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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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)