Download The World Economy - Nuffield College, Oxford

The World Economy
Gavin Cameron
Oxford University
April 2005
plan of the session
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16.30
17.30
18.00
19.00
19.20
19.50
Short-run Macroeconomics
Discussion in groups of short-run issues
Long-run Macroeconomics
Discussion in groups of long-run issues
Presentations
Summary
short-run macroeconomics
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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 fiveyear 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?
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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
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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
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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 carrytrade’).
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
Output Growth
1960-1973
1973-1979
1979-1989
1989-1999
Unemployment
1960-1973
1973-1979
1979-1989
1989-1999
Inflation
1960-1973
1973-1979
1979-1989
1989-1999
Source:
OECD
EU
USA
JAPAN
GERMANY FRANCE ITALY
UK
4.9
3.2
2.9
2.6
4.7
2.6
2.2
2.0
4.0
2.9
2.8
3.0
9.7
3.5
3.8
1.7
4.3
2.4
2.0
2.2
5.4
2.7
2.1
1.7
5.3
3.5
2.4
1.3
3.1
1.5
2.4
1.9
2.9
5.0
7.3
7.4
2.6
4.6
9.4
9.9
4.8
6.7
7.3
5.8
1.2
1.9
2.5
3.1
1.0
3.0
5.8
7.5
2.6
4.4
8.8
11.2
5.7
6.0
8.2
10.9
3.3
4.9
9.8
8.3
3.9
8.8
5.4
2.7
4.1
9.6
6.6
3.4
3.1
7.8
5.3
2.4
6.1
9.5
2.5
1.0
3.4
4.6
2.8
2.4
4.9
11.1
7.5
2.1
4.9
16.7
11.4
4.6
4.8
15.6
7.0
3.8
Economics of the OECD 2000 exam paper data tables 1, 4 and 5.
equilibrium unemployment
labour supply
workforce
equilibrium wage
labour demand
natural rate
equilibrium employment
employment
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 wage
target real wage
labour supply
workforce
feasible real wage
employment
the NRU and the NAIRU
target real wage
labour supply
workforce
feasible real wage
natural rate
NAIRU
employment
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
OECD
EU
USA
Japan
Germany
France
Italy
UK
TFP Growth
1960-73 1973-79
2.9
0.6
3.4
1.2
1.9
0.1
4.9
0.7
2.6
1.8
3.7
1.6
4.4
2.0
2.6
0.5
Source:
Economics of the OECD 2000 exam paper data table 2.
1979-97
0.9
1.1
0.7
0.9
1.2
1.3
1.1
1.1
Labour Productivity Growth
1960-73 1973-79 1979-97
4.6
1.7
1.7
5.4
2.5
1.8
2.6
0.3
2.2
8.4
2.8
2.3
4.5
3.1
2.2
5.3
2.9
2.2
6.4
2.8
2.0
4.1
1.6
2.0
Note: Growth of total factor productivity= Growth of output minus weighted growth of inputs
the Japanese TFP miracle
0.1
0
1955
1960
1965
1970
1975
1980
1985
1990
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
Log Relative TFP in Japanese manufacturing relative to the USA
1995
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
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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)