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The World Economy

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Title: The World Economy


1
The World Economy
  • Gavin Cameron
  • Oxford University
  • April 2005

2
plan of the session
  • 16.30 Short-run Macroeconomics
  • 17.30 Discussion in groups of short-run issues
  • 18.00 Long-run Macroeconomics
  • 19.00 Discussion in groups of long-run issues
  • 19.20 Presentations
  • 19.50 Summary

3
short-run macroeconomics
  • What determines aggregate demand?
  • The unemployment-inflation trade-off
  • Monetary Policy
  • Fiscal Policy
  • The Open Economy
  • Global Macroeconomic Imbalances

4
what determines aggregate demand?
  • Aggregate demand comprises five components
  • consumption
  • investment
  • primary government spending (i.e. net of
    transfers)
  • net exports (i.e. exports minus imports)
  • inventories (i.e. changes in stocks held by
    businesses)
  • The level of income (both current and expected)
    is a major determinant of consumption, government
    spending and net exports.
  • The real exchange rate is a major influence on
    net exports.
  • The interest rate is also an influence on
    consumption and investment (with the latter being
    also dependent upon output expectations and
    animal spirits).

5
the circular flow of income
6
recent performance
Source CESifo Report on the European Economy 2005
7
the Phillips Curve
  • In 1958, A.W. Phillips of the LSE found relation
    an empirical relationship between unemployment
    and inflation in the UK the Phillips curve.
  • Original interpretation
  • There is a permanent trade-off between inflation
    and unemployment.
  • Problem
  • After sustained inflation, the empirical
    relationship broke down.
  • New interpretation
  • There is a trade-off between unemployment and
    unexpected inflation.
  • But in the long-run, there is no such trade-off.

8
the unemployment-inflation tradeoff
  • In the short-run, there is no reason to expect
    actual output to equal its equilibrium rate.
  • Here are four reasons why output can deviate from
    its equilibrium rate
  • sticky-wages
  • worker-misperception
  • imperfect information
  • sticky-prices.
  • All of these lead to a surprise-supply
    function, where
  • output equilibrium output b(unexpected
    inflation)
  • Therefore output deviates from its equilibrium
    level by the extent to which inflation deviates
    from its expected level.

9
inflationary pressure
Source CESifo Report on the European Economy 2005
10
monetary policy
  • Monetary policy can be implemented through either
    changes in the money supply or interest rate, or
    through direct controls on lending.
  • Changes in the interest rate will affect the
    interest-sensitive components of aggregate
    demand. The exact size and timing of these
    effects will differ from country to country.
  • If economy is at equilibrium output, interest
    rate cuts will lead to an inflationary boom,
    which eventually will lead only to higher prices.
  • If economy is below equilibrium output, interest
    rate cuts will tend to raise output (as well as
    prices) and shift the economy back towards
    equilibrium.

11
Taylor rules and inflation targeting
  • After the inflationary difficulties of the 1970s
    and 1980s, many countries moved towards having
    independent central banks and the use of
    inflation targets.
  • This form of constrained discretion seems to
    work because it takes control of monetary policy
    out of the hands of politicians!
  • In practice, most monetary authorities operate
    something called a Taylor rule. That is, they
    raise the real interest rate (the nominal rate
    minus expected inflation) whenever inflation is
    above target or when capacity constraints appear
    in the economy (since these may predict future
    inflation).

12
recent loose monetary policy
Source CESifo Report on the European Economy 2005
13
even on a real basis
Source CESifo Report on the European Economy 2005
14
fiscal policy
  • Changes in the governments fiscal stance (that
    is, the difference between government spending
    and taxation) will change the level of aggregate
    demand.
  • If economy is at equilibrium output, increases in
    spending (or tax cuts) will lead to an
    inflationary boom, which eventually will lead
    only to higher prices.
  • If economy is below equilibrium output, increases
    in spending (or tax cuts) will tend to raise
    output (as well as prices) and shift the economy
    back to equilibrium.

15
the limits to fiscal policy
  • But there are problems with the use of fiscal
    policy
  • Measurement of output where are we? where are
    we going? how fast? will we know when we get
    there?
  • Lags in the fiscal policy process implementation
    (recognition administrative lags) and
    operational
  • What kind of fiscal policy? Spending (on what?)
    or tax cuts (for whom?)
  • Will spending crowd-out other spending, either
    directly or indirectly?
  • Will consumers attempt to offset the actions of
    the government (Ricardian Equivalence) if they
    recognise that higher current deficits imply
    higher future taxes?

16
fiscal rules
  • Even now that most monetary policy is conducted
    by independent monetary authorities, there is
    still the problem that politicians may pursue
    fiscal policies that are incompatible with stable
    inflation.
  • Consequently, some countries have adopted fiscal
    rules. The two most famous are
  • The Stability and Growth Pact (revised!)
    countries should aim to run no more than a 1
    deficit over the business cycle cannot borrow
    more than 3 of GDP (cf. France and Germany!) in
    any one year government debt should be kept
    below 60 of GDP.
  • Gordon Browns Golden Rule over the business
    cycle borrowing should equal net government
    investment government debt should be kept below
    40 of GDP.

17
breaking the rules?
Source CESifo Report on the European Economy 2005
18
the open economy
  • The Balance Of Payments is a record of all the
    transactions between residents of one country and
    another.
  • The Current Account comprises the visibles
    account (the balance of trade in goods) and the
    invisibles account (trade in services plus net
    external investment income plus net transfer
    payments).
  • The Capital Account comprises international
    transactions in assets (physical and financial).
  • Official Financing comprises intervention in the
    foreign exchange market.
  • Current Account Capital Account Official
    Financing ? 0
  • A Current Account deficit must be financed by a
    Capital Account surplus.

19
the exchange rate
  • When the exchange rate floats freely, what
    determines its level?
  • Purchasing Power Parity (PPP)
  • Baskets of goods in the USA and euro area should
    cost the same
  • PPP is the cost of the euro area basket divided
    by the cost of the US basket (/)
  • Interest Parity
  • Expected returns should be equal on foreign and
    domestic assets.
  • The interest rate differential between two
    countries is equal to the expected rate of
    depreciation.
  • The Terms of Trade
  • Relative supply and demand for tradeables.

20
the dollar weakens
Source CESifo Report on the European Economy 2005
21
global imbalances
  • Euroland growth has been slow since 2000
  • US recovery from recession has been good,
    although employment has not recovered as much as
    output
  • The UK has grown steadily
  • Japan continues to grow slowly China and India
    continue to grow rapidly.

22
not much sign of a European recovery
Source CESifo Report on the European Economy 2005
23
cheap money is on the way out
  • World monetary policy has been extraordinarily
    relaxed since 2000, with interest rates of around
    0 in Japan, 1 in the USA and 2 in Euroland.
  • But short-term interest rates are now rising in
    the UK, USA, Australia and Canada, with the
    markets predicting further monetary tightening
    over the next two years.
  • Meanwhile, in Japan and Europe, limited signs of
    economic recovery have not yet led to any
    decisive moves in monetary policy.

24
house prices will decline
  • A recent paper by the BIS argues that a 1
    percentage point rise in the short-term real
    interest rate reduces prices over a five-year
    period by more than 1.25 in German-style
    markets, 1.8 in US-style markets and 2.6 in
    UK-style markets. However, this likely
    understates the risks in those countries that are
    currently overvalued, for two reasons
  • Expectations In overvalued markets, there is the
    possibility of a major change in perceptions of
    future house price appreciation and a consequent
    correction.
  • Credit Conditions In US- and UK-style markets,
    there are strong links between bank credit
    expansion and house prices, so there is a risk
    that falling house prices and shrinking bank
    credit will be mutually reinforcing.

25
a worst case scenario
  • What might a house price crash mean for real
    consumption in the UK and the USA?
  • UK scenario 30 real fall in house prices over
    two years with a 100 basis point monetary
    tightening might knock ½-¾ of a percentage point
    off growth during that period.
  • US scenario 10 real fall in house prices over
    two years with a 200 basis point monetary
    tightening might achieve about the same in the
    USA.
  • However, there is scope for monetary easing in
    both countries, but central banks should beware
    creating expectations that they are underwriting
    asset prices indefinitely.

26
a Japan style meltdown?
  • One possibility is the risk that the bursting of
    housing bubbles will lead to a repeat of the
    economic meltdown experienced by Japan in the
    1990s.
  • Fortunately for the slow-growing euro area
    economies, given their general lack of housing
    bubbles, the ECB should not face too many
    problems.
  • US-style markets are rather more risky since the
    housing bubble has allowed households to become
    highly geared. When house prices fall, it is
    likely that households will want to rebuild their
    balance sheets and that real consumption will be
    affected. However, mortgage-backed securities
    (MBS) tend to spread the risk of house price
    falls throughout the financial system, although
    in the USA there are question marks about the
    roles played by the two federal institutions
    Fannie Mae and Freddie Mac.
  • The most exposed markets are those, like the UK,
    where households typically hold a great deal of
    floating rate debt. The joint consequences of
    rising mortgage payments and falling house prices
    could be severe, especially if the financial
    system itself comes under stress due to the link
    between falling house prices and shrinking bank
    credit.

27
global policy
  • According to the IMF, between 2001q3 and 2003q4,
    US real domestic demand rose 8.9, UK 6.9, Japan
    2.7, the euro area 2.0, Germany -0.7. GDP has
    been rising rapidly recently in the US (over 5
    at an annualized rate) - this is being driven by
    higher domestic demand and is being reflected in
    higher profits but not higher wages.
  • US needs a lower real exchange rate, higher real
    interest rates, and a lower government deficit -
    this would help to correct the trade deficit and
    crowd investment and exports back in. The UK
    needs this to a lesser extent.
  • The counterpart of the US situation is that the
    euro area and Japan will have to accept higher
    real exchange rates. To some extent they also
    need lower real interest rates and larger
    government deficits, although these may be
    difficult to achieve. It is possible that euro
    area domestic demand could rise enough to boost
    euro area output and stabilize world output.
  • China would also benefit from a higher real
    exchange rate to help combat inflationary
    pressures.

28
the worlds biggest hedge fund
  • The US trade deficit is around 600bn, with net
    foreign investment income of around 60bn,
    leaving a current account deficit of around
    540bn.
  • The US finances this deficit by selling domestic
    assets, a mix of government bonds (around 450bn
    a year), corporate bonds, equities, and real
    assets.
  • Amazingly, the USA runs a surplus on foreign
    direct investment of around 150bn - that is, US
    firms buy more foreign firms than vice-versa.
  • Furthermore, the US runs an investment income
    surplus despite having net foreign liabilities of
    24 of GDP. As pointed out by the chief
    economists of both Goldman Sachs and Morgan
    Stanley, this is because the cost of finance is
    so low in the US, that the US acts like a giant
    hedge fund, borrowing cheaply at home to invest
    in higher yielding foreign assets (this is
    sometimes called the carry-trade).
  • When interest rates go up, the investment income
    surplus will fall sharply since the US Treasury
    will be paying more to foreigners to hold its
    debt.

29
oil shocks I
Source CESifo Report on the European Economy 2005
30
oil shocks II
Source CESifo Report on the European Economy 2005
31
unemployment to remain high
Source CESifo Report on the European Economy 2005
32
Source CESifo Report on the European Economy 2005
33
global risks
  • Over-valued housing markets pose substantial
    risks in a number of countries, especially
    Australia, Canada, Ireland, Spain, Sweden, the
    United Kingdom and the United States.
  • As interest rates rise over the cycle, there will
    be downward pressure on house prices and there is
    a risk that a number of housing bubbles will
    burst.
  • This in turn will pose risks to the financial
    system and to macroeconomic policy, although
    given that the inflation outlook is still fairly
    benign there is scope for appropriate policy
    responses.
  • There are also risks to financial markets. A
    fall in US asset prices could lead to a credit
    contraction elsewhere, and a big rise in US bond
    yields might raise bond yields across the whole
    world.
  • Given the likelihood of a flight to quality,
    this would be especially marked for developing
    countries and other low grade debt (q.v. the Peso
    crisis of 1994), even if the effect on the US is
    only transitory.

34
euro area risks
  • In addition, there are a number of other risks to
    euro area growth
  • Continued high and volatile oil prices
  • Inflationary pressure and possible slowdown in
    China
  • Failure of the reformed Stability and Growth
    pact
  • Failure of German labour market reforms
  • Failure of the Lisbon agenda talks.

35
discussion
  • Each group has been allocated a country to
    analyse.
  • Have a look at the materials provided and think
    about the short-run macroeconomic position of the
    country.
  • Some suggested important issues inflation,
    unemployment, growth, monetary and fiscal policy,
    foreign trade.

36
long-run economic performance
  • Is there some action a government of India could
    take that would lead the Indian economy to grow
    like Indonesias or Egypts? If so, what,
    exactly? If not, what is it about the nature of
    India that makes it so? The consequences for
    human welfare involved in questions like these
    are simply staggering Once one starts to think
    about them, it is hard to think about anything
    else, Robert Lucas, 1988.

37
OECD macroeconomic performance
38
equilibrium unemployment
labour supply
workforce
real wage
equilibrium wage
labour demand
natural rate
equilibrium employment
employment
39
the natural rate and the NAIRU
  • The natural rate model assumes that markets clear
    and that there is competition in all markets.
  • In fact, the labour market may be dominated by
    unions.
  • If so, there is bargaining between unions and
    firms.
  • Other things being equal, this will raise the
    level of unemployment for any given real wage.
  • Also, goods markets may be dominated by a few
    large sellers (imperfect competition) in which
    case the labour demand curve may be less steep,
    possibly even horizontal.

40
wage bargaining
  • Unemployment is the means by which the competing
    claims of employers and unions are reconciled.
  • Unions bargain over wages relative to prices (the
    target real wage) and reduce their demands when
    unemployment is high.
  • Unions care about the employed (insiders) without
    caring too much about the unemployed (outsiders).
  • Employers set prices relative to wages (the
    feasible real wage) this leads to a relatively
    flat labour demand schedule.

41
the target real wage
target real wage
labour supply
real wage
workforce
feasible real wage
employment
42
the NRU and the NAIRU
target real wage
labour supply
real wage
workforce
feasible real wage
natural rate
employment
NAIRU
43
two views of the labour market
  • The natural rate model suggests that most
    equilibrium unemployment is voluntary in the
    sense that workers could find jobs at the current
    real wage, but choose not to.
  • The NAIRU model suggests that some equilibrium
    unemployment is involuntary in the sense that
    workers would like to work at the current real
    wage but cannot find jobs.

44
  • how to reduce unemployment
  • Retraining and work experience schemes for
    long-term unemployed and unskilled
  • Reform of the benefit system
  • Limitations on union power increased
    coordination of bargaining
  • Tax reform (lower payroll taxes for the
    unskilled)
  • Increased labour mobility.
  • how not to reduce unemployment
  • Cunning demand-side policies (unlikely to have
    much effect in the long-run, plus very
    expensive)
  • Job-sharing, cuts in working hours, or employment
    protection
  • Increased investment by firms (although this will
    raise wages)
  • Protectionism (any benefit to workers massively
    outweighed by costs to consumers).

45
is long-run aggregate supply stable?
  • Lots of evidence that the idea of equilibrium
    unemployment and equilibrium output are useful
    concepts.
  • We can estimate the NAIRU from statistical
    models.
  • However, three complications
  • the NAIRU shifts over time and is hard to
    estimate precisely
  • even when unemployment is above the NAIRU, very
    rapid rises in demand could still lead to
    increased inflation
  • if unemployment is high for a very long time, the
    NAIRU may rise due to hysteresis.

46
important elements of long-run growth
  • Technical Change (q.v. Smiths pin factory)
  • Over time, technology becomes more advanced, and
    hence output per worker rises
  • Factor Accumulation (q.v. Ramsey on investment)
  • Over time, with sensible property rights, people
    accumulate capital assets (physical, human and
    environmental), even though factors are typically
    subject to diminishing returns
  • Factor Substitution (cf. Ricardo on land)
  • Over time, factors cannot earn economic rents
    unless their supply is restricted, even then,
    other factors can be used as substitutes
  • Product Substitution (q.v. Schumpeter on creative
    destruction)
  • Over time, new products are invented which
    replace older versions and types.

47
international labour productivity
48
the sources of economic growth
  • Growth of output weighted growth of inputs
    growth of total factor productivity
  • Growth of labour productivity weighted growth
    of capital per worker growth of total factor
    productivity
  • Growth of inputs
  • Capital and labour
  • Materials and energy
  • Growth of total factor productivity
  • Higher quality products
  • New products
  • Better ways to use existing inputs

49
productivity growth in business
Note Growth of total factor productivity Growth
of output minus weighted growth of inputs
50
the Japanese TFP miracle
51
total factor productivity
  • A typical worker in US or Switzerland is 30 to 40
    times more productive than a worker in Haiti or
    Nigeria.
  • Between-country differences much greater than
    within-country differences.
  • Some of this can be explained by natural
    resources, oil.
  • Some can be explained by physical capital, but
    investment rates surprisingly similar across
    countries.
  • Nor can human capital explain differences, unless
    investments in intangibles much bigger than we
    think.
  • Therefore, differences in technology must matter.
  • What are the barriers to efficient adoption and
    use of technologies across the world?

52
high productivity countries
  • Private ownership and good quality institutions
  • Institutions that favour production over
    diversion
  • Openness to international trade
  • Well-educated workforce
  • Low rate of government consumption (i.e.
    excluding investment or transfers)
  • International language
  • Temperate latitude away from equator, with
    river-fed irrigation
  • Easy access to coast and ports.

53
summary
  • The labour market is imperfectly competitive due
    to the presence of trade unions and large
    employers.
  • In the long-run, the labour market tends to
    settle at an equilibrium where there is both
    voluntary and involuntary unemployment.
  • Policies to tackle unemployment need to take into
    account both of these types!
  • When the economy is at equilibrium unemployment,
    the main source of growth is the accumulation of
    capital, whether that capital is physical, human
    or technological.
  • Successful countries tend to be ones that are
    able to maintain high levels of investment for
    long periods of time.

54
discussion
  • Each group has been allocated a country to
    analyse.
  • Have a look at the materials provided and think
    about the long-run macroeconomic position of the
    country.
  • Some suggested important issues investment,
    competition, entrepreneurship, innovation
    skills.

55
presentations
  • After the discussion, each group is invited to
    make a five minute presentation on the short and
    long-run economic challenges facing its allocated
    country.

56
summary
  • Productivity Growth isnt everything, but in the
    long-run, it is almost everything, Paul Krugman,
    1990.
  • Unemployment and business cycles are important in
    explaining short and medium run growth, but play
    almost no rôle in the long-run in the long-run,
    national output is determined by supply.
  • In the long-run, the main source of rising living
    standards is rising output per worker.
  • Rising output per worker is due to the
    accumulation of capital and technological
    progress.

57
laggards can catch up
Source OECD (2005)
58
Source OECD (2005)
59
Source OECD (2005)
60
Source OECD (2005)
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