Two Economic Challenges

1. Two Economic Challenges 1) Slow GDP Growth 2) Maintaining the Social Welfare System

2. What is GDP?Or, how do we measure the size of an economy? Gross domestic product (or GDP) is the total value of all the goods and services produced by an economy • Cars • Cappuccinos • iPods • Insurance policies • Haircuts The US is the world’s largest economy. It has the highest GDP If the euro area is counted as a single economy, it would be second largest

3. How can we compare the standard of living? GDP per capita – total GDP divided by the population size, tells you the average standard of living (how “rich” or “poor”) US GDP = $13 trillion. US Population = 300 million Luxembourg GDP = $25 billion Luxembourg Population: 0.5 million

4. Measuring GDP growth Nominal GDP growth Inflation Real GDP growth • Our GDP measure can increase because: • The economy produces more goods and services • The prices of goods and services increase • We are only interested in (a), the real increase! - =

5. Explaining differences in living standards Euro Area (15)United States (2008)(2008) GDP (USD billions) 14 043.78 14 294.5 Population (million) 320.1 305.5 GDP per capita (USD) 43 873 46 790 Employment rate 54% 62% Hours worked per employed person 1,600 1,781 Output per hour worked (USA = 100) 87 100

6. Does GDP per capita measure “quality of life”? Euro area GDP per capita is only 70% of US level, so the standard of living is lower in euro area on this measure • But Europe has: • Much longer holidays! • Slightly higher life expectancy • Notably lower infant mortality • Lower poverty and earnings inequality • Lower levels of crime and violent crime • Universal health care

7. How do we raise the rate of economic growth? If the economy is experiencing weak growth, sometimes the solution is to change macroeconomic policy and stimulate the economy. Imagine you are driving a car. • If you want to go faster, you step on the gas: • Monetary policy – reduce interest rates • Fiscal policy – cut taxes, raise government spending

8. Macroeconomic policy must avoid generating inflation But if policy is too loose, this can lead to higher inflation. This is like driving too fast and going into a skid. • Avoid a skid (ease off the gas and gently apply the brakes): • Monetary policy – raise interest rates • Fiscal policy – raise taxes, cut government spending

9. Driving at a safe speed: the potential growth rate The rate at which an economy can safely grow without triggering higher inflation is called the potential growth rate. This rate will differ between economies. € area: 2% to 2.2%? US: 2.5% to 3%? The potential growth rate depends on the growth of the labor force as well as productivity growth. Higher employment rates, longer hours worked and more productive workers all help to raise the potential growth rate.

10. Productivity is a key determinant of long-term growth Productivity – a measure of how much each worker produces Marie-Claude Karl-Heinz • Marie-Claude designed 5 web sites • Karl-Heinz designed 8 web sites • Who is more productive? • Marie-Claude worked 200 hours • Karl-Heinz worked 400 hours • Now who is more productive? • Web sites designed per hour – Marie-Claude: 0.025, Karl Heinz: 0.020 • Marie-Claude has a higher hourly productivity than Karl-Heinz

11. Slow growth and high unemployment raise concerns In the recent past, Europe has suffered from slow growth, high unemployment and low productivity growth Labor and product markets less flexible than the US, harder to deal with economic shocks, globalization, etc Low productivity growth seems to stem from low investment in information and communications technology (ICT), less use of ICT relative to US, low R&D spending and relatively low workforce skills

12. The Lisbon Strategy* was adopted in 2000 to create a more dynamic and knowledge-based EU economy Initial results disappointing, Lisbon re-launched in 2005 with clearer focus Key objectives: raise R&D spending to 3% of GDP, raise employment rate to 70% by 2010 Structural reforms now contributing to better economic performance in Europe (higher productivity and employment rates), but more reforms needed, e.g. to cope with ageing The Lisbon Strategy: Europe gets a tune-up! *Also called Lisbon Agenda or Strategy for Growth & Jobs http://ec.europa.eu/growthandjobs

13. Challenge #2: Sustaining the “social welfare system” - What is a social welfare system? - Does Europe have one or many? - What does it mean to have a system that’s “sustainable”?

14. What is a social welfare system? Pensions Health care Unemployment benefits

15. Europe has many types of social welfare system high Rhineland: low employment, low inequality Scandinavian: high employment, low inequality unemployment benefits English-speaking: high employment, high inequality Mediterranean: low employment, high inequality low employment protection weak strong There are (at least) four different European models

16. Why is welfare system “sustainability” at risk? Europe is Ageing Rapidly! • The “old-age dependency ratio” will rise due to fall in birth rate, fall in death rate and retirement of “baby boomers” • 2000: Four people of working age for every one retired person • 2050: Only two people of working age for every retired person 16

17. Economic consequences of changing demographics • What happens to the economy when the working-age population shrinks? • EU growth rate will more than halve by 2050 (fewer workers) • Reduction in potential growth • Social model under stress (fewer taxpayers, more social spending, e.g. on pensions, health care, long-term care)

18. Sustaining the Social Welfare System Can Europe still afford its Welfare States? Does it need to adapt its social model?