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Economic
Environment
Lecture 1
Joint Honours 2003/4
Professor Stephen Hall
The Business School
Imperial College London
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© Stephen Hall, Imperial College London
Economic Environment
• Introduction & Overview
• Macroeconomics is the study of economic aggregates and
their dynamics. Examples include the inflation rate, gross
domestic product (GDP), the unemployment rate, and so on.
• As we will demonstrate, the state of the macro economy and
government economic policy are interrelated.
• In this course, we wish eventually to assume the point of
view of (a manager of) a single business firm, whose task it is
to
–
–
–
–
–
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understand how the economy functions
anticipate government policies in light of the state of the economy
anticipate how those policies will affect the business climate in
general, and his/her business in particular, and finally
make managerial decisions today based upon these anticipations
© Stephen Hall, Imperial College London
Economic Environment
• This viewpoint is best depicted as follows:
Macro
Economy
Government
Firms
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© Stephen Hall, Imperial College London
Economic Environment
• The preceding figure provides an appropriate perspective
from which to approach the course material.
• The preceding figure is not, however, the best way of
understanding economics. A business firm is itself a part of
the macroeconomy, and so should rightly be placed inside
the “macroeconomy” box. Moreover, there is also the rest of
the world to consider. (Economically speaking, the UK is not
an island!) The government has not only (monetary and
fiscal) policies to deal directly with the macroeconomy, they
also have internationally-oriented policies, and others
directed more precisely at individual business firms.
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© Stephen Hall, Imperial College London
Economic Environment
A more comprehensive list of government policies would be:
• Fiscal policy: dealing with government spending and taxation
• Monetary policy: establishing interest rates and money
supply
• Exchange rate policy: dealing with the international value of
the pound sterling
• International Trade policy: involving measures taken to affect
the magnitude and direction of international trade
• Supply-side policy: designed to directly encourage business
firms to produce more
• Prices and incomes policy: introduced to reduce inflation or
support income
• Employment policy: designed to protect or create jobs
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© Stephen Hall, Imperial College London
Economic Environment
• A more comprehensive depiction of the firm, its position in the
economy, and the effect of economic policies is provided by:
Firm
Domestic
economy
International
Economy
Oil price shocks,
Exchange rate policy,
Fiscal policy, Monetary
Policy, Trade…
The Business Environment
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The Economic Problem
If we were to list government objectives, this would
include things like low inflation, high incomes,
economic growth, low unemployment, etc. There
would also be a long list of “non-economic”
objectives like low crime rates, a “fair” income
distribution, better education, and so on. We
may illustrate the government’s task as follows:
• policy instruments -> policy targets -> ultimate
goals
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Some key issues in macroeconomics
• Inflation
– the rate of change of the general price level
• Unemployment
– a measure of the number of people looking for work, but who
are without jobs
• Output
– real gross national product (GNP) measures total income of
an economy
•
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it is closely related to the economy's total output
© Stephen Hall, Imperial College London
More key issues in macroeconomics
• Economic growth
– increases in real GNP, an indication of the
expansion of the economy’s total output
• Macroeconomic policy
– a variety of policy measures used by the
government to affect the overall performance of
the economy
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Economic Environment
• However ..
• The fundamental economic problem is that resources are
limited, so a government and its people cannot have
everything they want. Choices must be made. Put another
way, everything has an “opportunity cost”.
• Referring back to the previous list of government policies, it is
apparent that the policies frequently overlap one another
and, implicitly, policy objectives conflict with each other. This
is simply a result of the fact that all policies require choices
and involve costs.
• The government’s job is to understand the effects of their
various policies, i.e., the opportunity costs involved, and to
make choices accordingly.
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Economic Environment
• How to Proceed:
• What we need to do is to develop a model - or
several models - of the macroeconomy.
• Because we are dealing with economic aggregates, a
high level of abstraction is required.
• This means that our model will be both simple and
highly unrealistic.
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Economic Environment
Question:
• if a model is simple and unrealistic, is it
necessarily a bad model?
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Economic Environment
• Essentially, we will start with bits and
pieces, build a simple model, and then
gradually add on to it. Eventually, we will
have a model that allows us to understand
the interrelationships between the interest
rate, inflation, unemployment, government
spending, taxation, output, and so on.
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One important caveat
• The model we will use is a static model, i.e. dealing only
with the present.
• From it, we will make inferences about future economic
behavior and government policy.
• Unfortunately, the model is not well equipped to deal with
questions regarding long-term economic strategies.
• However, it is a very useful model for understanding
short- and medium-term economic problems and, more
importantly, for anticipating government policies.
• (Despite all the political rhetoric, governments from all
parties and in all western countries re extremely shortsighted; much more so than private businesses!)
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Economic Environment
• A good way to think about the model is that it
is appropriate for understanding economic
behavior and government policy within a
business cycle, but tells us nothing about the
long-run. (Indeed, in some cases, the best
short-run policies turn out to be the worst
long-run policies!).
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Economic Environment
The Business Cycle and
National Income
determination.
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Economic Performance
Before introducing the model, it is useful to have some idea
of the state and recent history of UK economic performance.
General areas of interest include:
• Economic growth (in output): which was low relative to other western
economies until the 1980s.
• Profitability and productivity: which were low relative to other western
economies until the 1980s.
• Unemployment: which was relatively high throughout most of the 1980s
(and again presently).
• Inflation: which was extremely high in the early- and, again, the late1970s, but relatively low throughout most of the 1980s (and especially
so presently).
• Balance of payments (i.e. net exports) and the exchange rate: both of
which have declined throughout most of the 1980s to present.
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Inflation in the UK, 1950-99
30
25
% p.a.
20
15
10
5
19
90
19
70
19
50
0
Source: Economic Trends Annual Supplement, Labour Market Trends
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© Stephen Hall, Imperial College London
Inflation in selected European countries
Germany
France
Belgium
EU
Finland
UK
Spain
Italy
Portugal
Greece
0
1
2
3
4
5
% change 1998 compared with 1997
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© Stephen Hall, Imperial College London
Inflation in UK, USA and Germany
% p.a.
16
14
12
10
8
6
4
2
0
1960-73
1973-81
UK
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USA
1981-90
1990-98
Germany
© Stephen Hall, Imperial College London
Unemployment in the UK, 1950-99
14
12
% p.a.
10
8
6
4
2
19
90
19
70
19
50
0
Source: Economic Trends Annual Supplement, Labour Market Trends
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© Stephen Hall, Imperial College London
Unemployment
in selected European countries
Germany
France
Belgium
EU
Finland
UK
Spain
Italy
Portugal
Greece
0
5
10
15
20
% unemployment (ILO measure) 1998
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© Stephen Hall, Imperial College London
Unemployment
in UK, USA and Germany
10
% p.a.
8
6
4
2
0
1960-73
1973-81
UK
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USA
1981-90
1990-98
Germany
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Economic growth
in UK, USA and Germany
5
% p.a.
4
3
2
1
0
1960-73
1973-81
UK
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USA
1981-90
1990-98
Germany
© Stephen Hall, Imperial College London
Economic Sectors and Flows
To understand how an economy functions, we
need a model. Regardless of which of several
models we choose, the model must:
• Define various “sectors” of the economy;
and
• Characterise economic activity as flows of “real”
commodities (or, alternatively, financial capital)
between these sectors.
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Sectors
• Households: who provide the “factors of production” to
business firms and ultimately (in one form of another)
receive all of what the economy produces.
• Business firms: who transform inputs (factors of
production) into output.
• Government: which functions somewhat like a firm in that
it uses inputs and produces output; but it has different
objectives and faces different constraints than do firms.
• Financial services: which essentially facilitate the flow of
financial capital between sectors, but do not use or
consume “real” resources.
• Foreigners: who import into, and export from, the
economy.
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The circular flow of income, expenditure and
output
I
C
S
C+I
Households
Firms
Y
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Government in the circular flow
I
C+I+G
C
S
G
Households
C + I + G - Te
Te
Government
Firms
B - Td
Y + B - Td
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Y
© Stephen Hall, Imperial College London
Measuring Economic Activity
• To measure the total amount of economic
activity, one must find an appropriate place on
the flow diagram (i.e. one in which all
economic activity must pass through) and
measure the amount of economic activity that
does in fact pass through.
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Measuring Economic Activity
There are three such places at which economic activity can
be measured. The measurement of economic activity is
done differently - and has a different name - depending
upon which such place is chosen.
• Output method: (at the “firm” box at left) measures the value of final
output produced by firms.
• Income method: (at the “households” box at right) measures the
value of all income received by households.
• Expenditure method: (at the “market for goods and services” box at
top) measures the total expenditure by various sectors on the
economy’s output.
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Measuring Economic Activity
• All of these methods should lead to the same
total amount of economic activity. Therefore,
the terms “output” (GNP), “income” (GNI),
and “expenditure” (GNE) are used
interchangeably.
• The actual measurement of a country’s
economic activity is documented in the
“national income account”.
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UK National Income 1988
• The Handout has a detailed picture of the
UK national accounts as a table.
• This shows all the adjustments necessary
to make
• Income=Output=expenditure
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Problems in Calculating National Income
From the flow chart, it would seem straight-forward to
calculate national income. However, there are three main
complications:
• Depreciation: Over time, firms’ capital stock (i.e. machinery) loses
value. This lost value must be accounted for.
GNP - depreciation = Net National Product (NNP)
• Prices: The expenditure method uses the market prices paid for
goods and services, which is net of indirect taxes (like VAT) and
subsidies. The other methods use factor costs, which are exclusive of
taxes and subsidies. Therefore, GNE must be adjusted as follows:
GNE (factor cost) = GNE (at market prices) - taxes + subsidies
• Foreign firms: Do we wish to measure domestic economic activity
(which would include foreign firms producing in the UK, but exclude
British firms producing abroad), or national economic activity (which
would include British firms producing abroad, but exclude foreign firms
producing in the UK)?
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Economic Environment
Gross Domestic Product (GDP) vs GNP:
GDP = GNP - net property income from abroad
(NYA)
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National income accounting: a summary
NYA
G
GNP
(and
GNI)
at
market
prices
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I
X-Z
C
NYA
Deprec'n
Indirect
taxes
GDP
NNP
at
market at basic National
prices prices income
Profits,
rents
Selfemployment
Wages
and
salaries
© Stephen Hall, Imperial College London
What GNP does and does not measure
• Some care is needed:
– to distinguish between real and nominal
measurements
– to take account of population changes
– to remember that GNP is not a comprehensive
measure of everything that contributes to
economic welfare
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Leakages and Injections
From the flow diagram, we can see that total household
expenditure (consumption (C) + saving (S) + taxes (T) +
imports (M)) must equal the total expenditure on goods and
services (consumption (C) + investment (I) + government
spending (G) + (X))
C+S+T+M=C+I+G+X
As the C’s cancel,
S+T+M=I+G+X
From the household income point of view, this is interpreted as
“leakages” = “injections”
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Crowding Out
The equation above can be re-written as:
S - (X - M) = I + (G - T)
where
- (X - M) is minus net exports; identically net
imports,
(G - T) is government borrowing (the PSBR)
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Crowding Out
Ignoring net exports (which are frequently close to
zero), the equality (actually, an identity!) states that
private saving = private investment + government
borrowing
To ensure sufficient private investment (which is the
engine of long-term economic growth), an economy
must have considerable private saving and little
government borrowing. Government borrowing
which takes away from private investment is known
as “crowding out”.
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Crowding Out
Injections
Investment
Savings
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Government
Taxes
Leakages
Exports
Imports
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A Note on Where We Are Heading
Presently, we will begin introducing simple models of the economy,
and gradually build upon them to obtain a workable, comprehensive
model of the macroeconomy. The steps we will eventually take are:
•
A focus on the commodities market. We will first look at demand-side models
of output determination, with no concern for prices of any kind.
•
The introduction of the interest rate. This extra variable means that we can
solve only for output/interest rate combinations, which satisfy commodity
market equilibrium. (The IS-Curve).
•
The introduction of money supply (and the banking system) and money
demand. WE show that money-market equilibrium is actually a set of
output/interest rate combinations. (The LM-Curve).
•
We argue that both the commodities market and the money market must be
in equilibrium. (Essentially, this involves solving this IS and LM curves
simultaneously for equilibrium values of output and interest rate). This gives
us a unique macroeconomics equilibrium. (The IS-LM model).
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Where we are heading……..
• The introduction of an over-all price level. We show that,
through the money market, the IS-LM model implies an inverse
relationship between the price level and output (which we
interpret as a downward-sloping demand curve).
• The introduction of the labour market (including the wage rate)
and firms, who use labour to help produce output. We
demonstrate that profit-maximisation on the part of firms implies
that more will be produced as the price level rises (which we
interpret as an upward-sloping supply curve).
• Argue that the final equilibrium is where supply equals demand.
Finally, we can perform “comparative static” exercises, using our
model to see what happens when, for example, the government
raises taxes or lowers the interest rate.
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