Powerpoint class 1 International Macroeconomics

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International macroeconomics
Thomas Lagoarde-Segot, PhD, HDR
Grading 
Macroeconomic simulation report
15%
Class assignments
35%
Individual exam
50%
TOTAL
100%
Macroeconomic simulation report: an analysis of your results on Macsim2
Theoretical cases : answers to class assignments 
The individual exam is a take-home essay
All need to be submitted in hard copy only by February 15th 
 
Overview 
 
Session 1 to 6: classes and assignment. Topics covered:
Introduction to macroeconomic aggregates
The labor market: wages, prices and unemployment
Policy and economic fluctuation
The open economy: understanding exchange rates
The goods market and the open economy
Interest rates
Session 7 to 9: macroeconomic simulations with MACSIM 2
Recommended textbooks: 
 Macroeconomics (Blanchard, Pearson)
Politiques macroéconomiques (Brillet, Cette, Gambini, Lagoarde-Segot, De Boeck, 2014)
 
Macroeconomic aggregates
5
Words such as production, unemployment and inflation are frequently used to describe or comment the economy
They constitute the three fundamental concepts of macroeconomics
Therefore, we must understand precisely what they mean, and how they are measured to become statistical aggregates
We will then be able to analyze the economic factors that determine the value of these statistical aggregates
Introduction
Aggregate production
7
French physiocrat François Quesnay designed an ‘economic table’ in 1759 which was the first global representation of the functioning of the economy
Physiocrats believed that an economy’s power derived from its agricultural sector
He divided the economy into 3 classes: landowners, farmers, and others, called "sterile" classes, who consumed everything they produced and left no surplus for the next period
In Tableau Economique, he detailed his famous zigzag diagram, a circular flow diagram of the economy that showed who produced what and who spent what.
This table was the first intellectual attempt understand and explain the causes of economic growth
Aggregate production
8
9
This approach lacked a clear method to estimate the income of France. It relied on partial information such as production of wheat, steel, or retail sales…
In fact it was not before the end of WWII that national accounting systems were put in place in developed countries. 
Two economists received Nobel prizes for their contributions to national accounting: Simon Kuznets (1971), Richard Stone (1981)
Indicators of aggregate production have been published since the end of the 1940s. Earlier data is available but has been constructed retrospectively
Aggregate production
10
Gross domestic product (GDP) is the measure of an economy’s aggregate production. There are three ways to conceive GDP:
GDP is equal to the monetary value of the final goods and services produced by an economy over a given period
GDP is equal to the sum of the value added generated by an economy in a given period
GDP is equal the sum of incomes distributed in the economy during a given period
Let us have a look at each of these definitions
GDP, added value and income
11
Consider definition 1: GDP is the monetary value of final goods and services produced by an economy in a given period.
The important word here is ‘final’. Consider the following example of an economy consisting of only two firms:
Firm 1 produces steel and firm 2 manufactures cars
Firm 1 sells its output for 100 euros to firm 2. It pays 80 euros in wages, leaving a profit of 20 euros
Firm 2 sells cars for 210 euros. Deducting the cost of steel (100 euros) and wages (70 euros), this leaves a profit of 40 euros
GDP, added value and income
12
GDP, added value and income
Steelfirm(firm1)
Turnover
100 euros
Expenses
80euros
Profit
20 euros
Car manufacturer (firm2)
Turnover
210 euros
Expenses
170 euros
Ofwhich:Wages
70 euros
Ofwhich:Purchaseofsteel
100 euros
Profit
40euros
What is the economy’s GDP?
13
GDP, added value and income
Steelfirm(firm1)
Turnover
100 euros
Expenses
80euros
Profit
20 euros
Car manufacturer (firm2)
Turnover
210 euros
Expenses
170 euros
Wages
70 euros
Purchaseofsteel
100 euros
Profit
40euros
The GDP is the value of final goods produced: 210 euros
14
Steel is an intermediary good used in the production of a final good (cars)
It is not included in the calculation of GDP, which measures the value of the final product
To understand this, assume the two companies merged. We would be let with one company with a turnover of 210 euros, paying 150 euros in wages (80 euros + 70 euros) and making a profit of 60 euros (20 euros + 40 euros)
GDP would be unchanged.
Note that GDP includes all the incomes generated and distributed in the economy during a given period
GDP, added value and income
15
Consider definition 2: GDP is the sum of value added generated by an economy in a given period
A firm’s value added is the value of its production minus the value of intermediary consumption.
Consider our former example:
Firm 1 produces steel and has no intermediary consumption. Its value added is equal to the value of its production: 100 euros 
Firm 2 purchases steel and manufactures cars. Its value added is equal to the value of cars minus the value of steel: 210-100 = 110 euros
Adding up value added yields our previous result: 100 +110 = 210 euros
GDP, added value and income
16
Consider definition 3: GDP is the sum of incomes distributed in the economy in a given period
GDP can also be constructed by aggregating revenues (rather than production). The income generated by our two firms is distributed as follows:
Indirect taxes on sales: 0 euros
Wages: 80 euros + 70 euros
Profit (i.e. dividends): 20 euros + 40 euros
Therefore, the economy’s value added can also be obtained by adding up the value of indirect taxes, wages and capital income
Adding up revenues yield GDP = (80 + 70) + (20 + 40) = 210 euros
GDP, added value and income
 Titre du document - page 17
Distribution of income at current market prices in EU countries, 2016
18
 The GDP of France was 65 billion euros in 1963, versus 2 000 billion euros today
Does it mean that production was multiplied by 31 ? No!
We must distinguish nominal GDP from real GDP
Two factors contribute to the growth of nominal GDP : (i) increasing prices, (ii) increasing production. Take the following example:
Nominal GDP has increased by 44% between 2013 and 2014
One cannot tell whether this is due to increases in production or prices
Nominal GDP versus real GDP
Year
Production
Prices
NominalGDP
2013
10cars
10 000 euros
100 000 euros
2014
12 cars
12 000 euros
144 000 euros
2015
13 cars
13 000 euros
169 000 euros
19
The real GDP concept eliminates price effects.
It is defined as the sum of final goods produced multiplied by a constant price (rather than a current price)
 Consider our former example. Taking 2014 as the base year:
Nominal GDP versus real GDP
Year
Production
2014prices
Real GDP
2013
10cars
12 000 euros
120 000 euros
2014
12 cars
12 000 euros
144 000 euros
2015
13 cars
12 000 euros
156 000 euros
Real GDP has increased by 20% between 2013 and 2014
This corresponds to an actual increase in production (+20%)
The GDP growth rate corresponds to the growth of real GDP between year t and t+1:
A positive real GDP growth is called an expansion
A negative real GDP growth (for more than two quarters) is called a recession
GDP growth rate
22
Different factors make firms purchase equipment, households purchase food, or governments invest in public infrastructures
To analyze the determinants of economic growth, one must decompose GDP per type of product and type of buyer:
The determinants of GDP
Thedecompositionof French GDP (last quarter of 2016)
Billioneuros
GDPshare(%)
GDP (Y)
556
1.Consumption(C)
285.4
51.3%
2.Investment(I)
101.8
18.3%
3.Governmentexpenses(G)
171.6
30.8%
4.Currentaccount(CA)
-10.4
-1.87%
Exports
162.9
Imports
173.3
5.Inventories
7.5
1.34%
23
Macroeconomists use the following equation to analyze GDP:
Y is GDP
C is consumption: goods and services purchased by households (food, holidays, cars...)
I is ‘fixed capital investment’: equipments purchased by corporations and household real estate investment 
G is ‘government expenses’: purchases of goods and services by the government. Includes all expenses (from office furniture to war planes etc..) 
 The value of public services (which actually cannot be measured) is estimated at their cost
CA is ‘the current account’: difference between the value of exports and the value of imports. If CA is positive, there is a trade surplus, otherwise, there is a trade deficit.
The determinants of GDP
 Titre du document - page 24
Unemployment
25
The unemployment rate (u) is defined as the ratio of unemployed workers (U) over total active population (L):
Total active population (L) is the sum of number of employed and unemployed workers:
The unemployment rate depends on the number of unemployed workers, and hence on the definition of unemployment
Counting people registered in employment offices is insufficient to compute unemployment
According to the International Bureau of Labor Statistics: an unemployed worker is an individual who (i) does not have a job and (ii) is actively searching for one
Those who are not searching for a job (i.e. students, stay-home mums, discouraged workers) are excluded from the total active population (L), and hence not counted as unemployed
There is a distinction between and the unemployment rate and the participation rate
Unemployment
Economists agree that there is a negative relationship between unemployment and economic growth: (the Okun law (1962)
Unemployment and economic growth
 Titre du document - page 27
Inflation
28
Inflation is a sustained increase in aggregate prices. It is often expressed in percent point (the inflation rate). There are two main inflation indicators:
The GDP deflator, defined as the ratio of nominal GDP to real GDP during a given year:
The consumer price index (CPI), which gives the average price of a ‘representative basket’ of goods and services
The GDP deflator and the consumer price indices are both indices (equal 1 at the base period) and are usually correlated
However, they can differ when inflation is imported (e.g. oil shock): the GDP deflator only takes domestic goods into account
Inflation
Inflation
30
Economists care about inflation for several reasons:
Inflation does not affect all economic agents in the same way. For instance, pensions are not inflation-adjusted. Inflation has an impact on the distribution of income
 For instance, the 1990’s Russian hyperinflation had a dramatic effect on the elderly due to the collapse of the real value of pensions
Inflation does not affect all prices equivalently: some prices are regulated (e.g. energy prices), some are not. Therefore inflation modifies the system of relative prices and generates higher uncertainty
Economists agree that a negative relationship between inflation and unemployment exists in the short run (the Philips curve)
Inflation
 Titre du document - page 31
To understand what determines GDP, unemployment and inflation, economists distinguish the short, middle and long run
In the short run, factors affecting the demand of goods and services determine GDP (taxes, investment, household confidence, interest rates...)
In the middle-run, innovation matters (technologies, capital stock, labor force skills...)
In the long run, economic development depends upon a country’s ability to generate innovation (education system, quality of the legal system, quality of governments...)
In this class, we will focus on the short and middle run.
Conclusion: short run vs. middle run and long run
 Titre du document - page 33
International accounting interdependencies
35
Macroeconomic equilibrium
 
 
Y = Gross Domestic Product (GDP)
C = Private consumption
I = Private investment
G = Government spending
CA = current account (exports X – imports M)
Macroeconomic demand
Real GDP
36
 
 
Y = Gross Domestic Product
C = Private Consumption
S = Savings
T = Taxes
Uses of macroeconomic income
Real GDP
Macroeconomic equilibrium
37
 
The current account is equal to the sum of a country’s private sector and government financial position 
A trade deficit (CA<0) indicates the presence of public debt [(T-G)<0] and/or private debt [(S-I)<0]
A trade surplus (CA>0) indicates the presence of public savings [(T-G)>0] and/or private savings [(S-I)>0]
The “twin deficit hypothesis”
 Titre du document - page 38
The “twin deficit hypothesis”
39
 
For the current account to be at equilibrium (CA = 0), private savings and government savings must compensate each other
For instance, if private savings are positive [(S-I)>0] the necessary condition for an equilibrated trade balance is that the government posts a deficit (otherwise the country will post a trade surplus)
For instance, if private savings are negative [(S-I)<0] the necessary condition for an equilibrated trade balance is that the government posts a surplus (otherwise the country will post a trade deficit)
International interdependencies
Historical example: the 1980’s
Country
Privatesavings
(S-I)
Public balance
(T-G)
Trade balance
(CA)
USA
-1.1
-2.4
-3.5
Japan
2.9
0.7
3.6
EuropeanEconomicCommunity
4.2
-3.5
0.7
Source: OECD, 1987. All numbers expressed as a % of GDP.
 The USA posted a trade deficit (-3.5) which we can relate to the public deficits of the Reagan administration (-2.4)
 Japan posted a trade surplus (3.6) which we can relate to high private savings (2.9)
 The European Economic Community (EEC) posted a near trade equilibrium (0.7)
Historical example: the 1980’s
Country
Privatesavings
(S-I)
Public balance
(T-G)
Trade balance
(X-M)
USA
-1.1
-2.4
-3.5
Japan
2.9
0.7
3.6
EuropeanEconomicCommunity
4.2
-3.5
0.7
Source: OECD, 1987. . All numbers expressed as a % of GDP.
 The USA blamed Japan’s trade surplus (3.5) for their own trade deficit (-3.5)
 Europe blamed Japan’s excess savings (2.9) for sluggish international growth
 Japan answered that its trade surplus (3.6) was a consequence of the USA’s ‘twin’ public deficit (-2.4) and trade deficit (-3.5)
42
 
While each view is correct from an accounting point of view, however the accounting approach does not tell us about the direction of causality:
Was it the domestic US public deficit that caused US trade deficit, and the Japanese surplus ? (that was the view of the Japanese government)?
Or, was it the Japanese excess savings and that causes their trade surpluses, and hence the US trade and public deficit? (that was the view of the US government)
Economists agree that all mentioned factors played a role
Historical example: the 1980’s
Assignment