GDP as a Measure of Economic Wellbeing, the Phillips Curve and How Central Bank Maintain Market Confidence in National Currency

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Introduction

Giannetti et al. (2015) acknowledge that the GDP since its invention after the Second World War has been the default standard for social and economic well progress. However, there is an increasing consensus that GDP is not adequate as a tool to measure economic wellbeing and quality of life of a nation’s population. As such, this essay will highlight how well the GDP captures the quality of life. In addition, Andor (2014) argues that in the recent years, historical relationship between inflation and unemployment appears to have changed. For example, despite unemployment rate falling, wage growth and inflation have not accelerated as the original Phillips Curve tends to claim. This weak tradeoff between unemployment and inflation in the recent years has made some economist to question whether Phillips Curve is still operative at all. Consequently, this essay will discuss how this curve is used today by policymakers albeit in its modified and sophisticated form. Lastly, the essay will discuss how central banks maintain market confidence in their national currency.  

How well the GDP captures economic well being

Despite its widely accepted use as an economic indicator, the GDP falls short as a measure of well-being. Some of its shortcomings include;

Firstly, according to Charles and Klenow (2016) it ignores some components that do not involve monetary transactions. Further on, it excludes almost all of non-monetary production for example child care and the work done at home. Relatedly, Giannnetti et al. (2015) explain this further by arguing that despite non market production being partially integrated in the GDP, such as the health care and the government’s defence expenditures, several economic activities are not included in its measures, for example, donations and many other determinants of well-being such as the value of economic security, personal safety, social relations, and health. Moreover, it fails to measure changes in the human capital (both organisational and social), and do not assess income circulation among individuals, which enhances social and personal well-being (Feldstein, 2017).

Secondly, it assesses all expenditures as positive and do not differentiate welfare-reducing activity from welfare-enhancing activity (Giannetti et al., 2015). For example, defensive expenditures involve both non crime related expenditures such as insurance and crime-related expenditures such as security and police.  Consequently, an increase in these expenditures will result to a higher GDP, but do not amount to an increase in economic well-being as they only repair or prevent environmental and social costs (Feldstein, 2017).

Thirdly, Charles and Klenow (2016) explicate that GDP does not consider different goals of development visions, for example, cultural differences, but overlooks consequences of increasing social-economic inequalities. Relatedly, since it does not always address the inequalities (social and economic), it as such, does not provide societal insights properly into economic welfare as a result of reducing productivity by workers and escalating crime (Giannetti et al., 2015). Additionally, when growth is only experienced in one area of society, it does not contribute to improved global economic prosperity.

Fourthly, Charles and Klenow (2016) put forth that it omits the environment by ignoring rates of natural resources depletion, environmental costs, and on the contrary, it includes environmental remediation costs as valuable production. Furthermore, it disregards long-term negative effects of short-term exploitation/ degradation of the ecosystem, which in turn results to negative well-being of the population (Darius et al., 2015). Lastly, Feldstein (2017) pin points that most national accounting systems and GDP are limited by the national borders and ignore unsustainability that is generated by each country isolated actions and effects of the national development on overall biosphere or the individual countries. More so, well-being and GDP may experience growth in one country by exporting negative aspects of that growth to other nations at expense of wellbeing of workers in the developing countries and ecosystems.

How The Phillips Curve might be used for policy purposes 

Immediately after its invention, the Phillips Curve encouraged policymakers to aim at full employment by using monetary and fiscal policies at their disposal (Blanchard, 2016). This was as a result of the movement along this curve with wages increasing faster than the norm for a certain level of employment during economic expansion periods and slower than usual during the economic slowdowns, leading to the idea that government policies could be used in order to influence the employment and inflation rates. As such, by implementing right policies, governments hoped that they would achieve permanent balance between inflation and employment that would foster long-term prosperity (Blanchard, 2016).

Andor (2014) profess that prior to the stagflation of the 1970s the Phillips Curve in its original form seemed to work well for policymakers. However, in the 1970s the curve started to perform badly as it could not explain observed stagflation in developed world, that is, increasing unemployment and increasing inflation at the same time (see the figure below).

Figure 1: Phillips Curve and its outward shift as a result of the oil price shocks and resulting stagflation of the 1970s.

Source: Andor (2014)

It was concluded that in the long term, the curve becomes vertical because the economy reaches a natural rate of unemployment that depends only on the structural factors. Consequently, policymakers’ policies shifted to the structural reforms to lower structural unemployment (Andor, 2014).

Today, Phillips Curve is still relied upon and used in the short term scenarios with accepted wisdom that policymakers may manipulate a country’s economy only on temporary basis (Mcleay and Tenreyro, 2018). In its modified form it is referred to as ‘short-term Phillips Curve’ or ‘expectations augmented Phillips Curve’ (see figure 1 above). The reference to the inflation augmentation is the recognition that this curve shifts when the inflation rises. Consequently, this shift fosters a longer-term theory called ‘long-run Phillips curve’ or Non-Accelerating Rate of Unemployment (Mcleay and Tenreyro, 2018). Under this theory policymakers believe that there is an unemployment rate that occurs whereby inflation is stable. For example, if unemployment rate is high and remains so for a long time and is accompanied with high stable inflation rate, the curve shifts reflecting the unemployment rate that accompanies higher inflation rate “naturally.”

Moreover, the arguments for ‘independent’ central banks mandated to securing inflation target through the interest policy, relies on expectations-augmented Phillips Curve on several ways (Andor, 2014). In a more general way, accelerationist approach aims to bring inflation in control and avoid high demand levels since it maintains that hyperinflation results from allowing inflation to begin (Davig, 2016). As such, the curve is the expression of the demand-pull inflation, and inflation control is envisaged as to be as a result of policies on interest rates which affects level of demand and which in turn rises or lowers the rate of inflation (Mcleay and Tenreyro, 2018).

Blanchard (2016) elucidate that portrayed as ‘menu of choice’, the curve tolerates the argument that politicians will more likely pursue low unemployment policies (even if it causes subsequent inflation) whereas, ‘conservative’ central bankers places more weight on avoidance of inflation. This view is buttressed by Mcleay and Tenreyro, (2018) who assert that where it is believed that policy makers will act in order to constrain inflation and it is expected that their policies will be successful, favourable effects on the expected inflation occurs.

Davig (2016) contends that despite the use of the Phillips Curve by policymakers, it is evident that its relationship breakdown experienced since the 1970s has presented numerous challenges for the monetary policymakers. This is because once relied on as ultimate and unchanging framework for policymakers to choose between unemployment and inflation, despite its many virtues has some serious vices. However, albeit in its sophisticated and modified version, the curve has continued to be used even today as a vital guide for policymakers.

How Central Banks maintain confidence in national currency

To start with, Smets (2014) explains that when a central bank implements restrictive monetary policy, it decreases the money supply in a country. Consequently, as a result of expensive borrowing due to higher interest rates, the economy experiences lower consumer spending and lower business investments and therefore low economic growth. High interest rates on the other hand, and decrease in demand would lead to lower inflationary pressure. However, by implementing this policy, real interest rates are increased by the central banks resulting to capital and financial assets becoming more appealing as a result of their rates of return. Consequently, foreign investors tend to invest more in the domestic bonds, stocks and real estates which causes the balance on country capital account to improve. Increase in investment activities by both domestic and foreign investors leads to increase demand for domestic currency which increases the exchange rate of domestic currency (Smets, 2014). In sum, when a central bank implements a restrictive monetary policy, it will cause a positive impact on the value of national currency thereby maintaining confidence in the currency.  

Additionally, Svensson (2014) posits that the last financial crisis taught a lesson that countries must contain risks to their financial systems with dedicated financial policies. As such, central banks that have a role to promote the financial stability have advanced their frameworks by establishing and implementing macroprudential policy frameworks. Nergiz and Eichengreen (2014) add that due to their capacity to study and analyse systematic risk, central banks are the best placed institutions to conduct macroprudential policy. Regardless of the model used so as to implement this policy, the institution set up must be strong to counter opposition from political pressures and financial industry since empirical evidence as explained by  (KPMG, 2014) shows that when well implemented it fosters financial stability and a stable currency.

Similarly, Calomiris (2016) contends that after the financial crisis, commercial banks have faced huge increase in the regulatory demands for capital requirements and liquidity. Consequently, the central banks role of supervising stability and the regulatory compliance has increased and in order to achieve the goal of price and currency stability, the central banks have to work closely with other financial institutions in their countries.

Moreover, coordination between central bank and debt managers in a country is important, not just for smooth operation of monetary transmission systems but also for the monetary and also financial system stability (IMF, 2016). One area of this coordination is related to portfolio of the public debt, which should be sustainable. As such, size of the debt and the scheduled repayments should not overwhelm the budget of a country. Svensson (2014) concedes that by sharing assessments about probable factors and associated risks, central bank can aid the government to develop a sustainable debt strategy that would not result to market shocks such as sudden drop in exchange rate and sharp increase in short-term interest rates (Nergiz and Eichengreen, 2014). This would result to confidence in the national currency as it would remain stable despite of the debt repayment.

Conclusion

This essay has highlighted how the GDP not only fall short as a measure of the quality of life, but also triggers economic activities which are contrary to the societal well-being by assessing all expenditures as positive even those negative to well-being such as environmental degradation. Although it has value as an economic indicator, most economist argue that it does not give a reliable and full appraisal of a nation’s economic prosperity for both the present and the future as it does not assess quality of life, wellness, happiness and other vital societal parameters. Moreover, the essay has shown that in order to understand inflation and unemployment relationship, a more sophisticated approach is needed. However, despite its shortcomings, the ideas of Phillips Curve have since its inception been influential in independent central banks, development of inflation targeting, and use of interest rates in order to influence inflation. Lastly, this essay has discussed how restrictive monetary policy by central bank and how by advising government on debt, central banks can maintain market confidence in a national currency.    

References

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Darius,L., Shafrin,J., Lucarelli,C., Nicholson,S., Khan,Z., and Philipson,T.( 2015). ‘Quality-Adjusted Cost Of Care: A Meaningful Way To Measure Growth In Innovation Cost Versus The Value Of Health Gains.’ Health Affairs, 34(4), 555-61.

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Giannetti,B., Agostinho,F., Almeida,C., and Huisingh,D.(2015). ‘A review of limitations of GDP and alternative indices to monitor human wellbeing and to manage eco-system functionality’ Journal of Cleaner Production, 87(2015), 11-25

IMF (2016): Monetary Policy and Central Banking [Online] Available at:

https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/16/20/Monetary-Policy-and-Central-Banking (Accessed on 27 March 2020)

KPMG (2014): Central banking services [Online] Available at: https://assets.kpmg/content/dam/kpmg/pdf/2014/06/central-banking-services-fs.pdf (Accessed on 26th March 2020)

McLeay,M., and Tenreyro,S. (2018): Optimal inflation and the identification of the Phillips curve [Online] Available at: https://voxeu.org/article/optimal-inflation-and-identification-phillips-curve (Accessed on 27th March 2020)

Nergiz,D. and Eichengreen, B. (2014), ‘Central bank transparency and independence.’ International Journal of Central Banking, 10(1), 189–25

Smets, F. (2014). ‘Financial Stability and Monetary Policy: How Closely Interlinked?’ International Journal of Central Banking, 10(2), 263–300.

Svensson, L. (2014). ‘Inflation Targeting and ‘Leaning against the Wind.’ International Journal of Central Banking, 10(2), 103–114.