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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)