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Understanding the key drivers of an economy

Asset managers, economists, analysts and the majority of those working in the financial services sector, and those who have a particular vested interest on the sanity of the global economy, regularly discuss and closely monitor key economic data prints such as GDP, unemployment figures, and inflation. Why are these statistics given that much importance? Amongst a handful of reasons, the most critical is that they are the main drivers of a country’s economic performance.

A country’s workforce is merely a proportion, a percentage, of the country’s population. Generally 16-65 year olds who are eligible to work are considered to make up the work force. An employee work force coupled primarily with the existence of capital resources and technological improvements through investment are said to make up the GDP of a country. These factors can then be reviewed on a per capita basis to measure efficiency and productivity of output.

The Economic Output of an economy is the result of the above factors. Quantifying it, ensuring consistency and accuracy in calculation methodologies, is pivotal in not only gauging the state of an economy but also in carrying out a periodical analysis over time. Generally a proportional increase in all inputs leads to higher economic growth, yet developed countries, many a time have the capital factor of economic output operating near full capacity. This would leave economic growth to depend on additional labour and/or technological progress.

It is hence why GDP per capita is often an additional critical tool to measure the progress and efficiency of economic growth, but also to assess the standard of living and economic wellbeing. Given a pre-set of capital resources, an additional unit of labour output, is beneficial to an economy up to the point where the utility of additional labour given available capital reduces production efficiency, and the rate of GDP growth per capita.

It then comes as no surprise that developed economies therefore emphasise a great deal on Human Capital, which nowadays is considered an integral part of economic growth formula, over and above physical/tangible capital resources so as to ensure that continued innovation through education helps sustain and boost economic growth through technological progress to support the Labour and Capital factors.

Fiscal and monetary policies can then be used by central governments and Central Banks to intervene in the economy to control investment, capital flows, currency fluctuations, unemployment and inflation.

Inflation on the other hand has been historically inversely related to unemployment. The lower a country’s interest rates are, the more investment arises from borrowing, leading to increased demand, and inflation through higher product prices. Governments usually would then be in a position to intervene when inflation reaches unsustainable levels and the economy is operating beyond its long term output given available labour and capital resources. Higher interest rates would curb inflation, reduce investment and increase saving by consumers. Capital inflows would in fact occur as higher interest rates attract foreign demand for the country’s currency given the higher savings rate.

Monetary policy is then often used to limit the excessive appreciation of a nation’s currency, which would ultimately make it uncompetitive vs foreign peers on a relative basis, especially for a country’s reliance on exports. Developing economies, notably emerging markets, generally benefit from higher GDP growth rates. Their capital resources would be much lower than their developed economy peers and hence have much upside to gain, when increasing capital investment, adopting technological innovations and promoting participation of the work force.

Over time, through globalisation, free trade, and limited capital restrictions GDP growth of these developing nations are expected to converge to the long term average of developed nations. China for example has for the past decade had a superior and positive GDP growth rate, which albeit is still increasing, is doing so at a much slower pace, hinting that the nation is continuing to converge from a developing to a developed economy.

Disclaimer: This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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