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INSTRUMENTS FOR ECONOMIC ANALYSIS
III. Contents and Methods of analysing, assessing the results and performance of economic development processes.
In Part 2, we have studied technics of representing data in a manner that readers can get primary information on the state of development in sectors of concern. However, it is not enough. In practice, to understand the development nature of an economic phenomenon, we need to calculate other economic indicators for an more comprehensive and in-dept assessment of the results and performance of every main sectors of the economy. The EU-MPI in the part of selected economic indicators, presented some tables of analyse results. To clarify the methods of EU-MPI project, below are some methods of analysis, using both macro-economics and sectoral economics applicable for provinces.
The objective of trend caluclation is to measure the trend of GDP growth, production outputs by sectors and by main products and some other indicators along the time.
A right calculation of trend has a great significance in economic analysis as it allows to estimate the performance of the most important economic variables over a given period of time, then to make comparisons among them. It provides insights into key features of varibales performance and stimulates the analyst to explore the causiality relationships between different variables and between them and economic policies.
Methods of measurement: one of the common ways to measure trends is through the calculation of annual growth rates, e.g. the percentage value that indicates how much a variable has changed on the average each year. There are 3 ways to measure growth rates of economic indicators:
- the observed values
- a linear regression
- the exponential regression
The first method is simplest; it consists of computing the annual growht compound rate according to the following formula:
Yt = Y0 * (1 + r)t hay r = (Yt / Y0) (1/t) - 1 (1)
where Yt is the observed value of year t, Y0 is the initial value, t is the number of years, r is the annual compound growth rate.
The most serious drawback of this method lies with the fact it utilizes only the first and the last value of the time series, forgetting ablt all the rest. If one the two values is abnormal, also the growth rate will be abnormal. The inconvenient can be partly offset by taking an average of the first and last three years,, but still all the remaining years have no role in the determination of the growth rate.
The second proposed method consists of the use of the linear regression on determining the trend then to compute the growth rate. In this case, all the observed values are used and a line is drawn among them. The theoretical values of the first and last year (called Yt and Y0), which lie on the trend line, are then used to derive the growth rate by applying the above formula.
The third method consists in computing the growth rate using the exponential regression. By taking the logarithm, we linearize the above formula of growth rate:
Log(Yt) = t * Log(1+r ) + Log(Y0)
Which corresponds to the familiar linear form: Y = B * t + A (2)
where t is a time variable, B= Log(1+r) is the slope coefficient of the logarithm regression. Once we calculate Z= Log(Y) through observed values and the linear function (2), we can calculate B. So, because:
Log(1+r) = B , we have: (1+r) = exp(B), so: r = exp(B) - 1 (3)
The United Nations, IMF, WB and many countries are using the formula (3) to calculate the annual average growth rates. EVIEWS or EXCEL softwares can be used in the above 3 methods of calucaltion.
2/ Calculation of economic growth
The purpose of studying economic growth is to introduce the concept of economic growth and the techniques for its measurement. In particular, it will focus on the measure of gross domestic product GDP and its trend.
Studying GDP growth has a great significance in economic policy analysis as GDP is one of the most common indicators for measuring the welfare of a country. GDP can be expressed in many forms: absolute terms, relative terms, an index, per capital terms, at current and constant prices, per USD etc.
All of these ways to measure the GDP allow the analyst to make comparisons with the previous years and with other countries and tell them if their country is better off or worse off, that is if the people are living in the country is richer or poorer. They also stimulate the analyst to investigate the reasons of growth or decline of GDP and the policy intervention that may be implemented for its improvement.
Methods of measurement: in studying growth, we usually calculate the follwing indicators:
a) GDP at current and constant prices:
Detailed method to calculate GDP at current prices have been presented in Chapter IV. In this section, we just introduce a combined and simple way of calculation as follow:
As GDP growth over time is the result of two different factors: price increase and quantity increase, we then have the formula:
GDP = P * Q
where P is price for calculating GDP or the difference between the sale price and productive costs of a product unit, Q is productive quantity. GDP derived from this formula is the GDP at current price (or actual price) and also called the nominal GDP. In this case, the growth rate of nominal GDP is measured by the change of GDPt+1 over GDPt , concretly by the formula: GDP growth= (GDPt+1 / GDPt - 1) * 100, where GDPt and GDPt+1 are GDP at current price of respectively year t and t+1. Since we are interested to measure the real growth of GDP, we have to somehowe net the GDP growth from the price effect by dividing GDP at current price to price index of GDP then multiple by 100 as showed in the formula. nominal.
In the above formula, if we replace the current price P by a constant or comparative price P0, we have a GDP directly calclated from a constant or comparative price, e.g the GDP growth rate at year t+1 versus year t is (GDPt+1 / GDPt - 1) * 100.
b) Index number of GDP
The index number of GDP is a concept similar to price indicator. It reflects the evolution of GDP over the time, say a base year. The base year is usually the first year of which data are avaible. To calculate the GDP index number, we divide all the time series values of GDP (expressed in comparative prices) by the value of base year then multiple it by 100.
For example in table 1, GDP in 1996 was 213833, in 1997 was 231264 etc. To caculate GDP index number in according with the base year 1996, we divide the GDP values of every year by 213833 then multiple with 100. The GDP index numbers in the period 1996-1999 are respectively 100; 108.15; 114.39 and 119.85.
c) GDP per capita
This is the indicator to assess the overall level of development and welfare of a country. It is calculated as ther ratio of GDP at current price to total population. Thios indicator, although widely used, has some shortcomings especiallu when used for international comparisons. It is in one hand, because that the estimates of population and GDP of coutries concerned are inaccurate due to lack of information, particularly in developing countries. On the other hand, the official exchange rates used to convert the GDP of different countries in common currency, usually USD, can mislead the results. There is no solutions so far to overcome efficiently those difficulties.
d) GDP growth rate
Once the GDP time series is expressed in constant prices, we can measure the average growth rate or trend of GDP over a period of time by 3 methods of calculating trend presented in section III.1.
According to geometric mean, GDP growth rate can be calculated by the following formula:
r = (Yn / Y0) (1/n) – 1 (4)
with Yn, ,Y0 are respectively the values fo GDP at the first and the last year, n is number of year in the period examined.
According to linear regression, we can regress all GDP values along the time variable t by the following formula:
Y = a + b * t
then we calculte Yn = a + b * n and Y0 = a, and use again formula (4) to determin the GDP growth rate r.
According to exponential regression, we use the function :
Log (Y) = a + b * t
to determine the value of “b”, then continue to calculate GDP growth rate by the following form:
r = exp (b) –1
3/ Calculation of proprotional links in national accounts.
The purpose of this calculation is to analysis structural changes and proportional links in national accounts. Data for calculation come from the national account table. The general equilibrium equation is as follow:
GDP + M = DA + E
where M = import of goods and services; E= Export of goods and services; DA= Domestic Absorption. DA is calculated by this formula:
DA = GC + PC + VS + GFCF
where: GC is Government Consumption; PC Private Consumption; VS Variation in Stock; GFCF Gross Fixed Capital Formation
These equalities indicate that when a component changes, other components should also changes to restore the equality, e.g. if DA excess GDP, then M must excess E. In other words,if a country consumes more than what is produces, it has to experience a trade difficit.
In the other case, if the Government want to balance imports and exports, it has to achieve equlity between GDP and DA. Yet, GDP may be difficult to increase significantly in the short run, the only possibility to achieve balance is therefore to reduce DA. From the above formula, we can see many ways to reduce DA, inter alia, reduction of Government Consumption, private consumption, investments and stocks or a combination of those measures together
The ratio identities which are very needed in global equilibrium analysis and made in EU report, are:
Consumption / GDP Ratio: (GC + PC) / GDP
Investment / GDP Ratio: GFCF / GDP
These ratios indicate trend of consumption and investment changes and if people are interested in investment or consumption. The higher the investment rate is, the higher the expected growth of the economy can be achieved and therefore future consumption is more supported.
4/ Calculation of Incremental Capital Output Ratio (ICOR)
The purpose of this calculation is to measure an important indicator in assessing the efficiency of an economy to use its national resources for development and growth. This indicators, called ICOR is to meausre the impact of an increase on the stock of fixed capital on GDP.
Methods of calculating annual ICOR and averge ICOR for a period of years: Formula for annual ICOR can be written as follows:
ICOR= Variation in Capital Stock/ Variation in GDP
or = I/DGDP (5)
The numerator of the formula is the net increase of fixed capital stock. Since data on the capital stock are rarely avalaible, the numerator can also be measureed by the annual flows of new investments net of the amortization of existing capital.
Since numerators and denominator are differences of values in different years, the values should be omogenous and calculated with the same prices. Usually, we use constant prices to express them to deflate the investment flows as well as the GDP before calculatinhg the numerator and denominator of the ratio.
Removing the impact of other factors to GDP: In calculating ICOR through the above method, we measure only the impact of additional capital on the GDP, other things are assume constant. This is rather a strong assumption, not realistic. In order to smooth random of variations in investment and GDP (and to smooth variations in GDP which do not depend on investments), we calculate a moving average (usually 3 year moving average) for both the numerator and the denominator.
ICOR with time lag: In calculating ICOR, we also face the fact that new investment exercise their impact in GDP only in some delay. There is always a time lag from the moment when an investment is started and the time it becomes productive. This time lag depends, inter alia, very much on the kind of investment realized: for example, it can be very short for machinery replacement and very long for main infrastructure. The time lag is also different from one economy to the other.
There are many ways to calculate the time lag. In this paper, we base on the assumption which is widely used that a time lag is usually one year, e.g that investment in year t will affect change in GDP in year t+1. The formula (5) to calculate ICOR will be replaced by the following:
ICOR = It-1 / DGDPt (6)
we can write: DGDPt = (1 / ICOR) * It-1
corresponding to the linear form: DGDPt = b * It-1
with the constant term: a=0, and b = 1/ICOR. The estimation of this equation give us the coefficient b, from which, we have:
ICOR = 1 / b (7)
The ICOR calculated as above provides a global estimate of the efficiency of the economy, implementation and use of its investment. However, since there are a number of factors that can influence the results obtained, we need to further analysis if the decrease of economic efficiency is due to the decline of investment returns or due to other factors. For example, agriculture production can fall because of poor rain, drop of domestic and international prices etc.
5/ Assessment of external sector
The purpose of this section is to assess the external performance and structural changes. The analysis of external balance is of primary important in policy analysis, especially in monitoring strategy for long term economic development in that it gives information about the capacity of the country to earn foreign exchange and the contribution of trade to gross domestic product generation.
The performance of external trade depends upon several factors, some of which are internal, mostly determined by domestic economic policies and other external, commonly called external shocks. When we study the major indicators of trade performance (growth rate, trend, structure etc.) and compare them either with the situation in the past or with other countries, we must question ourselves on what are the causes of such performance and, in the case of an imbalance between imports and exports, try to identify the policy measures necessary to improve the external trade.
Some main tools used in external sector analyse:
a) Export structure
The analysis of export structure is carried out by calculating the shares of the main exported items over the total exports and the changes occurred over the time. Despite the technique used is very simple, the findings can be quite interesting as they can show changes in the composition of exports such as the decline of traditional agricultural export or increase of non-traditional goods and services. The analysis is conducted in current prices.
Similarly, we calculate the import structure by dividing shares of main imported items by the total imports.
b) Concentration Index
Concentration index is actually export structure of some main exported items. It can be calculated as follows: selecting few exported items (say 4 to 5 major ones) and calculating their incidence on total export.
This index tells how much the country’s export is generated by a few goods and services and how the “dependency ratio” has changed over the time. The highest their export share, the more dependent and volatile are likely to be the export revenues. For example, a country with a high share o its total external revenue coming from one or few crops will be greatly affected by international price fluctuation for these crops. It is not a desirable fact. In practice, we need to diversify exported goods, in other words, to reduce the concentration index.
The same approach can be used to calculate a concentration index for imported goods. Measuring changes in import concentration index is useful to assess the success of a country that has followed an import-substitution policy. The lower the index, the higher the degree of substitution as the economy can be self-sufficient in a large number of products. For example, a country import food as a main imported good but its import share is relatively small in the total imports then the country is becoming food self-sufficient.
c) Terms of trade
The terms of trade can be measured by the ratio between export price index and import price index. When the terms of trade decrease, the country concerned is receiving less from exports while paying more for imports. Some countries have felled to economic crises as their term of trade has declined steadily and considerably, especially when a country export only one or two main products such as petroleum, coffee, cacao, d rubber etc.
d) Estimation of impact of external shocks
A large fall in export prices or a large increase of import prices can be a source of great external shock to the economy. It is therefore necessary to measure its impacts so that intervention policies can be drawn for remedy and reduce their social and economic consequences. The following formula can be applied to this purpose:
B = DPe * E / GDP
where B is the costs (or benefits) of external shocks, DPe is export (import) price variation, E is the total export value. The above indicators are homogeneously expressed at current prices.
The above formula indicates the degree of loss or benefits from exports over the GDP. The same formula can be appiled to imports.
6/ Structural changes
Structural change consists of changes in structure of main economic sectors, within every sector and also the change in the relative importance of crops, cattle and industrial products in the economy.
Analysis of structural change has great significance in economic policy as it is fundamental to the process of economic growth and development. By analyzing the evolution of structural change, we can understand the direction, magnitude and the speed at which structural change is taking place as well as other factors affecting the process. From such analysis, policy options can be made to direct the structural change towards an increased economic efficiency and competitiveness.
The method for measuring structural change is very simple: it is to divide each component value by the total. Below is an example in agricultural sector.
Supposing that there is a time series of production from 1986 to 2000 provided for 32 crops. We simply take the following steps:
Step 1: construct a database of 16 columns, beginning with the list of products, the following 15 columns are for data from 1986 to 2000. There are 33 rows in the table, the first row labels the years in consideration, the second rows to 33rd rows are used for express the annual production volume (by quantity, e.g. tons) of every product.
Step 2: Grouping comparative prices in 1994 of 32 products, then constructing a table for comparing prices
Step 3: Calculating production values of all the captured products over the years in consideration according the price of 1994 by multiple the production values with their corresponding prices. Constructing a table of production outputs at 1994 prices
Step 4: Dividing production output of each product by the total agriculture production value to breakdown agriculture structure.
Step 5: Grouping some products into secondary sub sector to calculate the ratio of this sector. For example, we can divide 32 products in question in 6 groups: cereals, vegetables and nuts, short-term industrial crops, long term industrial crops, forestry and livestock. We can get the secondary sector’s output by cumulate all the production values in every groups.
Step 6: Dividing production output of each secondary sector to the total agricultural output to make the secondary sub sectors’ ratios.
Once step 3 and 6 completed, we have the structure of sector over years. In policy analysis, to eliminate random variations, we calculate a moving average for both agricultural production value and its component in the first and last three years, the result will be used for calculating the agricultural structure for the first and the last year, e.g. to analyze structural changes in 1986-2000, we need to calculate a moving average ratio for 1986-1988 as the first base year, then another moving average for 1998-2000 as the last year. Ratios calculated are usually expressed under the form of charts, mostly component bar chart and pie chart.
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