The Economic Picture Understanding the global economy Prof. Patrick GOUGEON, ESCP-EAP Understanding...

The Economic PictureUnderstanding the global economy

Prof. Patrick GOUGEON, ESCP-EAP

Understanding the economic system:“The circular flow”

Understanding the economic system:“The circular flow”

Production, technology & employment:GDP growth , technological change,

productivity and labour

Production, technology & employment:GDP growth , technological change,

productivity and labour

Consumption, saving & investment:Determinants of consumption & saving,

role of financial institutions

Consumption, saving & investment:Determinants of consumption & saving,

role of financial institutionsGovernment intervention: growth vs inflation

Fundamentals of budget, monetary & foreign exchange policy

Government intervention: growth vs inflationFundamentals of budget, monetary & foreign

exchange policy

The globalisation trend: a European perspectiveFacts & figures, growing importance of emerging

economies, the threat of US deficits

The globalisation trend: a European perspectiveFacts & figures, growing importance of emerging

economies, the threat of US deficits

Understanding the economic system: the “circular flow”

FirmsFirms

HouseholdsHouseholds

AggregateDemand*

AggregateDemand*

Consumption (c)

Income(Y)

FinancialInstitutions

FinancialInstitutions

Saving (S)

Investment (I)

GovernmentGovernment

Export (X)Import (M)

InternationalCapital flows

Privatetransfers

Publictransfers

Self financing

*Aggregate demand = C+I+G+X-M

G

p

q

OD

market


FIRM

Creation,Processing

Creation,Processing

Intermediategoods

SuppliersUpstream markets

Sales

ClientsDownstream markets

Value Added = Sales – Cost of Intermediate goods

To be shared between all participantsTo be shared between all participants

FIRMSSource of value

GDP (Gross Domestic Product) = Total value added = Total Income

Production, technology & employment


Sharing Value Added …..Sharing Value Added …..

Employees (wages)

Government (Taxes)

Creditors (interest)

Shareholders

€

Dividends self financiang

� Net Profit� allowances for depreciation



EU: GDP per capita

GDP per Capita (PPS, EU25=100, estimates 2004)source: Eurostat

31,2 31,7

47,4 48,5 51,2 51,5

62,069,9

78,173,3

81,6

96,2

106,2 108 110,3 113,4 115,1 116,2 118,5 120,1 120,9 124,4130,8

0,0

20,0

40,0

60,0

80,0

100,0

120,0

140,0

RO BG LV LT EE SK HU CZ SN PT GR ES IT DE FIN FR SW BE NL UK AT DK IRE

Incoming countries EU 15



TRENDS

• Substitution of Capital for Labour• Labour heterogeneity• International differences in labor cost• Service activities are growing in importance



comments on productivity

Productivity

0

20

40

60

80

100

120

140

BE DK DE GR ES FR IRE IT NL AT PT FI SW UK JP US

per pers. employed

per hour worked

Labour productivity with reference to GDP in Purchasing Power Standards (PPS) per person employed relative to EU-15 (EU-15 = 100) , year 2003 (Eurostat)



comments on productivity

A productivity primer; Nov 4th 2004 ;From The Economist print editionA productivity primer; Nov 4th 2004 ;From The Economist print edition



comments on labour costs



From the economist

Comments on working hoursProduction, technology & employment


From the economist

Saving & consumption:importance of the age structure

Age

Income, Consumption

Income

C

BorrowingPhase

Saving phase

Capital consumption

Retirement

Consumption, saving & investment


Age

Income, Consumption

Income

C

BorrowingPhase

Saving phase

Capital consumption

Retirement

Households saving and investment

0

Net saving

Net Debt

45-50

Capital tobe transferred

Investmentsaving



Population Structure: few comparisonsConsumption, saving & investment


Saving rates:what they tell us

Saving rates:what they tell us

Anglosaxon entrpreneurial optimism

Euro anxiety



From the economist

Comparing UK and France

Households debt*

UK: 120%France: 60%* As % of total disposable income, OECD

Households debt*

UK: 120%France: 60%* As % of total disposable income, OECD

Public debt*

UK: 39.8%France: 63.7%* As % of GDP, Eurostat

Public debt*

UK: 39.8%France: 63.7%* As % of GDP, Eurostat


Prof. Patrick GOUGEON, ESCP-EAPFrom the economist

And Germany

Money supply: a summary

M V = P Q

Quantity of money

Velocity

Price level

Real value oftransactions

Quantity of money : 100, three agents A B C

exchanges:A - B : 100B - C : 100C - A : 100

Total value of transactions:300

= M x V 100 3

Cash in circulation outside banks+ sight deposits at bank

= M1+ other types deposits

= M2, M3, M4

Cash in circulation outside banks+ sight deposits at bank

= M1+ other types deposits

= M2, M3, M4

A basic equation:

Government intervention: growth vs inflation


Factors affecting output and income level

AggregateDemand (AD)

Income, output (Y)

45°

45°

C = a Y + b

a: marginal propensity to consumeb: autonomous consumption

S = Y - C = (1-a) Y - b

1 - amarginal propensity to save

b

I

AD = C + I

Y = C + I = C + S

Yr

ADr

Equilibrium: if and only if plans coincidePatrick GOUGEON, ESCP-EAP



Income, output (Y)

45°

45°

C = a Y + b

b

Ip planned investment

Yp

ADr

Planned consumption

ADp = Cp + Ip < Yp

Unplanned investment(inventories)

Firms will reduce the output until the

equilibrium is reached

ADp

Patrick GOUGEON, ESCP-EAP


The multiplierWhat will be the final impact of an additional investment (+100) ?

(Marginal Propensity to Consume = 80%)

+ 100S: 20

C: 80 S: 16

C: 64S: 12.8

C: 51.2…….

……. Final dY100/(1-0.8) = 500

MULTIPLIER = 1/ 1-MPC = 1/MPS

Patrick GOUGEON, ESCP-EAP

An exercise on tax policy...

Consider the following situation:

Y: income = outputConsumption function is: C = 0.8 Y + 50Autonomous 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 ?


Consider the following situation:

Y: income = outputConsumption function is: C = 0.8 Y + 50Autonomous investment: I = 100

1/ If there is no government intervention (no taxes, no government expenditures), determine the equilibrium output

we need to have:

A G = C + I = Y 0.8 Y + 50 + 100 = Y Y = 750


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 0.8 (1000) + 50 + 100 + G = 1000 G = 50

We can observe that:

Y = 250 = G / (1 – c) = 50/ (1-0.8) where 1/(1-0.8) = 5 is the multiplier



Income, output (Y)

45°

45°

C = 0.8 Y + 50

b

I = 100

750

+50

1000+ 250 = 50 / (1-0.8)

750 1000


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 = 1000With:C = 0.8 (1-t) 1000 + 50 I = 100G = t x 1000We obtain: t = 25%

We can observe that:Tax receipts = 250 C = - 200

G = +250 Global impact = + 50

Multiplier = 1/(1-0.8) = 2 Final impact on AG = 5 x 50 = 250


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 = + 30

Total impact on AG = + 30 x 5 = 150The 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

Role of Financial intermediairies

SAVINGSAVING Demand for moneyDemand for moneyFinancialmarket

Financialintermediairies

Financialintermediairies

banks, insurance firmsPension funds...

Sight deposits,time depositsInsurance policies,...

Credits, seed capital,…

Listed assets :

shares, bonds,...

moneyFinancialassets

Provide information

Create liquidity



Official Settlements

Adjustment

Understanding the balance of payments

Current accountsGoodsServices

Investment incomeTransfers

Capital accountDirect investmentPortfolio investmentOthers

Items Balance

Trade balance

Balance of goodsand services

Current accountsbalance

Basic Balance

Monetary Position

Expression of Aggregate Demand: AD = C + I + G + (X - M)

The globalisation trend: a European perspective


Exchange rate policy

Quantity

€/£value of’1 €

in £

Demand € (= supply of £ against €)

Supply € (= demand for de £ against €)

Market exchange

rate

What if the the basic balance is on deficit?

Net supply of € to compensate for the

global deficit

Risk of depreciationRisk of depreciation

Stabilisationsupply of currencies by the cantral bank or increase in interest rates



Exchange rate determination:“Purchasing Power Parity” (ppp) theory

Europe Japan

Exchange rate 1 € = 125 Yens1 € = 125 Yens

Inflation4%4% 1%1%

Evolution of 100 € purchasing power if the exchange rate if fixedBeginning of the year……….... 100 € ………………………….…12500 YensEnd of the year ……….. 100/1.04 € ………………………...…12500/1.01 Yens 96.15 (- 4%) 12376 (-1%)

Purchasing power of 100 € in Japan = 12136/1.01 YensThat is: 1201 (-4%, as in Europe)

ADJUSTEMENTdevaluation of 3%

100 € = 12500/1.03 = 12136 Yens100 € = 12500/1.03 = 12136 Yens

Purchasing Power Parity is restored

(real exchange rate)

(remark: at the same time the purchasing power of 1 yen has decreased by 4% in Europe but 1% only in Japan



Interest rate - Exchange rate - Inflation

Exchange rateExchange rate Interest rateInterest rate

An increase in interest rate is expected to attract capital flows and limit the risk of a devaluation

Inflation rateInflation rate

Anticipated inflation is included in the interest rate

Purchasing Power Parity theory:

high inflation is likely to weaken the currency

Conclusionif a country intends to

maintain its exchange rate,the interest rate needs to be

adjusted accordingly



Exchange rate movements and pricing

(the economist)

Trade deficit

Devaluation

Cheaper more expensive Exports Imports

Exports ImportsIncrease decrease

Deficit reduced

Assumed automatic correction And real life !

The globalisation trend: a European perspective

The Economic Picture Understanding the global economy Prof. Patrick GOUGEON, ESCP-EAP Understanding...

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