goethe business school chapter ii: macroeconomics and the global economy a. macroeconomic...

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Chapter II: Macroeconomics and the global economy

A. Macroeconomic consistency

B. Consistency in a market economy

C. The role of money

D. International linkages


2

What ismacroeconomics?

S, I

Y

S(Y)

I(r1)

r

Y

r

II(r)

Investment

“Keynes’ cross”

I(r1) Y1Y2

I(r2)

I(r2)

r2

r1

IS curve


3

Essence of macroeconomics

Traditional textbooks are geared toward macroeconomic policy making, not to decision making of the firm

OutcomePolicyMACROMODEL

Feedback


4

Aggregate thinking

Macroeconomics aggregates individual agents’ decisions

Why? To achieve consistency within macroeconomic

constraints: Total production limits aggregate claims

To link real activities to financial constraints:Monetary policy affects price levels and interest rates

To link the economy to the rest of the world To analyze the impact of government policies


5

Total production and claims

Gross national product (GDP) usually limits the “size of the cake”

Do we still know what GDP measures? Let’s make a little test (anonymous):

Which of the four following definitions is not GDP?


6

Quiz: Which definition of GDP is wrong?

A. The value of gross production minus the value of inputs

B. The value of private consumption, public consumption, investment, and net exports

C. The sum of gross profits, gross wages, net indirect taxes and depreciation

D. The sum of private consumption, public consumption, investment, and net imports

ThinkThink


8

Reading

Abel, Bernanke, Croushore, Chapter 2 (only 2.1 through 2.3, without Application) For participants needing to “brush up” GDP

definitions and components: Full assignment For other participants: Only Box 2.1


9

What is GDP?

There are various perspectives to look at GDP: From the production side From the perspective of income earners

by groups (wages, profits, indirect taxes, etc.) From the perspective of income usage

(consumption, investment, etc.) All three definitions are equivalent


10

The three definitions of GDP Production

GDP = Gross value of production minus value of inputs

Income distributionGDP = Gross profits, gross wages, net indirect taxes and depreciation

Usage of incomeGDP = Private consumption, public consumption, investment, and net exports


11

The production account

Purchases of inputs

Sales to othereconomic agents(+ change of inventoriesof own products andself-produced fixed assets)

(Gross value of production)

GVPDepreciationFactor incomeIndirect taxes(Net value of production)

NVP = GDP

It records the transformation of goods and services (inputs) by using factors of production (labor, capital)


12

Production: special problems

Non-marketed services Non-profit organizations Government services Compulsory military service Exploitation of natural resources Repairing ecological damages Transactions of existing assets Financial transactions


13

Reading

On differences in measuring GDP

Reading 2-1“Europe's work in progress: Why does Europe's productivity growth lag so far behind America's?”The Economist, November 14, 2002


14

Primary income distribution

The account shows the distribution of GDPonto factors of production and the state

Gross social product(GSP)

Net foreign factor income

GDP

Indirect taxes

Depreciation

Net wagesNet profitsDirect taxes

Net social product(at factor costs) *)

Net

socia

l p

rod

uct

(at

mark

et

pri

ces)

*) “National income”


15

Secondary redistributionof national income The public sector contributes to GDP

via public consumption and investment, which is valued at input costs

Government changes the original income distribution through taxes and transfers

Does this affect the level of GDP? No, if simply redirecting circular flows Yes, if this leads to “behavioral” changes


16

Redistribution and “behavioral” change Redistributing income through taxes and

transfers may affect aggregate economic behavior

For instance income might be transferred from high savers to high consumers

This could reduce investment and increase consumption and affect growth


17

“Circular” redistributionDefinitions

Y = GDP

C = Private consumption

G = Government consumption

I = Investment (IP private; IG government)

Ti = Indirect taxes

Td = Direct taxes

Tr = Transfers

S = Private saving (SP) + Public saving (SG)


18

Macro consistency and redistribution of resource flows

Private households

Net wealth

CP

Td

Ynet

Ti

CG=G

SP

SG

IP+G

Enterprises

GovernmentTr


19

Enterprises:GDP = Ynet + Ti = C + G + I gross

Households: Ynet - Td +Tr = C + SP

= “Disposable income”

Government:Td + Ti - Tr = G + SG

Consistency within a“closed economy”


20

I = S

The various resources flows are rendered consistent, for the closed economy, but we shall focus on the fundamental identity:

I = S, or

InvestmentGross = SavingPrivate + Public

=


21

Macroeconomic consistency...

... which, in a closed economy, is established through “hard budget constraints”, i.e. definitional relationships


22

Compare this...

Latest survey shows that 3 out of 4 people make up 75% of the world's population!


23

Can a market economy achieve macro consistency? It is a truism that macroeconomic

consistency is always achieved by definition ex post, the contentious question is whether a market economy can achieve consistency through micro planning ex ante

The debate created a deep rift in economic thinking for most of the 20th century


24

Consistency through market allocations (micro level) Microeconomic theory demonstrates

that general equilibrium can be achieved through competitive markets under certain conditions (Walras model)

Generalized consistency of real activities of individual agents (consumers and producers) is called “general equilibrium”

Government only sets the framework; there is no need for direct intervention


25

Example: Exchange equilibriumBen has 2 bottles of milk Susan 2 boxes of popcorn

What will happen?


26

Marginal rates of substitution In economic language, Ben and Susan

“compare marginal rates of substitution” Ben evaluates the marginal utilities of getting

popcorn for sacrificing milk Susan evaluates the marginal utilities of getting

milk for sacrificing popcorn If U(popcorn)/ U(milk)Ben > U(popcorn)/U(milk)Susan

the two kids will start trading voluntarily until the marginal rates of substitution become equal


27

The market and arbitrage Economists call the process triggered by

comparing marginal rates of substitution “arbitrage”. This drives market transactions

It is akin to the 2nd Law of Thermodynamics What is this Law? In a nutshell it answers the question:

“You have two adjacent rooms: one heated, the other coldWhat happens if you open the insulating door between the rooms?”


28

Multiplier effects

The comparison of arbitrage with thermo-dynamics is incomplete however

In economics, energy is not simply dissolved, it triggers multiplier effects

These interact with the energy source creating positive feedbacks

Dissipating income comes back, partly, through growth and import demand


29

Income flows andthe import multiplier Income transferred from one country to another

spurs export production (and creates income) through import demand by the recipient

Imports

Income growthIncome

Country A Country B


30

Other internationalmacro linkages Induced imports by faster growing countries

may explain the growth of exports of countries with stagnating or declining domestic demand

Other international macro linkages work in favor of country A through Benefits for consumers from cheap imports Remittances of migrant workers Related party trade for direct investments

Second-round effects are often overlooked


31

United States:Related party trade

Source : US Department of Commerce


32

Efficiency

In the real world arbitrage will not work directly, but works through relative prices

With free competition and full information, relative prices will reflect marginal rates of substitution for consumers and producers

So the price mechanism renders the allocation of resources efficient


33

Maximization of social welfare

As relative prices will adjust to arbitraging in a market economy, there is no scope for market disequilibria (i.e. excess supply or demand)

Moreover, general “welfare” is maximized in an economy as long as the price mechanism works without restrictions

Everybody wins, but the outcome may not please those who do not have any assets

The market can not deal with “justice”


34

Is the market fair?

Do you know a popcorn trader?Mary may be a happy girl,

but she has nothing to trade


35

Market fairness

However the market is fair in that it gives a choice and allows an “exit”

This limits economic rents and political arbitrariness

It can be fairer than state administered allocations of resources

It also limits the power of bureaucracy and acts against corruption


36

Government interventionand social justice Social justice or fairness are important reasons

for government intervention in a market economy: the redistributive function of government

Redistribution is not only a moral issue, it also stabilizes the political environment by reducing social conflict potentials, and it may even promote growth

Yet could be other reasons for government intervention as is discussed later

These interventions fall into two categories:the stabilization and allocation functions


What is not GDP? Results

37


38

What is the role of money? Microeconomics does not need money:

any good can function as “numéraire” Earlier theories link the general price level

to the quantity of money (gold) If gold is the numéraire, all other prices are measured

in units of gold (weight = pound, peso, livre, lira) The quantity of gold (and its velocity of circulation)

determine the “general price level” of GDP The “quantity theory” completes Walras’ model


39

A theoretical dichotomy: allocation and monetary anchoring

Transmission into monetary prices

Neutral

Walras Model:

General equilibrium is achieved through relative prices in free markets

plays the role of a “monetary anchor”

Quantity theory:

M , the gold price


40

Quantity theory of money:Watch out!

The quantity theory of money is “naive” in that it uses a very simple transmission model: M V = P Y, where

M = the money stock ($)V = is the velocity of circulation (constant / time)P = the general price levelY = GDP (or transaction volume: $ / time)

In reality the transmission process has to account for credit money, which is more complex


41

How is the economy linked to the “rest of the world”? Net exports is a key component of GDP If we add net foreign transfers to net

exports, the “current balance” CB is obtained

CB = (Net exports + Trforeign), so

GDP + Trforeign = C + G + Igross + CBA = Absorption

(GDP - A + Trforeign) = CB = National saving


42

The current balance and its financing A negative CB appears to imply a “softening”

of the hard budget constraint National absorption can exceed production But a negative CB has to be financed by

foreign capital: the country borrows abroad - CB = + Crforeign

A positive CB (national saving) signals

an accumulation of net wealth abroad


43

The main macro linkages...

... work through Aggregate exports and imports

of goods and services Aggregate financial flows

How are deficit countries constrained through international capital markets?

Are surplus countries unconstrained? We shall have to analyze global financial

flows to answer these questions


44

Example: The trade balance of the United States

The US trade account has deteriorated:


45

Global capital flows


Global capital flows

46


47

What is the “global economy”?

The “global economy” is not only measured in terms of trade

Merchandise trade as a percentage of GDP was comparable even before World War I

But there is a massive structural change in trade

What is different are new opportunities for arbitrage and monetary anchoring Source: Economist


48

Global output growthand trade


49

Global economy and monetary anchoring The global economy

allows new anchoring of net wealth positions and trade

This can be used to “hedge” risks, but also for speculation

We also have to examine those risks


50

Dimensions of globalization

Factors driving the global economy are: Technical progress

(telecommunication, computers) Common knowledge base Information products and procedures Interdependence of markets Economic and cultural rapprochement

(“global village”) Integration of national economies

(EU, NAFTA)


51

“Moore’s Law”,and telecommunication costs

Source: Economist

Source: Intel


52

The impact of technology

Technical progress has dramatically enhanced the prospects for arbitrage at a world scale

Ben and Susan can now compare across continents


53

Enhanced prospectsfor arbitrage (1) We can compare prices of standard goods

and services across countries Moreover some high-value-adding

services have become “tradable” We can compare labor standards and

wages, which induces new migration We compare investment opportunities and

rates of return, which drives the allocation of capital at the world scale


54

Enhanced prospectsfor arbitrage (2) The comparison extends well beyond economic

activities and also affects general policies and culture (“Globalization of values”)

While it is possible to erect barriers to trade, migration and financing, this is more difficult for cultural values

Globalization could therefore provoke cultural clash and conflicts, but also expand human rights


55

Globalization and human rights


UN Human Rights Commission

56


57

Should we control globalization? We can control trade through customs

duties, quota, and outright bans Can we use these to control globalization? The answer is no!

Trade barriers are typically used to protect singular interest

For the economy as a whole it is profitable to avoid such barriers

Protection is a sure recipe for losing out !


58

Example: Protectionism and the Great Depression

JanuaryFebruary

March

April

May

JuneJuly

August

September

October

November

December 1929

1930

1931

1932

1933

The Smoot-Hawley Act and its impact on US trade


59

Market liberalization

The damaging effects of such barriers are increasingly being recognized

There are international institutions that stand for for the liberalization of markets

These organizations also survey the observance of established global rules

The WTO is responsible for securing free trade under “fair” conditions


60

Source : US Department of Commerce, 1994

1821 1850 1900 1930 19671950 1993

Tariffs ofabominations

(1826)

Walker(1846)

Morrill & War tariffs(1861-1864)

McKinley (1890)

Smoot-Hawley(1930)

Kennedy R. (1967)

Tokyo R. (1979)

10

20

30

40

50

60

Uruguay R. (1993)

Closure and openingof international trade

Average level of customs duties in the United States (1821-1993)Average level of customs duties in the United States (1821-1993)


61

“Hidden” protectionism

Of course protectionism is still with us, only in subtler forms: Standardization of products Regulation of markets “Non market” practices in general

(subsidization, administered prices) “Manipulated” exchange rates “Security relevant” (defense) Ecological rules Sanitary rules


62

Protectionism is always obstructive Protectionism grants

extra economic rents These invite “arbitrage”

Contraband Illicit counterfeiting Substitution effects Global shifts in production

and consumption Telework Invention of new products

and technologies

INNOVATIONINNOVATION

STAGNATIONSTAGNATION

CRIMECRIME


63

Reading

Reading 2-2“Topsy turfy world: How long will

emerging economies continue

to finance America's spendthrift habits?”The Economist, Sept 14, 2006


64

What micro links offers the global economy? Global markets are characterized by

competition for factors of production, in particular skilled labor and know how

Know how often goes with capital investments, leading to competition among economic systems and government regulations to attract investors

Under such pressures whole economic systems may collapse (“communism”)


65

Impact on national policies The global economy is characterized by

thinking in terms of share holder value and highest return

It puts pressures on government policies National frontiers will become less

important through the integration of markets, standardization of products and procedures and the adaptation of harmonized policies


66

Exploiting internationalmicro linkages Economic transactions in a global economy are

fostered through New means of telecommunication

and transportation, cut in costs Information processing technologies Advances in management techniques Advances in logistics

and outsourcing (dismemberment of the value chain) Improved risk management Deregulation and liberalization of markets


67

Information technologyand financial markets Financial markets have particularly

benefited from globalization Today trade of information products is

ubiquitous and almost instantaneous “Controlling” international finance would

lead to exclusion and segmentation So negative consequences of controlling

financial flows are felt immediately


68

Who reigns the global economy? The “old” capitalism

critique makes multi-nationals responsible for dominating economies and governments

Turnover data are compared with national GDP and used as a “dependency criterion”

For instance


69

Three big carmakers:

2004

$550 bill.

Turnover

GM

DaimlerChrysler IndiaGDP of

Ford


70

The largest firms

Source: Forbes


71

Large firms: Europe


72

Large companies: North America


73

Large firms: Asia


74

...it is hard to identify a “power center”

But in the global economynetwork...


75

So ...

even large companies are under global competitive pressures (Ford, GM)

Those firms failing to adapt are likely to lose in the globalizing economy: Countries, firms, even individuals

And never compare turnover with income figures !(Profits of the three car makers were $10bill.)


76

A new capitalism debate:“..swarm of locusts” The “new capitalism debate” recognizes

global micro links that impose constraints onto the firms’ decisions, but It attempts to “contain” some of those links

(labor markets, capital holdings, taxation) It appeals to “moral values” and “patriotism”

to counter arbitraging Such protectionist strategies are futile,

inconsistent, and damaging in the long run


77

Reading

Reading 2-3“Locust, pocus”The Economist, May 5th 2005(optional, just to see how othercountries react to German politics)


78

Is the global economy fair? Again, a market economy cannot be

expected to bear justice But global economics appears to play

in favor of some of the more dynamic developing economies

They draw on the global knowledge base as they “open up” for competition

Economies still based on raw materials and “rent seeking” are falling behind


Income inequality is often a problem “within countries”

79


80

Discussion 2:Globalization: Who wins, and who fails?

What are the principal advantages and disadvantages of globalization?

What should poorer countries do to benefit from the global economy?

What strategies should firms adopt toward nations that fail to adjust to the global economy?

goethe business school chapter ii: macroeconomics and the global economy a. macroeconomic...

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value of gross production

gdp definitions

curve slide

capital slide

equivalent slide

net exports slide

net imports slide