receipts on account of services/invisible account. It is also known as theinvisible balance. Investment income received from assets abroad includes

interest payments, dividends, royalties and other returns that residents of a

country receive from assets (such as bonds, stocks, or patents) that they own

outside their own country. Payments of investment income to foreign owners ofassets in country and debit items because they represent funds that flow out of the

country. Net investment income from assets abroad equals investment income

received from assets abroad minus investment income paid to foreign owners ofdomestic assets.

iii. Net Unilateral Transfers. Unilateral transfers are payments from one country

to another that do not correspond to the purchase of any good, service, or asset.Examples are official foreign aid or a gift of money from a resident of one


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country to family members living in another country. A countrys net unilateral

transfers equal unilateral transfers received by the country minus unilateral

transfers flowing out of the country.

Adding all the credit items and subtracting all the debit items in the current account yields a

number called the current account balance. If the current account balance is positive, the countryhas a current account surplus. If the balance is negative, the country has a current account deficit.

Capital Account

This mainly consists of changes in the financing of current account deficit / surplus. Capital

account is a record of all international transactions for assets. Assets include bonds, treasury

bills, bank deposits, stocks, currency, real estate, etc.

The current account includes only the trade of currently produced goods or service. The

transaction of the existing assets is not part of the current account. Trade between countries inexisting assets, either real or financial, is recorded in the capital account. When the home country

sells an asset (existing) to another country, the transaction is recorded as a capital inflow for thehome country and as a credit item in the capital account. When the home country buys an asset

(existing) from abroad, the transaction is a capital outflow from the home country.

The capital account balance equals the value of capital inflows (credit items) minus the value of

capital outflow (debit items). When residents of a country sell more assets to foreigners than theybuy from foreigners, the capital account balance is positive, creating a capital account surplus.

When residents of the home country purchase more assets from foreigners than they sell, the

capital account balance is negative, creating a capital account deficit.

A country that increases its net holdings of reserve assets during a year has a balance of

payments surplus, and a country that reduces its net holdings of reserve assets has a balance ofpayments deficit.

The Relationship between the Current Account and the Capital Account

Current account Capital account = 0

Suppose that a Pakistani buys an imported British sweater, paying Rs.500 for it. This transaction

is an import of goods to the Pakistan and thus reduces the Pakistan current account balance byRs.500. However, the U.S exporter who sold the sweater now holds Rs.500. What will he do

with it? There are following three possibilities, any one of which will offset the effect of the

purchase of the sweater on the sum of the current and capital account balance.

Case I: Pakistan imports sweater at the worth of Rs.500 from British, British imports wheat at

the worth of Rs.500 from Pakistan

Current Account

Exports + Rs.500


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Imports - Rs.500

Current Account Balance = 0

Capital Account

No transactionCapital Account Balance = 0

Sum of Current and capital account balance = 0

Case 2: Pakistan imports sweater at the worth of Rs.500 from British, British buys bonds worth

Rs.500 from Pakistan

Current Account

Exports 0

Imports - Rs.500

Current Account Balance = - Rs.500

Capital Account

Capital inflow + Rs.500

Capital Account Balance = + Rs.500


Case 3: Pakistan imports sweater at the worth of Rs.500 from British, State Bank of Pakistan

sells British pounds at the worth of Rs.500 to British Bank

Current Account

Exports 0

Imports - Rs.500

Current Account Balance = - Rs.500

Capital Account

Capital inflow (reduction in official reserve assets) + Rs.500

Capital Account Balance = + Rs.500


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Development Economics

Capital Formation or Investment

This is the part of countrys wealth which is used for the production of more wealth. Capital

formation or investment is financed by savings. Savings have following components:

Suppose total investment during a year is 20% of GDP. National savings are 15% of GDP; the

remaining 5% will be financed by borrowing, investment etc. from abroad; this will be countrys

external liabilities; these are also called foreign savings and are equal to current account deficitof countrys balance of payments.

National savings comprise of two components: domestic savings (savings by factors of

production working / operating within the territorial boundary of the country) and net factorincome from abroad (income from the factors of production of Pakistans origin operating and

working abroad); technically these are residents (like senders of home remittances.

Do not confuse net factor income from abroad with foreign savings. Foreign savings as

explained above are the countrys liabilities. But net factor income from abroad is not thecountrys liability but are savings of Pakistani factors of production working abroad. These do

not create any foreign liability of the country.

Capital Output Ratio: is the ratio between the investment and its output / income. For instanceto create a capacity to produce income (net value added) of Rs.1 million we need investment of

Rs.3 million. This capacity will continue to produce the income over several years.

Capital output ratio varies from sector to sector of the economy: it is low in agriculture but very

high in case of capital intensive projects and social and physical infrastructure.

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