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MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY The Wealth of Nations The Supply Side 3-2 Key Concepts GDP Growth Total output Output per capita Elements of Growth Labor Capital Total Factor Productivity 3-3 The Importance of Economic Growth "No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable." --Adam Smith 3-4 GDP Growth An increase over time in the quantity of goods and services produced by an economy Rate of growth Real GDP: adjusts for inflation Real GDP per capita: adjusts for size of population 3-5 World GDP Growth by Century 350% 300% 250% 200% 150% 100% 50% 0% -50% 0 to 10th 11th 12th 13th 14th 15th 16th 17th 18th % change in GDP per capita over each century 19th 20th 3-6 Rise In GDP per capita by Region 35000 GDP per Capita (1990 $) 30000 25000 20000 15000 10000 1820 2010 5000 0 3-7 Relative importance of trend growth and business cycles 3-8 Importance of Growth Growing population Life expectancy Improving standards of living Poverty reduction 3-9 Growth rate, 1980 – 2000 (per annum) Growth rate and Level of GDP 6% 4% 2% 0% -2% -4% -6% 0 5,000 10,000 15,000 20,000 GDP per capita, US $$ 25,000 3-10 Growth rate, 1980 – 2000 (per annum) Growth rate and Level of GDP China 6% India 4% 2% 0% -5000 -2% 5000 15000 25000 -4% -6% GDP per capita, US $$ Points are weighted by size of population in 1980 3-11 World GDP per capita and Life Expectancy 10000 70 GDP per Capita (LHS, Log Scale) GDP per capita (1990 $) Life expectancy (RHS) 50 40 1000 30 20 10 100 0 0 200 400 600 800 1000 1200 1400 1600 1800 2000 Life expectancy at birth (years) 60 3-12 World Population Growth 10000 Asia Africa Europe Latin America N. America Oceania Millions of People 8000 6000 4000 2000 0 3-13 Trends in Global Inequality 1 0.8 Global inequality 0.6 0.4 Within-country inequality 0.2 0 1820 Between-country inequality 1850 1870 1890 1910 1929 1950 1960 1970 1980 1992 2000 3-14 Trends in Global Poverty 1600 1400 millions of people 1200 China 1000 Rest of E. Asia Latin America 800 India Rest of S. Asia 600 Sub-Saharan Africa Rest of World 400 200 0 1981 1984 1987 1990 1993 1996 1999 2002 2005 Population with income of less than $1 a day 3-15 Inequality and Growth More Inequality 0.80 0.70 0.60 0.50 0.40 0.30 0.20 -10 -5 0 5 10 Growth Rate 15 20 3-16 Which enhances welfare? Eliminate business cycle movements Enhance growth rate 3-17 Compounding is a wonderful thing… 1999 GDP per capita (US = $30600) Years to attain US 1999 level Actual growth rate (1990-99) 1% growth 3% growth 6% growth 9% growth 20 years 7 years 4 years 3 years 1.5% $22640 32 years 11 years 6 years 4 years 2.1% Brazil $4420 196 years 66 years 34 years 23 years 1.7% China $780 370 years 145 years 64 years 44 years 9.8% $100 577 years 194 years 99 years 67 years 2.2% Germany UK Ethiopia $25350 3-18 Analysis of Growth Capital (buildings, infrastructure and machines) Output (GDP) Labor (Hours worked, number of workers) Total Factor Productivity (technological knowledge and efficiency) 3-19 GDP per capita GDP per capita = GDP Population GDP Hours Number Employed Labor Force Hours Number Employed Labor Force Population Labor Productivity Average Hours Worked Employment Rate Labor Force Participation Rate 3-20 GDP per capita Labor productivity Average hours worked Employment rate = 1 – Unemployment Rate Labor force participation rate 3-21 US Population by Labor Market Status (2011) Not working age 23% Employed 45% Unemployed 5% Not in labor force 27% 3-22 Decomposition of GDP per capita (2008) 3-23 Total Employment 256000 Thousands of People 128000 64000 UK USA Japan 32000 Italy France Canada 16000 8000 3-24 Average Annual Hours Worked Average annual hours worked 2300 2100 1900 1700 1500 1300 Canada France Japan Sweden UK W. Germany USA 3-25 Role of Inputs More inputs means more output Diminishing returns 1 worker = $10 in output 2 workers = $18 in output 3 workers = $24 in output Marginal return is $8 in output Marginal return is $6 in output 3-26 The Production Function 3-27 Production Function Output = TFP Capital Stocka Labor Hours(1-a) Real GDP Total Factor Productivity A parameter (a number, 0 < a < 1) 3-28 Cobb-Douglas example 1000 Real GDP 900 800 700 TFP = 1 Capital = 500 a=0.6 600 500 400 300 200 100 0 0 500 1000 1500 2000 2500 Hours worked 3-29 Output (500)0.6 (Labor Hours)0.4 Real GDP 1000 900 800 700 600 500 400 300 200 100 0 0 500 1000 1500 2000 2500 Hours Worked 3-30 Output (Capital Stock)0.6 (1000)0.4 1800 Output 1600 1400 1200 1000 800 600 400 200 0 0 500 1000 1500 2000 2500 Capital Stock 3-31 Implications for labor productivity Output = TFP Capital Stocka Labor Hours(1-a) Capital GDP TFP Labor Hours Labor Hours Labor Productivity a 3-32 Changes in Labor Productivity Total Factor Productivity Capital per Labor Hour 3-33 Labor Productivity Labor Productivity = TFP (Capital Stock/Labor Hours)a 12 8 500 1000 Capital Stock per labor hour 3-34 Output Growth % GDP per capita = % Labor Productivity and Capital % Labor Productivity = % TFP a % Labor Hour 3-35 Increase in TFP Output/Labor Hour = TFP (Capital/Labor Hour)a Labor Productivity y2 y1 k1 Capital Stock per Labor Hour 3-36 Growth in Output Increase in labor supply May have no impact on GDP per capita Not sustainable Increase in capital stock Must increase at faster rate than labor Increase in TFP No diminishing returns in this framework 3-37 Growth accounting for Japan, Germany, the UK, and the United States, 1913–1950. 3 TFP Labor Capital 2 1 0 Japan UK US Germany 3-38 Growth accounting for Japan, Germany, the UK, and the United States, 1950–1985. 8 TFP Labor Capital 7 6 5 4 3 2 1 0 Japan UK US Germany 3-39 Growth accounting for Japan, Germany, the UK, and the United States, 1985–2008. 4 TFP Labour Capital 3 2 1 0 Australia -1 Canada France Germany Italy Japan Sweden UK US 3-40 Growth Accounting Asian Tigers, 1966 - 1990 3-41 Europe and Asia Total Output: Of Which Capital Labor TFP Golden Age 1950-73 France UK W. Germany Asian Miracle 1960-94 5.0% 3.0% 6.0% 1.6% 1.6% 2.2% 0.3% 0.2% 0.5% 3.1% 1.2% 3.3% China Hong Kong Indonesia Korea Thailand Singapore 6.8% 7.3% 5.6% 8.3% 7.5% 8.5% 2.3% 2.8% 2.9% 4.3% 3.7% 4.4% 1.9% 2.1% 1.9% 2.5% 2.0% 2.2% 2.6% 2.4% 0.8% 1.5% 1.8% 1.5% Europe relied on capital and TFP – Asian countries have relied on capital 3-42 Growth Accounting Japan Capital growth important through out Labor, TFP important ’50 – ’85 US TFP important until ’85 Labor important after ’85 UK and Germany rely less on labor 3-43 Growth accounting in the BRIC Economies. 10 TFP 9 Labour Capital 8 7 6 5 4 3 2 1 0 Brazil China India Russia 3-44 Summary Importance of Growth Sources of Growth GDP per capita Hourly productivity Number of hours worked Productivity Capital Accumulation TFP Growth Accounting MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Endogenous Growth and Convergence 45 3-46 Key Concepts Endogenous growth Conditional convergence Poverty traps Steady state determinants 3-47 Sources of growth Exogenous growth (Solow model) Capital produces growth until economy reaches steady state Continuous growth arises from technological progress Technological progress is exogenous to model Endogenous growth Provide explanation internal to the model 3-48 Constant MPK Output Output = AK K: Capital Y: Output A: Parameter s: Investment Rate Investment = sY Depreciation Capital Stock 3-49 Constant MPK Output Output = AKLb Investment = sY Depreciation K0 K1 Capital Stock 3-50 Does constant MPK make sense? Interaction between physical and human capital Suppose increase in K induces increase in human capital? Consider IT investment and education This represents a spillover effect 3-51 In equation form Output = A x (Human capital)b x Ka x Lc Output = A x (DxK)b x Ka x Lc Output = A x (D)b x Ka+b x Lc 3-52 Social versus Private Return Output = A x (DxK)b x Ka x Lc Private Return measured by this term 3-53 Social versus Private Return Output = A x (DxK)b x Ka x Lc Extra return due to spillover effect 3-54 Marginal product of capital Case: a + b < 1 Cost of Capital, r/p Social MPK Private MPK KP KS Capital Stock 3-55 Marginal product of capital Effect of subsidy Private MPK Social MPK Cost of Capital Cost of Capital with subsidy KP KS Capital Stock 3-56 Poverty Traps Marginal product of capital Increasing MPK MPK Cost of Capital, r/p K0 Capital Stock MPK is less than cost of capital, so capital decreases to zero 3-57 Poverty Traps Marginal product of capital Increasing MPK MPK Cost of Capital, r/p K0 Capital Stock MPK is higher than cost of capital, so capital increases continuously 3-58 Why increasing MPK? Agglomeration Interdependencies in inputs Spillovers Increasing MPK leads to income divergence between sectors (states, countries, etc.) 3-59 Just the facts, Ma’am What does the data say about convergence? What does convergence mean empirically? Levels of income should coincide in the long run Low income countries grow faster than high income countries Higher MPK for low income countries 3-60 Growth and per capita GDP 9% Average GDP growth 1960-2007 8% 7% 6% 5% 4% 3% 2% 1% 0% 0 500 1000 1500 2000 2500 3000 GDP per capita 1960, USD 3500 4000 4500 3-61 Income per Capita and Growth Rank of Income in 1960 top 2nd 3rd bottom 2 2.1 2.2 2.3 2.4 Annual GDP per capita growth 1960-2007 % 2.5 3-62 Convergence in OECD Economies Average GDP growth 1060-2007 6% 5% 4% 3% 2% 1% 0% 0 1000 2000 3000 GDP per capita 1960 USD 4000 5000 3-63 Convergence across US States 3-64 Conditional Convergence Little evidence of convergence across all countries Some evidence of convergence for select, similar countries Countries may have different steady states 3-65 Two Steady States Output Real GDP Depreciation Investment (30% of GDP) Investment (20% of GDP) SS 1 SS 2 Capital Stock 3-66 What determines the steady state? Level of investment and savings Accumulation of human capital (education) Government policies Economic environment (e.g., corruption, property rights, crime) 3-67 Empirical Evidence Data supports conditional convergence Investment, education, health have positive effects on growth Effects of other variables are harder to discern in available data 3-68 Determinants of steady state for selected countries. 3-69 Determinants of steady state for selected countries. 3-70 Why is Africa so poor? 1999-2011 1973–98 1950–73 1913–50 World Africa Latin America 1870–1913 Asia (exc. Japan) Western Europe 1820–70 0 2 4 6 Average GDP per capita growth 8 3-71 Possible explanations Ethnic/linguistic diversity Climate and disease Colonial influence The impact of aid 3-72 Institutional Quality in Africa Africa is characterized by poor governance and institutional quality, although there are some exceptions. Countries are ranked by percentile (0 is the worst and 100 is the best). 3-73 Artificial Borders Europe Asia Percent of population belonging to groups partitioned by border Fractal Index of borders (low figure = straighter borders) Africa North South America America 19.9 20.6 48.0 7.6 15.2 0.052 0.037 0.028 0.027 0.036 Although North America has the most artificially straight borders, Africa’s borders separate a far higher share of its ethnic groups. 3-74 Geographical Characteristics of Selected Regions 3-75 GDP per Capita by Latitude 70 60 50 40 Latitude 30 20 10 Equator -5 -15 -25 -35 -45 0 5000 10000 15000 20000 GDP per capita 2005-2007 $ 25000 30000 3-76 Urbanization in 1500 versus GDP per capita in 2008 $64,000 SINGAPORE USA AUSTRALIA CANADA LOG GDP PER CAPITA, PPP, 2010 $32,000 HONG KONG NEW ZEALAND ARGENTINA MALAYSIA PANAMA CHILE MEXICO URUGUAY COSTA RICA BRAZIL PERU VENEZUELA JAMAICA TUNISIA COLOMBIA DOMINICAN REP. EL SALVADOR ECUADOR BELIZE GUYANA EGYPT SRI LANKA ALGERIA GUATEMALA PARAGUAY INDONESIA BOLIVIA $16,000 $8,000 $4,000 PHILIPINNES INDIA VIETNAM MOROCCO HONDURAS NICARAGUA LAOS PAKISTAN $2,000 BANGLADESH HAITI $1,000 0 2 4 6 8 10 12 URBANISATION IN 1500 14 16 18 20 3-77 The Curse of Natural Resources 3-78 Major Aid Donors 20 15 $ billion p.a. (LHS) % of GNI (RHS) 1.0% 0.8% 0.6% 10 0.4% 5 0 0.2% 0.0% 3-79 Major Aid Recipients 7 6 35% $ billion p.a. (LHS) % of GNI (RHS) 30% 5 25% 4 20% 3 15% 2 10% 1 5% 0 0% 3-80 Evidence on the Impact of Aid Hypothesis Tested Number of Studies evaluated Consensus of Results Does aid increase Saving and Investment? 43 75% of aid is crowded out by lower saving. Does aid increase Growth? 103 No significant effect Is aid effective in moderation but harmful in excess? 22 No evidence Is aid more effective when policy is good? 28 No evidence Is aid effective when local institutions are strong? 10 Some evidence but too few studies The balance of evidence suggests that development aid has no significant effect on economic development. 3-81 Summary Constant MPK Increasing MPK (spillovers and interactions) Poverty traps Factors affecting steady state The example of Africa Aid Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein. MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY International Trade 82 3-83 Key Concepts Comparative Advantage Terms of trade Opportunity Cost Heckscher – Ohlin model New Trade Theory 3-84 Patterns of World Trade Top ten exporters (2009) Exporters Rank 1 2 3 4 5 6 7 8 9 10 EU trade with rest of world China United States Japan Korea, Republic of Hong Kong, China domestic exports re-exports Canada Russian Federation Singapore domestic exports re-exports Mexico value($bn) 1528 1202 1056 581 364 329 17 313 317 303 270 138 132 230 share of world trade 16.2 12.7 11.2 6.2 3.9 3.5 0.2 3.3 3.4 3.2 2.9 1.5 1.4 2.4 3-85 Patterns of World Trade regional Trade Flows (2009) Destination Origin World North Latin America America Europe CIS Middle East Africa Asia World 2026 437 5105 311 391 510 3197 12178 N. America 769 128 292 9 28 49 324 1602 S. & Central America 115 120 90 6 13 11 96 459 Europe 366 75 3620 147 162 154 426 5016 (CIS) 23 5 239 87 7 14 63 452 Africa 66 9 149 1 45 12 85 384 Middle East 60 5 76 4 34 107 357 690 627 95 641 57 102 163 1846 3575 Asia 3-86 Patterns of World Trade Growth rate in world output and volume of world trade 10% trade 8% output 6% 4% 2% 0% 1950-63 1963-73 1973-90 1990-01 2001-09 3-87 Comparative Advantage Focus on activities in which disadvantage is least Trade benefits all countries 3-88 Example Eurasia Oceania Coffee 1 4 Cloth 2 2 Number of workers to produce one pound of coffee or one yard of cloth 3-89 Production possibilities Eurasia Oceania Coffee 10 1 10 4 Cloth 2 5 20 2 Assume Eurasia has 10 workers and Oceania has 40 workers. 3-90 Production Possibilities Coffee 10 Eurasia Oceania 5 20 Cloth Suppose a trade agreement says that 1 cloth trades for 1 coffee 3-91 Trade Possibilities, Eurasia Eurasia produces at this point 10 Coffee But can trade to any point on this line Eurasia Oceania 5 10 20 Cloth Suppose a trade agreement says that 1 cloth trades for 1 coffee 3-92 Trade Possibilities, Oceania But can trade to any point on this line Coffee 10 Oceania produces at this point Eurasia Oceania 5 20 Cloth Suppose a trade agreement says that 1 cloth trades for 1 coffee 3-93 Comparative Advantage ALL countries benefit from free trade However, not all countries will be equally well off Gains may not be equal Not all citizens benefit Coffee producers in Oceania Cloth producers in Eurasia 3-94 Trade Possibilities, Oceania 10 Eurasia consumes at this point Coffee Oceania consumes at this point Oceania produces at this point Eurasia Oceania 5 10 15 20 Cloth Suppose Oceania trades 5 of its cloth for 5 coffee 3-95 Terms of Trade Ratio of the price of a country’s exports to the price of a country’s imports Gains from trade rise with terms of trade Prebisch-Singer hypothesis Hypothesis that commodity prices fall in value over time so developing countries (often commodity exporters) tend to lose out to developed ones. Decline in terms of trade for commodity exporters has been dramatically reversed in recent years 3-96 Terms of Trade 180 160 Australia 140 United States 120 United Kingdom Japan 100 80 60 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 3-97 Real Agricultural Commodity Prices 300 250 200 150 100 50 3-98 Contribution to global demand growth for major crops 4 Other developing economies China Percentage Points 3 Advanced economies 2 1 0 1998 -1 2000 2002 2004 2006 2008 2010 3-99 Natural Resource Exports Forestry Fish 2% 3% Mining 18% Fuels 77% 3-100 The Hotelling Rule Price e PBe r T The rule predicts that the price of an exhaustible natural resource rises at the rate of interest (r) to reach the backstop price (PB) when it is economically exhausted. 3-101 Oil Prices 120 dollars 100 2010 dollars 80 60 40 20 0 1861 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 3-102 Heckscher-Ohlin model Comparative advantage is in good whose production requires factor input which is abundant Examples China – labor Mexico – fruits and vegetables US – pharmaceuticals, chemicals 3-103 Chinese–US Merchandise Trade 2009 3-104 Composition of US merchandise imports, 2009 Other goods Foods, feeds and beverages Industrial supplies Consumer goods Automotive vehicles Capital goods 3-105 Assumptions of the H-O model No differences in tastes for goods among countries Free trade (no trade restrictions) All countries use same technology No intra-industry trade 3-106 Extent of intra-industry trade A very high proportion of trade for developed countries represents exports of types of goods or services that the country also imports 3-107 Distributional Effects of Trade Distribution of income National competitiveness New Trade Theory Interest Groups 3-108 Is trade a good thing? Egypt United States Italy Mexico Japan South Africa France Indonesia Turkey Poland Nigeria Britain Sweden Canada Russia Pakistan Australia Brazil South Korea Israel Spain Kenya India Germany Malaysia Kuwait China 50% 60% 70% 80% 90% 100% Percentage who agree that trade is a good thing by country 3-109 Competitiveness Trade as a zero-sum game Countries do not go bankrupt Trade is not adversarial 3-110 Strategic Trade Theory Airbus Enter Enter Boeing Don’t enter Don’t Enter -$100m -$100m $500m 0 $500m 0 0 0 3-111 Strategic Trade Theory Airbus Enter Boeing Enter $100m Don’t enter 0 Don’t Enter $100m $500m 0 $500m 0 0 Suppose both governments subsidize to the tune of $200m 3-112 Summary Trade is an increasing feature of the world economy Comparative advantage and terms of trade Heckscher-Ohlin model Features Issues Strategic trade theory MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Globalization 113 3-114 Key Concepts Growth in trade Inward-looking policies Liberalization Liberalization and Growth Foreign Direct Investment and Multinationals Immigration Problems with Globalization Role of the WTO 3-115 Market Liberalization 0.9 0.8 0.7 0.6 Electricity and Telecoms Domestic Financial Sector 0.5 Agriculture 0.4 Capital flows Trade (ex. rate) 0.3 Trade (tariff) 0.2 0.1 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 0 Globalization has been associated with significant deregulation of many markets by most countries. 1882 1885 1888 1891 1894 1897 1900 1903 1906 1909 1912 1915 1918 1921 1924 1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 3-116 Annual Growth in World Trade 15% 10% 5% 0% -5% -10% -15% 3-117 Trade Liberalization Comparative advantage One-time increase in output Growth Theory Data 3-118 Inward-looking policies Develop domestic industries Prebisch-Singer hypothesis Infant industry argument Import substitution Substitute imports with domestic goods Concerns Raises price of capital Decrease TFP growth 3-119 Average Tariff Protection 25 20 15 10 5 0 3-120 Evidence Tariffs and GDP Geography as a proxy for openness Impact of openness on GDP growth China Hong Kong, Singapore, Malaysia 3-121 Tariffs & GDP per Capita Average Tariff Rate 2007-2009 (%) 25 20 15 10 5 0 100 400 1600 6400 25600 Average GDP per capita 2007-2009 ($), Log Scale 102400 3-122 Liberalization and Growth 5 Average economic growth 4 3 2 1 0 -1 -2 -25 -20 -15 -10 -5 0 5 10 years before and after liberalization 15 20 25 3-123 Liberalization: The Case of India 140 1 0.9 120 0.8 100 0.7 0.6 80 0.5 60 0.4 40 Average Tariff Rate (%) LHS 20 Non-Tariff Barriers (share of trade covered) RHS 0 0.3 0.2 0.1 0 India undertook a rapid liberalization process in the early 1990’s 3-124 Liberalization: The Case of India 600 GDP per capita (index 1960=100) GDP per capita 1960-80 trend 500 400 300 200 100 Liberalization Period 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 0 Trend Growth seems to have increasing significantly since then 3-125 Global Capital Flows 12 10 8 $ trillion 6 fdi 4 equity securities 2 debt securities 0 lending & deposits -2 % of Global GDP 4.7 5.4 13.5 9.4 7.8 9.9 13.3 15.9 17.3 20.7 3.1 1990 2002 -4 1995 2000 2001 2003 2004 2005 2006 2007 2008 Global capital flows increased steadily until the financial crisis 3-126 Foreign Direct Investment 500 Western Hemisphere Sub-Saharan Africa 400 Middle East & North Africa Developing Asia 300 Former Soviet Union Central & E. Europe 200 100 0 FDI tends to be more stable than other types of capital flow 3-127 Tax and Multinatnationals Multinational firms can respond in a number of ways to changes in taxation in host nations. For example, they can restructure themselves so that profits can be shifted to lower tax locations, or they can change their level of investment in new or existing locations. The consensus of studies suggests that firms engage in all three. 3-128 Immigration % of resident OECD population 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1986 1991 1996 2001 Immigration into OECD (richer) countries has risen steadily 3-129 The Economic Impact of Immigration 3-130 Globalization and Inequality New Zealand United States Norway Germany Italy Sweden Canada Czech Republic OECD average Japan Netherlands Denmark United Kingdom Spain France -0.04 -0.02 0.00 0.02 0.04 0.06 0.08 Inequality has risen in most OECD Economies 3-131 WTO and Tariff Reduction 3-132 WTO and Tariff Reduction 50 $ billion (2004 prices) 40 30 20 10 Agriculture and Manufacturing Agriculture, Manufacturing and Services 0 Estimated impact on World GDP of implementing the Doha Round 3-133 World Trade Organization Administer trade agreements Deal with trade disputes Provide technical assistance and training Facilitate trade meetings 3-134 World Trade Organization Member countries committed to following all rules and agreements Enforcement mechanism Legislation GATT GATS: General agreement on trade in services TRIPS: Trade related aspects of intellectual property rights 3-135 Summary Importance of Globalization Impact of Economic Liberalization Global Capital Flows Immigration WTO MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Business Cycles 136 3-137 Key Concepts Business Cycle characterization Recessions and Depressions Frisch-Slutsky Paradigm Real Business Cycle Theory 3-138 Business Cycle Periodic fluctuations in macroeconomic variables, particularly GDP Measurement … growth versus cycle De-trend Consider growth rate 3-139 Italian Real GDP 1600 Billion Euros (base year 2000) GDP Trend 800 400 200 3-140 Italian Business Cycle 6 Percentage deviation from trend 4 2 0 -2 -4 -6 3-141 Co-movement in Macro Variables Rising Investment Rising GDP Rising Employment Rising Consumption 3-142 French GDP, Consumption and Investment 15 Consumption Investment GDP % Growth 10 5 0 1997 1993 1989 1985 1981 1977 1973 1969 -10 1965 1961 -5 3-143 5 1.5 4 1 3 0.5 2 0 1 -0.5 0 -1 2000 1998 1996 1994 1992 1990 1988 -2 1986 -1 -1.5 -2 Change in Unemployment Rate GDP Growth French Real GDP and Unemployment 3-144 Business Cycle Facts Expansions are longer than recessions Recessions are sharper than expansions 3-145 Expansions last longer than recessions Luxembourg Recessions Expansions Ireland Netherlands Belgium Spain Italy UK France Germany Japan Canada USA 0 50 Duration in Months 100 3-146 Recessions are sharper Ireland Belgium Italy France Decline in Contraction Growth in Expansion Japan USA 0 0.5 1 1.5 2 3-147 Business Cycle Facts Cycles are correlated across regions and across countries GDP is less volatile in more industrialized countries 3-148 Business Cycle Characteristics 3-149 Business Cycle Characteristics 20% Government 15% Manufacturing Services 10% Construction 5% 0% -5% -10% -15% 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 All sectors rise and fall together over the business cycle, but volatility is most pronounced in manufacturing and construction (UK data) 3-150 Real GDP, Germany and Peru 15 10 5 0 -5 -10 Germany Peru -15 3-151 Okun’s Law (US data) Unemployment (percentage pt. devaition from trend) 6 -8 2009 Q4 2010 Q4 2010 Q2 2010 Q1 2010 Q3 4 2 0 -6 -4 -2 0 -2 -4 Output gap % 2 4 6 8 3-152 Regional Correlations 3-153 Global Correlations 60% 50% 40% 30% 20% 10% 0% Share of countries with falling output 3-154 Have Business Cycles Changed? 1.8 1.5 1.2 "The Great Moderation" 0.9 0.6 0.3 0 Rolling 5-year standard deviation of quarterly US output growth 3-155 Impact of Recession on consumption by Age 3-156 Impact of Recession on consumption by occupation 3-157 Distribution of Consumption costs of Recession 3-158 Trend Growth and business cycles volatility 1961-2009 Standard Deviation of Growth 20 15 10 5 0 0 1 2 3 4 5 Average Growth 6 7 8 3-159 Business Cycle Paradigm Impulse Propagation Business Cycle 3-160 AD – AS Model Price Level AD = C + I + G + X - IM AS = production P0 Y0 Real GDP 3-161 Shift in AD AD = C + I + G + X - IM Price Level AS = production P1 P0 Y0 Y1 Real GDP 3-162 Shift in AS AD = C + I + G + X - IM Price Level AS = production P0 P1 Y0 Y1 Real GDP 3-163 Fluctuations Increase in demand Increase in C, I, G Increases prices and output Increase in supply Increase in labor, capital, TFP Decreases prices and increases output 3-164 Real Business Cycle Both growth and business cycles are caused by supply shocks Business cycles are outcome of market mechanism No role for government in changing the nature of business cycles 3-165 Increase Supply Price Level AD AS P0 P1 Y0 Y1 Real GDP 3-166 Decrease Supply Price Level AD AS P2 P0 Y2 Y0 Real GDP 3-167 Role of labor RBC story depends on shifts in labor Increase in supply requires increase in quantity of labor Increase in labor demand Increase in wage Increase in quantity of labor 3-168 Labor Market Labor Demand Real Wage Labor Supply W1 W0 N0 N1 Employment 3-169 Labor Market Real Wage Labor Demand Labor Supply W1 W0 N0 N1 Employment 3-170 Keynesian View Prices, wages or interest rates may be sticky … may not adjust to equilibrate markets Recessions caused by low demand for goods and services Government must step in to shore up demand … policy can alter the business cycle. 3-171 Increase Demand Price Level AD AS P1 P0 Y0 Y1 Real GDP 3-172 Decrease Demand Price Level AD AS P0 P2 Y2 Y0 Real GDP 3-173 Increase Demand Price Level P1 AD P0 AS Y0 Y1 Real GDP 3-174 Increase Demand AS Price Level AD P1 P0 Y0Y1 Real GDP 3-175 Increase Demand AS AD Price Level P2 P1 P0 Y0 Y1 Y2 Real GDP 3-176 Keynesian story Increase in output due to increase in demand In long run Supply curve is vertical Increase in AD just increases prices 3-177 How do firms respond to increased demand (UK)? 3-178 Frequency of Price Reviews (UK) 3-179 Frequency of Price Changes over one year (UK) 3-180 Summary Characteristics of the cycle Shocks and propagation Explanations Demand side (Keynesian) Supply side (Real Business Cycle) MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Monetary Policy 181 3-182 Key Concepts Targets Inflation Intermediate Policy Goals Open Market Operations LM Curve Transmission Mechanism Quantitative Easing 3-183 The Growth of Central Banks Number of Central Banks 200 160 120 80 40 0 1870 1890 1910 1930 1950 1970 1990 2010 3-184 Basic Structure of a Central Bank Key feature of a Central Bank is it ability to create Monetary Base (only supplier) Assets Liabilities Government Debt Currency Other Domestic Assets Reserves Monetary Base Foreign Exchange Reserves Other Debt and Equity 3-185 Goal of Monetary Policy Price stability Low unemployment Real GDP growth Policy Targets 3-186 Central Bank instruments & targets 3-187 Federal Reserve System “High employment consistent with stable prices” Organization Board of Governors – 7 Members 12 Federal Reserve District Banks Federal Open Market Committee (FOMC) Instrument Short term market interest rates (Discount rate) Reserve Requirements Open Market Operations Federal Funds rate Rate charged on interbank loans 3-188 European Central Bank Price stability with inflation under 2% Organization The European System of Central Banks (ESCB) -- 6 members of the executive board and 15 national Central Banks of the European Union. Interest rate decisions are made at fortnightly council meetings Instruments Repo rate – overnight interest rate Discount rate and Lombard rate (rates at which commercial banks acquire or deposit reserves) Intermediate Target – Inflation and M3 3-189 Bank of England Keep inflation at rate set by government (2.5%) Organization The Monetary Policy Committee (MPC) 9 members, 5 full time Bank of England employees and 4 external experts Instruments Repo rate No reserve requirement, but no bank overdrafts Intermediate target: An Inflation target based on a two-year-ahead inflation forecast 3-190 IS Curve A combination of interest rate and output (or income) such that investment is consistent with savings) When interest rate falls: investment rises This rise in investment must be accompanied with a rise in saving Since saving is a portion of income: a rise in savings can only happen with a rise in income Hence, the IS curve is upward-sloping. 3-191 LM Curve Equilibrium in the money market Demand for money Opportunity cost of holding money Interest rate increase means hold less money Supply of money Role of Federal Reserve Role of banks 3-192 Recall quantity theory MV = PY Md/P = (1/V)Y Real Money Demand Velocity, depends on interest rate 3-193 Money Market Nominal Interest Rate Money Supply R0 Money Demand M0 Quantity of Money 3-194 Money Market Increase in Income Nominal Interest Rate Money Supply R1 R0 Money Demand M0 Quantity of Money 3-195 Money Market Increase in Money Supply Nominal Interest Rate Money Supply R0 R1 Money Demand M0 M1 Quantity of Money 3-196 LM curve Increase in income is associated with rise in interest rates For a fixed income, increase in money supply lowers interest rate 3-197 IS-LM model The equilibrium in the market comes at the intersection between the IS curve and the LM curve. The IS curve fails to take into account the financial market -> need of the LM curve 3-198 IS-LM Model Interest Rate LM Curve Decrease in Money Supply Increase in Money Supply Output 3-199 IS-LM Model LM Curve Interest Rate R0 IS Curve Y0 Output 3-200 Increase in money LM Curve Interest Rate R0 R1 IS Curve Y0 Y1 Output Lowers the interest rate and increases income 3-201 IS-LM Model Money Supply Targeting LM Curve Interest Rate R1 R0 IS Curve Y0 Y1 Output 3-202 IS-LM Model Interest Rate Targeting LM Curve Interest Rate R0 IS Curve Y0 Y1 Output 3-203 Monetary Policy Targets GDP growth Unemployment Price Stability New Zealand England European Central Bank Why not target zero inflation? 3-204 The Risk of Deflation 3-205 Intermediate Targets Variable which Tracks policy goal (e.g., inflation) Over which central bank has reasonable control Three main targets Money supply Exchange rate Inflation 3-206 Monetary Policy Targets (IMF countries) 100% Other Inflation Target 80% Money & inflation 60% Money supply Exchange rate & money 40% Exchange Rate 20% 0% 2002 2004 2006 2008 3-207 Money Supply Targeting Quantity Theory implies direct relationship between money supply growth and inflation Assume velocity constant Assume real output controlled by real factors US: money targeting used in early 1980s 3-208 Difficulties in targeting money Which aggregate to use? Is velocity constant or at least predictable? Can central bank control the money supply? What role do banks play (is money supply vertical)? What about supply shocks? 3-209 Growth in US monetary aggregates 20.0 M1 M2 15.0 10.0 5.0 -5.0 -10.0 05/10 11/07 05/05 11/02 05/00 11/97 05/95 11/92 05/90 11/87 05/85 11/82 0.0 3-210 UK Velocity of Money 2 34 1.5 30 1 26 Broad Money (M4) Narrow Money (Notes and Coins) 0.5 06/82 22 06/85 06/88 06/91 06/94 06/97 06/00 06/03 06/06 06/09 3-211 Exchange Rate Targets Fix exchange rate against another currency Will tie domestic inflation to foreign inflation Cost is lack of flexibility in influence on domestic economy 3-212 Inflation Targeting Specified a target range for realized inflation Allows for discretion in implementation Discretion comes at a price 3-213 Operational Instruments Short term interest rate Base money Central bank can supply money to or drain money from the monetary system 3-214 ECB Interest Rates 6 Repo rate 5 Discount Rate Deposit rate 4 3 2 1 0 01/99 01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11 3-215 Open market operations Expand money supply Buy treasury bonds from public Supply public with cash Decrease money supply Sell treasury bonds to public Remove cash from circulation 3-216 Money Market Interest Rate Money targeting Money Supply R1 R0 Money Demand Increase in Money Demand M0 produces rise in interest rate if Money Supply is fixed Quantity of Money 3-217 Money Market Interest Rate Money targeting Money Supply R1 R0 Money Demand Increase in Money Demand M0 produces no rise in interest rate if Money Supply is allowed to increase Quantity of Money 3-218 Transmission Mechanism Market Rates Asset Prices Domestic Demand Net External Demand Official Rate Expectations and Confidence Exchange Rate Import Prices Domestic Inflationary Pressure Inflation 3-219 Estimated Impact of a 1% increases in interest rates 3-220 Taylor Rules Nominal Interest Rate = Equilibrium Nominal Interest Rate + λ x Output Gap + α x (Inflation – Inflation Target) Classic Taylor Rule λ = 0.5 , α = 1.5 3-221 US Interest Rates 10 US 8 6 4 2 0 -2 Taylor Rule Official Rate -4 -6 01/91 01/93 01/95 01/97 01/99 01/01 01/03 01/05 01/07 01/09 01/11 3-222 UK Interest Rates 16 UK Taylor Rule 14 Official Rate 12 10 8 6 4 2 0 01/91 01/93 01/95 01/97 01/99 01/01 01/03 01/05 01/07 01/09 01/11 3-223 Euro Interest Rates 8 Euro Zone 6 4 2 0 Taylor Rule -2 Official Rate -4 12/98 12/00 12/02 12/04 12/06 12/08 12/10 3-224 Japanese Interest Rates 10 Japan Taylor Rule 8 Official Rate 6 4 2 0 -2 -4 -6 01/91 01/93 01/95 01/97 01/99 01/01 01/03 01/05 01/07 01/09 01/11 3-225 Quantitative Easing Interest Rate MD M Quantitative Easing R Quantity of money MQE 3-226 Quantitative Easing Monetary Base expanded dramatically during quantitative easing 16% 14% % of GDP 12% 10% 8% UK 6% US 4% Euro Zone 2% 0% 05/06 05/07 05/08 05/09 05/10 3-227 Summary Targets Intermediate Instrumental Policy IS-LM model Intermediate targets Transmission mechanism Quantitative Easing MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Stabilization Policy 228 3-229 Key Concepts Phillips Curve Credibility Rules versus Discretion Time Consistency 3-230 Overview Business Cycle and the AD-AS analysis Monetary policy and the IS-LM analysis Arguments against stabilization policy The Inflation Output trade-off Time-Inconsistency Monetary policy as a game Rules versus Discretion 3-231 Output Gaps 7 5 3 1 CAN: Canada DEU: Germany -1 JPN: Japan GBR: United Kingdom -3 USA: United States -5 -7 -9 1972 1978 1984 1990 1996 2002 2008 3-232 The causes of business cycle Demand shocks Decrease in Demand Increase in Demand Supply shocks Increase in supply Decrease in supply 3-233 Decrease in Demand Keynesian view LRAS Price Level AD AS P0 P1 Y1 Y0 Real GDP 3-234 Decrease in Demand Keynesian view LRAS Price Level AD Government responds by increasing demand AS Increase G Decrease T Increase M P0 P1 Y1 Y0 Real GDP 3-235 Increase in Demand Keynesian view LRAS Price Level AD AS P1 P0 Y0 Y1 Real GDP 3-236 Increase in Demand Keynesian view LRAS Price Level AD Government responds by decreasing demand AS Decrease G Increase T Decrease M P0 Y0 Real GDP 3-237 Decrease in supply Keynesian stabilization response LRAS Price Level AD Government responds by increasing demand AS Big increase in price P0 Y0 Real GDP 3-238 Using Monetary Policy to offset higher spending 3-239 Using Monetary Policy to offset lower spending 3-240 Arguments against Stabilization Policy Uncertainty Policy Lags (mostly with fiscal policy) Problems with Fiscal Policy Ricardian Equivalence Consumer Expectations Crowding Out Monetary Policy 3-241 Policy lags Recognition lag Legislative lag Administration lag 3-242 Phillips Curve Inflation = Expected Inflation + A*(Natural Rate Unemployment – Actual Unemployment) Rate of Inflation Anticipated by Consumers A(U U ) e N Rate of Unemployment when all resources are fully employed at long-run level 3-243 What do we see in the data? Inflation versus Unemployment Wage Inflation versus Unemployment Is the relationship exploitable in the short run? 3-244 US Phillips Curve, 1945 - 1970 8 Unemployment. 7 6 5 4 3 2 0 2 4 6 Wage inflation. 8 10 3-245 Inflation & unemployment,1980–2009 United States 16 14 12 Inflation (%) 10 8 6 4 2 0 0 2 4 6 -2 Unemployment (%) 8 10 12 3-246 Inflation & unemployment,1980–2009 Japan 10 8 Inflation (%) 6 4 2 0 0 1 2 3 -2 Unemployment (%) 4 5 6 3-247 Inflation & unemployment,1980–2009 Germany 7 6 5 Inflation (%) 4 3 2 1 0 0 2 4 6 -1 Unemployment (%) 8 10 12 3-248 Inflation & unemployment,1980–2009 United Kingdom 18 16 14 Inflation (%) 12 10 8 6 4 2 0 0 2 4 6 8 Unemployment (%) 10 12 14 3-249 UK Inflation & unemployment, 1856–1997 Point a denotes observations in period 1856–1956; point b in period 1957–97. 3-250 The Long Run Phillips Curve 3-251 Graphically… e A(U N U ) Inflation 0 A(U U ) N 10% 5% U < UN U > UN 0% Natural Rate Unemployment 3-252 Graphically… 0 A(U U ) Inflation N 5% 0 A(5% 2%) 10% 5 A 3 5% 5% Natural Rate 2% 0% Unemployment 3-253 Expectations catch up with reality Inflation 10% 5% 5% A(U N U ) U N U 5% 0% Natural Rate Unemployment 3-254 Disinflation 3-255 Unemployment (percentage points) Sacrifice Ratios 10 8 6 4 2 0 Estimates of the unemployment cost of reducing inflation 1pp (1980-2010) 3-256 Time Inconsistency Scenario Your child, Laura, has just graduated from high school, and is planning to attend State U in the fall. How should she spend her summer? Working to help pay for tuition (parents’ preference) Playing computer games (Laura’s preference) You tell her the following If she works, you will help with tuition If she plays, she’s on her own in August 3-257 Time Inconsistency Will you do what you say you’re going to do? Pay for College Don’t Pay What you say… Laura Pay for College Don’t Pay 3-258 Time Inconsistency Will you do what you say you’re going to do? What Laura thinks… Pay for College Don’t Pay Laura Pay for College Don’t Pay 3-259 What is likely to happen? ? 3-260 Time Consistency & Credibility Points on this line are ones where expectations are the same as reality Inflation 5% Preferences of Monetary authority 2% Natural Rate Unemployment 3-261 Prisoner’s Dilemma Prisoner 2 Don’t Talk Talk Don’t Talk -1, -1 -9, 0 Talk 0, -9 -6, -6 Prisoner 1 3-262 Stabilization Policy Citizens’ Expectations Policy Maker High Inflation Low Inflation High Inf. -3,0 3, -3 Low Inf. -5, -3 0, 0 •If expectations = reality, then unemployment = natural rate • If expectations < reality, then unemployment is low •If expectations > reality, then unemployment is high 3-263 Stabilization Policy Citizens’ Expectations Policy Maker High Inflation Low Inflation High Inf. -3,0 -3, -3 Low Inf. 0, -3 0, 0 •If expectations = reality, then unemployment = natural rate • If expectations < reality, then unemployment is low •If expectations > reality, then unemployment is high 3-264 Inflation Bias 3-265 Rules versus Discretion Can rules solve time consistency problem? Can rules solve credibility problem? Two examples of rules Central Bank Independence Fiscal Stability rules 3-266 Summary Stabilization Policy Difficulties with stabilization policy Phillips curve and discretionary policy Time inconsistency Rules and Discretion MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Sovereign Debt and Default 267 3-268 Key Concepts Debt and deficits Deficits and the Business Cycle Long Run Debt Sustainability The Intertemporal Budget Constraint Sovereign Default Credit Risk and Credit Agencies Debt Forgiveness 3-269 Government Borrowing Deficit: debt issued in a particular fiscal year An aside on the government debt market Debt: accumulation of past deficits and surpluses 3-270 Deficit Debt Debt 3-271 Surplus Debt Debt UK Government Debt % of GDP 300 250 200 Debt GDP ratio 3-272 150 100 50 0 1692 1712 1732 1752 1772 1792 1812 1832 1852 1872 1892 1912 1932 1952 1972 1992 Government Debt – IMF Forecast % of GDP 120 Advanced Economies 100 Emerging and Developing Economies 80 % of GDP 3-273 60 40 20 0 1995 2000 2005 2010 2015 3-274 Gross Government Debt (2012) % of GDP 250 200 150 100 50 0 3-275 Government Borrowing (2012) % of GDP 2 0 -2 -4 -6 -8 -10 3-276 Government Borrowing (2011) % of GDP Fiscal Balances, Primary Balances Debt Interest Payments U.S. -10.1 -8.2 1.9 Japan -8.9 -7.3 1.6 Germany -2.1 0.0 2.1 France -5.6 -3.1 2.5 Italy -3.9 0.5 4.4 U.K. -8.7 -6.1 2.6 Canada -4.9 -4.2 0.7 Spain -6.3 -4.6 1.7 All OECD -6.7 -4.9 1.8 3-277 Structural Deficits α = elasticity of government revenue with respect to output Β = elasticity of government spending with respect to output 1970 1972 1973 1975 1976 1978 1979 1981 1982 1984 1985 1987 1988 1990 1991 1993 1994 1996 1997 1999 2000 2002 2003 2005 2006 2008 2009 2011 2012 % of GDP 3-278 US Structural Deficits 2 0 -2 -4 -6 -8 Budget Deficit -10 Structural Budget Deficit -12 Crowding Out Recall ‘cost of capital’ model Interest Rate 3-279 Private Savings 5% Investment I0 Output Crowding Out Deficit = Negative Savings Private Savings + Government Savings Interest Rate 3-280 Private Savings Deficit 6% 5% Investment I1 I0 S1 Output 3-281 Perfect Crowding Out Interest Rate Private Savings + Government Savings Private Savings Deficit 6% 5% Investment I1 I0 = S1 Output Dynamic Response Suppose savings increases with the deficit Private Savings + Government Savings Interest Rate 3-282 Private Savings 6% 5% Investment I1 I0 = IS11 S1 Output 3-283 Intertemporal Budget Constraint Year 2005: D(2005) = G(2005) - T(2005) Suppose debt is paid off in Year 2006 Year 2006: T(2006) = G(2006) + D(2005)x(1+R) Hence, taxes are higher in 2006 T(2006) - G(2006) = D(2005)x(1+R) Year 2005: G(2005) = T(2005) + T(2006)/(1+R) 3-284 Implications Countries with high debt must Default Run tighter fiscal policy in future Debt levels should vary across countries Purpose of spending (consumption versus public investment) Role of expected future liabilities (pensions) Intergenerational equity 3-285 Generational Accounts Present value of net tax payments (until death) by different generations indexed by age in 1995. 3-286 Ricardian Equivalence Only G matters, not T or D Thought experiment …. G1 = $1000, G2 = 0 Year 1: T1 + D1 = $1000 Year 2: T2 = (1 + r)D1 T1(1 + r)+ T2= $1000(1 + r)= G1 (1 + r)+ G2 The budget constraints in two periods are: C1 + S1 = Y1 – T1 C2 = Y2 + S1(1+r) – T2 3-287 Ricardian Equivalence The inter-temporal budget constraint is C1 (1+r)+ C2 =(Y1 – T1) (1+r)+ Y2– T2 Since T1(1 + r)+ T2=G1 (1 + r)+ G2 we have C1 (1+r)+ C2 = Y1 + Y2 + G1 (1 + r)+ G2 There is no role for taxes T: the timing of taxes does not matter There is no role for deficits: deficits or not makes no difference. 3-288 Ricardian Equivalence Savings expands to match the deficit Holds when Taxation is non-distortionary Fiscal debt is held domestically The savers are the same people that get taxed – intergenerational equity What is the sustainable level of debt? 3-289 Optimal Budget Deficits For what purpose is spending being used? Consumption Investment Cyclical considerations Recessions mean low tax collections, high payouts Should taxes increase during recessions? Distortionary effects of taxation Tax smoothing 3-290 Sustainability of Debt p=(r-g)d p = primary surplus required to stabilize the debt/GDP ratio r = real interest rate g = real growth rate of GDP d = debt/GDP ratio 3-291 Sustainability of Debt p=(r-g)d If r > g, must have primary surplus If r < g, can run deficit indefinitely Abstracts away from cyclical movements in deficit 3-292 Sustainability of Debt GDP Public Debt Deficit Interest Debt/ GDP Deficit GDP Interest/ GDP Year 1 $700bn $350bn $35bn $10.5bn 50% 5% 1.5% Year 2 $735bn $395.5b $36.8bn $11.9bn 53.8% 5% 1.6% Year 3 $771.8b $444.1b $38.6bn $13.3bn 57.5% 5% 1.7% Year 4 $810.4b $496.0b $40.5bn $14.9bn 61.2% 5% 1.8% Year 1 $700bn $350bn $7bn $10.5bn 50% 1% 1.5% Year 2 $735bn $367.5b $7.35bn $11.0bn 50% 1% 1.5% Year 3 $771.8b $385.9b $7.72bn $11.6bn 50% 1% 1.5% Year 4 $810.4b $405.2bn $8.1bn $12.2bn 50% 1% 1.5% Unsustainable Sustainable 3-293 Countries in Sovereign Default 50% Share of World GDP Share of Countries 40% 30% 20% 10% 0% 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 3-294 Serial Defaulters since 1800 Year of Independence Number of Defaults/restructurings % of years in default/restructurings Africa Nigeria 1960 5 21% Europe Greece Portugal Russia Spain Turkey 1829 Pre-1800 Pre-1800 Pre-1800 Pre-1800 5 6 5 8 6 51% 11% 39% 24% 16% 1816 1825 1822 1818 1819 1821 1945 1830 1821 1821 1821 1821 1811 1821 1811 1830 7 5 9 9 7 9 7 9 5 7 8 6 6 8 8 10 33% 22% 25% 28% 36% 38% 29% 58% 26% 34% 45% 45% 23% 40% 13% 38% Latin America Argentina Bolivia Brazil Chile Columbia Costa Rica Dominican Republic Ecuador El Salvador Guatemala Mexico Nicaragua Paraguay Peru Uruguay Venezuela 3-295 Some Recent Debt Haircuts Country Date of Exchange Amount of debt ($ mill.) Pakistan (external bonds) Ecuador Russia Uruguay Serbia & Montenegro Argentina Belize 1999 2000 2000 2003 2004 2005 2006 610 6,700 31,943 3,127 2,700 1,100 516 Estimated reduction in debt value 14% 38% 53% 11% 71% 77% 25% 3-296 Original Sin Advanced Economies Emerging Economies Share of Debt in Foreign Currency 1% 42% Average Maturity of Local Currency Debt 7.1 years 4.9 years Original Sin means that Emerging Economies are required to undertake a significant proportion of their borrowing in foreign currency of in short term instruments. 3-297 Borrowing Costs around a Crisis Cost of borrowing relative to normal (percentage points) 16 12 8 4 0 -36 -32 -28 -24 -20 -16 -12 -4 -8 -4 0 4 8 Months relative to Crisis 12 16 20 24 28 32 36 3-298 Debt Levels at Default 40% share of defaulters 30% 20% 10% 0% 0 to 20% 20% to 40% 40% to 60% 60% to 80% 80% to 100% Debt GDP ratio in year before default above 100% 3-299 Debt and Growth 5% Developing Countries Developed Countries 4% Average Growth 3% 2% 1% 0% below 30% -1% 30% to 60% 60% to 90% Debt GDP ratio above 90% 3-300 Borrowing Costs (10 year Yields) 35 Portugal 30 France Germany 25 20 Greece Ireland Spain 15 10 5 0 2006 2007 2008 2009 2010 2011 2012 3-301 Credit Ratings 2001 2002 2003 2004 2005 2006 USA Spain Japan Italy Ireland Iceland 2007 2008 2009 Greece 2010 2011 July 3-302 Expected Debt Service The Debt Relief Laffer Curve Level of Debt 3-303 Summary Debt and deficits Deficits and the Business Cycle Long Run Debt Sustainability The Intertemporal Budget Constraint Sovereign Default Credit Risk and Credit Agencies Debt Forgiveness MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Exchange Rate Determination I – The Real Exchange Rate 304 3-305 Key Concepts Real and Nominal Exchange Rates Law of One Price Purchasing Power Parity Current account and capital account 3-306 Exchange Rate Nominal Price of one currency in terms of another currency (bilateral) Real Purchasing power of a currency Price of currency adjusted for cross-country differences in prices of goods and service Effective Average exchange rate over several other currencies Trade weighted When averaging, use amount of trade to weight the currency 3-307 Euro Effective Exchange Rate Hong Kong 1.8% Denmark 2.7% Czech Republic 4.2% China 14.1% Hungary 3.2% Japan 8.3% Norway 1.3% Poland 4.8% Romania 1.7% Singapore 1.7% South Korea 3.9% Sweden 5.0% Canada 1.8% Switzerland 6.5% Rest of the World 2.0% United States 19.2% United Kingdom 17.8% 3-308 $ effective exchange rate 2% Brazilian Real 2% Thai Baht 2% Australian Dollar 3% Malaysian 2% Sw iss Franc Ringgitt 3% Hong Kong Dollar 1% Indonesian Rupiah 1% Philippine Peso 19% Canadian Dollar 3% Singapore dollar 4% Korean Won 4% Taiw anese Dollar 5% Pound Sterling 9% Mexican Peso 7% Chinese Yuan 18% Euro 16% Japanese Yen 3-309 Nominal exchange rate Appreciation of $: rise in value of $, so $1 buys more foreign currency 130 Yen/$ to 140 Yen/$ Depreciation of $: decline in value of $, so $1 buys less foreign currency 133 Yen/$ to 118 Yen/$ 3-310 Importance of Exchange Rates Determines price at which we buy imported goods French wine costs 20.40 Euro Exchange rate is 1.02 Euro/$ US price is 20.40/1.02 = $20 But we care about aggregate prices 3-311 Real Exchange Rate $ Domestic Price Level Real Rate = Nominal Rate x Foreign Price Level ¥ /$ ¥ Note that the real rate is unit-less 1964 1965 1966 1968 1969 1970 1972 1973 1974 1976 1977 1978 1980 1981 1982 1984 1985 1986 1988 1989 1990 1992 1993 1994 1996 1997 1998 2000 2001 2002 2004 2005 2006 2008 2009 2010 3-312 Nominal and Real UK Effective exchange rate 220 Nominal Effective Exchange Rate 180 Real Effective Exchange Rate 140 100 60 3-313 Law of One Price Identical commodities sell at same price no matter where they are sold Gas in Minneapolis, gas in St. Paul Big Mac index Implies real rate = 1 Based on idea of arbitrage 3-314 Law of One Price Transportation costs US/Japan prices imply distance of 43 million miles. Border effects (tariffs, non-tradeables, etc.) Goods prices are “sticky”, nominal exchange rates aren’t Pricing to market Exchange rate pass-through 3-315 Estimated transport cost for global trade Figure 19.2 3-316 Price differences between US and Canadian Cities. Figure 19.4 3-317 Purchasing Power Parity UK Price Level PPP Nominal Rate (£/$) = US Price Level US Price Level Real Rate = Nominal Rate (£/$) x UK Price Level Real Rate = 1 3-318 Purchasing Power Parity Big Mac price in local currency Australia Brazil Canada China Egypt Euro-Area Japan Malaysia Pakistan Poland Russia S. Africa Sweden Turkey UK USA A$ 4.35 R$ 8.71 C$ 4.17 ¥ 13.2 E£ 13.0 €3.38 ¥ 320 RM 7.05 Rs 210 Zł 8.30 P. 71 R 18.42 kr 6.50 Tl 5.95 £ 2.29 $ 3.73 PPP exchange rates against dollar Implied Big Mac PPP 0.85* 2.33 1.12 3.54 3.48 1.10* 85.7 1.89 56.3 2.22 19.0 4.94 13.0 1.59 1.63* - IMF PPP 1.16* 1.68 1.22 3.89 2.59 1.18* 108.4 1.82 35.3 1.98 21.3 5.41 9.53 1.225 1.49* - Actual Exchange Rate mid 2011 Under/over valuation of actual exchange rate against Big Mac PPP 1.06* 1.64 0.97 6.51 5.94 1.42* 80.8 3.00 85.5 2.76 28.0 7.00 6.34 1.59 1.62* Actual and PPP exchange rates against the dollar in 2011 *quoted as number of US dollars per unit of local currency 25% 42% 15% -46% -41% 29% 6% -37% -34% -20% -32% -29% 105% 0% -1% IMF PPP -9% 2% 26% -40% -56% 20% 34% -39% -59% -28% -24% -23% 50% -23% 9% 3-319 PPP Change in exchange rate (£/$) = UK Inflation – US Inflation Increase in UK inflation implies $ appreciation Increase in US inflation implies $ depreciation 3-320 Inflation and Currency Depreciation Five Year Window Currency Depreciation (% pa) 30 23 17 10 3 -3 -10 -20 -10 0 Inflation Differential 10 20 30 3-321 Inflation and Currency Depreciation Twenty Year Window 12 Currency Depreciation (% pa) 9 6 3 0 -3 -6 -10 -5 Inflation Differential 0 5 10 15 3-322 Balassa-Samuelson Effect Prices tend to be higher in industrialized countries Industrialized countries Higher productivity growth in tradeable goods sector Higher wage growth in non-trade sector Thus, higher inflation in non-trade sector 3-323 Balassa-Samuelson Effect GDP Per Capita relative to US (US=100) 256 64 16 4 1 25 50 100 Price Level relative to US (US=100) 200 3-324 Trade Accounts Current account Records net transactions in goods and services Exports - Imports Capital & Financial account Records net transactions in assets Net Saving 3-325 Current Account Exports – Imports Goods Services Investment income and dividends Net transfers 3-326 Capital & Financial Account Capital transfers Financial account Direct investment Portfolio investment Other investment Reserve Assets Errors and omissions Fudge factor © Shutterstock Images 3-327 Balance of Payments Capital and Current Account Flows, 2009 ($bn) Balance on Goods Balance on Services Balance on Goods & Services Net Investment Income Net Transfers Current Account Capital Account Net Direct Investment Net Portfolio Investment Net Other Investment Financial Account Net Errors and Omissions Overall Balance Reserve Assets U.S. -504 129 -375 121 -125 -378 -0 -134 -27 429 268 163 52 -52 China 250 -29 220 43 34 297 4 34 39 70 143 -43 401 Euro-Area 32 43 75 -12 -140 -77 12 -112 259 -44 104 -33 6 -401 -6 1977 1979 1980 1981 1982 1984 1985 1986 1987 1989 1990 1991 1992 1994 1995 1996 1997 1999 2000 2001 2002 2004 2005 2006 2007 2009 2010 % of GDP 3-328 Net Financial Asset Positions USA 50% -10% -30% Japan Euro-Area 30% UK 10% 3-329 Net Financial Asset Positions Creditors (100% of GDP+) Creditors Debtors Debtors (100% of GDP+) Kuwait (+311%) Norway (+59% Canada(-2%) Jamaica (-100%) Hong Kong (+234%) Japan (+50%) Russia (-11%) Portugal (-101%) UAE (+208%) Iran (+37%) US (-17%) Greece (-104%) Singapore (+170%) Venezuela (+32%) UK (-20%) Iceland (-113%) Switzerland (+141%) Germany (+26%) Italy (-21%) Lebanon (-130%) Taiwan (+137%) China (+22%) India (-25%) Rep. of Congo (-139%) Saudi Arabia (+101%) Nigeria (+15%) Brazil (-41%) Seychelles (-232%) Botswana (+100%) France (+12%) Australia (-65%) Liberia (-767%) 3-330 Trade Accounts PS = GDP + NIFA – C – T GDP = C + I + G + (X – M) X – M = T – G + PS – I – NIFA X – M = S – I – NIFA 3-331 Trade Accounts X – M + NIFA = S – I Net Exports = Current Account Surplus Net Saving = Capital Account Deficit Current Account + Capital Account = 0 3-332 Net Export Market Real Exchange Rate S-I ₤/$ E0 E1 X – M + NIFA Net Exports Increase in net savings reduces real exchange rate 3-333 Net Export Market Real Exchange Rate S-I ₤/$ E0 E1 X – M + NIFA Net Exports Decrease in net savings increases real exchange rate 3-334 Net Export Market Real Exchange Rate S-I ₤/$ E1 E0 X – M + NIFA Net Exports Increase in current account increases real exchange rate 3-335 Real Exchange Rate Movements Decrease in Net Savings Causes Decrease in private savings Increase in investment spending Fiscal Deficit Effect Increases real exchange rate (dollars buy more pounds) Increases current account deficit 3-336 Real Exchange Rate Movements Increase in Net Exports Causes Increase in Exports Decrease in Imports Effect Increases real exchange rate (dollars buy more pounds) 3-337 Summary Definitions of exchange rates Law of one price Goods should sell at the same price everywhere PPP Real exchange rate = 1 Balance of Payments Capital account + current account = 0 Copyright © 2012 John Wiley & Sons, Inc. 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MACROECONOMICS UNDERSTANDING THE GLOBAL ECONOMY Currency Crisis and Exchange Rate Systems 338 3-339 Key Concepts 1st & 2nd Generation Currency Crisis Models FX intervention and Reserves Sovereign Wealth Funds The Role of the IMF Capital Account Liberalization Currency Regimes 3-340 Currency Crisis Sudden and dramatic currency depreciation, accompanied by decline in the real exchange rate Number of Currency Crises per year 30 (here defined as a depreciation of more than 15% in a year ) 25 20 15 10 5 0 1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 Source: Reinhart and Rogoff, “This Time It’s Different: Eight Centuries of Financial Folly” (Princeton). 3-341 Currency Crisis Currency Crises tend to lead to dramatic declines in GDP GDP Growth around Currency Crises Year Before Crisis Argentina (2001) Iceland(2008) Indonesia (1997) Year of Crisis Year After -0.8 -4.4 -10.9 6.0 1.0 -6.5 8 4.5 -13.1 South Korea (1997) 6.8 5 -6.7 Philippines (1997) 5.8 5.2 -0.6 Russia (1998) 1.4 -5.3 6.3 Thailand (1997) 5.9 -1.4 -10.5 Turkey (2001) 7.4 -7.5 7.8 3-342 First Generation Model Inconsistent Economic Policy Nominal exchange rate constant… …But Central Bank forced to lend to government (to finance fiscal Deficit) Outcome Initially Central Bank can run down foreign reserves to finance government, but eventually must resort to money printing which is inconsistent with fixed exchange rate Because financial markets are forward-looking, they attack the peg before it fails naturally 3-343 First Generation Model D exchange rate A B Shadow floating rate (consistent with risk of money printing) C – Point at which exchange rate peg will fail naturally C time foreign reserves Exchange rate: Reserve depletion Moves from A to B and then speculative attack breaks peg so follows D from then on time 3-344 Vicious circle Fiscal Deficit and Monetization Inflation and downward pressure on exchange rate 3-345 End game Government eventually runs out of reserves Currency traders anticipate a currency depreciation Speculative attack 3-346 Second generation model Again starts with a fixed exchange rate Government undertakes cost benefit analysis of keeping the peg (i.e. decides if peg has economic benefits that outweigh its cost) will drop peg if costs too great. Defending the peg from speculative attack raises the cost of keeping the peg (e.g. forced to raise interest rates and incur higher unemployment) Outcome: Self-fulfilling equilibria An attack can raise the cost of keeping the peg and so cause an exit that would not have occurred without the attack. 3-347 Tradeoff Fixed Rate No Fixed Rate Low and Stable Inflation Lower interest rates, more growth 3-348 Snowball effect Slow Growth Incentive to abandon fixed rate Investors sell currency Interest rate must rise 3-349 Second Generation Model 3-350 The ERM Crisis 3-351 Foreign Exchange Intervention Stylised Central Bank Balance Sheet Assets Liabilities A. Foreign Exchange Reserves C. Monetary Base B. Other Domestic Assets D. Other Debt and Equity Unsterilized Intervention: Change in FX Reserves (A) = Change in Monetary Base (C) Sterlized Intervention Change in FX Reserves (A) = Change in other domestic assets (B) (or D). 3-352 Foreign Exchange Reserves Shares of Global FX reserves Switzerland Brazil 3% Hong Kong 2% S. Korea 3% India 3% 3% Saudi Arabia 4% RoW 34% Russian Federation 5% US 5% Japan 10% China 28% 3-353 Foreign Exchange Reserves Import cover:. Conventional wisdom (and IMF advice) was that reserves should exceed three months of imports to cover for a temporary loss of export revenue). Global Reserves: Import Cover (months) 3-354 Foreign Exchange Reserves Reserves to short term debt. This measure focuses on the role of reserves in mitigating the impact of financial crises in which countries are unable to refinance their foreign debt. The so so-called Greenspan-Guidotti rule suggests that reserves should be equal to external debt coming due within the next year. Reserves to Short Term Debt 3-355 Foreign Exchange Reserves Reserves to M2. As well as problems in refinancing external debt, financial crises are often characterised by capital flight when domestic citizens attempt to convert domestic assets into foreign ones. Thus a reserves to M2 ratio of around 20% is often recommended . Global Reserves: Reserves to M2 3-356 Foreign Exchange Reserves Estimated Currency shares of Global Reserves (exc. Gold) 100% 90% 80% Other Japanese Yen 70% Swiss Franc 60% 50% Euro/former Euro-area currencies 40% UK Pound 30% 20% 10% 0% US Dollar 3-357 Sovereign Wealth Funds 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Total assets (1)+(2) 86 123 150 484 797 1,023 1,364 1,793 2,547 2,915 Of which: total external assets 86 123 150 484 765 972 1,302 1,738 2,375 2,712 Total: Commodity Funds(1) 28 48 74 408 600 795 1,088 1,475 1,960 2,321 n.a. 28 n.a. n.a. n.a. n.a. 4 n.a. 43 n.a. n.a. n.a. n.a. 6 n.a. 69 n.a. n.a. n.a. n.a. 6 2 94 85 21 n.a .1 200 8 4 115 148 37 n.a .2 286 14 5 140 192 19 60 1 10 354 59 0 59 0 0 n.a. 75 0 75 0 0 n.a. 76 0 76 0 0 n.a. 75 0 75 0 0 n.a. 197 0 74 0 0 123 229 0 78 13 0 137 29 1 8 160 238 44 126 8 3 20 452 276 0 77 15 20 163 46 9 14 200 306 82 197 19 5 35 571 318 0 88 18 20 182 49 14 20 250 384 181 271 33 8 56 708 587 200 98 26 20 223 64 20 28 265 326 209 433 33 8 60 875 594 200 98 26 25 245 Algeria Chile Kazakhstan Kuwait Norway Russia Saudi Arabia Venezuela Oman Qatar UAE Total: Excess Reserve Funds(2) China Hong Kong Malaysia Korea Singapore 3-358 Sovereign Wealth Funds 3-359 International Monetary Fund Established in 1946 Bretton Woods, 1944 Lender of last resort 184 member countries http://www.imf.org/ 3-360 Elements of IMF lending Special Drawing Rights (SDR) Member quota Emergency lending service Wednesday August 4, 2004 1 SDR = 1.456 USD 1 USD = 0.686811 SDR SDR Interest Rate = 1.91% 3-361 IMF Intervention and GDP growth Figure 21.8a 3-362 IMF Intervention and Fiscal Deficits Figure 21.8b 3-363 IMF Intervention and Interest Rates Figure 21.8c 3-364 Capital Account Liberalization Advantages of Liberalization Financing investment and stimulating growth Risk diversification Improving government policy Increasing efficiency of financial sector 3-365 Pre-crisis IMF Statements In October 1998 the IMF argued that “Capital controls may also turn out to be an important setback not only to that country’s [Malaysia] recovery and potentially to its future development, but also to other emerging market economies” 3-366 Michael Mussa -- IMF’s former chief economist “High openness to international capital flows, especially short-term credit flows, can be dangerous for countries with weak or inconsistent macro-economic policies or inadequately capitalized and regulated financial systems” 3-367 Evidence on Liberalization 8% Capital Mobility (LHS) Index of Capital Mobility 0.8 6% Countries entering crisis (RHS) 0.6 4% 0.4 2% 0.2 0 1820 % entering banking crisis (10-year moving average) 1 0% 1840 1860 1880 1900 1920 1940 1960 1980 2000 Source: Reinhart and Rogoff, “This Time It’s Different: Eight Centuries of Financial Folly” (Princeton). 3-368 Evidence on Liberalization 3-369 Evidence on Liberalization Capital Controls: An Evaluation NBER 3-370 The Impossible Trilogy Independent monetary policy Fixed exchange rate Absence of capital controls 3-371 Exchange Rate Regimes 100 90 80 70 60 Floating 50 40 30 20 10 0 Intermediate Soft Peg Hard Peg 3-372 Exchange Rate Regimes 3-373 Fixed Rate Exchange rate fixed at constant level Advantages Provides a nominal anchor Encourages trade and investment Avoids speculative bubbles Reduces risk premium 3-374 Choice of Anchor Currencies 100% 90% 80% 70% 60% Other DEM 50% 40% EUR FRF GBP 30% 20% 10% 0% USD 3-375 Floating Rate Let nominal exchange rate adjust to market conditions Like US, Canada, Australia Advantages Independent monetary policy Automatic adjustment to trade shocks Seignorage Avoid speculative attacks 3-376 Intermediate Regime Float, but within boundaries Exchange Rate Time 3-377 Hard Peg Fix one bilateral nominal exchange rate Dollarize (Ecuador) Abandon own currency and use another nation’s currency No more seignorage! Currency Board (Argentina) Central bank holds interest-bearing foreign assets Will exchange domestic currency for foreign currency at a fixed exchange rate, backed by assets 3-378 Currency Board Role of Central Bank Exchange domestic currency for foreign reserves at fixed rate of exchange Can never produce fiat money Cannot issue liquidity of domestic banks Goals? If FX reserves fall, domestic money supply falls 3-379 Performance of Currency Boards 3-380 Why go Euro? © Shutterstock Images 3-381 The euro Optimal Currency Area Degree of trade between countries Similarity of economic shocks Labor market mobility Nature and amount of fiscal transfers 3-382 The road to Euro 1979 European Monetary System Establishes the Ecu Blueprint for monetary union 1986 European Single Act Free movement of people, goods, capital 1992 Maastricht Treaty (Treaty on European Union) Provides legal basis for EMU Provides for single currency 2002 Euro replaces domestic currencies 3-383 Convergence Criteria Inflation Rate cannot be more than 1.5% above average inflation rate of three lowest Member states Public Budget Deficit Can’t exceed 3% of GDP Public Debt Can’t exceed 60% of GDP Interest Rate Rate cannot be more than 2% higher than the average of the three states with the lowest inflation rates Currency No currency fluctuations outside the normal EMS margins for two years 3-384 Benefits Reduce business costs for intra-EU trading Ease purchases for tourists and people in bordering areas Decrease prices Increase stability in EU 3-385 Countries and Trade 60 250 50 200 Number of countries 40 150 30 100 20 50 10 0 1900 0 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Number of Countries in the World World Merchandise trade to GDP (%) Trade to GDP ratio 3-386 Summary Currency crises Models – 1st generation, 2nd generation FX Intervention IMF Exchange rate regimes Euro