Powerpoint class 6

Esta é uma pré-visualização de arquivo. Entre para ver o arquivo original

International macroeconomics
Thomas Lagoarde-Segot, PhD, HDR
“The classical economists resemble Euclidean geometers in a non Euclidean world who; discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axioms of parallels and to work out a non Euclidean geometry”
J.M Keynes (1936), p.16
Introduction
 Back in the late 19th century and early 20th century mainstream economists concentrated on individual markets while ignoring the overall economic system within which those markets functioned
 Economists assumed that a good understanding of the system’s component parts would be sufficient for deigning policies and institutions necessary to support the economic system
 There was an implicit belief that the economy automatically tends to move towards a stable equilibrium where all workers who seek work are employed and firms sell everything they produce to willing buyers
 The Great Depression of the 1930 made it clear that the economy’s equlibrium could change quickly and drastically even though most of the component parts (capital stock, technololgy,..) changed hardly at all.
Introduction
 The Great Depression of the 1930’s shifted away economists’ priorites away from the component parts to how the overall system performed
 In The General Theory of Employment, Interest and Money (1936), Keynes presented a model that showed how the major components of the economy interacted to affect economic aggregates such as GDP and the level of employment
 This model explained why most of the world’s major economies were failing to achieve market-clearing equilibria in the product and labour markets
 It also showed that policymakers had the tools to do more than just wait for the markets to slowly adjust back towards full employment
Introduction
 Early versions of the Keynesian model (such as the one popularized by Hicks (1937) focused on the closed economiy
 This assumption may have been appropriate in 1936, but the post WWII economy was increasingly open to international trade investment and finance
 This weakness of the original Keynesian model was adressed by Fleming (1962) and Mundell (1963)
 We will analyze a simplified version of the model – by focusing on the international goods market (that is leaving aside the money market and the asset market)
The international product market
The demand for national goods
The demand for national goods is given by the following equation:
 The first three terms (C, I, and G) constitute the economy’s internal demand
 To obtain the demand for national goods, we need to :
Substract imports by multiplying the volume of imports by the real exchange rate ‘e’: 
 The real exchange rate ‘e’ is defined as the price of foreign goods in terms of domestic goods. Formula: e= λ*(P*/P) where P* is foreign price level, P is the domestic price level and λ is the nominal exchange rate
2. Add exports : the foreign demand for national goods
The determinants of internal demand
The economy’s internal demand can be broken down as follows:
 Consumption (C) is a positive function of household income (Y) net of taxes (T)
 Investment (I) is a positive function of production (Y) and a negative function of the real interest rate (r)
 The level of government spending (G) is exogenous
 This is a simplified version of the model discussed in the previous chapter
The determinants of imports
The import function can be written as:
 Imports (M) increase with income (Y): higher income increases domestic demand for foreign goods
 Imports (M) decrease with the real exchange rate (e): higher real exchange rate makes foreign goods more expensive relative to domestic goods
Remember that e is defined as the price of foreign goods relative to the price of domestic goods
The determinants of exports
The export function can be written as:
 Exports (X) increase with the level of foreign income (Y*): a wealthier foreign economy will purchase more national goods
 Exports (X) increase with the real exchange rate (e): domestic good become more competitive relative to foreign goods
 Remember that e is defined as the price of foreign goods relative to the price of domestic goods
Analyzing internal demand
 Internal demand is a positive function of domestic income (Y): 
 This is represented as the DD curve
The internal demand
Real GDP
Demand
v
The DD line shows that internal demand (C+I+G) is a positive function of production. The slope is lower than 45 degrees: 1 unit increase in real GDP increases international demand, but by less than 1 unit. One obvious reason is that households will choose allocate a portion of their income to savings rather than consumption.
(DD)
Analyzing the demand for national goods
 To get the demand for national goods we first need to substract imports from internal demand: 
 This is represented as the AA curve
 The distance between DD and AA represents the value of imports e.M
 Imports increase with income Y, so that the distance between DD and AA increases with income
From internal demand to the demand for national goods
Real GDP
Demand
v
The AA line shows the internal demand net of imports (M). The slope of AA is positive but more shallow than the slope of DD. This is due of the fact that when real GDP increases, one share of internal demand goes to foreign goods rather than domestic good. As a result the demand for national goods does increases, but less so than internal demand 
(DD)
(AA)
Imports e*M
Analyzing the demand for national goods
 To yield the demand for national goods we need to add exports: 
 The demand for national goods is represented by the ZZ curve
 Note that the level of exports (X) is unrelated to national income (Y)
 As a result the ZZ curve is parallel to the AA curve
Real GDP
Demand
v
The (ZZ) line shows the demand for domestic goods. Given that exports do not depend on national income, (ZZ) and (AA) are parallel. Net exports are represented by the distance between (DD) and (ZZ). When (ZZ) lies above (DD) net exports are positive. When (DD) lies above (ZZ), net exports are negative. It appears that net exports are a negative function of real GDP.
(DD)
(AA)
Exports (X)
(ZZ)
From internal demand to the demand for national goods
Analyzing the demand for national goods
 Other things equal, net exports (X-M) are negatively correlated with domestic income
 Indeed, when real GDP (Y) increases, imports (M) increase, but exports (X) are left constant
 There is a negative relationship between real GDP and the trade balance 
The demand for national goods and the trade balance
Real GDP
Demand
When real GDP is equal to Y1 : (ZZ) > (DD), net exports are positive. When real GDP increases to Y2 : (ZZ) = (DD), net exports are zero. When real GDP increases to Y3: (ZZ)>(DD), net exports are negative. Other things equal there is a negative relationship between real GDP and the trade balance.
(DD)
(AA)
(ZZ)
Net exports
Real GDP
(Y1)
(Y2)
(Y3)
The equilibrium product and the trade balance
 The goods market reaches an equilibrum level when the demand for national goods (ZZ) is equal to supply (real GDP (Y)):
 The nature of the equilibrium point can represented as the intersection between (ZZ) and a 45o line (where real GDP = demand)
 The equilibrium point corresponds to a value of net exports
 There is a relationship between the domestic goods market equilibrium and the trade balance
 
At the equilibrium point, the trade balance can be in surplus or in deficit
The equilibrium product and net exports
Real
GDP
Demand
The goods market reaches an equilibrium point A where real GDP is equal to the demand for national goods (Y*=(ZZ)). The equilibrium real GDP level determines the level of net export (which decreases with real GDP). In this example Y*>Y2, so that net exports are negative. 
(ZZ)
Net exports
Real GDP
450
(Y*)
Trade deficit
A
(Y2)
The impact of domestic stimulus on the trade balance
 The demand for domestic goods can be written as follows:
 The government may want to increase internal demand (C+I+G) in order to increase economic growth and reduce unemployment
 The most direct way to do this is through an increase in the level of public spending G
 This will increase the equilibrium product more than proportionnally due to the multiplier effect
Example: assume the government distributes 100 euros to households. Households save 10 euro, buy 20 euros of imported goods and purchase 70 euros of domestic goods from domestic firms. These 70 euros are then distributed as profits and wages. One portion of profits goes to investment, and one portion of wages goes to consumption. A new cycle begins. At the end of the day real GDP has increased more than 100 euros
Real GDP
Demand
 (ZZ)
450
 (ZZ’)
(Y*)
(Y**)
(ΔG)
A1
A2
A3
The international multiplier effect
(ΔY)
Government spending increases by (ΔG). The demand for national goods increases from (ZZ) to (ZZ’). The equilibrium shifts from A1 to A*. Real GDP increases from Y* to Y**. Real GDP increases more proportionally than public spending: (ΔY)>(ΔG). This effect is known as the international multiplier effect.
 
A*
The impact of domestic stimulus on the trade balance
 An increase in public spending will increase the equilibrium product more than proportionnally due to the multiplier effect
 Remember that when real GDP (Y) increases, imports (M) increase, but exports (X) are left constant
Other things equal there is a negative relationship between real GDP and the trade balance 
 Other things equal, an increase in public spending will thus also have a negative impact on the trade balance
Overall impact of an increase in public spending
Real GDP
Demand
An increase in public spending generates a higher real GDP and a trade deficit. The more open the economy, the lower the impact on real GDP and the higher the impact on the trade balance. For instance, the Belgian economy has an import to GDP ratio of 90%: when demand increases by 1, 10% goes to internal demand (small effect on real GDP) and 90% goes to imports (strong effect on trade deficit). 
(ZZ)
Net exports
Real GDP
450
(Y*)
Trade deficit
A
(Y2)
(ZZ’)
ΔG
A historical example: the French 1981-1983 stimulus program
1980
1981
1982
1983
FrenchGDPgrowth(%)
1.6
1.2
2.5
0.7
EuropeanGDPgrowth(%)
1.4
0.2
0.7
1.6
Budget
0
-1.9
-2.8
-3.2
Net exports
-0.6
-0.8
-2.2
-0.9
In 1981, the French Socialist Party won the Presidential election amidst high unemployment (7%). The elect government increased pensions, subsidized the private sector, created public sector jobs, and opened free training programs for young and unemployed workers. 
As a result economic growth increased sharply in 1982 (3 times above the European average). In the mean time, the trade balance deteriorated and the French franc lost 20% against the Deutsch Mark.
The alternative was either to leave the European Monetary System or to adopt a more restrictive budgetary policy. In 1983 a new government was formed and policy shifted to budgetary ‘austerity’. These policy orientation has remained the same ever since - regardless of the political orientation of governments
The impact of a foreign stimulus 
 When an expansion takes place in a foreign economy, its real GDP (Y*) increases
 As a result the demand for domestic goods increases given that exports X increase:
 The internal demand curve (DD) does not move 
 The demand for domestic goods (ZZ) shifts upwards
 Exports increase for any level of domestic product Y: therefore the net export curve also shifts upwards
 A foreign stimulus therefore generates an increase in the domestic product and a trade surplus
Domestic stimulus, equilibrium product and net exports
Real GDP
Demand
An increase in foreign demand increases domestic product (ZZ) to (ZZ’) and net exports (from (NX) to (NX’). and NX’>0 when domestic product is B); Real GDP increases from Y1 to Y2.
(ZZ)
Net exports
Real GDP
450
(Y2)
A
(Y1)
(ZZ’)
ΔX
(NX)
(NX’)
B
International macroeconomic coordination
Implications for international economic policy
 We have thus reached two key results:
An increase in internal demand induces higher real GDP at the cost of a trade deficit
An increase in foreign demand induces higher real GDP and a trade surplus
Governments are averse like trade deficits as they create public debt
They have a preference an increase in foreign demand to an increase in domestic demand
This ‘prisoner’s dilemma’ can have disastrous consequences
Consider a group of opening economies goind through a recession. Each country is reluctant to increase its public spending in order to avoid a trade deficit, and counts on the stimulus in other countries to bring back growth to their own domestic economy. As a result no stimulus program is implemented, and the recession goes on…
Implications for country strategy
 One way to avoid this vicous circle is to coordinate macroeconomic policies across countries
The increase in demand in all countries increases both exports and imports for all economies, so that all economies expand without experiencing a trade deficit
 However, coordination to implement for several reasons:
Countries unaffected by the recession have no incentive to run a stimulus. Therefore, government stimulating their economy will have a trade deficit vis à vis those who do not
Countries with high levels of public debt might be reluctant to implement a stimulus program
Countries have an incentive to cheat (the ‘free rider’ ) to benefit from both an expansion and a trade surplus. 
The ‘prisoner’s dilemma’
 This kind of problem is known in economics as a ‘prisoner’s dilemma’ as formulated in game theory (Tucker, 1950).
 It is in the best interest of countries to cooperate (i.e. run a joint stimulus program)
 However if one country cooperates while the others betray, the cooperator is strongly penalized
The betrayer enjoys an increase in real GDP and a trade surplus, while the cooperator experiences a trade deficit
 Without international coordination, the optimal answer of individual countries is to betray each other
 This leads to the worst possible macroeconomic outcomes for all parties
The ‘prisoner’s dilemma’
Stimulus
No stimulus
Stimulus
(150;150)
(200;-200)
No stimulus
(-200; 200)
(-150; -150)
 This table shows the two sets of possible strategies for country A and country B and associated payoffs
 In the event of a recession, each country can choose to either implement a stimulus program or not
 The combination of the two strategies lead to different individual payoffs
Country A
Country B
The ‘prisoner’s dilemma’
Stimulus
No stimulus
Stimulus
(150; 150)
(200;-200)
No stimulus
(-200; 200)
(-150; -150)
 A and B both gain from running a joint stimulus (150; 150)
 Both countries’ real GDP increase, while net exports are unaffected
Country A
Country B
The ‘prisoner’s dilemma’
Stimulus
No stimulus
Stimulus
(150;150)
(200;-200)
No stimulus
(-200; 200)
(-150; -150)
 If country A implements a stimulus program while country B doesn’t: country A gets (-200) while country B gets (200)
If country B implements a stimulus program while country A doesn’t: country A gets (200) while country B gets (-200)
 The country implementing a stimulus faces a trade deficit while the other benefits from both a trade surplus
and an increase in real GDP.
Country A
Country B
The ‘prisoner’s dilemma’
Stimulus
No stimulus
Stimulus
(150;150)
(200;-100)
No stimulus
(-100; 200)
(-150; -150)
 Without coordination, the rational response of A and B is to not run a stimulus
 The recession goes on and both countries get negative payoffs 
 (-150;-150)
 International macroeconomic governance and coordination is important to avoid such a situation
Country A
Country B
The exchange rate
The impact of the exchange rate
 An increase in the real exchange rate (e) has three impacts:
Exports (X) increase: domestic goods become cheaper relative to foreign goods
Imports (M) decrease: foreign goods become more expensive relative to domestic goods
The cost of imported goods increase (-eM). The same volume of imported goods will cost more in terms of domestic goods
Effects (1) and (2) have a positive impact on net exports
Effect (3) has a negative impact on net exports
In the short run, effect (3) dominates: depreciation decreases net exports
In the middle run, effects (1) and (2) dominate: depreciation increases net exports
The impact of the exchange rate
 Consider the definition of net exports:
 An increase in the real exchange rate (e) has three impacts:
Exports (X) increase: domestic goods become cheaper relative to foreign goods
Imports (M) decrease: foreign goods become more expensive relative to domestic goods
The cost of imported goods increase (e).M) The same amount of imports costs more.
 
Net exports
Time
Long term effect of a depreciation (1) and (2)
Short term effect of a depreciation (3)
Depreciation and net exports: the “J curve”
Assignment
Appendix: the international multiplier
Let c be consumption ratio, t the tax rate, andYd the available income, and PM the propension of domestic consumers to import:
Inserting (3) and (2) into (1) yields:
What happens if domestic demand increases? Assuming G increases by 1, we have:
The impact on aggregate income is:
The international multiplier
Assume the following values. The income tax rate is 5%. Average households use 70% of their income for consumption. Imports represent 50% of aggregate domestic consumption. Now, what happens to the national income if government spending increases by 1 ?
The value of the multiplier is:
The international multiplier
Increasing public spending by 1euro increases aggregate output by 1.23 euros
Decreasing public spending by 1 euro lowers aggregate output by 1.23 euros
The impact of public spending on real GDP depends negatively on the propension of domestic consumers to import:
Therefore:
The foreign real GDP increases following a domestic stimulus due to higher imports of foreign goods (the impact depends on the propension of domestic consumers to import)
The domestic real GDP increases following a foreign stimulus due to higher foreign demand for domestic goods (the impact depends upon the propension of foreign consumers to import)
The international multiplier