By RMB Senanayake –

RMB Senanayake

Mr Chandra Jayarane has urged professional economists to respond to an statement by S.B Dissanayake in the Sunday Observer that in 10 years the per capita income under President M.R would top US$ 10,000. Here is what he said “this story noted below appearing in the Front Page of the Sunday Observer today, meant to fool us and all along with all the  citizens of Sri Lanka and make us Venerate with “Sadu Sadhu” and hands above our heads, the Development Strategy that unfolds in the horizon”

Economists have pointed out that the per capita money income includes inflation and when converted at a prevailing over-valued nominal rate of exchange instead of at the purchasing power parity rate of exchange represents nothing. It is not a measure of the standard of living. Imagine the Government borrows Rs 200 million from the Central Bank and gives Rs 1 million to each person. Then the nominal GDP per capita will increase to Rs 1 million plus and if we convert this nominal GDP per capita at the current exchange rate of Rs 125 to the US$ the GDP per capita would be US$ 10,000 now and doesn’t have to wait for 10 years as stated by Mr. S.B Dissanayake. This gift of Rs 1million to each person in the population doesn’t mean that the amount of goods & services has gone up.  In fact it may not have gone up at all although per capita nominal GDP has gone to Rs 1 million plus. Does this measure an improvement in the standard of living of the people? Not at all since people need goods not money and money is wanted only for the purpose of buying goods & services. So it is erroneous to measure thestandard of living by the nominal GDP per capita. What is wanted is to increase the “quantity of goods & services”But the quantity of goods cannot be added together because they are measured in different units- in pounds, gallons etc. How do you add up such different units? They can’t and hence economists use their money value to add up. But the money value varies with the prices and hence we have to measure them at a previous  price level to see if there is an actual increase in quantity and not a mere increase in prices. So economists do such calculation of the sum of goods & sevices at a previous year’s price level called the base year. This summation provides a measure of the quantity of goods & services and is called the real GDP. If it has gone up then the standard of living may be said to have improved ( GDP per capita is not however a good measure of the standard of living but it is commonly used so)  .

GDP Per Capita Real income is the relevant measure but even that is not a measure of personal incomes but of economic activity.

In my opinion there is a total misunderstanding of development theory by the authorities. There is a short term theory of economic growth and a long term theory which are different. If we want to talk about ten years then what is relevant is the long term growth and not an extrapolation of the short term growth theory. What determines the long term growth rate are the real variables.

Generally, economists attribute the ups and downs in the short term to fluctuations in Aggregate Demand with no changes in Aggregate Supply.  The theory of long run growth is different and is based on real variables like the amount of labor and human capital, the stock of physical capital in the form of machinery & equipment, buildings, infrastructure of roads, power plants , the availability of land & natural resources  and entrepreneurship;  while the short run growth is based on nominal variables like the rate of inflation, the rate of interest and the exchange rate. These real factors of production determine what economists call the ‘potential output” which involves the full employment of all f actors of production particularly labor. Our unemployment rate is 3-4% and would constitute full employment since economists consider what is called the natural rate of unemployment is about this level since  workers are all the time leaving one job for another and  this level of unemployment is the minimum required for labor  mobility to respond to wage incentives. As regards the other factors of production like capital ( machinery & equipment, tools etc ) or entrepreneurship, these cannot be increased in the short run. So they are already fully employed. So when an increase in Aggregate Demand due to say higher government expenditure takes place and the actual price level is higher than the expected price level,  the response of the producers is to run down their stocks  causing the GDP to increase . So the GDP fluctuates according to the inventory cycle if the actual price level in the economy is higher than the price level expected by the producers. We are still an agricultural economy and any fluctuation in GDP in response to higher aggregate demand is not possible for it depends on the weather. So any increase in Aggregate Demand produces a higher price level along with a higher nominal GDP. It may also produce more imports and cause a current account deficit.

The topic of economic growth is concerned with the long-run trend in production due to structural causes such as technological growth and factor accumulation. The short term cycle moves up and down, creating fluctuations around the long-run trend in economic growth

In the short run the changes in GDP are primarily caused by changes in Aggregate Demand. Economists draw Aggregate Supply and Aggregate Demand curves .The Aggregate Demand curve is like the normal demand curve for a single product sloping downwards in relation ot price level- higher  the price level lower the Aggregate Demand. But the curve can shift to the right meaning that at each price level the amount demanded will be more than earlier.

Short run economic growth theory explains both GDP increase as well as Price level changes and changes in the current account of the Balance of Payments. In the short term what the authorities have to do is to manage Aggregate Demand to control inflation and ensure there is no balance of Payments crisis. So the growth rate projected by the Central Bank of 7.5% is possible but is it desirable for it risks a larger current account deficit which if there are not adequate foreign capital inflows could cause a serious balance of Payments crisis.