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Tag Archives | Indian Economy

Potential Output – Importance and Estimation

Potential output is of vital importance in macroeconomic policy making, despite imperfections in its estimation.

In order to have an effective monetary and fiscal policy, policy makers need to gauge the level of economic activity in the economy and whether this level is consistent with the potential level. In economic terms, policy makers look at the real output and its deviation from potential output, called the output gap. Potential output – the trend growth in the productive capacity of an economy – is an estimate of the level of GDP attainable when the economy is operating at a high rate of resource use.  This is not a technical ceiling on the maximum level of output attainable. Rather, it is an estimate of maximum sustainable output – output that can be sustained in the long run without leading to macroeconomic instability.

While this may seem like a purely academic and statistical exercise, in reality, understanding and proper estimation of potential output has grave consequences for the economy. If actual output is lower than potential output, that is, if the output gap is negative, then the economy is performing below its potential – resources and capacity are underutilized and unemployment is higher than what it should be. On the other hand if the output gap is positive (actual output is higher than potential output), the economy is overheated, demand exceeds supply and inflationary pressures on the economy is high. As is self-evident, neither state is desirable. The manifestation of the output gap is usually through inflation in the economy. A positive output gap results in higher inflation and a negative output gap results in deflation.

For policy makers, therefore, understanding potential output and the output gap is of crucial importance. Negative output gap should ideally be followed by an expansionary fiscal and monetary policy, so as to increase spending and demand in the economy, which will result in actual output converging towards potential output. A contractionary monetary and fiscal policy is required in the case of a positive output gap to reduce the demand in the economy and to provide liquidity to the suppliers to increase their production.

Many central bankers around the world indeed use the concept of potential output in determining the rate of interest. In deciding the policy rate, central bankers use a popular rule of thumb called the Taylor rule, which reduces the complexities in choosing the interest rate to a formula that incorporates the difference between the actual and targeted inflation rate and the difference between the actual and potential GDP[1].

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

As can be seen from the graph, real GDP has exceeded potential GDP during the boom years in the late 1990s and has significantly fallen below the potential GDP after the recession off 2007. It can also be seen that inflation reacts to the output gap. Inflation is above the targeted rate of 2% when output gap is positive and vice versa.

Estimating Potential Output

Despite its overwhelming importance to policy making, there seems to be no consensus amongst economists regarding the best method to estimate potential output. Different countries and organizations use different methods based on country specific circumstances. However, no method has been able to provide consistently robust estimates and each method has its own set of lacunae.

The various methods of estimating potential GDP can be broadly classified into two categories: the production function approach and the statistical approach. The first approach, followed by the Congressional Budget Office, USA, relates the level of output to level of technology and factor inputs, namely capital and labour. Potential Output, thus, would be the output if both labour and capital are fully utilized in an efficient manner. This manner would also require certain assumptions regarding the specific form of the production to be made. Usually, a constant returns to scale production function, such as the Cobb-Douglas production function, is used.

However, for emerging market economies, where reliable data on labour and capital is unavailable, time-series statistical techniques have become quite popular. A widely used approach in the Indian context is the Hodrick-Prescott filter, which decomposes the actual real GDP into two components – a trend and a cyclical component – and potential output is proxied by the trend component.  In other words, the GDP growth rate has an underlying structural component (trend) and another component that is seemingly random due to natural variations in the business cycles and external demand and supply shocks (cyclical). The purpose of the statistical tools is to remove the cyclical part and project the long run potential GDP based on the trend growth rate.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

The graph below shows the estimates of output gap for India using various statistical techniques. While there are differences between the different techniques, broad generalizations can be derived: the economy was overheated for a prolonged period between 2005 and 2012 and has been in slack ever since.

Irrespective of which method is used, it is important to understand the shortcomings in these approaches. However, the presence of short-comings should not be a reason to undermine the immense importance of the concept of potential output in determining macroeconomic policies.

Anupam Manur is a policy analyst at Takshashila Institution. He can be found on twitter @anupammanur


[1] Specifically, it is: it = i* + α (πt – π*) + β (yt – y*), where it is the policy rate; πt and π* are the actual and targeted inflation rates, respectively; yt and yt* are actual and potential output, respectively; and i* is the federal funds rate consistent with on-target inflation and output.



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Looking beyond the debate of bilateralism versus multilateralism

by Varsha Ramachandran

It is important to not to look at bilateral and multilateral engagements as being mutually exclusive of one another. In fact, bilateralism is the first step towards broader economic integration.

For a country to enhance its national power in the era of globalisation, it is important that it has strategic, yet unbiased economic agreements with countries across the globe. Taking this idea of economic integration further is the concept of one global economy which involves unification of economic policies, monetary policies, abolishing tariffs and taxes between various countries, and providing promising prospects of peaceful livelihood.

To engage internationally, a country can enter into several kinds of agreements. Such agreements can be classified into two categories based on the number of countries involved. Bilateral agreements are the ones that exist between only two countries, while multilateral agreements exist between several countries. Both these agreements can further be classified as Free Trade Agreements (FTAs), which does not involve any kind of tariff or non-tariff barriers to trade, or Preferential Trade Agreements (PTAs) which involves partial elimination of tariff or non-tariff barriers.

The debate on advantages and disadvantages of bilateral and multilateral trade agreements has existed for many decades in the field of international trade. Numerous studies have been conducted, using empirical data, to determine the success or failure of bilateralism and multilateralism. While the general consensus among economists is that multilateralism is more effective in the long run, this is sharply contrasted by the failure of the WTO multilateral agreements in the past few years and the success of multiple bilateral agreements instead. Economists who believe in multilateralism however point out that although bilateralism and regionalism increases trade, it harms the welfare of the world trade system.

The first half of nineteenth century saw a more closed global economy where nations engaged in bilateral agreements. Studies have noted that bilateralism contributed majorly towards harming the world trade during the inter war period. Economists argued that the highly discriminatory agreements made war inevitable. Similar opposition towards bilateral trade occurred post the Great Depression where it was argued that discriminatory agreements created vicious cycles of rising prices which further deepened economic depression.

The “Bandwagon Effect”, a situation where the non-trading partners will try to enter an existing bilateral agreement, thus rendering the original agreement less meaningful, is considered to be the biggest shortcoming in bilateralism. Creation of bilateral agreements can immensely complicate the trading environment due to creation of multiple rules. Most of these agreements have their own specific rules of origin which only complicate the production process and thus business and trade. At the same time, this also complicates the functioning of customs union as they have to assess same product differently for different countries. In the words of Professor Bhagawati, this is known as the “Spaghetti Bowl” phenomenon.

There is enough evidence to prove the failure of bilateral arrangements made way for openness among economies around the globe thereby leading to the formation of International Monetary Fund, World Bank, GATT, etc. Multilateralism soon gained popularity among policymakers as they started to explore the benefits of multilateral trade by removing stringent discriminations.

Though bilateralism allows countries to venture into different territories of similar interests, facilitate trade diversification and provides for simplified processes, multilateralism is often preferred because the risks and responsibilities associated with it get distributed among the members. Multilateralism acts as a central point to systematically deal with global concerns such as environment. Multiple countries can achieve better results than single countries working independently. Transaction costs reduce when nations pool in their resources. Multilateralism leads towards the realization of “one world, one law” with minimal complications and complete cooperation among all nations. It ensures that all nations participate in the management of global affairs.

Is multilateralism then the best option? Unfortunately, no!

The economic and geopolitical multilateral cooperation of eight countries of South Asia, SAARC, is a perfect example of the failure of a multilateral setup. Two of the largest economies of the SAARC, India and Pakistan have had inherent and long standing political tensions. The Indo-Pakistan dispute over Kashmir has proved to be one of the biggest impediments in the progress of SAARC. This shows that failure of a strong bilateral relationship between two countries will only cause a multilateral agreement including the same two countries to fail.

Economists have also pointed out some rather interesting shortcomings of multilateral arrangements. For instance, the United States was accused of having become increasingly dominant and inclined towards acting unilaterally, thus, making a number of developing nations question the very relevance of multilateralism. It is much more complicated and challenging as it involves many nations coming to a consensus which may become a tedious task. It may even happen that certain issues remain unresolved due to lack of cooperation among few countries.

Despite bilateralism and multilateralism, both, having strong drawbacks, bilateralism is believed to be here to stay. The fact is that bilateralism has always been around makes it very unreasonable to believe that it will cease to exist. The need of the hour is to identify how best bilateral trade can be used in the ultimate goal of reaching complete free trade. Practical ways of how integrate the two can be identified. For instance, a stronger multilateral system that has a bigger control over bilateral trade agreements, which are used to supplement the multilateral trading system by addressing issues that are more specific to countries and regions.

Multilateralism is necessary to reach a world of free trade. The first step towards multilateralism is, of course, bilateralism. Better regulation and a robust policy framework will educate nations engaged in bilateral agreements to expand their horizons and become part of multilateral trading blocs.

Varsha is an intern at the Takshashila Institution.

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Look before you repo

Sneha Shankar

The Indian economy needs a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. 

Last Wednesday came as a bit of a surprise to most of us that follow the RBI’s moves. The Raghuram Rajan-led inflation-fighting squad did not increase the repo rate by the 25 basis points it was predicted to. Rajan attributes his move, or a lack thereof, to insufficient data and ‘noise’ in the available set: Given the wide bands of uncertainty surrounding the short term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty.”

The animadversion to this has been plenty with many bringing to question his hardboiled inflation-fighting reputation.  Increasing repo rates would have been the next logically sound move: it would have increased the cost of borrowing for banks, which in turn would have resulted in an increase in interest rates, and thus reduced spending within the economy. With a pause on market consumption, aggregate demand would have reduced to soothe inflationary pressures. While I agree with these folks to a large extent, they have failed to take into account that we aren’t undergoing just inflation; it’s stagflation – a precarious combination of high inflation, high unemployment, and poor growth. By hiking repo rates right now, the cost of debt for businesses would have increased, only exacerbating growth, resulting in an economic zugzwang.

What the Indian economy needs is a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. Maybe the move was a good, calculated one at that.

How does that work?

Let’s take a look at what’s causing the inflation. The high rates (11.24 percent yoy increase in November) have predominantly been attributed to supply shocks in the food and fuel sectors. The food Consumer Price Index (CPI) has been indicating a month on month increase 1.38 percent from October to November, and increase of 2.42 percent from September, and fuel prices reflect similar rises, having grown from 136.1 in September to 137.5 in November.

This food-price driven inflation could, if the RBI is right, subside with the introduction of the recently-harvested kharif crops into the market, but even that might be being a tad quixotic. CPI data over the past few years doesn’t reflect that. The last time we saw a decline post-November in food CPI was November 2011 to February 2012 (a decline from 113.9 in November to 112.4 in December, but an increase then on to 113.4 in February), but even that reduction was not sufficient to bolster the RBI’s current stand.

Also, there hardly seems to be any evidence to indicate a fall in fuel prices. The CPI in the fuel sector indicated an increase from 136.1 in September to 137.5 in November, despite the fall in petrol prices in both September and October.  Also, interestingly enough, Diesel prices have increased by Re.1 (pre-tax) from September to November, and almost all agricultural equipment run on diesel. There is nothing to indicate the extent of impact that this fuel price hike could have had on the aforementioned inflation in the food sector, but one can’t entirely discount it either. Are there other indications that fuel prices will fall in the near future? None, really, but some hopefuls state that with the Rupee having stabilised, fuel inflation should moderate soon.  But then again, they are hopeful about it, and there seems to be little evidence to corroborate that.

Although everything seems to be pointing at a continued inflation, there is a lack of clarity about the possible outcomes. This was probably the ‘noise’ Rajan was talking about. It could either flip either way, and if they do occur, we do not know if one will offset the other.  On a slightly-off note, many Keynesian analysts have repeatedly stated that this is a supply-side related inflation and tightening the monetary policy would not suffice to address it, but might actually worsen the growth rate.

What about ‘growth’?

Wednesday’s lack of a move, gave the equity market, and businesses in general, a lot to rejoice about. It went a little something like this: By not changing the CRR and the repo rates, businesses that were earlier expecting a more expensive cost of borrowing found that it is now cheaper to borrow than anticipated over the past couple of days. This illusion of a cheaper cost of borrowing has greatly improved business sentiment in the economy, causing most to rejoice and calling this Rajan’s “Christmas gift”. In fact, some banks like SBI, with the same psychological thrust, are reducing home loan rates. This indicates that personal borrowing might also increase. With high liquidity, low CRR, and low IBLR (Inter Bank Lending Rate), this retention of status quo has fuelled credit demand.

So not doing anything has actually done something to boost growth.  But the big, fat concern now is that it results in a surge in the aggregate demand of the economy that could aggravate and contribute to the existing inflationary pressures.

But Rajan and co. claim to be at the ready: “The Reserve Bank will be vigilant… If the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted.”

So what does this mean?

It’s all a waiting game now. Some of it looks promising: Baig and Das, economists at Deutsche Bank, in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7 percent month on month(mom) on an average in the first fortnight of December).”

If the inflationary pressures are cordoned off on the food front, they could be exacerbated by the increase in aggregate demand. But to control that, there are measures in place with the contractionary fiscal policy and a growing trade deficit. The extent of the effects of each can only be concluded over time. For now let’s safely say that Wednesday’s move was not as bad as the online chatter says, and fervently hope the RBI gets rid of the ‘noise’ in the meantime.

Sneha Shankar is a research associate at the Takshashila Institution

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The Auto-Rickshaw Economy

“Indian Economy’s mascot needs to be the Autorickshaw. Slow, rattling, overloaded, undercapitalised, jugaad, good mileage with a bad driver.”*

 Saurabh Chandra

The humble auto-rickshaw surely performs a useful function. Like most popular things in India, it is multi-faceted: acts as point-to-point taxi, shared transport service or a small within city goods carrier. The best part about it is the awesome fuel efficiency. The next is probably the manoeuvrability which is a mixed blessing depending on whether the auto’s guardian angels were watching carefully over it or not. It is difficult to find any other positive qualities worth expounding. Perhaps we can add the easy repair and the ability to run with parts missing as another one. After this we must make a longer list of the other qualities: slow, poor acceleration, noisy, ugly, poor start, rattling, unsafe, bumpy and in poor maintenance.

All these qualities, good and bad, are found in abundance in most of the Indian economy. Most of the Indian goods tend to be optimised only on one dimension: short term costs. Sector after sector is replete with examples of how under-investments give us poor results but there is no capital to make superior good things that will pay themselves over time. Typically a society should be able to lend money to itself to build goods that it can repay to its future self once those goods generate an economic return greater than or equal to the time value of that money. If we look at any commercial skyline in an Indian city, one can’t help but notice that precious retail space is highly inefficiently constructed since plot sizes are sub-optimally small and even buildings poorly made. One would think it is a no brainer to buy contiguous plots, utilise the floor area ratio efficiently and make good retail spaces. We also see the recent phenomena of massive malls which seem to be from a different planet. Why do we see this range in the same Indian city, sometimes within the same locality of a swanky mall, an old run down shop and a scrap structure with commercial purpose (a jugaad of a shop)?

The way a society lends to itself is via the economic invention called banking. A bank pools capital from the society and can lend it towards projects pledging future returns from the project. Some types of banks in the modern era can even create fiat money towards funding such investments. The basic support a bank needs is enforcement of contracts, credit history and clear property rights. Absence of just these fundamental basics have stifled the Indian economy. Entrepreneurs with great Ideas can’t get a bank to fund their dreams since the bank can’t get any contract enforcement done in the Indian courts in half a generation. There is a lot of focus on venture capital today but venture funding is meant to fund really very risky ideas that banks won’t touch. The size of the venture funding when compared to banking will be found to be puny. The tragedy in India is that projects of much lessor business risk can’t find funding. The result is that we will see banks running behind the few credit worthy entrepreneurs to fuel more and more of their businesses and a first timer will mostly be standing in a long queue to nowhere. This manifests in the economic composition we have of few business houses doing so many businesses. We keep seeing few examples of excellence amongst a sea of mediocre output, not limited by capability but limited by the fuel of mere jugaad rather than capital.

All jugaad is of similar nature, Indian innovation driven by lack of capital. Efficient on utilisation but often compromising on long term value. Imagine what innovation funded by capital will look like in India! Surely, not like the rickety auto-rickshaw. Till then, mind your bones while traveling in the auto-rickshaw economy.

 (*This preceding tweet on Twitter met the approval of many good folks and formed the inspiration for this post.)

Saurabh Chandra is a bangalore based tech entrepreneur with an interest in public policy.

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