1

C-AE12: ECONOMIC DEVELOPMENT A. The Traditional Theory of

FINAL TERM REVIEWER International Trade

MODULE 10: INTERNATIONAL TRADE The phenomenon of transactions and

and DEVELOPMENT exchange is a basic component of human
activity throughout the world. Even in the
OVERVIEW most remote villages of Africa, people
regularly meet in the marketplace to
Economic globalization refers to the exchange goods, either for money or for
increasing interdependence of world other goods through simple barter
economies as a result of the growing scale of transactions.
cross-border trade of commodities and
services, flow of international capital and A transaction is an exchange of two
wide and rapid spread of technologies. It things—something is given up in return for
reflects the continuing expansion and mutual something else. In an African village, women
integration of market frontiers, and is an may barter food such as cassava for cloth or
irreversible trend for the economic simple jewelry for clay pots. Implicit in all
development in the whole world at the turn of transactions is a price.
the millennium.
For example, if 20 kilos of cassava are traded
The rapid growing significance of information for a meter of bark cloth, the implicit price (or
in all types of productive activities and terms of trade) of the bark cloth is 20 kilos of
marketization are the two major driving cassava. If 20 kilos of cassava can also be
forces for economic globalization. In other exchanged for one small clay pot, it follows
words, the fast globalization of the world’s that clay pots and 1-meter pieces of bark
economies in recent years is largely based cloth can be exchanged on a one-to-one
on the rapid development of science and basis. A price system is already in the
technologies, has resulted from the making.
environment in which market economic
system has been fast spreading throughout COMPARATIVE ADVANTAGE
the world, and has developed on the basis of
increasing cross-border division of labor that Why do people trade?
has been penetrating down to the level of
production chains within enterprises of Basically, because it is profitable to do so.
different countries. Different people possess different abilities
and resources and may want to consume
The participation of developing countries in goods in different proportions. Diverse
the globalization process can enable them to preferences as well as varied physical and
better utilize their comparative advantages, financial endowments open up the possibility
introduce advanced technologies, foreign of profitable trade.
capital and management experience. It is
also favorable for eliminating monopolistic People usually find it profitable to trade the
behaviors and strengthening market things they possess in large quantities
competition. Nevertheless, while providing relative to their tastes or needs in return for
more development opportunities for things they want more urgently.
developing countries, the globalization
process is also posing enormous risks

Compiled by: Jade R. Montoya

 2

Because it is virtually impossible for to produce in Germany and can profitably be

individuals or families to provide themselves exported to other countries like Kenya; other
with all the consumption requirements of things (agricultural goods) can be produced
even the simplest life, they usually find it in Kenya at a lower relative cost and are
profitable to engage in the activities for which therefore imported into Germany in
they are best suited or have a comparative exchange for its manufactures.
advantage in terms of their natural abilities or
resource endowments. They can then The concept of relative cost and price
exchange any surplus of these home- differences is basic to the theory of
produced commodities for products that international trade. The principle of
others may be relatively more suited to comparative advantage, as it is called,
produce. The phenomenon of specialization asserts that a country should, and under
based on comparative advantage arises, competitive conditions will, specialize in the
therefore, to some extent in even the most export of the products that it can produce at
primitive of subsistence economies. the lowest relative cost.

These same principles of specialization and Germany may be able to produce cameras
comparative advantage have long been and cars as well as fruits and vegetables at
applied by economists to the exchange of lower absolute unit costs than Kenya, but
goods between individual nations. In answer because the commodity cost differences
to the question of what determines which between countries are greater for the
goods are traded and why some countries manufactured goods than for agricultural
produce some things while others produce products, it will be to Germany’s advantage
different things, economists since the time of to specialize in the production of
Adam Smith have sought the answer in manufactured goods and exchange them for
terms of international differences in costs of Kenya’s agricultural produce.
production and prices of different products.
Countries, like people, specialize in a limited So even though Germany may have an
range of production activities because it is to absolute advantage in the cost of both
their advantage to do so. They specialize in commodities, its comparative cost
activities where the gains from specialization advantage lies in manufactured goods.
are likely to be the largest. Conversely, Kenya may be at an absolute
disadvantage vis-à-vis Germany in both
But why, in the case of international trade, manufacturing and agriculture in that its
should costs differ from country to country? absolute unit costs of production are higher
For example, how can Germany produce for both types of products.
cameras, electrical appliances, and
automobiles cheaper than Kenya and It can nevertheless still engage in profitable
exchange these manufactured goods for trade because it has a comparative
Kenya’s relatively cheaper agricultural advantage in agricultural specialization (or
produce (fruits, vegetables, coffee, and tea)? alternatively, because its absolute
disadvantage is less in agriculture).
It is this phenomenon of differences in
Again, the answer is to be found in comparative advantage that gives rise to
international differences in the structure of beneficial trade even among the most
costs and prices. Some things unequal trading partners.
(manufactured goods) are relatively cheaper

Compiled by: Jade R. Montoya

 3

B. Export Promotion vs. Import Basically, the distinction between these two
Substitution traditional trade-related development
strategies is that advocates of import
A traditional way to approach the complex substitution (IS) believe that a developing
issues of appropriate trade policies for economy should
development is to set these specific policies
in the context of a broader strategy of looking initially substitute domestic production of
outward or looking inward. In the words of previously imported simple consumer goods
Paul Streeten, outward-looking (FIRST-STAGE IS) and
development policies “encourage not only
free trade but also the free movement of then substitute through domestic production
capital, workers, enterprises and students , for a wider range of more sophisticated
the multinational enterprise, and an open manufactured items (SECOND-STAGE IS)
system of communications.”
—all behind the protection of high tariffs and
By contrast, inwardlooking development quotas on these imports. In the long run, IS
policies stress the need for nations to evolve advocates cite the benefits of greater
their own styles of development and to domestic industrial diversification (“balanced
control their own destiny. This means growth”) and the ultimate ability to export
policies to encourage indigenous “learning some previously protected manufactured
by doing” in manufacturing and the goods as economies of scale, low labor costs,
development of technologies appropriate to and the positive externalities of learning by
a country’s resource endowments. doing cause domestic prices to become
more competitive with world prices.
According to proponents of inward-looking
trade policies, greater self- reliance can be By contrast, advocates of export
accomplished, in Streeten’s words, only if promotion (EP) of both primary and
“you restrict trade, the movement of people, manufactured goods cite the efficiency and
and communications and if you keep out the growth benefits of free trade and competition,
multinational enterprise, with its wrong the importance of substituting large world
products and wrong want-stimulation and markets for narrow domestic markets, the
hence its wrong technology distorting price and cost effects of protection,
and the tremendous successes of such
A lively debate regarding these two export-oriented economies as South Korea,
philosophical approaches has been carried Taiwan, Singapore, Hong Kong, China, and
on in the development literature since the others in Asia.
1950s. The debate pits the free traders, who
advocate outward-looking export promotion
strategies of industrialization, against the
protectionists, who are proponents of
inward- looking import substitution strategies.
The latter predominated into the 1970s; the
former gained the upper hand in the late
1970s and especially among Western and
World Bank economists in the 1980s and
early 1990s.

Compiled by: Jade R. Montoya

 4

They stress that firms in these economies However, since the mid-1970s, the EP
have learned a great deal from the firms in strategy has been increasingly adopted by a
the United States, Japan, and other growing number of countries. The early EP
developed-country economies that have adherents—South Korea, Taiwan,
been their long-term customers. Sometimes Singapore, and Hong Kong—were thus
a distinction is made between “strong export joined by the likes of Brazil, Chile, Thailand,
promotion,” in which policies are explicitly and Turkey, which switched from an earlier
geared to expansion of exports (in general, IS strategy. It must be stressed, however,
such as through a weak currency), rather that most successful East Asian export
than production for the domestic market, and promoters have pursued protectionist IS
“weak export promotion,” which emphasizes strategies sequentially and simultaneously in
free trade and a level playing field and is certain industries, so it is inaccurate to call
viewed by advocates as likely to promote them free traders, even though they are
exports by comparison with previous import outward-oriented (Todaro & Smith, 2010,
substitution policies (which tend to pp.594-595).
discourage exports in relative terms).
Against this background, we can now
Beyond this, many Asian countries also examine the issue of outward-looking export
adopted a more nuanced approach that promotion versus inward-looking import
draws on some elements of both to develop substitution in more detail by applying the
targeted sectors, examined later in the following fourfold categorization:
chapter.

In practice, the distinction between IS and EP

strategies is much less pronounced than
many advocates would imply. Most
developing economies have employed both
strategies with different degrees of emphasis
at one time or another. For example, in the
1950s and 1960s, the inward-looking
industrialization strategies of the larger Latin
American and Asian countries such as
Chile, Peru, Argentina, India, Pakistan,
and the Philippines were heavily IS-
oriented. C. The Industrialization Strategy Approach
to Export Policy
By the end of the 1960s, some of the key
sub-Saharan African countries like Nigeria, In matters of economic development, the last
Ethiopia, Ghana, and Zambia had begun to 40 or so years have been dominated by what
pursue IS strategies, and some smaller Latin has come to be known as export-led growth
American and Asian countries also joined or export promotion strategies for
in.32 industrialization. Export-led growth occurs
when a country seeks economic
development by engaging in international
trade.

Compiled by: Jade R. Montoya

 5

The export-led growth paradigm (MNCs) for the setting up of low-cost

replaced—what many interpreted as a production centers to provide cheap exports
failing development strategy—the import to the developed world. While developing
substitution industrialization paradigm. nations benefited from the creation of new
While an export-led development strategy jobs as well as technology transfer, the new
met with relative success in Germany, Japan, model hurt the
and East and Southeast Asia, current domestic industrialization process.
conditions suggest that a new development
paradigm is needed. This new paradigm was expanded more
globally through the establishment of
The period from around 1970 to 1985 saw the World Trade Organization (WTO) in
the adoption of the export-led growth 1995. According to the Economic Policy
paradigm by the East Asian Tigers—Hong Institute, China’s admission into the WTO in
Kong, Singapore, South Korea, and 2001 and its export-led growth is an
Taiwan—and their subsequent economic extension of Mexico’s model. However,
success. While an undervalued exchange China was much more successful in
rate made exports more competitive, these leveraging the benefits of greater openness
countries realized that there was a much to international trade than Mexico and other
greater need for foreign technology Latin American countries.
acquisition if they wanted to compete in auto
manufacturing and electronics industries. Perhaps this is partly due to its greater use
of import tariffs, stricter capital controls, and
Much of the success of the East Asian its strategic skill in adopting foreign
Tigers has been attributed to their acquisition technology to build its own domestic
of foreign technology and the implementation technological infrastructure. Regardless,
of that technology compared to their China was dependent on MNCs around 2011,
competitors. The ability of these countries to when 52.4% of Chinese exports come from
acquire and develop technology was also foreign-owned firms, and those firms
supported by foreign direct investment accounted for 84.1% of trade surplus.
(FDI).
D. The Terms of Trade and the Prebisch-
Some newly industrializing nations in Singer Hypothesis
Southeast Asia followed the example of the
East Asian Tigers, as did several countries in The opposite hypothesis—the Prebisch-
Latin America. This new wave of export-led Singer hypothesis of long-term
growth is perhaps best epitomized by deterioration in the terms-of-trade of primary
Mexico’s experience that began with trade products—can be traced back to the early
liberalization in 1986 and later led to the mid-twentieth-century writings of Charles
inauguration of the North American Free Kindleberger. He thought it inexorable for the
Trade Agreement (NAFTA) in 1994. terms-of-trade to turn against primary
producing countries because of the
NAFTA became the template for a new operation of Engel’s law—which states the
export-led growth model. Rather than using demand for goods needed for bare
export promotion to facilitate the subsistence such as food rises less than
development of domestic industry, the new proportionately while demand for other luxury
model for developing nations became a consumption goods rises more than
platform for multinational corporations proportionately—in the process of world

Compiled by: Jade R. Montoya

 6

economic growth and improvements in So, in the process of industrialization these

the standard of living. It was, however, a countries began to face acute balance-of-
1945 League of Nations report prepared by payments problems. This led many southern
Folke Hilgerdt and its subsequent follow-up countries to follow the path of export-oriented
by the United Nations in 1949 that is actually industrialization. Dependence on a few
the origin of the Prebisch-Singer hypothesis primary-product exports was reduced and
and the related debate. It was observed in these began to be substituted by
these reports that during the sixty years manufactured exports.
preceding 1938 primary product prices had
fallen relative to prices of manufactures. Meanwhile, the emphasis of the Prebisch–
Singer hypothesis shifted from the relations
In the 1950s both Raúl Prebisch and Hans between types of commodities to relations
Singer referred to this so-called historical between types of countries. The shift of
fact and questioned the classical proposition emphasis too had its origin in the writings of
and its implicit support for the colonial pattern Kindleberger in the mid- to late 1950s.
of trade. It was pointed out that productivity
increased faster in the industrialized He found no conclusive evidence of
countries (constituting the North or the deterioration in the terms-of-trade of primary
industrial center) than in the primary- products, but he did have some evidence of
producing countries (constituting the a decline in the terms-of-trade of the primary-
South or the raw-material supplying producing countries (South) vis-à-vis the
periphery), so that the terms-of-trade should industrialized countries (North). In fact, both
have moved in favor of the South, given the Prebisch and Singer had in mind the concept
factors of free trade and competition. of terms-of-trade between the North and the
South.
The South could have enjoyed the fruits of
technical progress taking place in industry But, in the absence of appropriate data, they
through free trade and specialization (in used the series on terms-of-trade between
primary production) without going for primary products and manufactures as a
industrialization, as suggested in the proxy, with the logic that primary products
classical writings. But this did not happen as dominated the then export structure of the
the available evidence showed. So the South and manufactures dominated that of
primary-producing countries were advised to the North.
pursue a vigorous policy of industrialization
with the suspension of the free play of The factor highlighted by Singer is the raw-
international market forces. material saving and/or substituting
technical progress in the North which
In the post–World War II period, the created a demand bias against southern
Prebisch–Singer hypothesis provided the exports in the process of growth of northern
theoretical basis for the policy makers of the manufactures leading to a fall in the southern
newly independent countries to adopt a path terms-of-trade.
of import-substituting industrialization (ISI)
through protective commercial policy. The In his 1950 work Prebisch tried to explain the
path of ISI in basically agricultural countries phenomenon in terms of the interaction of the
required imports of machines and technology. diverse economic structures of the North and
the South with different phases of business
cycles.

Compiled by: Jade R. Montoya

 7

In an upswing, wages and profit, and so Under these circumstances, if both the North
prices, rise more in the North than in the and the South grow at the same rate (or the
South due to stronger labor unions and South tries to catch up by pressing for a
higher monopoly power of the northern higher rate of growth), the global macro
capitalists. In the downswing, northern profits balance requires a steady deterioration in the
and wages do not fall much due to the same terms-of-trade of the South vis-à-vis the
reason. The burden of adjustment falls on the North
raw material suppliers of the South; their
prices fall more than the prices of INTERNATIONAL TRADE AND
manufactures. DEVELOPMENT

(supplemental infos)
The diverse economic structures created an
asymmetry in the mechanism of distribution
Globalization
of the fruits of technical progress, argued
Prebisch, Singer, and Arthur Lewis in their
The increasing integration of national
individual works published in the 1950s. In
economies into expanding international
the North, technical progress and
markets.
productivity improvements led to higher
wages and profit while in the South, these led
Market integration
to lower prices.

The North-South models of Findlay (1980) refers to how markets trade with one another.
When markets are highly integrated, there
and Sarkar (1997 and 2001b) supported this
are less trade barriers and prices are similar.
asymmetry. Granted this asymmetry, the
In case of low integration, prices among
terms-of-trade would turn against the interest
these markets fluctuate and there are several
of the South in the process of long-term
barriers in trade. International trade helps the
growth and technical progress in both the
integration of markets because the latter
North and the South.
allows price signals to be transmitted from
one market to another.
In 1997 Sarkar provided another explanation
in terms of product cycles. A new product is
World Trade Organization (WTO)
often introduced in the North. Initially there is
a craze for this product and its income
Geneva-based watchdog and enforcer of
elasticity is very high. Owing to a lack of
international trade agreements since 1995;
knowledge of its production technique, the
replaced the General Agreement on Tariffs
South cannot start its production.
and Trade.
The South produces comparatively older
International trade has often played a central
goods with lower income elasticity. By the
role in the historical experience of the
time the South acquires the knowledge, the
developing world. In recent years, much of
North has introduced another new product. In
the attention to trade and development
such a product cycle scenario, the income
issues has been focused on understanding
elasticity of southern demand for northern
the spectacular export success of East Asia.
goods is likely to be higher than that of the
northern demand for southern goods.

Compiled by: Jade R. Montoya

 8

Taiwan, South Korea, and other East Asian It is based on three principles: equal, non-
economies pioneered this strategy, which discriminatory trade treatment for all member
has been successfully followed by their much nations, the reduction of tariffs by multilateral
larger neighbor, China. negotiation, and the elimination of import
quotas. Hence, GATT provided a forum for
Primary products. the multilateral negotiation of reduced trade
barriers.
Products derived from all extractive
occupations—farming, lumbering, fishing,
The Association of Southeast Asian
mining, and quarrying, foodstuffs, and raw
Nations (ASEAN).
materials.

Export dependence The ASEAN is the top preferential trade

agreement in the Asia Pacific area.
Established in 1967, ASEAN is an
A country’s reliance on exports as the major
organization for economic, political, social
source of financing for development activities.
and cultural cooperation among its members.
Free trade Its original members are Indonesia, Malaysia,
Brunei, Singapore, Thailand and Philippines.
In July 1995, Vietnam was admitted to the
The importation and exportation of goods
ASEAN while Cambodia and Laos were able
without any barriers in the form of tariffs,
to join in July 1997. Burma, now Myanmar,
quotas, or other restrictions
was granted admission in 1998.
Export earnings instability
Gulf Cooperation Council (GCC).
Wide fluctuations in developing-country
In May 1981, GCC was established by Qatar,
earnings on commodity exports resulting
Oman, Saudi Arabia, Bahrain, Kuwait, and
from low price and income elasticities of
the United Arab Emirates. The purpose of
demand leading to erratic movements in
GCC is to foster unity among its members
export prices
based on their common objectives and their
Commodity terms of trade similar political and cultural identities, which
are rooted in Islamic beliefs. Gulf finance
ministers outlined an economic cooperation
The ratio of a country’s average export price
agreement in terms of financial and monetary
to its average import price
coordination, investment, petroleum and
General Agreement on Tariffs and Trade abolition of custom duties.
(GAAT)
The European Union.
In 1947, twenty three nations including the
United States signed the GATT until it In 1951, Belgium, Germany, France, Italy,
Luxembourg and the Netherlands were the
became a treaty among 123 nations whose
only European countries which started to
governments agreed to promote trade
cooperate economically. Over time, 22 more
among members. The treaty was intended to
countries decided to join.
be multilateral and GATT negotiators did
succeed in liberalizing world merchandise
trade.

Compiled by: Jade R. Montoya

 9

The Union’s members (aside from the North American Free Trade Agreement
pioneer members) include Denmark, (NAFTA).
Ireland, United Kingdom, Greece,
Portugal, Spain, Austria, Finland, Sweden, On August 12, 1992, representatives from
Cyprus, Czechia, Estonia, Latvia, Canada, Mexico, and United States
Hungary, Lithuania, Malta, Poland, concluded negotiations for the NAFTA. The
Slovakia, Slovania, Bulgaria, Romania three member countries’ governments
and Croatia. The Euro is the official pledged to promote economic growth
currency of 19 EU countries and they are through tariff reductions and expanded trade
collectively known as the Eurozone. The EU and investment. The benefits of continental
is more than a common market because the free trade benefited these countries through
citizens of the member countries are able to the gradual elimination of barriers to the flow
freely cross borders within the Union. This is of goods, services, and investment.
because the Union encourages the
development of a community wide labor pool. The United States-Mexico-Canada
Agreement, also known as the USMCA, is a
South African Development Community trade deal between the three nations which
(SADC). was signed on November 30, 2018.

Established in 1992, the SADC is referred to Common Market of the South (Mercosur)
as a mechanism by which the region’s black
ruled states could promote trade, The government of Brazil, Paraguay,
cooperation, and economic integration. Uruguay, and Argentina signed the Asuncion
SADC members are Angola, Botswana, Treaty to form the Common Market of the
Democratic Republic of Congo, Lesotho, South (Mercado Comun del Sur or Mercosur)
Malawi, Madagascar, Mauritius, in March 1991. The presidents of the four
Mozambique, Namibia, South Africa, countries agreed to begin phasing in tariffs
Seychelles, Swaziland, Tanzania, Zambia on August 5, 1994. A few months after,
and Zimbabwe. goods, services, and factors of production
moved freely throughout the member
Economic Cooperation of West African countries.
States (ECOWAS).
Andean Community.
To promote trade, cooperation, and self-
reliance in West Africa, 15 states signed the Formed in 1969, the Andean Community,
ECOWAS in May 1975. The member formerly the Andean Pact, was aimed to
countries include Benin, Burkina Faso, Cape accelerate development of member states
Verde, Gambia, Ghana, Guinea, Guinea- namely, Peru, Bolivia, Ecuador, Venezuela
Bissau, Liberia, Mali, Niger, Nigeria, Senegal, and Colombia through economic and social
Sierra Leone, Mauritania and Togo. These integration. These countries agreed to lower
countries agreed to establish a free trade tariffs among members and work together to
area for unprocessed agricultural products decide what products each country should
and handicrafts and abolished tariffs on produce. Foreign goods and companies
industrial goods. were kept out as much as possible.

Compiled by: Jade R. Montoya

 10

Foreign Finance, Investment, and Aid: Foreign direct investment (FDI)

Controversies and Opportunities
Overseas equity investments by private
multinational corporations.
The international flow of financial resources
takes three main forms: Global factories

(1) private foreign direct and portfolio

Production facilities whose various opera-
investment, consisting of (a) foreign
tions are distributed across a number of
“direct” investment by large multinational
countries to take advantage of existing price
(or transnational) corporations, usually
differentials.
with headquarters in the developed
nations, and (b) foreign portfolio Transfer pricing
investment (e.g., stocks, bonds and
notes) in developing countries’ credit
An accounting procedure often used to lower
and equity markets by private institutions
total taxes paid by multinational corporations
(banks, mutual funds, corporations) and
in which intracorporate sales and purchases
individuals;
of goods and services are artificially in-
voiced so that profits accrue to the branch
(2) remittances of earnings by international
offices located in low-tax countries (tax
migrants; and
havens) while offices in high-tax coun- tries
show little or no taxable profits.
(3) public and private development
assistance (foreign aid), from (a) Foreign aid
individual national governments and
multinational donor agencies and,
The international transfer of public funds in
increasingly, (b) private
the form of loans or grants either directly from
nongovernmental organizations (NGOs),
one government to another (bilateral
most working directly with developing
assistance) or indirectly through the vehicle
nations at the local level.
of a multilateral assistance agency such as
the World Bank.
Portfolio investment
Concessional terms
Financial investments by private individuals,
corporations, pension funds, and mutual
Terms for the extension of credit that are
funds in stocks, bonds, certificates of deposit,
more favorable to the borrower than those
and notes issued by private companies and
available through standard financial markets.
the public agencies.
Official development assistance (ODA)
Multinational corporation (MNC)
Net disbursements of loans or grants made
A corporation with production activities in
on concessional terms by official agencies,
more than one country.
historically by high-income member
countries of the Organization for Economic
Cooperation and Development (OECD).

Compiled by: Jade R. Montoya

 11

Technical assistance MODULE 11:

MEASURING NATIONAL INCOME
Foreign aid (either bilateral or multilateral)
that takes the form of the transfer of expert National Income
personnel, technicians, scientists, educators,
and economic advisers, and particularly their National Income is the total income earned
use in training local personnel, rather than a by all households and businesses in an
simple transfer of funds. economy within a given period of time.

Absorptive capacity It was very difficult to ascertain whether the

economy of a country has improved or not
The ability of a country to absorb foreign over the year before the concept of gross
private or public financial assistance (to use domestic product (GDP) was introduced.
the funds in a productive manner). During those times, we mostly relied on
personal experience in determining past
Tied aid performances.

Foreign aid in the form of bilateral loans or Though personal observations contributed
grants that require the recipient country to information, such as information may not
use the funds to purchase goods or services have accurately reflected the state of
from the donor country. economy as a whole. Although nobody
patented the discovery of GDP, the name of
Nongovernmental organizations(NGOs) Simon Kuznets comes into view for his path-
breaking work on the accounting of the
Nonprofit organizations often involved in national product. The concept of GDP
providing financial and technical assistance opened the door to a systematic
to developing countries. understanding of how the economy performs
on a macro level. Since then, it has become
Answer the following questions: the most basic tool in describing the
1. Why does the Philippines need foreign aid? performance of the economy.

2. Which countries mostly constitute the Gross Domestic Product

Philippines’ foreign aid donors?
Gross Domestic Product refers to the
3. How does foreign trade and globalization market value of all final goods and services
aid the Philippines in economic development? produced domestically in a given period of
time. In defining the GDP, the “value” is in
monetary terms, which in our case, the
market price in Philippine peso (Ᵽ). However,
it does not include the value of intermediate
products used in the production of final
products in order to avoid double or multiple
counting. It also does not include the non-
productive transactions such as purely
financial transactions.

Compiled by: Jade R. Montoya

 12

In addition, the computation of GDP exclude COMPUTATIONS FOR NOMINAL AND

second- hand sale and existing assets or REAL GDP
properties that were sold or transferred, the
presence of underground economy and
unpaid productive services.

NOMINAL GDP AND REAL GDP

Nominal GDP is the value (at current price)

of final goods and services produced within a
country for a specific period of time. It is given
APPROACHES TO GDP
by the following formula:
1. Industrial – Origin or Production
Nominal GDP = Price x Quantity
This approach sums up the market value of
Real GDP is the value (at constant price) of
the gross value added of all sectors and its
final goods and services produced within a
sub-sectors of the economy.
country for a specific period of time. Real
GDP is computed as follows:
To illustrate:
Real GDP = Nominal GDP x 100
Gross Domestic Product Using Industrial-
GDP Deflator
Origin Approach
Where the denominator, GDP deflator is also
1. AGRICULTURE, HUNTING,
called as the price index. It is given by the
FORESTRY AND FISHING
following formula:
A. Agriculture
B. Fishing

2. INDUSTRY SECTOR
Real GDP reflects only the changes on the
quantity of goods and services holding the A. Mining and Quarrying
price at a constant level. Considering the B. Manufacturing
variety of products produced in an economy, C. Construction
it is necessary to have one price index that D. Electricity, Gas and Water Supply
will be used to divide the total current value
of production. 3. INDUSTRY SECTOR

By keeping the price at a constant level, it is A. Transport, Storage and

now more accurate to compare economic Communication
performance from different years’
perspective in terms of the actual quantity of B. Trade and Repair of Motor Vehicles,
production of goods and services rather than Motorcycles, Personal and
the market value of all goods and services. Household Goods

C. Financial Intermediation

Compiled by: Jade R. Montoya

 13

It will be added if the value of the GDP using

D. Real Estate, Renting and Business the industrial approach is greater than the
Activities value from (C + I +G + (X –M). Otherwise, it
should be deducted.
E. Public Administration and Defense;
Compulsory Social GROSS NATIONAL INCOME (GNI)
Security
GDP is one of the ways in measuring the
F. Other Services performance of an economy. It represents
the value of final goods and services
2. Expenditure Approaches produced domestically. But if we are going
to consider the value of goods and services
Sums up all the expenses of the produced by Filipino citizens abroad, then we
institutional sectors: households, are dealing with gross national income (GNI).
businesses, government and the rest of
the world. The GDP using this approach Gross National Income is defined as the
is calculated as follows: value of final goods and services produced
domestically and abroad by Filipino citizens.
GDP = C + I + G+ (X-M) GNI was previously known as gross national
product (GNP).
Where C stands for consumption, I for
investment, G for government spending, To compute:
X for exports and M for imports.
GNI = GDP + Net Primary Income from the
The expression (X-M) gives what we call rest of the world
Balance of Trade or net exports. The
value of net exports can either be positive NET PRIMARY INCOME (NPI)
or negative. It is positive whenever
exports exceed imports (which is also Net primary income (NPI) is the difference
called as a trade surplus) and it is between inflows and outflows of income.
negative when imports exceed exports Inflows of income refer to the value of
(which is also known as a trade deficit) compensation and property income that the
Philippines receives from the rest of the
Ideally speaking, the value of the GDP world.
using the two approaches must come up
with the same value. But in reality, where Outflows of income, on the other hand,
data gathering is very complex, resulting represent the value of compensation and
to a hundred percent accuracy in values property income that is sent abroad.
is somehow difficult. Whenever the
values of GDP differ, the value of the The formula of GNI as shown is derived after
GDP using the first approach is followed. adding or deducting NPI to or from the value
Whatever the value of the difference of GDP. But when we are going to add or
between the two approaches will be deduct the value of NPI to GDP in order to
called as Statistical Discrepancy. This derive GNI? When NPI is positive, meaning,
value will be added or deducted to the inflows of income are greater than outflows:
value of GDP using the expenditure NPI will be added to the value of GDP.
approach.

Compiled by: Jade R. Montoya

 14

And when NPI is negative, meaning, outflows MODULE12

of income are greater than inflows, NPI must The Role of the Financial System in
be deducted from the value of GDP. Economic Development

PROBLEMS WITH MEASUREMENT OF Six Major Functions of Finance

GDP AND GDP PER CAPITA
1. Providing payment services
Changes in GDP does not necessarily
indicate the changes in the quality of life It is inconvenient, inefficient, and risky to
because in the measurement of GDP there carry around enough cash to pay for
are some activities that are unreported and purchased goods and services. Financial
therefore not included in the computation. institutions provide an efficient alternative.
For instance, transactions without money The most obvious examples are personal
such as subsistence farming and home- and commercial checking and check-
making are left out too. In this regard, there clearing and credit and debit card services;
is a more better gauge in measuring the each is growing in importance, in the modern
quality of life, which is called as GDP per sectors at least, even in low-income
capita. It is given by the following formula: countries.

2. Matching savers and investors.

GDP per capita = GDP
Total Population Although many people save, such as for
retirement, and many have investment
GDP per capita is literally an economy’s projects, such as building a factory or
average productivity per person, which is expanding the inventory carried by a family
only one aspect of the quality of life. GDP microenterprise, it would be only by the
can give us an idea of the quality of life, but wildest of coincidences that each investor
it does not reveal everything. saved exactly as much as needed to finance
a given project. Therefore, it is important that
GDP does not include important non-market savers and investors somehow meet and
activities, such as home making. Also, agree on terms for loans or other forms of
externalities (or spillovers) are not accounted finance.
for by GDP. In other words, GDP counts the
3. Generating and distributing information.
final goods, like new cars, but it does not
count everything that is good about an From a society wide viewpoint, one of the
economy. And it does not count “the bads” most important functions of the financial
like greenhouse gas emissions. system is to generate and distribute
information. Stock and bond prices in the
If we compare nations solely on the basis of daily newspapers of developing countries
GDP per capita, developing nations appear (and increasingly on the Internet as well) are
to be further behind and industrialized a familiar example; these prices represent
nations, further ahead. A scale called the average judgment of thousands, if not
Purchasing Power parity (PPP) helps millions, of investors, based on the
measure GDP adjusted for the lifestyle it can information they have available about these
afford in a given country. and all other investments.

Compiled by: Jade R. Montoya

 15

Pump priming
4. Allocating credit efficiently.
an action taken by a government wherein
Channeling investment funds to uses they inject a small amount of money into a
yielding the highest rate of return allows sluggish economy in hopes of spurring
increases in specialization and the division of economic growth.
labor, which have been recognized since the
time of Adam Smith as a key to the wealth of
nations. The monetarist theory of economic activity
advocates argue that by controlling the
5. Pricing, pooling, and trading risks. growth of the money supply, governments of
developed countries can regulate their
Insurance markets provide protection nations’ economic activity and control
against risk, but so does the diversification inflation.
possible in stock markets or in banks’ loan
syndications. Monetary policy.

6. Increasing asset liquidity. Activities of a central bank designed to

influence financial variables such as the
Some investments are very long-lived; in money supply and interest rates.
some cases—a hydroelectric plant, for
example—such investments may last a
century or more. Sooner or later, investors in Money supply.
such plants are likely to want to sell them. In
some cases, it can be quite difficult to find a The sum total of currency in circulation plus
buyer at the time one wishes to sell—at commercial bank demand deposits and
retirement, for instance. Financial sometimes savings bank time deposits.
development increases liquidity by making it
easier to sell, for example, on the stock
market or to a syndicate of banks or Currency substitution.
insurance companies.
The use of foreign currency (e.g.,U.S. dollars)
as a medium of exchange in place of or along
Keynesian Economists vs Monetarist with the local currency (e.g., Mexican pesos).
Theory
Transparency (financial).
The Keynesian economists argue that an
expanded supply of money in circulation In finance, full disclosure by public and
increases the availability of loanable funds. private banks of the quality and status of their
Expanded supply of money in circulation loan and investment portfolios so that
increases the availability of loanable funds. A domestic and foreign investors can make
supply of loanable funds in excess of informed decisions.
demand leads to lower interest rates.
Organized money market.
Because private investment is assumed to
be inversely related to prevailing interest The formal banking system in which loanable
rates, businesspeople will expand their funds are channeled through recognized and
investments as interest rates fall and credit licensed financial intermediaries.
becomes more available.

Compiled by: Jade R. Montoya

 16

Unorganized money market. Rotating savings and credit association

(ROSCA).
The informal and often usurious credit
system that exists in most developing A group formed by formal agreement among
countries (especially in rural areas) where 40 to 50 individuals to pool their savings and
low-income farms and firms with little allocate loans on a rotating basis to each
collateral borrow from moneylenders at member.
exorbitant rates of interest.
Microfinance.

Financial liberalization. Financial services, including credit, supplied

in small allotments to people who might
Eliminating various forms of government otherwise have no access to them or have
intervention in financial markets, thereby access only on very unfavorable terms.
allowing supply and demand to determine Includes microsavings and microinsur- ance
the level of interest rates, for example. as well as microcredit.

Group lending scheme.

Central bank.
A formal arrangement among a group of
The major financial institution responsible for potential borrowers to borrow money from
issuing a nation’s currency, managing commercial or government banks and other
foreign reserves, implementing monetary sources as a single entity and then allocate
policy, and providing banking services to the funds and repay loans as a group, thereby
government and commercial banks. lowering borrowing costs.

FISCAL POLICY
Currency board.
the use of government spending and taxation
A form of central bank that issues domestic to influence the economy. When the
currency for foreign exchange at a fixed government decides on the goods and
exchange rate. services it purchases, the transfer payments
it distributes, or the taxes it collects, it is
engaging in fiscal policy.
Development banks.

Specialized public and private financial TAXES

intermediaries that provide medium- and
long- term credit for development projects. Direct taxes.

Taxes levied directly on individuals or

Informal finance.
businesses—for example, income taxes.
Loans not passed through the formal banking Indirect taxes.
system—for example, loans between family
members. Taxes including customs duties (tariffs),
excise taxes, sales taxes, value added taxes
(VATs), and export duties— levied on goods
purchased by consumers and exported by
producers.

Compiled by: Jade R. Montoya

 17

Expansionary fiscal policy

is when the government expands the money

supply in the economy using budgetary tools
to either increase spending or cut taxes—
both of which provide consumers and
businesses with more money to spend. The
purpose of expansionary fiscal policy is to
boost growth to a healthy economic level,
which is needed during the contractionary
phase of the business cycle. The
government wants to reduce unemployment,
increase consumer demand, and avoid a
recession.

Keynesian Theory of Employment

John Maynard Keynes was an early 20th-

century British economist, known as the
father of Keynesian economics. His career
included academic roles and government
service.

One of the hallmarks of Keynesian

economics is that governments should
actively try to influence the course of their
nations' economies—especially to increase
spending and lower taxes in order to
stimulate demand in the face of recession.

The Monetarist Approach

The monetarist theory, as popularized by

Milton Friedman, asserts that money supply
is the primary factor in determining
inflation/deflation in an economy.
According to the theory, monetary policy is a
much more effective tool than the fiscal
policy for stimulating the economy or slowing
down the rate of inflation.

Contractionary fiscal policy

is when the government either cuts spending

or raises taxes. It gets its name from the way
it contracts the economy. It reduces the
amount of money available for businesses
and consumers to spend. The goal of
contractionary fiscal policy is to reduce
inflation.

Compiled by: Jade R. Montoya