The World Economy

1. The World Economy Gavin Cameron Oxford University April 2005

2. plan of the session • 16.30 Short-run Macroeconomics • 17.30 Discussion in groups of short-run issues • 18.00 Long-run Macroeconomics • 19.00 Discussion in groups of long-run issues • 19.20 Presentations • 19.50 Summary

3. short-run macroeconomics • What determines aggregate demand? • The unemployment-inflation trade-off • Monetary Policy • Fiscal Policy • The Open Economy • Global Macroeconomic Imbalances

4. 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’).

5. the circular flow of income

6. recent performance Source: CESifo Report on the European Economy 2005

7. 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.

8. 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.

9. inflationary pressure Source: CESifo Report on the European Economy 2005

10. 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.

11. 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).

12. recent loose monetary policy Source: CESifo Report on the European Economy 2005

13. …even on a real basis Source: CESifo Report on the European Economy 2005

14. 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.

15. 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?

16. 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.

17. breaking the rules? Source: CESifo Report on the European Economy 2005

18. 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.

19. 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.

20. the dollar weakens… Source: CESifo Report on the European Economy 2005

21. 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.

22. not much sign of a European recovery Source: CESifo Report on the European Economy 2005

23. 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.

24. 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 five-year 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.

25. 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.

26. a Japan style meltdown? • 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.

27. global policy • 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.

28. the world’s biggest hedge fund • 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 carry-trade’). • 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.

29. oil shocks I Source: CESifo Report on the European Economy 2005

30. oil shocks II Source: CESifo Report on the European Economy 2005

31. unemployment to remain high Source: CESifo Report on the European Economy 2005

32. Source: CESifo Report on the European Economy 2005

33. 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.

34. 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.

35. 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.

36. 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.

37. OECD macroeconomic performance

38. equilibrium unemployment labour supply workforce real wage equilibrium wage labour demand natural rate equilibrium employment employment

39. 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.

40. 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.

41. the target real wage target real wage labour supply real wage workforce feasible real wage employment

42. the NRU and the NAIRU target real wage labour supply real wage workforce feasible real wage natural rate employment NAIRU

43. 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.

44. 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).

45. 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’.

46. 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.

47. international labour productivity

48. 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

49. productivity growth in business Note: Growth of total factor productivity= Growth of output minus weighted growth of inputs

50. the Japanese TFP miracle