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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
Prof. Patrick GOUGEON, ESCP-EAP
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
Prof. Patrick GOUGEON, ESCP-EAP
Sharing Value Added …..Sharing Value Added …..
Employees (wages)
Government (Taxes)
Creditors (interest)
Shareholders
€
Dividends self financiang
� Net Profit� allowances for depreciation
Production, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
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
Production, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
TRENDS
• Substitution of Capital for Labour• Labour heterogeneity• International differences in labor cost• Service activities are growing in importance
Production, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
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)
Production, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
comments on productivity
A productivity primer; Nov 4th 2004 ;From The Economist print editionA productivity primer; Nov 4th 2004 ;From The Economist print edition
Production, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
comments on labour costs
Production, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
From the economist
Comments on working hoursProduction, technology & employment
Prof. Patrick GOUGEON, ESCP-EAP
From the economist
Saving & consumption:importance of the age structure
Age
Income, Consumption
Income
C
BorrowingPhase
Saving phase
Capital consumption
Retirement
Consumption, saving & investment
Prof. Patrick GOUGEON, ESCP-EAP
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
Consumption, saving & investment
Prof. Patrick GOUGEON, ESCP-EAP
Population Structure: few comparisonsConsumption, saving & investment
Prof. Patrick GOUGEON, ESCP-EAP
Saving rates:what they tell us
Saving rates:what they tell us
Anglosaxon entrpreneurial optimism
Euro anxiety
Consumption, saving & investment
Prof. Patrick GOUGEON, ESCP-EAP
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
Consumption, saving & investment
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
Prof. Patrick GOUGEON, ESCP-EAP
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
Factors affecting output and income level
AggregateDemand (AD)
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
Factors affecting output and income level
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 ?
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
we need to have:
A G = C + I = Y 0.8 Y + 50 + 100 = Y Y = 750
An exercise on tax policy...
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
Factors affecting output and income level
AggregateDemand (AD)
Income, output (Y)
45°
45°
C = 0.8 Y + 50
b
I = 100
750
+50
1000+ 250 = 50 / (1-0.8)
750 1000
An exercise on tax policy...
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
An exercise on tax policy...
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
Consumption, saving & investment
Prof. Patrick GOUGEON, ESCP-EAP
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
Prof. Patrick GOUGEON, ESCP-EAP
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
Government intervention: growth vs inflation
Prof. Patrick GOUGEON, ESCP-EAP
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
Government intervention: growth vs inflation
Prof. Patrick GOUGEON, ESCP-EAP
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
Government intervention: growth vs inflation
Prof. Patrick GOUGEON, ESCP-EAP
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