Inflation

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Inflation

  1. 1. Unit 6 - Inflation & Economic Growth<br />Inflation<br />As prices for goods and services that we consume increase, inflation is the result. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume. While inflation is a regular annual occurrence in modern economic systems, it only becomes a policy concern when reaching unacceptably high levels. As we shall see, many modern economic policymakers have developed a short fuse for reacting to potential increases in inflation.<br />To the majority of us, small doses of annual inflation seem normal and uneventful. Historically, despite bursts of sustained inflation during the Roman Empire, the Middle Ages and the reign in England of Queen Elizabeth I, prices remained broadly stable over long periods, including periods of falling prices. In fact, the average price level in Britain in the early 1930s was no higher than in the 1660s.<br />Measuring Inflation<br />An inflation rate gives us a consensus or aggregate measure of the price changes occurring for a number of different goods and services. When we look at individual goods, price changes often vary greatly. During the past decades the price of goods such as automobiles, gasoline, movies, health care, and housing have increased significantly. In contrast, the price of calculators and computing power has decreased substantially.<br />There are many different measures of inflation; we will focus on the most common index known as the consumer price index (CPI). There are several steps taken in calculating the current CPI:<br />Measuring the price changes of all goods is complex if not impossible. Instead a market basket of goods is used which represents many of the goods and services that we consume frequently. Items such as housing, food, transportation, communication, etc. are represented by specific goods whose price changes can be accurately recorded over time.<br />The individual items in the market basket are weighted as to their relative importance. The price of gasoline will receive a more significant weighting than that of tomatoes since we spend a greater percentage of our budget on fuel.<br />The prices of individual items and their respective weights are used in calculating the CPI.<br />The inflation rate for 2002 represents the rate of price increases of the weighted basket of goods (the CPI) since 2001. The calculation is:<br />Inflation rate (2002) =CPI (2002) - CPI (2001)x 100CPI (2001) <br />Although the consumer price index receives the lion's share of publicity and is the most closely followed price index, astute inflation watchers expand their horizons to include other price indexes. The two most important are the producer price index (PPI) and the wholesale price index. The PPI measures the average price level of goods sold by producers to wholesalers. This is a leading indicator, as higher producer prices are often translated into higher consumer prices. The wholesale price index measures the average price level of goods sold by wholesalers to retailers.<br />The CPI May Overestimate Inflation<br />The CPI is the most commonly used price index to measure the inflation rate. However, the CPI has several limitations that may cause it to report higher inflation rates than are actually occurring. The main flaws with using the CPI as a measure of consumer prices are:<br />a.       The CPI fails to adjust for improvements in quality.Over time we often pay more for a good. Compare the price of a Chrysler LeBaron convertible in 1995 to its price in 1985. However, along with the price increase have come substantial improvements in quality. After putting out dismal products in the 1980s, Chrysler made substantial quality improvements in the 1990s. The modern LeBaron buyers enjoy features such as CD stereo players, safety air bags, and a number of other quality improvements that add to the car's value. According to the CPI, we pay more for the LeBaron, contributing to inflation. Adjusting for quality improvements, the price has not increased nearly as much.<br />Although the prices of some goods have increased over time, the prices of others have consistently fallen, especially when measured in terms of the labor required to purchase that good. In 1908 is took 4,696 hours in terms of factory wages to purchase an automobile. By 1970, the hours required by the average factory worker to buy an new car had fallen to 1,397 hours. The price in terms of factory hours continued to decrease to 1,365 hours by 1997. Although the absolute price of a new car has steadily risen over time, in terms of labor effort prices have fallen, and the typical 1997 model boasted significant quality improvements over its 1970 counterpart.<br />In 1915, it cost $20.70 to make a coast-to-coast three-minute long-distance telephone call on the AT&T network - equivalent to 90 hours in factory wages. Today, the typical factory worker can pay for the cost of the same call by working two minutes.<br />In 1915, a factory worker needed to put in 3,162 hours in order to afford a refrigerator for his home. Today, it takes a week and a few days, 68 hours in total, to make the purchase.<br />b.      The weights used to add together the prices of different goods and services that go into the index are often out-of-date.The basket of goods is revised about every decade and lags changes in consumer tastes and preferences that influence consumption behavior. Over time, the CPI becomes increasingly outdated, failing to accurately reflect changing consumer spending patterns.<br />c.       Consumers often substitute away from goods that are increasing in price.This idea is closely related to #2 above but also reflects more immediate consumption patterns. If the price of a good is increasing, the consumer will seek out cheaper substitutes. The wise food shopper will adjust his grocery list to reflect changes in fresh food prices. Either rich or flippant is the shopper who insists on buying peaches in a drought year. During the 1970s oil shocks sent energy prices soaring by 218% between 1972 and 1980. Consumers flocked to alternatives such as fuel-efficient automobiles, insulation for their houses, and public transportation. Consequently, consumer outlays for energy during this period increased by only 140%. The CPI overestimates inflation by failing to allow for substitutes in consumption as relative prices change. Of course, these changes can be accounted for in the reevaluation of the CPI market basket that occurs every decade, but only after the fact.<br />Due to the above factors, the best guess is that the CPI overstates inflation by 1% to 1.5% on an annual basis. This is an important point, since economic policy often strives to achieve the lowest inflation rate possible. The implications are important for policy-makers, who could mistakenly aim for an inflation rate equal to zero, which could cause economic growth to disappear.<br />The CPI is calculated by the Bureau of Labor Statistics. It is based on a basket of 211 goods and services such as health care, education, entertainment, many of the items that we place in our shopping carts as we cruise the aisles of the grocery store and so on. To find current prices, Bureau agents go on a simulated shopping trip each month, tabulating prices.Comparing actual apples to apples is simple, but consider the case where a shopper wants to trade in his 1998 Chevy for a 2002 model. The price for a new model may have increased by several thousand dollars between 2002 and 1998, but the 2002 may also have standard features that include an improved electrical system, additional safety features, include a theft alarm, and most importantly, a deluxe CD sound system is now standard, while in 1998 Chevy may have been trying to cut costs by making the then-extinct 8 track tape player as the standard. For reasons that include the failure of the index to fully account for consumer substitution when the prices of some goods rise and improvements in quality (e.g. 2002 cell phones vs. 1992 cell phones), an independent commission found that the CPI overstated the actual inflation rate by 1.1. percent.In 2002, The Bureau of Labor Statistics, undertook an overhaul of the CPI statistic. The goal of the revisions are to better reflect consumer behavior and to give economic policy makers a better estimate of how social and technological changes affect the inflation rate.New weights will be used for the consumption of goods and services reflecting purchases made in 1999 and 2000. The weighting will be increased for goods and services such as college tuition (no surprise), cable TV, prescription drugs and nursing home care, while weights for full-service restaurant meals and men's suits among other goods, were reduced. The change in weights reflects consumer outlays for different goods and services. In 2000, a greater proportion of consumer spending went to pay the cable TV bill, than in 1990 while less money was spent on suits.<br /> <br />The Effects of Unanticipated Inflation<br />In many ways the problem with inflation is not the higher prices, but the way it can creep up, suddenly creating a big stir and causing us to lose our balance and spill our cup of tea. Or put another way, as long as we properly anticipate inflation, we can prepare and absorb much of its shock. Problems occur when inflation is greater than we predicted, when it is unanticipated. When the actual inflation rate is greater than the anticipated (planned for) rate, several problems may arise.<br />A redistribution of income and wealth within the economy. Institutions that lend money, such as banks, hate inflation. When a bank makes a loan, it charges an interest rate based on projections of future inflation, tacking on a few percentage points for profit. If inflation rises above the anticipated level, then profits are eroded or even eliminated.<br />Profits are hurt because of the way banks make money. Banks pay depositors interest to attract funds, which they can loan out at a higher rate. However, the rate paid to depositors adjusts more quickly to market conditions than the interest rate that banks charge borrowers. If inflation shoots upward, interest rates immediately follow. Banks are forced to quickly raise the return to depositors, while the rate on the overall portfolio of loans lags behind. Although banks are increasingly making flexible-rate loans and taking other defensive actions (such as interest rate swaps) they still prefer a low, steady, and predictable inflation rate.<br />The three things we can conclude:<br />bank profits fall during periods of rising interest rates (caused by increased inflation);<br />in general,unanticipated jumps in inflation hurt lenders while helping borrowers who pay off their debts with money, the value of which has been eroded by inflation; and<br />if inflation is properly anticipated lenders can raise the interest rates that they charge borrowers in order to maintain a positive rate of return.<br />Later in this course we will look at the issue of interest rate determination in more detail.<br />Another problem caused by unanticipated inflation is for workers on fixed contracts. If a labor union makes a long-term agreement for salary increases based on the projected inflation rate, then the real wage may actually decline if the inflation rate shifts up. The definition of the real wage is:real wage = nominal wage - inflation rateFor an example, assume the nominal wage increases at a 5% rate. If inflation is 3%, the real gain in wages is 2%. But if inflation unexpectedly jumps to 8%, the real wage gain is -3% (the real wage falls by 3%).<br />Other Consequences of Inflation<br />There are several other economic impacts to consider as a consequence of high inflation. Inflation has an impact on the output and employment decisions by firms that are altered by high inflation. Some possibilities include:<br />Inflation distorts the price mechanism by making it difficult to distinguish changes in relative prices from changes in the general price level.Changes in relative prices may be offset by the substitution of lower price inputs used in production. If almost all prices are rising rapidly, there is little incentive to search for cheaper substitutes that could help keep production costs low.<br />Inflation creates uncertainty.If businessmen are unsure about the future level of prices, and thus of real interest rates, they will be less willing to take risks and invest, especially in long-term projects. As investment is reduced, so is the long-run growth potential of the economy.<br />There may be a redistribution of resources and production into areas less affected by high inflation rates.Inflationary hedges are used to try to keep up with the effects of inflation, possibly to the detriment of the economy. The classic inflationary hedge is gold (and other precious metals). Gold is desirable in times of high inflation because the paper currency issued by the government rapidly loses its value (purchasing power), while gold prices tend to keep pace with inflation. The reason is that inflation increases the opportunity cost of holding paper currency (which loses its value) and gold is the closest available substitute. As the demand for gold increases, the price of gold rises (along with inflation). As savers shift their assets into gold, they reduce their holdings of stocks and bonds. This reduces the supply of funds available for businesses to borrow, raising the cost of investment (r, the interest rate). The result is less business investment and a reduction in the economic growth rate.<br />Inflationary uncertainty pushes up real interest rates, as lenders demand a bigger risk premium on their money.Longer-term interest rates are especially punished as a high inflation premium is added to account for inflationary uncertainty. As a result, the cost of borrowing by businesses and consumers increases substantially, reducing the rate of real economic growth.<br />Overall redistribution of productive and financial resources may lead to a loss in efficiency.As economic efficiency falls, so does the production of goods and services.<br />Certain elements of the tax code are deficient in adjusting for inflation. A capital gain represents an appreciation in the price of an asset, such as real estate. The capital gain is the difference between today's price and the purchase price (assuming that the market price has increased since the date of purchase). During times of high inflation, real estate prices usually appreciate, reflecting an inflationary adjustment among other factors. When the capital gain is realized (the asset is sold) the amount of the gain is taxed. However, tax rates fail to properly adjust for the part of capital gains due to inflation. Individuals are taxed on both their real and inflationary capital gains, while optimally they should only pay a tax on their real (after- inflation) capital gain.<br />We can observe a positive correlation of interest rates to inflation rates. Not surprisingly, empirical evidence shows that since 1973 countries with low inflation have tended to accomplish slightly faster GNP/GDP growth than those with higher inflation levels. In addition, countries with low inflation rates enjoyed the lowest unemployment rates.<br />We can conclude that inflation may cause many economic distortions, including slower growth and higher unemployment. Many policymakers advocate attempting to sustain the lowest possible rate of inflation. It is argued that low inflation rates yield benefits of:<br />Making possible the fastest long-term growth.<br />Eliminating the distorting consequences of unpredicted inflation.<br />Reducing the uncertainty and inefficiency associated with inflation.<br />Types of Inflation<br />There are three main types of inflation:<br />Demand-pull inflation<br />Cost-push inflation<br />Hyperinflation<br />Demand-Pull Inflation<br />Figure 6-1 illustrates the concept of demand-pull inflation. Consider the demand for automobiles. If economic growth is strong, consumer income rises and the demand for cars such as the Chrysler LeBaron convertible and other popular models increases, as shown graphically. The rightward shift in the demand curve for automobiles drives up auto prices from Po to P1. This is known as demand-pull inflation: inflation resulting from the increased demand for goods and services throughout the economy. As this example shows, demand-pull inflation is generally driven by purchases of final goods and services.<br />You may have noticed in the above graph that an increase in the demand for automobiles drove up auto prices and increased the quantity supplied by auto manufacturers. An important component used in the production of any automobile is steel. As auto producers increase their output of autos, they will demand more steel used in producing those cars. The price of steel and other inputs used in the production of autos will also rise. The graph is not shown here but the analysis for the steel market is the same as shown above.<br />Cost-Push Inflation<br /> <br />Figure 6-2 shows the idea behind cost-push inflation: higher production costs shift the supply curve to the left, causing prices to rise. Following our previous example, as Chrysler and other automobile producers increase their output to meet a surge in demand, they must pay higher prices for inputs such as steel. In addition, they will add extra production shifts, incurring increased overtime expenses for labor. As a result, the cost of producing an auto increases. Higher production costs cause the supply curve to shift inward resulting in higher prices for automobiles. The main cause of cost-push inflation is increasing prices of inputs used in production.<br />A potential leading indicator of cost-push, or supply-side, inflation is commodity prices. Economists track the prices of various commodities, from oil to gold. As the prices of inputs such as copper rise, the prices of outputs such as home wiring and plumbing will soon follow. To date there is no consensus as to which commodities to track and their relative weights (importance) in a commodity price basket. Although commodity prices do respond positively to increases in demand, they are also subject to noneconomic influences such as mining strikes and oil embargoes. For this reason commodity prices can undergo large swings for nondemand reasons, and their individual price spikes may not be a prolonged contributor to future inflation. Furthermore, raw materials represent only about 10% of total production costs, easily dwarfed by labor, which accounts for approximately 70% of the cost of production in the United States (a country with relatively capital-intensive production processes).<br />Commodities can yield an important leading indicator of future inflation, when their prices rise due to greater demand. Since the effects of short-lived supply problems (which are more easily compensated for) are hard to separate, commodities have failed to become a consistent and reliable leading indicator of future inflation.<br />On a larger, macroeconomic scale, cost-push inflation is a result of supply-side shocks. A well-known example of a supply-side shock was the OPEC oil embargoes during the early and late 1970s. The economic effect of the oil embargoes was a surge in the price of oil and other petroleum products. Higher oil prices caused energy prices to soar, which translated into electricity price spikes. As the producers of goods and services saw their utility bills climb, the increased cost of production led to a scenario as shown above by energy-intensive industries such as steel. Higher production costs led to a contraction of supply and higher prices of inputs and consumer goods.<br />Hyperinflation<br />As unappealing as demand-pull and cost-push inflation sound, they are a drop in the bucket compared to the grandest of all inflations, hyperinflation. The best definition of hyperinflation is price increases that are so out of control as to make the concept of inflation meaningless. For example, in Germany between January 1922 and November 1923 (less than two years!) the average price level increased by a factor of about 20 billion.<br />The German hyperinflation had its roots in the Treaty of Versailles, where the victorious allied nations imposed impossible war "reparation" payments on Germany. Faced with financial debts beyond its economic capacity to generate the required amount of payment, the German government started printing money to meet its obligations. As you see in this course, a major cause of inflation is printing money in large quantities, which can lead to an inflationary spiral.<br />During the hyperinflation, German workers would be paid in three shifts during the day. For example, after working the morning shift, workers would race to spend their fresh salary, which would be worthless within another few hours. There are pictures of children building play forts with bricks of worthless currency. Observers told stories of how Germans would order two beers at once, fearing that beer prices would rise before they finished their first one. Another story does have a silver lining. If a person purchased a bottle of wine, they could sell the empty bottle the next day for more than the purchase price - wine included.<br />As you might imagine, the value of domestically held savings was wiped out, and the German middle class eroded substantially. The economic chaos opened up an opportunity for Hitler and his brown shirts to take over, leading Germany and the world into World War II. Fortunately, the victorious allies learned their lesson and helped rebuild the devastated Axis governments through the Marshall Plan.<br /> <br />Measuring Economic Growth<br />In the first section of this course we used the production possibilities frontier to examine the concept of economic growth. Economic growth characterizes the expansion of an economy's capability to produce goods and services, and is usually accompanied by higher incomes. If there is no inflation, a 2% growth rate implies that the economy is producing 2% more goods and services than were produced in the prior year. The essence of a course in macroeconomics is understanding the management of economic growth along with the macroeconomic issues of inflation and unemployment.<br /> On the left we present Figure 1-3 from Topic 1. The concept of economic growth is represented by an outward shift in the production possibilities frontier. Factors that contribute to economic growth include:<br />an increase in the resources used in production, such as labor.<br />an improvement or advance in technology.<br />As shown here, growth implies higher production and allows for increased consumption of goods and services over time.<br /> <br /> There are times when an economy is not growing. Resources are underutilized; production contracts and increased unemployment rates are the result. Figure 1-2 illustrates this concept with a point inside the production possibilities frontier. In this case growth is nonexistent (the production possibilities frontier is not expanding) and the inefficient use of the available resources (excess unemployment) is represented by economic production at a point within the production possibilities frontier.<br />In this section we look at the most common measure of economic growth: gross domestic product, or GDP. GDP measures economic output as the total monetary value of the goods and services produced by a nation's residents during a given time period. GDP is most often quoted in real (corrected for inflation) annual rates, although updates are released on a quarterly (every three months) basis. As an example we use the United States for 1995. During the summer of 1995 the predicted inflation rate for the year was 3.0%. Nominal GDP was expected to grow at a 5.9% rate for 1995, leaving a projected growth rate in real GDP of 2.9% (5.9% - 3.0%). When we measure a nation's growth rate, real GDP is used as the measure of the actual increase in the value of economic production.<br />The outer boundary of the production possibilities frontier represents the potential output, or potential GDP of our economy. This is the level of production characterized by the full employment of available resources and the efficient utilization of technology. Points inside the production possibilities frontier indicate that actual output or actual GDP is less than its potential. A recession is the common expression for an economy that is producing below its potential, and undesirable high unemployment rates are a major consequence. A recession is defined as two consecutive quarters of negative GDP growth.<br />Calculating GDP<br />There are three ways to calculate either nominal or real GDP, each yielding identical results:<br />The final goods approach - which relies on data from the production of final goods and services<br />The value-added approach - which relies on data from the production of intermediate goods and services<br />The income approach - which looks at incomes of workers and employers.<br />We begin with the final goods approach. First we should distinguish between a final good and an intermediate good. Intermediate goods are used in the production of final goods. Suppose you suddenly have the urge to race to the nearest auto dealer and buy a new Chrysler LeBaron convertible. You will see glistening under the lights a final good. Probably the first thing you will do is kick the tires of the car. This will be followed by sitting in the fresh driver's seat and giving the horn a few toots. The tires, the seat, the horn, the steel of which the car body is made are intermediate goods used in the production of the automobile that you drive off into the setting sun.<br />The goods we buy are a collection of intermediate goods, assembled in a unique way to produce the final good. The final goods approach to calculating GDP only counts the price that consumers pay for the good. It does not include the price the manufacturer paid for intermediate goods, as that would be double counting. The value of the intermediate goods are included in the price of the final good.<br />The final goods calculation of GDP adds up the monetary value of all goods and services produced during a given time period (either a year or a quarter). Rather than tracking the value of goods and services produced, the price paid by end users goes into the GDP calculation. End users of goods and services fall into one of four categories:<br />Individual consumers buy approximately 70% (in the United States) of all final goods and services. This activity is known as consumption (C).<br />Businesses buy final goods to assist in the production process. Anything from staples and computers to heavy machinery is purchased and used by firms to produce other goods. Since business purchases aid in the production process this activity is known as Investment (I).<br />Government spending (G) includes purchases by federal, state, and local governments. The focus of this course will be on federal government spending.<br />Net Exports. Some of the goods produced domestically are sold abroad to foreign consumers in the form of exports. However, a portion of the goods consumed in our country are made by foreign producers and imported. The difference between exports and imports is known as Net Exports.<br />The last alternative method used to calculate GDP is the income approach, which measures the incomes generated by economic activity. Using the income approach,GDP = wages + interest payments + taxes + profitsWhen a firm sells a good, the sales price of the good can be used in the final goods approach to calculating GDP. Also, by selling a final good, the merchant receives revenues. Using the above formula, the revenues can be disbursed in the following ways:<br />wages - paid to labor;<br />interest payments - are paid on the money the firm borrows to finance capital expenditures. The recipients are individuals or institutions that lend money to the firm;<br />taxes - are paid by firms to the government in the form of corporate income taxes and indirect taxes such as excise taxes.<br />profits - is what is left over after meeting the three above obligations.<br />The four items above yield the total income of all individuals in a society plus government revenue from taxes. Note, however, that when we view GDP from the income approach all calculations of GDP exclude capital gains, which is the appreciation in the value of an asset such as a house or stock. Capital gains are not counted in GDP because they result from a market placing a higher value on an asset, not from the actual production of goods and services<br />For the purposes of this course, we will focus on the final goods approach to GDP, although you should keep in mind the income approach. No matter which calculation we use, the resulting GDP is the same.<br />Using GDP as an Economic Indicator<br />Despite the use of GDP as the foremost indicator of economic prosperity, the measure does have a number of noticeable faults.<br />GDP only counts the market value of economic activity. This excludes nonmarket activities such as:<br />housework by housewives and husbands.<br />the underground economy - a good deal of economic activity takes place outside the market. Examples range from illegal drug dealing to house painting. In some countries underground activity may account for as much as 25% of measured GDP. Including an estimate of underground activity would lead to a significantly higher level of GDP for many countries. <br />Production and consumption that creates negative externalities is counted equally. An example of a negative externality is air or water pollution. When a good is sold, its value adds to GDP, but if it is a polluting good there is no account for the negative impact on our environment. A country that has rapid GDP growth may accomplish the feat by sacrificing the environment, leading to GDP as a misleading measure of economic well-being.<br />GDP does not account for the value of unused natural resources such as minerals and forests. If these assets were valued in their natural state and included in GDP, rapid exploitation would actually reduce or slow the rate of GDP growth.<br />GDP counts all business investment, including purchases of machinery that simply replace worn-out capital and add nothing to overall productive capacity. To correct for this Net National Product (NNP) is used, which is defined as GDP minus depreciation.<br />There is no account for the value of knowledge or human capital. To date, there is no contribution to a nation's output from having a well-educated population, although there are tangible external benefits to education. If a nation can contribute to GDP by not only producing goods and services but also by providing better education for its population, then greater emphasis will be placed on education than is presently.<br />Although often used for international comparisons, GDP is a poor measure of international economic well-being. Economics often uses GDP per capita, which is calculated by taking real GDP divided by population. The use of GDP per capita leads to wide discrepancies. India, for example, has a GDP per capita below $400, an unrealistic comparison to many Western nations that are in the neighborhood of $20,000.<br />A better measure of international economic health is the purchasing power parity index (PPP), which gives an indicator of what people can afford in their own country given market and cultural differences. Another alternative to using GDP for international comparisons is the System of National Accounts (SNA), which is the result of a joint effort by the United Nations, the International Monetary Fund, the World Bank, the OECD and others. Another consideration is the attempt by the World Bank to include natural resource endowments and development as a source of national wealth. This information can be accessed by choosing the next option below.<br />An International Look at Economic Growth: The World Bank's New Measure of the Wealth of Nations<br />Economists have long been criticized for how they measure a nation's wealth. The conventional use of total GDP and GDP per capita tells us about the conversion of resources into finished goods and services but gives no information about the stock of natural resources or the skills and education of the population. GDP values production, ignoring preservation, and only considers education when it increases output, assigning no value to enlightenment. Certainly, measuring GDP as the value of production is fairly easy, we just look at the prices at which goods and services sell. Giving values to resource preservation, education, knowledge and skills is difficult and lacks accounting accuracy.<br />The World Bank is trying to apply a price tag to resources that are difficult to measure. Part of the reason is the recent emphasis by the World Bank on providing loans to developing countries which are choosing "sustainable development" - promoting long-run growth that carefully uses resources rather than rapidly deplete them to allow for faster short-term growth rates. (The name of the World Bank publication is "Monitoring Environmental Progress (MEP): A Report on Work in Progress.") The World Bank is trying to establish a framework that attempts to integrate economic indicators with environmental and social considerations.<br />The Report says that "it is time to move beyond the notion that investment is only that which is embodied in machinery, buildings, ..., etc." According to the World Bank, "investment in people, and in capacity building more generally, is crucial for sustainable development." The goal of the measure is to provide an alternative to conventional economic accounting and to define "sustainable development as giving future generations as many opportunities - or at least as much capital per person - as we have today," according to the World Bank.<br />The World Bank system breaks down national wealth into four major attributes in an attempt to create "an entire portfolio of national assets." The first three of the following four categories are included in the recent World Bank report:<br />Produced capital is the economic value of the machinery, factories, roads, water systems, and other parts of the nation's infrastructure.<br />Natural capital consists of the value of natural resources such as forests, mineral deposits, land, water, and other environmental assets.<br />Human resources considers the educational level of the population and other related factors.<br />Social institutions, such as banking and other lending institutions that provide money for the population to borrow to invest in new businesses. This consideration was not fully developed and was excluded from the report.<br />Using accounting methods, the development of natural resources both contributes to present GDP in the form of additional goods and services and subtracts a value equal to their discounted future value if they were left untouched. Estimates are made regarding the value of a country's land (which in part, depends on the income of the country in which it is located), water, timber, subsoil resources, buildings, machinery and infrastructure. Human resources make up the remainder of a nation's wealth and comprise a person's productive capacity and the value of families, communities, and social organization, and political infrastructure.<br />Some results that emerge from the report include:<br />Produced capital, which approximates the traditional method of calculating a nation's GDP, represents only 20% of the real wealth of most countries in the MEP study.<br />Genuine saving reflects produced goods minus consumption, depreciation of those produced assets, and the reduction in natural resources.<br />Countries that use their natural assets wisely end up with greater levels of wealth when they have invested in the nation's physical infrastructure and educating people.<br />Countries that sell their natural resources and fail to use the proceeds properly actually dissave. When natural resources are squandered the long-run outlook is poor.<br />Developing regions with a good record of converting natural resources into wealth and thus have a positive "genuine savings" level are East Asia and South Asia. In contrast, the Latin America and Caribbean region as a whole are slightly dissaving, while Sub-Saharan Africa has a significant level of dissaving over the past 15 years, according to the World Bank.<br />The experimental valuation attempts to estimate the value of each country's natural resources, human capital, and man-made capital. According to World Bank rankings, the world's wealthiest country is Australia at $835,000 per person (or per capita), 71% of which is reflected in its land and other natural resources. Another country rich in natural resources and with a relatively small population is Canada, which ranks second in the world with $704,000 per capita. In contrast, the wealth of the United States is $421,000 per person, coming in at 12th place in the world. Human capital accounts for 60% of the wealth in the U.S., natural resources only 25%. In contrast, using purchasing-power parity GDP per capita, the United States is the world's second wealthiest country (Luxembourg is tops).<br />Japan, resource poor, but human and physical capital abundant, ranks 5th with $565,000 per person. As the valuations show, countries that lack natural resources can compensate with a strong educational system.<br />The World's Wealthiest NationsPer capita wealth, in U.S. dollars, 1990 data and exchange ratesRankCountryPer CapitaMajor Source1Australia$835,000Natural resources2Canada$704,000Natural resources3Luxembourg$658,000Human Capital4Switzerland$647,000Human Capital5Japan$565,000Human Capital6Sweden$496,000Human Capital7Iceland$486,000Natural resources8Qatar$473,000Natural resources9United Arab Emirates$471,000Natural Resources10Denmark$463,000Human Capital11Norway$424,000Human Capital12United States$421,000Human Capital13France$413,000Human Capital14Kuwait$405,000Natural resources15Germany$399,000Human Capital55Russia$98,000Natural resources162China$6,600Human Capital<br />For the full table which shows rankings from lowest to highest, link here.<br />An International Look at Economic Growth: Resource Endowments and Long-Run Economic Growth<br />Recently, the World Bank released data on per capita wealth. The measure was a compilation of the value from the following sources:<br />Produced capital is the economic value of the machinery, factories, roads, water systems and other parts of the nation's infrastructure.<br />Natural capital consists of the value of natural resources such as forests, mineral deposits, land, water, and other environmental assets.<br />Human resources considers the educational level of the population and other related factors.<br />As a result of the inclusion of unconventional measures of wealth, such as the endowment of natural resources, the World Bank arrives at a unique ranking of per capita wealth by country.<br />A surprising result shows that three of the world's top five wealthiest countries include resource-poor Japan, Luxembourg, and Switzerland. What the table and history have exhibited is that natural resource endowments are no guarantee of economic success. Using conventional measures of GDP per head demonstrates that even the world's wealthiest nation, the United States, relies primary on human capital to generate wealth, not natural resources.<br />History has shown that there is little correlation between natural resource endowments and economic prosperity. The Soviet Union, perhaps at one time the world's most wealthy group of nations when considering stocks of natural resources, collapsed in an economically deficient heap. Turning back the pages of time, Russia lost a war and territory to Japan, a country which has succeeded by importing what it does not have on their land. Despite the wealth generated by cotton, the American South failed in a civil war against the industrial North. And at one time, the value of Haiti's exports (mostly sugar) was of greater value than the sum of exports from the original 13 American colonies.<br />The Correlation between Natural Resource Endowments and Economic Growth<br />Empirical evidence points to a negative correlation between resource endowments and economic growth. Countries with scarce natural resources, such as Hong Kong, Taiwan, South Korea, and others, lead the world in growth and development, while resource abundant nations such as Nigeria and Venezuela are economic basket cases. In a recent study(1), empirical results reveal that economic growth is higher among countries that are relatively lacking in natural resources than in those with abundant natural resources. The study finds that of the 18 most rapidly growing economies, only two - Malaysia and Mauritius - have ample supplies of natural resources.<br />(1) From a 1995 study of 97 countries by Jeffery Sachs and Andrew Warner. Harvard Institute for International Development, October 1995.<br />The study by Sachs and Warner gives empirical support to what is known as the "Dutch disease." Holland is a country where much of the land has been created by rolling back the sea with a system of dikes; an interesting choice for an example of the relationship of economic growth and plentiful natural resources. Yet in the 1950s, huge reserves of natural gas were discovered in Holland at a time when demand for this fuel source by utilities was growing rapidly. Yet even with generous natural gas reserves, Holland has not become an economic power like its neighbor Germany, which built its strength through industry, not resources.<br />In general, countries with abundant natural resources may experience slower long-run economic growth for the following reasons:<br />Consider the production possibilities frontier. For a given level of capital and labor resources, exploiting natural resources requires the transfer of labor from other industries. As a result, there is more capital and labor devoted to the development of often nonrenewable resources and less available for the advancement of the manufacturing, service, and other traded-goods industries. In the long run, economic growth is generated by investment in a strong manufacturing and service industries.<br />Countries that enjoy a boom in natural resource exports may find themselves with a current account trade surplus and as a result an appreciation in their currency's exchange rate value. With rising currency values, the relative prices of a nation's exports rise and import prices fall. This leads to an increased substitution of imported goods and a reduction in domestic production, usually in the critical manufactured goods and service industries.<br />Although not always the case, sudden government revenue windfalls created by the increased exporting of natural resources heighten expectations of future revenues. Resource and commodity prices are extremely volatile; today's premium price may be tomorrow's bargain. Optimistic forecasts of future prices accompanied by generous current government spending programs based on the expected revenues can lead to disaster when resource prices plummet. For example, in the late 1970s when oil had reached a price of $35 a barrel, rosy scenarios predicted that oil prices would reach $65 a barrel by the mid-1980s. Instead, they fell below $20. The oil price collapse caused a debt default by oil exporters Nigeria and Mexico, where government expenditures were based on unrealistically optimistic price forecasts. The net result is a boom-and-bust cycle, which is detrimental to long-run economic growth.<br />Governments that experience revenue spurts when resource prices are climbing often expand the public sector significantly. Governments may pass on the proceeds by expanding the welfare, transportation, military, and other parts of the public sector. As these sectors grow, so does the required annual expenditure to maintain them at a constant or expanding level. When resource revenues taper off, taxes are raised and often import tariffs are imposed to preserve the promised level of public services. The net result is a redistribution of spending from the private to the public sector in the long run and a reduction of beneficial international trade activity when trading partners retaliate with their own higher tariffs.<br />Economic theory points to rent-seeking behavior as an explanation for the tendency for governments to rapidly exploit natural resource endowments. For the owner of a resource, rent is the surplus of the market price received over the minimum price required to bring forth production. Rent-seeking governments will favor the income from the sale of resources that command a relatively high market price over alternative sources. As a result, public policy will encourage resource development and the associated rents. Since short-run rents connected with improvements in the manufacturing, service, and other traded goods sectors are lower, the development of these sectors will receive secondary attention from public policymakers. Industry and infrastructure will be orientated to the exploitation of the natural resource to the long-run detriment of other sectors of the economy.<br />In poorer, less-developed countries, rent-seeking behavior often leads to government irresponsibility and corruption. The inefficiencies will not be noticed by the public in the short-run because of the resource-generated windfall. In the long run, entrenched government inefficiencies and corruption are difficult to reduce. There are many examples of governments that have used natural resource revenues to finance the buildup of a large military and a totalitarian state. Money that should be spent in building up a nation's infrastructure in critical areas such as communications and productive industry are diverted into the pockets of officials and their supporters. Those excluded from the benefits often respond with civil war, coups, and the long-run devastation of the economy.<br />An Applied Example: Diamonds and Oil in Angola<br />If natural resource endowments were the primary determinant of wealth, Angola with its plentiful oil reserves and substantial diamond mining industry would be one of the world’s richest countries. In reality, diamonds have been a curse to Angola rather than any type of blessing.<br />The recent origins of Angola’s trouble began in 1975 when Jonas Savimbi, Angola’s leader at that time, lost an election. Rather that give up power peacefully, Savimbi formed a rebel group known as Unita. Realizing that the source of power was control of the natural resources, Unita took control of most of the diamond territory in Angola. Diamond exports provided a steady stream of revenues (about $3 billion in legal diamond sales) to finance Unita’s continuous war against the government.<br />After losing control of the diamond mines, the government needed to find an alternative source of revenues and turned to oil. Western oil companies paid about $3.5 billion to rights to oil located off the coast of Angola.<br />Angola fell into an extremely violent and prolonged civil war financed by the export of Angola’s natural resources. Both the government and Unita fought for control of those natural resources since whomever controlled the resources, had the power to rule the country. Angola’s abundant diamond and oil resources were plundered to purchase weapons that were in turn used against many innocent people in the country. Only about 5% of the money gained from exports was used by the government for productive social purposes such as housing, education, health care, building up the national infrastructure, and other positive contributions.<br />When Savimbi died in February of 2002, roughly 25% of Angola’s people were homeless, over ½ million citizens have died in the fighting over the past decades, many others have been maimed by land mines, rare diseases like leprosy and polio are spreading. With the death of Savimbi, perhaps Angola will find peace and be able to use the revenues from diamond and oil exports to build an economy and a country.<br />Copyright © 2002, Jay KaplanAll rights reservedLast updated June 2002<br />

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