How Does an Economy Work?

1. How Does an Economy Work? The Macro-Economics of European Economies MSc in Economic Policy Studies John FitzGerald, January 2015

2. Course Outline • How does an economy work? JF 16-1-2015 • The genesis of macroeconomics AM 23-1-2015 • Modern macroeconomics AM 30-1-2015 • Banks and financial markets AM 6-2-2015 • The recent crisis AM 13-2-2015 • The labour market JF 20-2-2015 • Fiscal Policy and forecasting JF 6-3-2015 • Trade JF 13-3-2015 • The economics of global warming JF 20-3-2015 • The future of the Irish economy AM and JF 27-3-2015

3. Outline of Lecture • Theory • Different “markets” • A model of the economy • Equilibrium and Disequilibrium • Market “Imperfections”, Expectations, Behaviour • Applied - examples from 2000-15 • The EU and the US economies • Disequilibria in EU economies • How economies adjust

4. Different Markets • Useful to consider the economy as a series of markets • The Goods (and Services) market • Money / Financial Markets • Labour Market • Housing Market • Government sector • These markets are interlinked – a “model” of the economy • For equilibrium in the economy the markets must be consistent

5. The Goods market - 1 • Demand for Goods (and Services) • C+I+G : Closed economy • C+I+G+X : Open economy • C=Private Consumption; I= Investment; G= Government consumption; X=Exports • Supply of Goods (and Services) • Y : Closed economy • Y+M : open Economy • Y = Domestic Output; M=Imports • Disequilibrium? • Inflation, Current account of the balance of payments • Imperfections?

6. The Goods market - 2 • Y=C+I+G (+X-M) • Y= GDP, output = expenditure = income – demand for goods (and services) • Y=Q • Q= National output – supply of goods (and services) • C=a + b(Y - T) • T=Government revenue; a and b are coefficients, where b is 0<b<1 • Y=a + bY – bT + I + G + (X - M) • Y(1-b)= a + I + (X - M) + G - bT • Assumes output will respond to an increase in demand • is the “multiplier”

7. The Goods market - 3 • S=Y-C-T • S= Savings • Y=C+I+G+(X-M) • Y-C-T=S=I+(X-M)+(G-T) • S+(T-G)=I+(X-M) • Total savings equals investment plus the current account surplus • What happens if people want to save more?

8. The Goods market - 4 • Growth? • Output is a function of inputs and productivity • Inputs: labour, capital, materials • Investment increases capital and hence the productive potential of economy • Investment in human capital (education) increases productivity of labour • Investment in R&D may raise productivity of all factors • Q= Y = a function of K,L,M, productivity • The stock of capital labour and materials determines potential output • However, how much will it be profitable to produce?

9. The Goods market - 5 • Profits=P*Q-W*L-Pk*K-Pm*M where firms maximise profits • P= price of output; W= price of labour; L= employment; Pk= price of capital; K= capital stock; M = materials; Pm= price of materials • This means that output doesn’t automatically adjust to meet demand • Open economy: is it profitable to produce in Ireland? • If it is, how much labour, capital and materials will you need? • Competitiveness matters • In the long run it is through raising output that living standards rise. • Raising demand on its own may not lead to increased output. • e.g. Irish government policy in 1977-1979 • Imperfections?

10. Money / Financial markets • Demand for Money • Need money to buy and sell • Affected by cost - credit • Supply of Money • Central Bank can create money • Banks extend credit based on their stock of money • Disequilibrium? • e.g. inflows on financial account of the balance of payments • Imperfections? • e.g. Expectations – drive bubbles

11. The Labour market • Labour Demand • How profitable are firms – what happens to output • Cost in home country relative to foreign determines share of world output • Price of labour (labour costs), price of capital, price of materials • Openness of economy affects behaviour • Labour Supply • Demographics, Wage Rates, Costs of working, Value of leisure, Culture • Openness of economy affects behaviour - migration • Equilibrium – Disequilibrium • Unemployment rate, rate of wage inflation • Imperfections?

12. The Housing market • Demand – factors driving demand • Demographics – natural increase • Income / wealth • Cost – user cost, a function of interest rates, expected prices • Supply – factors driving supply • Profitability of building – price relative to costs • Costs – labour, materials, land • Disequilibrium • How to measure it? • Rate of price increase? • Imperfections?

13. Government Sector • Revenue and Expenditure • Revenue • Economic costs of taxation • Economic impact of taxation • Other Revenue • Expenditure • Government Consumption • Government Transfers • Subsidies • Investment • Measure of imbalance – Deficit or Surplus • Debt - sustainability

14. A model of the economy • An equilibrium solution for economy requires equilibrium in all markets • Markets are interlinked. • Linked by many variables: • Interest rates, wage rates, prices, etc. etc. • How will economy adjust to exogenous changes? • e.g. changes in budget, changes in oil prices, changes in monetary policy • How can governments influence growth? • Importance of the supply side

15. Equilibrium, Disequilibrium • May be out of long-term equilibrium. e.g. • Running an increasing current account deficit – demand > output • Inflation high and rising (prices and wages) • Unemployment high • Will economy return to equilibrium of its own accord? • Possibility of multiple equilibria • What is the role of government? • Adjustment takes time • Time to invest, to change output, to change expectations • Never actually in equilibrium

16. Market Imperfections, Expectations, Behaviour • Market imperfections e.g.: • Monopolies / oligopolies: make more from lower output • Adjustment takes time e.g. investment • SME’s cannot finance themselves because of financial sector difficulties • Unions and employer cartels may affect wage bargaining • Restrictions on supply of building land may affect housing supply • Can Government improve the situation? • Expectations e.g. • People have economic “models” in their heads. These models may or may not be correct • Consumption affected by lifetime income – what is lifetime income? • Expect a rise in house prices – get on the property ladder! • Behaviour • In chemistry H2O always combine like that. • No such certainties with human behaviour. History rarely repeats itself.

17. Applied • Europe and the US 2007 • Goods market – Current account of the balance of payments and inflation • Money market – interest rates, nominal and real • Labour Market – unemployment and wage inflation • Housing Market – was there a housing market • Europe and the US 2015 • Goods market – Current account of the balance of payments and inflation • Money market – the “zero lower bound” • Labour market – out of equilibrium – will it return to full employment? • Housing market – EU economies and the US • The investment question

18. Current account of Balance of Payments - 1

19. Long-term real interest rates - 1

20. Rate of inflation - 1

21. House Price Inflation - 1

22. Government Borrowing - 1

23. Debt – GDP ratio - 1

24. Current account of Balance of Payments - 2

25. Long-term real interest rates - 2

26. Rate of inflation - 2

27. Government Borrowing - 2

28. Debt – GDP ratio - 2

29. Individual Countries in EU • Look at 3 examples of problems and adjustment • Latvia • Spain • UK

30. Latvia – current account of BOP

31. Latvia – rate of inflation • Consumer prices, nominal wages and house prices.

32. Latvia – real interest rate

33. Latvia – Investment share of GDP • Housing, building and construction and total

34. Latvia – exports share of GDP

35. Relative wage rates • Wage rates in a common currency to base 2000=100: • Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

36. Latvia – unemployment rate

37. Latvia – government borrowing as % of GDP

38. Latvia – Debt as % of GDP

39. Latvia – Conclusions?

40. Spain – current account of BOP

41. Spain – rate of inflation • Consumer prices, nominal wages and house prices.

42. Spain – real interest rate

43. Spain – Investment share of GDP • Housing, building and construction and total

44. Spain – exports share of GDP

45. Relative wage rates • Wage rates in a common currency to base 2000=100: • Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

46. Spain – unemployment rate

47. Spain – government borrowing as % of GDP

48. Spain – Debt as % of GDP

49. Spain – Conclusions?

50. UK – current account of BOP