Introduction Tripod

Document Sample
Introduction Tripod Powered By Docstoc
					BGIE Review:


      Ted Berk
    James Ratcliffe

 April 30 / May 2, 2001
• Wrap-up course topics since the midterm
  – Trade theory
  – Productivity analysis

• Exam format and approaches
   – Framework for country analysis

• Review of course tools
   – Fiscal policy
   – Monetary policy
   – Balance of payments
   – Exchange rates
                           Trade Theory
•   Theory of comparative advantage – “not obvious and not trivial”
     – By trading, countries can increase their total consumption
     – In essence, countries should focus on doing the things they do relatively
       (not absolutely) better
     – Countries have the most to gain by trading with countries that are the most
       unlike them

•   Imagine two countries, France and Germany, and two goods, cheese and beer
     – Each country has 100 units of labor
     – In France, 1 unit of beer requires 2 units of labor, and 1 unit of cheese
       requires 1 unit of labor, therefore 2B + C = 100
     – In Germany, 1 unit of beer requires 1 unit of labor, and 1 unit of cheese
       requires 2 units of labor, therefore 2C + B = 100
     – Alone, each country will want some of both goods, so total output for both
       goods will be below 200
     – If there is trade, each country can specialize, increasing total production
       across the two countries to 100 of each good
                 Issues With Free Trade
• Assumes that resources can be productively redeployed (i.e. the
  German cheesemakers can learn to brew)

• If this isn’t the case, there are political implications and distributional
   – The fact that total output in our example has increased isn’t much
       consolation if you’re a brewery worker in France (or a textile
       worker in the US)
   – Concentrated costs, distributed gains – those who are hurt by trade
       are vocal, while those who benefit do not gain enough individually
       to mobilize (sugar subsidies in the US)
Strategies to “Develop” Comparative Advantage

•   Infant industry protection: belief that you could develop comparative
    advantage if industries are protected from foreign competition and given time
    to develop
     – Hamilton in the US, or import substitution in India
     – Closely tied to economies of scale or learning curve theories

•   Externalities: view that having certain industries creates benefits for other
    parts of the economy
     – By having Airbus, Europe’s whole technology sector benefits

•   Issues
     – Process is highly subject to “political capture” by those being protected,
        e.g. infant industries demand protection long after they cease to be infants
     – Strategic trade policy also tends to invite retaliation from trading partners
•   “In the long run, productivity growth isn’t everything, but it’s almost
    everything.” – economist Paul Krugman

•   Output is a function of capital, labor, and how effectively you use those two
     – Labor productivity: units of output per unit of labor, often measured as
        GDP per hour worked
     – Capital productivity: units of output per unit of capital – not frequently
        used, hard to measure
     – Total Factor Productivity: increases in output, given constant levels of
        labor and capital

•   This means that you can increase output three ways:
     – Increase labor inputs (put more people to work, or work longer hours)
     – Increase capital inputs (deploy more machines, e.g. Soviet Union strategy)
     – Increase TFP (get better at making things)
     – Only the third is a viable long-term strategy
                  Exam Format and Tips
•   Historically a country case
     – Last year was macroeconomic reform in Italy
     – Analysis of economic strategy, political and social environment, and
        prescriptions for action
     – Usually some specific questions to answer

•   A few tips…
     – Watch the clock! Make sure you have time to answer all the questions.
     – Tell a story
         • Put together an argument, don’t just rearrange the case facts
         • Taking a position on a few key issues helps you clarify your exam,
            and gives the reader a flow to follow
     – Think before you write.
     – Use the data
         • the exhibits are there for a reason and can help you figure out a story
Approaching the Exam: Country Analysis
Context                      Strategies


            New strategy?
•   Internal and external factors influencing country strategy

•   Resources
     – Population: diversity, religion, size, growth, age
     – Geography: size, location
     – Natural resources

•   Players
     – Firms: nature, concentration, ownership
     – Government actors: political parties, stability, regulation
     – Other Organizations: trade unions, religious organizations

•   Rules of the game
     – Domestic: legal structures, property rights
     – International: trade agreements, community memberships
     – Formal and informal: social standards, societal norms (e.g. bribery)
• Goals and priorities
   – Overall economic growth
   – Sectoral development
   – Stability
   – Political development or control
   – Employment
   – Standard of living (for whom?)

• Examples of national strategies:
   – Central planning (USSR)
   – Import substitution (India)
   – Export-led growth (Japan)
   – Washington consensus (Uganda)
             Policies to Achieve Strategy
•   Fiscal policy (tight or loose)
     – Spending (G), Taxes (Ta), and Transfers (Tr) to stimulate or slow down
        the economy

•   Monetary policy (tight or loose)
     – Manage interest rates to stimulate or slow investment via Open Market
       Ops, discount rates, reserve requirements

•   Exchange rates (fixed, floating, or somewhere in between)

•   Trade policies (open, free trade vs. export focus vs. import barriers)

•   Investment policies (encourage FDI? Encourage saving?)

•   Industrial policy (sectoral focus or laissez faire)

•   Social policy (pensions, social welfare)
       Performance (Selected Indicators)
•   Economic                          •   Social
     – Growth (GDP and its                 – Income distribution
       components, per capital GDP)        – Mortality (life expectancy,
         • Real vs. nominal                   infant death rates)
     – Inflation and interest rates        – Literacy
     – BOP                                 – Environment
     – Exchange rates
     – Unemployment                   •   International
     – Productivity                        – Political clout in organizations
     – MBA salaries                        – Military power
                                           – Prestige
•   Political
     – Stability
     – Freedom
     – Human rights
    What has changed (or is about to change) in the context or performance
                that requires a reevaluation of the strategy?

•    Economic                             •   International
      – Inflation                              – New international economic
      – Recession                                  rules / guidelines (e.g. WTO)
      – Balance of payments crisis             – Change in economic strategy
      – Decline of important industry              by important trading partner,
                                                   or political turmoil in neighbor
      – Currency fluctuation
                                               – War

•    Political and social
                                          •   Other
      – New party or leader takes
          power / coup                         – Natural disasters
      – Dramatic demographic shift             – Crop failure
          (e.g. Baby Boomer retirement)
        New Strategy Recommendation
• Must respond to crisis or change AND reflect specific country goals

• Policy prescriptions in a number of areas:
   – Fiscal and monetary policy
   – Trade policy
   – Etc.

• Consider not only economic but also political and social implications
   – Who might object to the new policy?

• Consider issues of timing
   – Pace of change
                 “Managing” the economy
Actual > Potential        Actual               •   Output = Y = C + I + G + X – M
                           (Y)                 • Potential = ƒ (capital stock,
                                                 labor force,
                                                  – To grow and support
                                                     capital stock, must have I
                                               • Inflation when output >
                                   Potential   • When output < potential,
                                                 should have deflation, but
                                                 really have price stickiness,
                     Actual < Potential          hence Keynes’ arguments to
                                                 ward off vicious cycle
       Basic drivers of actual output (Y)
• Consumption and savings
   – Driven by personal disposable income
   – Basis for fiscal policy (Keynesian arguments): cut taxes or increase
     G, you put more money into people’s pockets to spend as C

• Investment
   – Depends on interest rates, since companies should make only
      NPV-positive investments
   – Also depends on businesses’ confidence in future economic
   – This is why monetary policy is so important

• Net exports
   – Falls with appreciation of the currency, rises with depreciation
   – Tends to fall when C is driven up by fiscal policy
       • More disposable income  consumption of foreign goods, too
    Fiscal policy and the income multiplier
•   Key tool for Keynesian fiscal policy is the income multiplier effect
     – If the government puts $100 in the pockets of consumers, output increases
         by more than $100
            • as the first recipient spends the money she causes a secondary effect,
              which in turn drives a tertiary effect, etc.
     – Leakages: imports, taxes, savings… so the entire $100 does not go
         towards boosting national output
            • i.e. anything that prevents this new income from being spent on
              domestically-produced stuff
     – Overall effect of income multiplier is 1 / ( 1 – Marginal Propensity to
         Consume )
•   Government spending (G) has a larger impact than a comparable-sized tax cut,
    since with the tax cut, you only get the secondary, tertiary, etc. effects, not the
    initial spike in GDP
•   The multiplier means that government action can actually have an effect on
    the economy – you get more bang for your buck
     – Government can also slow the economy by taking money out of
         consumers’ pockets, i.e. the multiplier works the same way with
         contractionary policies.
                Tools of monetary policy
•   Monetary policy can be a more flexible tool than fiscal policy
     – In the United States, the independent central bank can set and change
       policy without all the long debates and compromises of Congress
     – However, the Fed remains independent only as long as everyone agrees
       that it should

•   Discount rate: the rate at which the central bank loans money to other banks
     – The Fed can raise the discount rate to increase the cost of funds to banks,
        raising the “price” of borrowing money

•   Open market operations
     – Government securities are a large portion of the central bank’s asset base
     – By buying or selling these securities, the central bank can put money into
       the economy, or take it out

•   Reserve requirements
     – % of its deposits that a bank must hold as reserves
         • Reserves can be held as currency or deposited with the central bank
     – The higher this % is, the less money banks can lend
            Inflation and monetary policy
•   Inflation is an increase in the overall price level
     – Measured by a number of indices: GDP deflator, CPI, PPI, etc.

•   Inflation has costs
     – Uncertainty: companies can’t plan effectively
     – Impact on savings: people want to spend, rather than save
     – Impact on fixed incomes: real value of fixed incomes erodes (retirees)
     – Hoarding: people hold assets in goods, rather than money
     – Speculation: can become more profitable than productive work

•   An increase in the supply of money may boost Y in the short run
     – As prices are sticky, then additional money will lead to additional activity
     – But if prices will adjust in the long run, then ↑M leads to inflation

•   Basic money identity: M x V = P x Q
     – Amount of money x number of times it changes hands (velocity) =
        nominal prices x real output level
     “Managing” the economy (revisited)
•   Suppose policymakers believe that output is currently below potential
     – High unemployment, etc.

•   Loose fiscal policy
     – Increases G, cut Taxes  increase C  increase Y
     – As output approaches or exceeds potential  increased inflation
     – Increased government borrowing tends to put upward pressure on interest
       rates – increased demand for borrowed money

•   Monetary policy
     – Interest rate targets will be set by central bank, not by fiscal policymakers
     – Inflation probably leads bank to raise interest rates  decline in I
     – Also, all other things being equal, funds available for I would fall as
       government deficit rises

•   So, how to encourage I? One view…
     – Loose monetary policy (low interest rates) and tight fiscal policy (low
        government deficits, or even surpluses)
  National income and product accounts
• National Income Equation:

                  Y = C + I + G + (X – M)

• Y = total output (production) of a country’s economy
   – A measure of the level of economic activity
   – GDP is the output created domestically (within a country’s
       borders) and is more commonly used
   – GNP is created by a country’s nationals (citizens) wherever they
       live in the world
• C = consumption by private individuals
• I = investments by private business (capital expenditures + inventories)
• G = government spending on goods and services, i.e. government
  consumption and investment
• X = exports, M = imports  (X – M) = net exports
                    NIPA, Part Deux
               Y = C + I + G + (X – M)
           Y = C + S + Taxes – Transfers
           I = S + (Ta – G – Tr) + (M – X)

• In words…. investment can be funded from three sources:
   – Domestic private savings
   – Government savings (i.e. surplus)
   – Borrowings from foreigners
       • current account deficit  capital account surplus

• Implications include:
   – when the government runs a deficit, country needs to borrow from
     abroad or reduce investment
             Principles of BoP statements
•   The balance of payments is essentially an accounting statement that captures a
    country’s international transactions
     – Like with NIPA, the minutiae of how the statements are created are less
        important than interpreting them

•   Transactions are divided into 2 broad categories
     – Current account: transactions in goods and services
     – Capital account: transactions in financial assets

•   Financial transactions by government institutions (especially the central bank)
    are broken out separately as “reserves”

•   The balance of payments always adds to 0.
        “+” = sources of foreign exchange, “–” = uses of foreign exchange
     – As accounting necessarily involves some error and estimation, the plug in
        the BoP is called “errors and omissions”

     Current account + Capital account + Errors and omissions + Δ in reserves = 0
                                Current account
                                                     Exports are a source of
                                                      foreign exchange and
                                                   therefore a “+” in the BoP,
Merchandise                                        and vice versa for imports
     + Exports                             1000
     - Imports                            -1100
Trade Balance                              -100
                                                      Includes dividends and
+ Services (net)                            200     interest on securities, and
+ Military transactions (net)              -150   income on direct investment
+ Investment income (net)                   300    (i.e. overseas assets that are
                                                     owned and controlled by
Balance of Goods and Services              250          domestic residents)

+ Unilateral transfers (Net)
    Private                                 -10
    Government                              -50

Current Account Balance                    190       Includes foreign aid
                                                  programs, military aid, etc.
                                                    Capital account
                                                                                            Includes foreign direct
                                                                                           investment, purchases of
                                                                                        foreign securities (not interest
                  Current Account Balance                                 190             or dividends; that’s in the
Capital account

                                                                                               current account)
                  - Acq. of assets abroad by private domestic residents    -75
                  + Increase in domestic claims held by foreigners          35
                  - Domestic government investment in foreign assets       -10

                  Errors and Omissions                                     -15

                  Overall Balance                                         125

                  Changes in Reserves                                     -125

                                                                                 Always equal to the opposite of the
                                                                                   overall balance, therefore a “+”
                                                                                 change in reserves is actually a USE
                                                                                  of foreign exchange (a decrease in
                Exchange rates overview
•   People need to convert into foreign currencies to buy or sell foreign goods and
     – Ferrari needs to pay its workers in Italian Lira, so to import a car from
        them to the US, you need to pay Ferrari in Lira
     – The U.S. government buys goods and services in dollars, so to lend money
        to the government (buy Treasury bills), foreigners need dollars

•   Most simplistically, exchange rates should equalize the price of goods and
    services across all countries
     – Otherwise, one could buy a good in the “cheaper” country and sell at a
        profit in the more “expensive” (arbitrage)
     – Example: A Big Mac costs $2.50 in the United States. At a rate of
        US$1.00 = NZ$2.25, how much should a Big Mac cost in New Zealand?
          • NZ$ 5.63
     – BUT, certain goods are not easily tradable, and competition is not always
        perfect in every country…. So a Big Mac in New Zealand costs NZ$3.40
         Fixed vs. flexible exchange rates
•   Under a fixed-rate regime, countries agree to peg their currency to a known
     – e.g. to the price of gold (Gold Standard) or to the dollar (Bretton Woods)
     – Should reduce exchange-rate risk and facilitate trade and international
•   Maintaining a fixed-rate regime requires active participation by central banks
     – Balance of payments deficit  central bank must raise interest rates to
        attract foreign exchange and restore payments balance
     – Under a floating-rate regime, balance of payments deficit  excess
        supply of dollars  dollar depreciates
     – Central bank can target exchange rates or interest rates but not both.
•   Flexible rates are determined by the supply and demand for a currency in the
     – Supply is determined by monetary policy
     – Demand driven by:
          • Relative interest rates – in part determined by monetary policy
          • Trade balances – can be influenced by fiscal policy
          • Expectations of future exchange rates (and of 2 factors above) matter
             because they create arbitrage opportunities – self-fulfilling prophecy?

   Ted Berk (OD),, 868-8577
James Ratcliffe (OC),, 492-2974

(slides posted at:

Shared By: