Sunday 20 August 2017 News Updated at 01:08 PM IST
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Monetising the output gap in Indian economy - Deccan Herald
Monetising the output gap in Indian economy
P Sreelakshmi,
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An economy is said to be on the growth trajectory only when it is closely operating at potential levels of output. What could boost these growth rates in the economy? After the financial crisis the large economies of the world observed a continued sizeable output gap. A look at the World Bank estimates, one can find only Germany and the UK, near to closing the output gap, while France and Japan are still much behind the drift.

What exactly is this output gap? Output gap is the difference between what an economy can produce and what it is producing. The policy makers are not only concerned about the output of goods and services which is measured as GDP, but also about the potential output. Hence they are concerned about how close an economy’s current output to its potential one.

The difference between the actual output of an economy and its potential output is termed as output gap. Potential output is what an economy can churn out in terms of goods and services to its maximum at its full capacity and efficiency. An output gap signifies that the economy is running inefficiently, either overworking, which is positive or underworking its resources, which are negative. A positive gap indicates that there is a huge demand and that it has to put the resources to most efficient capacity to meet the demand. A negative gap indicates that there is a weak demand and hence there is a spare capacity or slack in the economy.

How do we measure the gap? There are two measures often used by the policymakers to gauge the output gap namely - inflation and unemployment. The logic is simple. When there is a positive output gap, prices begin to rise in response to demand pressure. Similarly, if there is negative gap over time, the prices will begin to fall to reflect weak demand. For many central banks, maintaining full employment becomes an important policy goal at the same time bringing inflation under control.
But, does the global output gap influence domestic prices? The answer is stil yes. In an increasingly integrated world economy, the global output gap can affect domestic inflation and employment. This calls for the central banks to pay close attention to developments in the growth potential of the world economies other than domestic labourand capital.

Now the question is, where do we stand in terms of global economy? Economies across the world are trying to close this output gap through policy changes to address the level of spare capacity. The recent $95 billion infrastructure commitment in Canada or the ECB stimulus packages are more direct approaches.

Recently, head of the IMF Christine Lagarde said, "Investing badly-needed, but well-designed infrastructure is an obvious area of great potential. Building or upgrading the infrastructure in the short term can boost the aggregate demand through increased construction activity and increased employment can boost economic growth by increasing the potential supply capacity of an economy. Literature supports the concept-one extra dollar spent on infrastructure could increase GDP by $2.5 to $3.5 in the long run. Can infrastructure investments reduce the output gap? Of late, many policy measures have been taken by the govt. for enabling environment for industrial growth.

Initiatives like 'Make in India’ and 'Smart Cities’ will provide impetus to the industrial sector, which is considered to be the key driver of economic growth, which would help in transforming infrastructure. Investing more in infrastructure is a potential and attractive approach to boost up growth rates, against boosting short term demand. Growth can happen when investment is in line with the economic, social and environmental objectives, aligned with government goals. This sort of investment offers an acceptable return on capital and also benefits directly or indirectly the wider economy in the long run.

Spending on these infrastructure initiatives creates jobs, and job growth leads to an increase in consumer demand, which in turn affects GDP growth and its stability. Infrastructure investment in India picked up starting with the Golden Quadrilateral Highway construction in 2001. Since then, the economy demonstrated an ability to generate 7.5 million new jobs annually in 12 years starting from 2000, and the employment in construction jumped from 26 million to 50 million.

Investment in infrastructure as a percentage of GDP increased from 4.9% in 2002-03 to about 7.2% in 2011-12, and is expected to reach 10% of GDP by 2016-17, as per a CII report. The government is taking every possible initiative to boost the infrastructure sector. The Construction Industry Development Board (CIDB) of Malaysia has proposed to invest $30 billion in urban development and housing projects in India, such as a mini-smart city adjacent to New Delhi Railway Station, a green city project at Garhmukhteshwar in Uttar Pradesh and the Ganga cleaning projects. All these initiatives are expected to generate immense employment opportunities and in turn increase productivity reducing the output gap.

The challenges: As per the IBEF report, India needs Rs 31 lakh crore to be spent on infrastructure over next five years.The challenge lies in prioritising the infrastructure with the limited funding resources.

Another challenge today is delay in implementation of these projects.The infrastructure unit must be empowered. However, the government initiated Infrastructure Investment Trusts aimed at raising about Rs 4,035 crore through its IPO. There are many other infrastructure firms to gear up to these trusts. This could reduce the funding problems to certain extent. Some changes should be brought about in the bidding of construction contractors like benchmarking and standardisation to enhance the quality of projects.Infrastructure can be looked as an economic enabler than a panacea. These investments make people more efficient and productive with their time.

(The writer is Professor in finance at Christ University, Bengaluru)