!

Macro&Economics&The&Institutional&Capital&Model&and&the&Emerging&Economies&

Ayush&Parekh&!! !

! 2!

Index&

Sr.!No.! ! ! Topic! Page!No.!

1.! Introduction! 3!

2.!

Basic!Macroeconomic!Concepts!< Output!and!Income!< Unemployment!!< Inflation!and!Deflation!

4!

3.!

Macroeconomic!Models!< Aggregate!demand!–!Aggregate!Supply!< IS!–!LM!< Growth!Models!

7!

4.!

Macroeconomic!Policies!< Monetary!Policy!< Fiscal!Policy!< Comparison!

10!

5.! Institutional!Capital! 14!

6.!Institutional!Equilibrium!and!Sustainable!Development!!

17!

7.! Emerging!Economies! 20!

8.!Emerging!Market!and!their!Policymaking!Process!

21!

9.!Growth!and!Future!prospects!of!International!Business!in!Emerging!Markets!

22!

! 3!

Introduction!

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets. This includes national, regional, and global economies. With microeconomics, macroeconomics is one of the two most general fields in economics. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indexes to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets. While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by governments to assist in the development and evaluation of economic policy.

! 4!

Basic macroeconomic concepts Macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research. Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also important to all economic agents including workers, consumers, and producers. Output and income National output is the lowest amount of everything a country produces in a given time period. Everything that is produced and sold generates income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. Output can be measured as total income, or, it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy. Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital all lead to increased economic output over time. However, output does not always increase consistently. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.

! 5!

Unemployment The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labor force. The labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force. Unemployment can be generally broken down into several types that are related to different causes. • Classical unemployment theory suggests that

unemployment occurs when wages are too high for employers to be willing to hire more workers. Other more modern economic theories suggest that increased wages actually decrease unemployment by creating more consumer demand. These more recent theories suggest that unemployment results from reduced demand for the goods and services produced through labor and suggest that only in markets where profit margins are very low and the market will not bear a price increase of product or service, will higher wages result in unemployment.

• Consistent with classical unemployment, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.

• Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs. Large amounts of structural unemployment can occur when an economy is transitioning industries and workers find their

! 6!

previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process.

• While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth. The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.

Inflation and deflation A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation. Central bankers, who control a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes. Changes in price level may be result of several factors. The quantity theory of money holds that changes in price

! 7!

level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level. Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand because of a recession can lead to lower price levels and deflation. A negative supply shock, like an oil crisis, lowers aggregate supply and can cause inflation. Macroeconomic models Aggregate demand–aggregate supply The AD-AS model has become the standard textbook model for explaining the macroeconomy. This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels. The downward slope is the result of three effects: the Pigou or real balance effect, which states that as real prices fall, real wealth increases, so consumers demand more goods; the Keynes or interest rate effect, which states that as prices fall the demand for money declines causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers and thus exports decline. In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential

! 8!

output, which corresponds with full employment. Since the economy cannot produce beyond more than potential output, any AD expansion will lead to higher price levels instead of higher output. The AD–AS diagram can model a variety of macroeconomic phenomena including inflation. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels.

The AS–AD diagram is also widely used as a pedagogical tool to model the effects of various macroeconomic policies. IS–LM The IS–LM model represents the equilibrium in interest rates and output given by the equilibrium in the goods and money markets. The goods market is represented by the equilibrium in investment and saving (IS), and the money market is represented by the equilibrium between the money supply and liquidity preference. The IS curve consists of the points where investment, given the interest rate, is equal to savings, given output. The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: As output increases more money is saved, which means interest rates must be lower to spur enough investment to match savings. The LM curve is upward sloping because interest rates and output have a positive relationship in the money market. As output increases, the demand for money increases, and interest rates

! 9!

increase.

In this example of an IS/LM chart, the IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y). The IS/LM model is often used to demonstrate the effects of monetary and fiscal policy. Textbooks frequently use the IS/LM model, but it does not feature the complexities of most modern macroeconomic models. Nevertheless, these models still feature similar relationships to those in IS/LM. Growth models The neoclassical growth model of Robert Solow has become a common textbook model for explaining economic growth in the long-run. The model begins with a production function where national output is the product of two inputs: capital and labor. The Solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles. An increase in output, economic growth, can only occur

! 10!

because of an increase in the capital stock, a larger population, or technological advancements that lead to higher productivity (total factor productivity). An increase in the savings rate leads to a temporary increase as the economy creates more capital, which adds to output. However, eventually the depreciation rate will limit the expansion of capital: Savings will be used up replacing depreciated capital, and no savings will remain to pay for an additional expansion in capital. Solow's model suggests that economic growth in terms of output per capita depends solely on technological advances that enhance productivity. In the 1980s and 1990s endogenous growth theory arose to challenge neoclassical growth theory. This group of models explains economic growth through other factors, like increasing returns to scale for capital and learning-by-doing, that are endogenously determined instead of the exogenous technological improvement used to explain growth in Solow's model.

! 11!

Macroeconomic policy

Typical intervention strategies under different conditions Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, which usually means boosting the economy to the level of GDP consistent with full employment. Monetary policy Central banks implement monetary policy by controlling the money supply through several mechanisms. Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell bonds and take money out of circulation. Usually policy is not implemented by directly targeting the supply of money. Banks continuously shift the money supply to maintain a fixed interest rate target. Some banks allow the interest rate to fluctuate and focus on targeting inflation rates

! 12!

instead. Central banks generally try to achieve high output without letting loose monetary policy create large amounts of inflation. Conventional monetary policy can be ineffective in situations such as a liquidity trap. When interest rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional means. Central banks can use unconventional monetary policy such as quantitative easing to help increase output. Instead of buying government bonds, central banks implement quantitative easing by buying other assets such as corporate bonds, stocks, and other securities. This allows lower interest rates for a broader class of assets beyond government bonds. In another example of unconventional monetary policy, the United States Federal Reserve recently made an attempt at such a policy with Operation Twist. Unable to lower current interest rates, the Federal Reserve lowered long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve. Fiscal policy Fiscal policy is the use of government's revenue and expenditure as instruments to influence the economy. Examples of such tools are expenditure, taxes, debt. For example, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. For example, when the government pays for a bridge, the project not only adds

! 13!

the value of the bridge to output, it also allows the bridge workers to increase their consumption and investment, which also help close the output gap. The effects of fiscal policy can be limited by crowding out. When government takes on spending projects, it limits the amount of resources available for the private sector to use. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates which limits investment. Defenders of fiscal stimulus argue that crowding out is not a concern when the economy is depressed, plenty of resources are left idle, and interest rates are low. Fiscal policy can be implemented through automatic stabilizers. Automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy. Automatic stabilizers use conventional fiscal mechanisms but take effect as soon as the economy takes a downturn: spending on unemployment benefits automatically increases when unemployment rises and, in a progressive income tax system, the effective tax rate automatically falls when incomes decline. Comparison Economists usually favor monetary over fiscal policy because it has two major advantages. First, monetary policy is generally implemented by independent central banks instead of the political institutions that control fiscal policy. Independent central banks are less likely to make decisions based on political motives. Second, monetary policy suffers shorter inside lags and outside

! 14!

lags than fiscal policy. Central banks can quickly make and implement decisions while discretionary fiscal policy may take time to pass and even longer to carry out. Institutional Capital New Institutional Economics

In general, the focal point in NIE is the incentives for economic activity (performance) provided by the “institutional environment”, consisting of institutions and “institutional governance”. Institutions are defined as the rules of the game in society. These rules provide incentives or disincentives for economic activity and determine which types of governance structures are most efficient from the economic point of view. Governance structures, also called “institutional arrangements”, concern the organisation of decision-making arrangements (e.g. markets vs. hierarchies such as firms, government agencies, bureaucracies and other types of organisations. Transactions (e.g. production and allocation of goods and services), taking place on the level of governance, are accompanied by transaction costs. The level of transaction costs influences the level of economic activity by determining which type of governance structure is the most efficient. For example, when the cost of using the market increases due to cheating, while an inefficient “institutional governance” hampers contract enforcement, it becomes more attractive to resign from buying via the market, and to start producing within the firm, even when the market price of the product in question is lower than in the case of own production. “Institutional governance” concerns the judge of the game, “organisations that interpret and

! 15!

enforce the rules of the game such as the judiciary, police, government and government agencies”.

Transaction costs, consisting of search, negotiation and control costs, concern friction in the process of exchange via the market (market transaction costs) and organisation of production within the company (managerial transaction costs). This type of cost exists because of incomplete and asymmetric information and the fact that human beings are fallible and have limited cognitive and calculative abilities. Search costs, the costs of obtaining information, and negotiation costs are incurred before a contract (transaction) has been concluded, while control costs concern monitoring and enforcing the fulfillment of the contract. When, for example, “institutional governance” becomes more efficient in contract enforcement, control costs decline, making the market a more at- tractive governance structure. Different types of institutions, such as freedom of contract (a formal institution) and trust (an informal institution) may reduce transaction costs, and as a result stimulate economic activity.

Institutions, the rules of the game in society, can be divided in formal and informal rules. Formal institutions, including the system of property rights, laws and regulations, basically can be “written down” and, in principle, can be enforced in court. When these rules of the game are clear and enforced, this, ceteris paribus, stimulates economic activity. Unclear rules or rules that change often create uncertainty, negatively influencing economic activity. Furthermore, unclear and poorly enforced formal rules in connection with high transaction costs create incentives for so-called opportunistic

! 16!

behaviour (lying and cheating Molho 1997. This not only may negatively influence economic performance, but also have negative social and environmental consequences.

Informal institutions concerns everything what people “have in their head”, and can neither be “written down” nor enforced in court. We talk about culture, mentality, values, trust, mental models, etc. As mentioned, informal institutions such as trust may reduce transaction costs. They also help to explain why change of formal institutions (system change) is difficult and more time consuming than often expected. A law or regulation may be changed immediately by administrative decision (e.g. tax law). However, “institutional governance” (e.g. the tax collector, courts), needs time to interpret and implement these new rules. More important, the way of thinking, culture, values, mental models, of citizens and people working in “in- situational governance” change less quickly, slowing down the speed of institutional change and making the outcome uncertain.

Informal institutions play a crucial role in the efficiency of formal institutions. As mentioned earlier, when formal institutions are weak (e.g. poorly defined property rights, unclear and/or quickly changing laws and regulations, inefficient “institutional governance”, high transaction costs), there are stronger incentives for opportunistic behaviour. Informal institutions determine the extent to which people use the opportunities to lie or cheat created by weak institutions, – an issue discussed in more detail in the next section.

! 17!

Institutional equilibrium and sustainable development

One of the factors determining “institutional capital” is the so-called “institutional equilibrium”. Such an equilibrium exists when informal institutions support and strengthen formal institutions and the functioning of “institutional governance”. Suppose, people are completely honest. In other words, they will not respond to incentives for opportunistic behaviour, as is the case people who find a wallet and bring it back to the police or the owner. In such a situation, weak formal institutions will rather have no negative influence in the economic, social and environmental field. The reasoning is simple. When people are honest, and trust each other, do they need formal rules of the game? This is related to the question, whether formal rules come into existence due to distrust in other people in order to reduce transaction costs of opportunistic behaviour, or whether they are a reflection of trust and are aimed at reducing the transaction costs of obtaining information and negotiation. An example of the first is the existence of laws and procedures to reduce the problem of late payment or lack of payment by customers. An example of the second is the use of money and the price mechanism in order to reduce the costs of information on prices and the costs of negotiation in case of barter trade. Thus, when people are honest, “institutional governance” in inefficient and the first type of formal institutions are missing, it is likely that the weak institutions will not have negative economic, social and environmental consequences. When the second type of formal institutions is missing, this will lead to an increase in

! 18!

search and negotiation costs. This may lead to a less economic activity and decision-making based on less reliable information, hampering sustainable development.

The simple model presenting the different degrees of “institutional equilibria” is based on the simplifying assumption that formal and informal institutions can either stimulate or hamper sustainable development. In reality, however, as North (1990) argues, rules are often a “mixed bag” of efficient and inefficient institutions. Analysis of efficiency of, for example, different formal institutions and their influence on particular aspects of sustain- able development and which aspect should receive priority is not taken into consideration in the model presented here.

A perfect institutional equilibrium, positively influencing sustainable development, is only achieved when formal and informal institutions stimulate sustainable development, and “institutional governance” is efficient in enforcing the formal rules of the game. Such rules and “institutional governance” stimulate sustainable consumption and production behaviour, and reduce opportunities for opportunistic behaviour and the transaction costs of obtaining information, while informal institutions have as a consequence that people do not show op- portunistic behaviour and support the sustainable production and consumption patterns.

Following Meadows (1999), the general idea presented in Table 1 is that mental models (informal institutions) are more important for achieving sustainable development than formal institutions and “institutional

! 19!

governance”. The main argument was discussed above. When people’s mental models support sustainable consumption and production patterns, they will rather not implement inefficient formal rules. Efficient rules become “self-enforcing”, which makes the efficiency of “institutional governance” less relevant. An interesting case is when formal institutions are inefficient, while “institutional governance” enforces these rules and people’s mental models stimulate sustainable development. The influence on sustainable development is unclear. However, when people do not accept the inefficient formal rules, they may just not carry them out or try to change them. Much depends on whether the people working on “institutional governance” share the same mental model as the rest of society, or that this group rather carries out the inefficient rules. In the first case, the inefficient rules may not be carried out and be changed later on. The second case is one of a mix of efficient and inefficient informal institutions, and a lot depends on whether “institutional governance” or the rest of society as more power.

! 20!

Emerging Economies

This article discusses how international businesses are affected by the rise of the emerging markets especially the BRICS (Brazil, Russia, India, China, and South Africa) and the next “Breakout Nations” from the second tier of the emerging markets. The point to note is that ever since the emerging markets opened up their economies and liberalized their procedures, international businesses have found a readymade market for themselves in which they can operate in, make, and sell goods. Often, it is the case that emerging markets provide the international businesses with the right opportunities to expand and grow further. When considered against the backdrop of falling growth rates in the West, the western multinationals could not have asked for more with countries like China and India opening up like never before. For instance, the recent decision by the government to push for FDI (Foreign Direct Investment) in most sectors is a step in the direction of benefit to western multinationals.

! 21!

EMERGING&MARKETS&AND&THEIR&POLICYMAKING&PROCESS&

The distinguishing volatility of emerging markets has been documented, for example, by Aguiar and Gopinath (2004) and the policy approaches to managing volatility have been discussed by Aizenman and Pinto (2004). The volatility arises from many sources, including natural disasters, external price shocks, and domestic policy instability. The key issue in assessing emerging market volatility is whether it results from uncontrollable factors or is the consequence of the policy framework within which countries operate. The distinction between these two sources of volatility is not straightforward since even shocks on account of natural disasters can be mitigated if prevention and disaster management measures are in place. Kaminsky, Reinhart, and Vegh (2004) document that rather than acting as a stabilizing force, as in most advanced economies, emerging governments’ policies are “procyclical,” i.e., they reinforce economic booms and aggravate recessions. However, of crucial importance is perceived arbitrariness in policymaking, which undermines investor confidence and hurts long-term investment in productive assets. Policy instability is seen to hurt growth severely (see, for example, Fata ́s and Mihov 2003 and Mody and Schindler 2004). Constraints on policymaking that reduce actual or perceived arbitrariness can, consequently, help.

That leads to the second defining characteristic of emerging markets: their transitional features. Emerging markets are in transition in several senses. They are almost always transitioning in important demographic

! 22!

characteristics, such as fertility rates, life expectancy, and educational status. Typically also, they are transitioning in the nature and depth of their economic and political institutions. Finally, and of special relevance, is the transition to greater interaction with international capital markets. The transitions are often long drawn and, at times, disruptive. Ranciere, Tornell, and Westerman (2003) argue that in attempting to force the transitions, countries may sometimes adopt policies that raise the rate of progress but, at the same time, increase the risks of crises.

The combination of high volatility and the transitional features of emerging economies generate a real challenge in policymaking. In conventional terminology, that challenge is the appropriate balance between commitment and flexibility, or between rules and discretion. To show good faith in policy initiatives, commitment is desirable and hence mechanisms that ensure such commitment will be valued by investors and will, ultimately, facilitate economic progress.

Growth of International Businesses in the Opening Decades of this Century Though globalization picked up in the 1990s and gathered steam subsequently, the recession following the dotcom bust proved to be a setback to international businesses. Further, the 911 attacks proved to be another obstacle to the expansion of international businesses. The closing years of the first decade witnesses the 2008 Great Recession, which dealt a decisive blow to international businesses. In this gloomy scenario, the growth in the emerging markets was the silver lining for the

! 23!

international businesses, which was captured well by experts like Ruchir Sharma in his book, The Breakout Nations, who pointed out that western capital had no choice but to migrate to countries like India and China. The Future Prospects of International Businesses in the Emerging Markets If we look into the future (though predicting the future is hazardous in these fast changing times) we find, the next frontier for international businesses is the tier two emerging economies like Vietnam, Ireland, and African countries. Without being too optimistic, it is clear that the growth in these markets would drive the expansion plans of international businesses. it is also clear that international businesses can leverage on the demographic dividend that these countries. To explain the term, the higher proportion of young people in the country’s population is called the dividend that these countries get because of their demography. Hence, with so many young people joining the workforce, it is apparent that the emerging economies offer the best possible means of growth for the international businesses. Closing Thoughts Finally, western multinationals have to contend with the international ambitions of emerging market companies as well. In recent years, there has been a trend wherein companies from India and China as well as Brazil and Russia have started to make rapid strides in their expansion plans overseas. Hence, it cannot be said that the flow of capital is unidirectional alone. In many ways, it can be said that the global economy is now at a stage where it is anybody’s game and hence, the world is

! 24!

indeed flat for those with the innovative edge, hard work, and sustainable business models.