Download ecomacro2005_avec_co..

The Economic Picture
Understanding the global economy
Understanding the economic system:
“The circular flow”
Production, technology & employment:
GDP growth , technological change,
productivity and labour
Consumption, saving & investment:
Government intervention: growth vs inflation
Determinants of consumption & saving,
role of financial institutions
Fundamentals of budget, monetary & foreign
exchange policy
The globalisation trend: a European perspective
Facts & figures, growing importance of emerging
economies, the threat of US deficits
Prof. Patrick GOUGEON, ESCP-EAP
Understanding the economic system: the “circular flow”
Saving (S)
Private
transfers
Consumption (c)
International
Capital flows
Households
Financial
Institutions
Government
Income
(Y)
G
Investment (I)
Public
transfers
Aggregate
Demand*
market
p
D
O
q
Firms
Self financing
*Aggregate demand = C+I+G+X-M
Import (M) Export (X)
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
FIRMS
Source of value
FIRM
Intermediate
goods
Sales
Creation,
Processing
Suppliers
Upstream markets
Clients
Downstream markets
Value Added = Sales – Cost of Intermediate goods
To be shared between all participants
GDP (Gross Domestic Product) = Total value added = Total Income
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
Sharing Value Added …..
Employees (wages)
Government (Taxes)
€
Creditors (interest)
Shareholders
•
Net Profit
•
allowances for depreciation
Dividends
self financiang
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
EU: GDP per capita
GDP per Capita (PPS, EU25=100, estimates 2004)
source: Eurostat
Incoming countries
EU 15
140,0
130,8
120,0
106,2 108
115,1 116,2
110,3 113,4
118,5 120,1 120,9
124,4
96,2
100,0
78,1
80,0
69,9
81,6
73,3
62,0
60,0
40,0
51,2 51,5
47,4 48,5
31,2 31,7
20,0
0,0
RO
BG
LV
LT
EE
SK HU
CZ
SN
PT
GR
ES
IT
DE FIN
FR SW
BE
NL
UK AT
DK IRE
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
TRENDS
• Substitution of Capital for Labour
• Labour heterogeneity
• International differences in labor cost
• Service activities are growing in importance
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
comments on productivity
Productivity
140
Labour productivity with reference to GDP in Purchasing Power Standards (PPS) per person
employed relative to EU-15 (EU-15 = 100) , year 2003 (Eurostat)
120
100
80
per pers. employed
per hour worked
60
40
20
0
BE
DK
DE
GR
ES
FR
IRE
IT
NL
AT
PT
FI
SW
UK
JP
US
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
comments on productivity
A productivity primer; Nov 4th 2004 ;From The Economist print edition
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
comments on labour costs
From the economist
Prof. Patrick GOUGEON, ESCP-EAP
Production, technology & employment
Comments on working hours
From the economist
Prof. Patrick GOUGEON, ESCP-EAP
Consumption, saving & investment
Saving & consumption:
importance of the age structure
Income, Consumption
Income
Saving phase
C
Capital consumption
Borrowing
Phase
Age
Retirement
Prof. Patrick GOUGEON, ESCP-EAP
Consumption, saving
& investment
Income, Consumption
Households saving
and investment
Income
Saving phase
C
Capital consumption
Borrowing
Phase
Retirement Age
Net saving
Investment
saving
0
Capital to
be transferred
Net Debt
45-50
Prof. Patrick GOUGEON, ESCP-EAP
Consumption, saving & investment
Population Structure: few comparisons
Prof. Patrick GOUGEON, ESCP-EAP
Consumption, saving & investment
Saving rates:
what they tell us
Euro anxiety
Anglosaxon entrpreneurial optimism
From the economist
Prof. Patrick GOUGEON, ESCP-EAP
Consumption, saving & investment
Comparing UK and France
Households debt*
Public debt*
UK: 120%
France: 60%
UK: 39.8%
France: 63.7%
* As % of total disposable income, OECD
* As % of GDP, Eurostat
From the economist
And Germany
Prof. Patrick GOUGEON, ESCP-EAP
Government intervention: growth vs inflation
Money supply: a summary
A basic equation:
Cash in circulation outside banks
+ sight deposits at bank
= M1
+ other types deposits
= M2, M3, M4
Price level
Quantity of money
MV=PQ
Real value of
transactions
Velocity
Quantity of money : 100, three agents A B C
exchanges:
A - B : 100
B - C : 100
C - A : 100
Total value of transactions:
300
=
M x V
100
3
Prof. Patrick GOUGEON, ESCP-EAP
Factors affecting output and income level
AD = C + I
Aggregate
Demand (AD)
C=aY+b
ADr
a: marginal propensity to
consume
b: autonomous consumption
I
S = Y - C = (1-a) Y - b
b
1-a
marginal propensity to save
45°
45°
Y=C+I=C+S
Yr
Income, output (Y)
Equilibrium: if and only if plans coincide
Patrick GOUGEON, ESCP-EAP
Factors affecting output and income level
Aggregate
Demand (AD)
Unplanned investment
(inventories)
ADr
C=aY+b
ADp
Planned
consumption
ADp = Cp + Ip < Yp
Ip planned investment
b
45°
45°
Yp
Firms will reduce the
output until the
equilibrium is reached
Patrick GOUGEON, ESCP-EAP
Income, output (Y)
Factors affecting output and income level
The multiplier
What will be the final impact of an additional investment (+100) ?
(Marginal Propensity to Consume = 80%)
S: 20
+ 100
C: 80
S: 16
S: 12.8
…….
C: 64
C: 51.2
…….
MULTIPLIER = 1/ 1-MPC = 1/MPS
Patrick GOUGEON, ESCP-EAP
Final dY
100/(1-0.8) = 500
An exercise on tax policy...
Consider the following situation:
Y: income = output
Consumption function is: C = 0.8 Y + 50
Autonomous investment: I = 100
1/ If there is no government intervention (no taxes, no government expenditures),
determine the equilibrium output
2/ If the level of output compatible with full employment is 1000 how much should
the government spend to reach this objective ? (without collecting taxes)
3/ If we now consider that government spending should be funded by tax receipts,
what should be the tax rate (t) to attain the level of output compatible with full
employment ?
4/ Keeping the objective of full employment, without budget deficit, what should
now be the tax rate if we assume a positive impact of government intervention on
anticipation with an autonomous investment moving upwards to reach 120 ?
An exercise on tax policy...
Consider the following situation:
Y: income = output
Consumption function is: C = 0.8 Y + 50
Autonomous investment: I = 100
1/ If there is no government intervention (no taxes, no government expenditures),
determine the equilibrium output
we need to have:
AG=C+I=Y 
0.8 Y + 50 + 100 = Y

Y = 750
An exercise on tax policy...
2/ If the level of output compatible with full employment is 1000 how much should
the government spend to reach this objective ? (without collecting taxes)
We now need to have :
AG = C + I + G = Y = 1000

G = 50

0.8 (1000) + 50 + 100 + G = 1000
We can observe that:
D Y = 250 = G / (1 – c) = 50/ (1-0.8)
where 1/(1-0.8) = 5 is the multiplier
Factors affecting output and income level
Aggregate
Demand (AD)
+50
1000
C = 0.8 Y + 50
+ 250 = 50 / (1-0.8)
750
I = 100
b
45°
45°
750
1000
Income, output (Y)
An exercise on tax policy...
3/ If we now consider that government spending should be funded by tax receipts,
what should be the tax rate (t) to attain the level of output compatible with full
employment ?
lets note t the income tax rate, then we must have:
AG = C + I + G = 1000
With:
C = 0.8 (1-t) 1000 + 50
I = 100
G = t x 1000
We obtain: t = 25%
We can observe that:
Tax receipts = 250 
DC
= - 200
G
= +250
Global impact = + 50
Multiplier = 1/(1-0.8) = 2  Final impact on AG = 5 x 50 = 250
An exercise on tax policy...
4/ Keeping the objective of full employment, without budget deficit, what
should now be the tax rate if we assume a positive impact of government
intervention on anticipation with an autonomous investment moving upwards to
reach 120 ?
Following the same method with I = 120, we need to have:
0.8 (1-t) 1000 + 50 + 120 + 1000 t = 1000 
t = 15%
The tax rate can be reduced because of an increase in Investment
With a multiplier = 5 the final impact on aggregate demand can be divided into two
components:
The tax effect:
tax receipts = 150

change in consumption = - 120
G = + 150
D = + 30
Total impact on AG = + 30 x 5 = 150
The investment effect:
Additional investment = 20

Total impact on AG = 20 x 5 = 100
Adding up both we obtain a 250 increase in aggregate demand needed to achieve full
employment
Consumption, saving & investment
Role of Financial intermediairies
money
Financial
assets
SAVING
Provide information
Create liquidity
Demand for money
Financial
market
Listed assets :
shares, bonds,...
Sight deposits,time deposits
Insurance policies,...
Financial
intermediairies
banks, insurance firms
Pension funds...
Credits, seed capital,…
Prof. Patrick GOUGEON, ESCP-EAP
The globalisation trend: a European perspective
Understanding the balance of payments
Items
Current accounts
Goods
Services
Investment income
Transfers
Balance
Trade balance
Balance of goods
and services
Current accounts
balance
Capital account
Direct investment
Portfolio investment
Others
Official Settlements
Basic Balance
Monetary Position
Adjustment
Expression of Aggregate Demand: AD = C + I + G + (X - M)
Prof. Patrick GOUGEON, ESCP-EAP
Government intervention: growth vs inflation
Exchange rate policy
€/£
Demand € (= supply of
value of’1 €
in £
Market
exchange
rate
£ against €)
Supply € (= demand for de £ against €)
What if the the basic
balance is on deficit?
Stabilisation
supply of currencies by the
cantral bank or increase in
interest rates
Net supply of € to
compensate for the
global deficit
Risk of depreciation
Quantity
Prof. Patrick GOUGEON, ESCP-EAP
Government intervention: growth vs inflation
Exchange rate determination:
“Purchasing Power Parity” (ppp) theory
Europe
Exchange rate
Japan
1 € = 125 Yens
Inflation
1%
4%
Evolution of 100 € purchasing power if the exchange rate if fixed
Beginning of the year……….... 100 € ………………………….…12500 Yens
End of the year ……….. 100/1.04 € ………………………...…12500/1.01 Yens
96.15 (- 4%)
12376 (-1%)
(remark: at the same time the purchasing power of 1 yen has decreased by 4% in Europe but 1% only
in Japan
ADJUSTEMENT
devaluation of 3%
100 € = 12500/1.03 = 12136 Yens
(real exchange rate)
Purchasing power of 100 € in Japan = 12136/1.01 Yens
That is: 1201 (-4%, as in Europe)
Purchasing Power Parity is restored
Prof. Patrick GOUGEON, ESCP-EAP
Government intervention: growth vs inflation
Interest rate - Exchange rate - Inflation
An increase in interest rate is expected to attract
capital flows and limit the risk of a devaluation
Exchange rate
Interest rate
Conclusion
Purchasing Power Parity
theory:
high inflation is likely to
weaken the currency
if a country intends to
maintain its exchange rate,
the interest rate needs to be
adjusted accordingly
Anticipated inflation is
included in the interest rate
iInflation rate
Prof. Patrick GOUGEON, ESCP-EAP
The globalisation trend: a European perspective
Exchange rate movements and pricing
Assumed automatic correction
And real life !
Trade deficit
Devaluation
Cheaper
Exports
Exports
Increase
more expensive
Imports
Imports
decrease
Deficit reduced
(the economist)