© Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 1 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College London

© Stephen Hall, Imperial College LondonPage 2 Economic Environment Introduction & Overview Macroeconomics is the study of economic aggregates and their dynamics. Examples include the inflation rate, gross domestic product (GDP), the unemployment rate, and so on. As we will demonstrate, the state of the macro economy and government economic policy are interrelated. In this course, we wish eventually to assume the point of view of (a manager of) a single business firm, whose task it is to –understand how the economy functions –anticipate government policies in light of the state of the economy –anticipate how those policies will affect the business climate in –general, and his/her business in particular, and finally –make managerial decisions today based upon these anticipations

© Stephen Hall, Imperial College LondonPage 3 Economic Environment This viewpoint is best depicted as follows: Government Macro Economy Firms

© Stephen Hall, Imperial College LondonPage 4 The preceding figure provides an appropriate perspective from which to approach the course material. The preceding figure is not, however, the best way of understanding economics. A business firm is itself a part of the macroeconomy, and so should rightly be placed inside the “macroeconomy” box. Moreover, there is also the rest of the world to consider. (Economically speaking, the UK is not an island!) The government has not only (monetary and fiscal) policies to deal directly with the macroeconomy, they also have internationally-oriented policies, and others directed more precisely at individual business firms. Economic Environment

© Stephen Hall, Imperial College LondonPage 5 A more comprehensive list of government policies would be: Fiscal policy: dealing with government spending and taxation Monetary policy: establishing interest rates and money supply Exchange rate policy: dealing with the international value of the pound sterling International Trade policy: involving measures taken to affect the magnitude and direction of international trade Supply-side policy: designed to directly encourage business firms to produce more Prices and incomes policy: introduced to reduce inflation or support income Employment policy: designed to protect or create jobs Economic Environment

© Stephen Hall, Imperial College LondonPage 6 A more comprehensive depiction of the firm, its position in the economy, and the effect of economic policies is provided by: Economic Environment Firm Oil price shocks, Exchange rate policy, Fiscal policy, Monetary Policy, Trade… The Business Environment Domestic economy International Economy

© Stephen Hall, Imperial College LondonPage 7 If we were to list government objectives, this would include things like low inflation, high incomes, economic growth, low unemployment, etc. There would also be a long list of “non-economic” objectives like low crime rates, a “fair” income distribution, better education, and so on. We may illustrate the government’s task as follows: policy instruments -> policy targets -> ultimate goals The Economic Problem

© Stephen Hall, Imperial College LondonPage 8 Some key issues in macroeconomics Inflation –the rate of change of the general price level Unemployment –a measure of the number of people looking for work, but who are without jobs Output –real gross national product (GNP) measures total income of an economy it is closely related to the economy's total output

© Stephen Hall, Imperial College LondonPage 9 More key issues in macroeconomics Economic growth –increases in real GNP, an indication of the expansion of the economy’s total output Macroeconomic policy –a variety of policy measures used by the government to affect the overall performance of the economy

© Stephen Hall, Imperial College LondonPage 10 However.. The fundamental economic problem is that resources are limited, so a government and its people cannot have everything they want. Choices must be made. Put another way, everything has an “opportunity cost”. Referring back to the previous list of government policies, it is apparent that the policies frequently overlap one another and, implicitly, policy objectives conflict with each other. This is simply a result of the fact that all policies require choices and involve costs. The government’s job is to understand the effects of their various policies, i.e., the opportunity costs involved, and to make choices accordingly. Economic Environment

© Stephen Hall, Imperial College LondonPage 11 How to Proceed: What we need to do is to develop a model - or several models - of the macroeconomy. Because we are dealing with economic aggregates, a high level of abstraction is required. This means that our model will be both simple and highly unrealistic. Economic Environment

© Stephen Hall, Imperial College LondonPage 12 Question: if a model is simple and unrealistic, is it necessarily a bad model? Economic Environment

© Stephen Hall, Imperial College LondonPage 13 Economic Environment Essentially, we will start with bits and pieces, build a simple model, and then gradually add on to it. Eventually, we will have a model that allows us to understand the interrelationships between the interest rate, inflation, unemployment, government spending, taxation, output, and so on.

© Stephen Hall, Imperial College LondonPage 14 One important caveat The model we will use is a static model, i.e. dealing only with the present. From it, we will make inferences about future economic behavior and government policy. Unfortunately, the model is not well equipped to deal with questions regarding long-term economic strategies. However, it is a very useful model for understanding short- and medium-term economic problems and, more importantly, for anticipating government policies. (Despite all the political rhetoric, governments from all parties and in all western countries re extremely short- sighted; much more so than private businesses!)

© Stephen Hall, Imperial College LondonPage 15 Economic Environment A good way to think about the model is that it is appropriate for understanding economic behavior and government policy within a business cycle, but tells us nothing about the long-run. (Indeed, in some cases, the best short-run policies turn out to be the worst long-run policies!).

© Stephen Hall, Imperial College LondonPage 16 Economic Environment The Business Cycle and National Income determination.

© Stephen Hall, Imperial College LondonPage 17 Economic Performance Before introducing the model, it is useful to have some idea of the state and recent history of UK economic performance. General areas of interest include: Economic growth (in output): which was low relative to other western economies until the 1980s. Profitability and productivity: which were low relative to other western economies until the 1980s. Unemployment: which was relatively high throughout most of the 1980s (and again presently). Inflation: which was extremely high in the early- and, again, the late- 1970s, but relatively low throughout most of the 1980s (and especially so presently). Balance of payments (i.e. net exports) and the exchange rate: both of which have declined throughout most of the 1980s to present.

© Stephen Hall, Imperial College LondonPage 18 Inflation in the UK, Source: Economic Trends Annual Supplement, Labour Market Trends

© Stephen Hall, Imperial College LondonPage 19 Inflation in selected European countries

© Stephen Hall, Imperial College LondonPage 20 Inflation in UK, USA and Germany

© Stephen Hall, Imperial College LondonPage 21 Unemployment in the UK, Source: Economic Trends Annual Supplement, Labour Market Trends

© Stephen Hall, Imperial College LondonPage 22 Unemployment in selected European countries

© Stephen Hall, Imperial College LondonPage 23 Unemployment in UK, USA and Germany

© Stephen Hall, Imperial College LondonPage 24 Economic growth in UK, USA and Germany

© Stephen Hall, Imperial College LondonPage 25 Economic Sectors and Flows To understand how an economy functions, we need a model. Regardless of which of several models we choose, the model must: Define various “sectors” of the economy; and Characterise economic activity as flows of “real” commodities (or, alternatively, financial capital) between these sectors.

© Stephen Hall, Imperial College LondonPage 26 Sectors Households: who provide the “factors of production” to business firms and ultimately (in one form of another) receive all of what the economy produces. Business firms: who transform inputs (factors of production) into output. Government: which functions somewhat like a firm in that it uses inputs and produces output; but it has different objectives and faces different constraints than do firms. Financial services: which essentially facilitate the flow of financial capital between sectors, but do not use or consume “real” resources. Foreigners: who import into, and export from, the economy.

© Stephen Hall, Imperial College LondonPage 27 The circular flow of income, expenditure and output Y HouseholdsFirms C + I IC S

© Stephen Hall, Imperial College LondonPage 28 Government in the circular flow Y C + I + G I C S HouseholdsFirmsGovernment C + I + G - T e TeTe G B - T d Y + B - T d

© Stephen Hall, Imperial College LondonPage 29 Measuring Economic Activity To measure the total amount of economic activity, one must find an appropriate place on the flow diagram (i.e. one in which all economic activity must pass through) and measure the amount of economic activity that does in fact pass through.

© Stephen Hall, Imperial College LondonPage 30 Measuring Economic Activity There are three such places at which economic activity can be measured. The measurement of economic activity is done differently - and has a different name - depending upon which such place is chosen. Output method: (at the “firm” box at left) measures the value of final output produced by firms. Income method: (at the “households” box at right) measures the value of all income received by households. Expenditure method: (at the “market for goods and services” box at top) measures the total expenditure by various sectors on the economy’s output.

© Stephen Hall, Imperial College LondonPage 31 Measuring Economic Activity All of these methods should lead to the same total amount of economic activity. Therefore, the terms “output” (GNP), “income” (GNI), and “expenditure” (GNE) are used interchangeably. The actual measurement of a country’s economic activity is documented in the “national income account”.

© Stephen Hall, Imperial College LondonPage 32 UK National Income 1988 The Handout has a detailed picture of the UK national accounts as a table. This shows all the adjustments necessary to make Income=Output=expenditure

© Stephen Hall, Imperial College LondonPage 33 Problems in Calculating National Income From the flow chart, it would seem straight-forward to calculate national income. However, there are three main complications: Depreciation: Over time, firms’ capital stock (i.e. machinery) loses value. This lost value must be accounted for. GNP - depreciation = Net National Product (NNP) Prices: The expenditure method uses the market prices paid for goods and services, which is net of indirect taxes (like VAT) and subsidies. The other methods use factor costs, which are exclusive of taxes and subsidies. Therefore, GNE must be adjusted as follows: GNE (factor cost) = GNE (at market prices) - taxes + subsidies Foreign firms: Do we wish to measure domestic economic activity (which would include foreign firms producing in the UK, but exclude British firms producing abroad), or national economic activity (which would include British firms producing abroad, but exclude foreign firms producing in the UK)?

© Stephen Hall, Imperial College LondonPage 34 Economic Environment Gross Domestic Product (GDP) vs GNP: GDP = GNP - net property income from abroad (NYA)

© Stephen Hall, Imperial College LondonPage 35 National income accounting: a summary GNP (and GNI) at market prices GDP at market prices NYA C X - Z I NYA G NNP at basic prices Deprec'n National income Indirect taxes Wages and salaries Self- employment Profits, rents

© Stephen Hall, Imperial College LondonPage 36 What GNP does and does not measure Some care is needed: –to distinguish between real and nominal measurements –to take account of population changes –to remember that GNP is not a comprehensive measure of everything that contributes to economic welfare

© Stephen Hall, Imperial College LondonPage 37 Leakages and Injections From the flow diagram, we can see that total household expenditure (consumption (C) + saving (S) + taxes (T) + imports (M)) must equal the total expenditure on goods and services (consumption (C) + investment (I) + government spending (G) + (X)) C + S + T + M = C + I + G + X As the C’s cancel, S + T + M = I + G + X From the household income point of view, this is interpreted as “leakages” = “injections”

© Stephen Hall, Imperial College LondonPage 38 Crowding Out The equation above can be re-written as: S - (X - M) = I + (G - T) where - (X - M) is minus net exports; identically net imports, (G - T) is government borrowing (the PSBR)

© Stephen Hall, Imperial College LondonPage 39 Crowding Out Ignoring net exports (which are frequently close to zero), the equality (actually, an identity!) states that private saving = private investment + government borrowing To ensure sufficient private investment (which is the engine of long-term economic growth), an economy must have considerable private saving and little government borrowing. Government borrowing which takes away from private investment is known as “crowding out”.

© Stephen Hall, Imperial College LondonPage 40 Crowding Out Injections InvestmentGovernmentExports Savings TaxesImports Leakages

© Stephen Hall, Imperial College LondonPage 41 A Note on Where We Are Heading Presently, we will begin introducing simple models of the economy, and gradually build upon them to obtain a workable, comprehensive model of the macroeconomy. The steps we will eventually take are: A focus on the commodities market. We will first look at demand-side models of output determination, with no concern for prices of any kind. The introduction of the interest rate. This extra variable means that we can solve only for output/interest rate combinations, which satisfy commodity market equilibrium. (The IS-Curve). The introduction of money supply (and the banking system) and money demand. WE show that money-market equilibrium is actually a set of output/interest rate combinations. (The LM-Curve). We argue that both the commodities market and the money market must be in equilibrium. (Essentially, this involves solving this IS and LM curves simultaneously for equilibrium values of output and interest rate). This gives us a unique macroeconomics equilibrium. (The IS-LM model).

© Stephen Hall, Imperial College LondonPage 42 Where we are heading…….. The introduction of an over-all price level. We show that, through the money market, the IS-LM model implies an inverse relationship between the price level and output (which we interpret as a downward-sloping demand curve). The introduction of the labour market (including the wage rate) and firms, who use labour to help produce output. We demonstrate that profit-maximisation on the part of firms implies that more will be produced as the price level rises (which we interpret as an upward-sloping supply curve). Argue that the final equilibrium is where supply equals demand. Finally, we can perform “comparative static” exercises, using our model to see what happens when, for example, the government raises taxes or lowers the interest rate.