February 18, 2005 --  The initially anemic global economic recovery from the 2001/02 recession really picked up steam in 2004.  Virtually every major economy in North America, South America, Europe and Asia grew faster in 2004 than in 2003. 

China continued to be the fastest growing major economy in the world at a 9.0 per cent annual rate.  [Note: If China's real GDP continues to increase at this annual rate, its real GDP will double in approximately 8 years!]  It is also noteworthy that the Japanese economy grew at a 4.4 per cent annual rate in 2004, compared to a 2.5 per cent growth rate in 2003.  It now appears that Japan has come out of its long tunnel of economic lethargy.  The International Monetary Fund (IMF) estimates Japan's GDP gap (the difference between its potential GDP and its actual GDP) to be a mere -0.8 per cent.  The United States, which is the world's largest economy, grew at 4.3 per cent in 2004 -- 1.3 percentage points faster than in 2003.  Because of its sheer size and the extent of its global integration, the U.S. economy has more influence on the overall global economy's performance than any other country.  In spite of the Euro's appreciation against the US dollar, the Euro area economies posted a 2.2 per cent growth rate in 2004, compared to the puny 0.5 per cent in 2003.  The economies of the United Kingdom, Canada, and Australia also picked up steam in 2004.

The table below presents the annual growth and inflation rates in 2003 and 2004 for the 17 largest economies in the world.  Altogether, these 17 countries account for over 75 per cent of the global economy's GDP.  A country's per cent of world GDP is Gross Domestic Product based on purchasing-power-parity (PPP).  Bold entries for 2004 indicate an increase from 2003.

Country
 Per Cent of
World GDP
 Growth
2003
 Growth
2004
 Inflation
2003		 Inflation
2004
  United States
 20.9
 3.0
 4.3
 2.3
 3.0
  China
 13.5
 9.1
 9.0
 1.2
 4.0
  Japan
 6.6
 2.5
 4.4
 -0.2
 -0.2
  India
 5.9
 7.2
 6.4
 3.8
 4.7
  Germany
 4.3
 -0.1
 2.0
 1.0
 1.8
  France
 3.1
 0.5
 2.6
 2.2
 2.4
  United Kingdom
 3.1
 2.2
 3.4
 1.4
 1.6
  Italy
 2.9
 0.3
 1.4
 2.8
 2.2
  Brazil
 2.7
 -0.2
 4.0
 14.8
 6.6
  Russia
 2.6
 7.3
 7.3
 13.7
 10.3
  Canada
 1.9
 2.0
 2.9
 2.7
 1.9
  Mexico
 1.8
 1.3
 4.0
 4.5
 4.4
  Spain
 1.7
 2.5
 2.6
 3.0
 2.8
  South Korea
 1.7
 3.1
 4.6
 3.5
 3.8
  Indonesia
 1.4
 4.1
 4.8
 6.8
 6.5
  Australia
 1.1
 3.0
 3.6
 2.8
 2.8
  Taiwan
 1.1
 3.3
 5.6
 -0.3
 1.1

Source: International Monetary Fund (IMF). World Economic Outlook, September 2004.

Figure 1 below provides a snap shot of each country's statistical coordinates for growth and inflation in 2004.  The rates of economic growth across the top of the figure indicate the country's annual per cent change in real GDP .  The rate of inflation is shown in red along the right side of the table.  For example, China grew at a 9 per cent rate and had 4 per cent inflation in 2004.  Italy's real GDP increased by 1.4 per cent, and its inflation rate was 2.2 per cent.

Figure 1: Economic Growth and Inflation in 2004 for Selected Countries
%
 1
 2
 3
 4
 5
 6
 7
 8
 9
 %










10










9










8










7










6










5










4









3










2










1










0










-1



Accelerating Inflation: Demand-Pull or Cost-Push?

The rate of inflation accelerated in 2004 in about half of the countries depicted in Figure 1.  This is not surprising, because empirical research in economics indicates that inflation begins to increase when an economy's recovery moves its output closer and closer to its full-employment, potential GDP.  It is called demand-pull inflation.  It is also not surprising that inflation is on the rise in many countries, because oil prices also rose in 2004.  Higher oil prices can cause inflation, because oil is the world's principal source of energy and production costs increase for many goods and services when oil prices rise.  This is called cost-push inflation.

The analytical diagram in Figure 2 below depicting the model of Aggregate Demand (AD) and Aggregate Supply (AS) can be used to see the difference between demand-pull and cost-push inflation. If an economy is initially at E5 in the diagram, then an increase in Aggregate Demand (AD) from AD2 to AD0  would move the economy along the Aggregate Supply (AS0) curve from E5 to E0.  The country's real GDP would increase, and prices would be pulled up by the increased demand.  If the economy were subsequently hit by an adverse oil price shock, then the AS curve would shift from AS0 to AS2 and the economy would move from E0 to E7 along the AD0 curve.  The real GDP would contract, but prices would be pushed up by the higher oil prices.

Figure 2



Higher oil prices in the mid-1970s caused severe global stagflation -- the combination of recession and inflation.  Economies around the globe were hurled from E0 toward E7 and beyond in Figure 2.  In contrast, oil prices rose rather dramatically in 2004 (See Figure 3 below), but the adverse impact on output and prices was much smaller than in the 1970s.

Figure 3

Source: U.S. National Energy Information Center

The adverse impact of higher oil prices in 2004 was less severe than in the mid-1970s for several reasons: (1) Many economies are now less dependent on oil as a per cent of total GDP than they were in the 1970s.  This means they are less vulnerable to cost-push inflation arising from an adverse oil supply shock.  For example, oil expenditures were about 10 per cent of United States GDP in the 1970s, compared to only 3 per cent in 2004.  (2) The percentage increases in oil prices in the mid-1970s were very high, exceeding 100, 200, and 300 per cent.  Today, an increase in the price of oil from $30 to $50 is still only a 66 per cent increase.  (3) The oil price increases in the 1970s were not being offset by increases in productivity in other sectors.  Today, productivity increases are being driven by information technology and globalization.  (4) The oil price increases in the mid-1970s caused aggregate supply to decrease by more than any increases in aggregate demand.  As a result, not only did inflation increase, but output fell as well.  In 2004, it appears that increases in aggregate demand were the greater force so that real GDP increased in spite of any decrease in aggregate supply due to higher oil prices.  This would explain why most countries around the world grew so rapidly in 2004.  Higher oil prices failed to stall the global economic recovery in 2004.

The Outlook for 2005

If oil prices were to go up again in 2005 at the same rate that they did in 2004, say from US $45/bl to $60/bl, then they might begin to have more severe adverse consequences on the global economy.  However, most analysts don't expect to see this happen.  A more likely development in 2005 is the probable rise in interest rates as central banks around the world begin to fear accelerating inflation and try to take the steam out of aggregate demand.  When central bankers expect higher and unacceptable rates of inflation, they try to engineer "soft landings" with tighter money.  Already, short-term interest rates in the United States have gone up from 1 per cent a year ago to 2.6 per cent today.  It's a tricky assignment to cool down an economy without going too far and causing a recession.


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