The World Economy

Gavin CameronOxford University

April 2005

plan of the session

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

short-run macroeconomics

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

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’).

the circular flow of income

recent performance

Source: CESifo Report on the European Economy 2005

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.

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.

inflationary pressure

Source: CESifo Report on the European Economy 2005

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.

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).

recent loose monetary policy

Source: CESifo Report on the European Economy 2005

…even on a real basis

Source: CESifo Report on the European Economy 2005

fiscal policy

• Changes in the government’s 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.

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?

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 Brown’s Golden Rule: over the business cycle borrowing should equal net government investment; government debt should be kept below 40% of GDP.

breaking the rules?

Source: CESifo Report on the European Economy 2005

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.

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.

the dollar weakens…

Source: CESifo Report on the European Economy 2005

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.

not much sign of a European recovery

Source: CESifo Report on the European Economy 2005

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.

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.

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.

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.

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.

the world’s 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.

oil shocks I

Source: CESifo Report on the European Economy 2005

oil shocks II

Source: CESifo Report on the European Economy 2005

unemployment to remain high

Source: CESifo Report on the European Economy 2005

Source: CESifo Report on the European Economy 2005

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.

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.

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.

long-run economic performance

• “Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s? 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.

OECD macroeconomic performance

OECD EU USA JAPAN GERMANY FRANCE ITALY UKOutput Growth1960-1973 4.9 4.7 4.0 9.7 4.3 5.4 5.3 3.11973-1979 3.2 2.6 2.9 3.5 2.4 2.7 3.5 1.51979-1989 2.9 2.2 2.8 3.8 2.0 2.1 2.4 2.41989-1999 2.6 2.0 3.0 1.7 2.2 1.7 1.3 1.9Unemployment1960-1973 2.9 2.6 4.8 1.2 1.0 2.6 5.7 3.31973-1979 5.0 4.6 6.7 1.9 3.0 4.4 6.0 4.91979-1989 7.3 9.4 7.3 2.5 5.8 8.8 8.2 9.81989-1999 7.4 9.9 5.8 3.1 7.5 11.2 10.9 8.3Inflation1960-1973 3.9 4.1 3.1 6.1 3.4 4.9 4.9 4.81973-1979 8.8 9.6 7.8 9.5 4.6 11.1 16.7 15.61979-1989 5.4 6.6 5.3 2.5 2.8 7.5 11.4 7.01989-1999 2.7 3.4 2.4 1.0 2.4 2.1 4.6 3.8

Source: Economics of the OECD 2000 exam paper data tables 1, 4 and 5.

equilibrium unemploymentre

al

wag

e

employment

labour demand

labour supply workforce

natural rate

equilibrium employment

equilibrium wage

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.

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.

the target real wagere

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wag

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employment

feasible real wage

labour supply

workforce

target real wage

the NRU and the NAIRUre

al

wag

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employment

feasible real wage

labour supply

workforce

natural rate

NAIRU

target real wage

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.

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).

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’.

important elements of long-run growth

• Technical Change (q.v. Smith’s 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.

international labour productivity

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

productivity growth in business

TFP Growth Labour Productivity Growth

1960-73 1973-79 1979-97 1960-73 1973-79 1979-97OECD 2.9 0.6 0.9 4.6 1.7 1.7EU 3.4 1.2 1.1 5.4 2.5 1.8USA 1.9 0.1 0.7 2.6 0.3 2.2Japan 4.9 0.7 0.9 8.4 2.8 2.3Germany 2.6 1.8 1.2 4.5 3.1 2.2France 3.7 1.6 1.3 5.3 2.9 2.2Italy 4.4 2.0 1.1 6.4 2.8 2.0UK 2.6 0.5 1.1 4.1 1.6 2.0

Source: Economics of the OECD 2000 exam paper data table 2.

Note: Growth of total factor productivity= Growth of output minus weighted growth of inputs

the Japanese TFP miracle

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

1955 1960 1965 1970 1975 1980 1985 1990 1995

Log Relative TFP in Japanese manufacturing relative to the USA

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?

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.

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.

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.

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.

summary

• ‘Productivity Growth isn’t 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.

laggards can catch up

Source: OECD (2005)

Source: OECD (2005)

Source: OECD (2005)

Source: OECD (2005)