The Economic Picture Understanding 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 institutions Government intervention: growth vs inflation Fundamentals of budget, monetary & foreign exchange policy Government intervention: growth vs inflation Fundamentals of budget, monetary & foreign exchange policy The globalisation trend: a European perspective Facts & figures, growing importance of emerging economies, the threat of US deficits The globalisation trend: a European perspective Facts & figures, growing importance of emerging economies, the threat of US deficits

Understanding the economic system: the “circular flow” Firms Households Aggregate Demand* Aggregate Demand* Consumption (c) Income (Y) Financial Institutions Financial Institutions Saving (S) Investment (I) Government Export (X)Import (M) International Capital flows Private transfers Public transfers Self financing *Aggregate demand = C+I+G+X-M G market Prof. Patrick GOUGEON, ESCP-EAP

FIRM Creation, Processing Creation, Processing Intermediate goods Suppliers Upstream markets Sales Clients Downstream markets Value Added = Sales – Cost of Intermediate goods To be shared between all participants FIRMS Source of value GDP (Gross Domestic Product) = Total value added = Total Income Production, technology & employment Prof. Patrick GOUGEON, ESCP-EAP

Sharing Value Added ….. Employees (wages) Government (Taxes) Creditors (interest) Shareholders € Dividendsself financiang  Net Profit  allowances for depreciation Production, technology & employment Prof. Patrick GOUGEON, ESCP-EAP

EU: GDP per capita 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 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 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 hours Production, technology & employment Prof. Patrick GOUGEON, ESCP-EAP From the economist

Saving & consumption: importance of the age structure Age Income, Consumption Income C Borrowing Phase Saving phase Capital consumption Retirement Consumption, saving & investment Prof. Patrick GOUGEON, ESCP-EAP

Households saving and investment 0 Net saving Net Debt Capital to be transferred Investment saving Consumption, saving & investment Prof. Patrick GOUGEON, ESCP-EAP

Population Structure: few comparisons Consumption, saving & investment Prof. Patrick GOUGEON, ESCP-EAP

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 of transactions Quantity of money : 100, three agents A B C exchanges: A - B : 100 B - C : 100 C - A : 100 Total value of transactions: 300 = M x V 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 Aggregate Demand (AD) Income, output (Y) 45° C = a Y + b a: marginal propensity to consume b: autonomous consumption S = Y - C = (1-a) Y - b 1 - a marginal propensity to save b I AD = C + I Y = C + I = C + S YrYr AD r Equilibrium: if and only if plans coincide Patrick GOUGEON, ESCP-EAP

Factors affecting output and income level Aggregate Demand (AD) Income, output (Y) 45° C = a Y + b b I p planned investment YpYp AD r Planned consumption AD p = C p + I p < Y p Unplanned investment (inventories) Firms will reduce the output until the equilibrium is reached AD p Patrick GOUGEON, ESCP-EAP

Factors affecting output and income level The multiplier What will be the final impact of an additional investment (+100) ? (Marginal Propensity to Consume = 80%) S: 20 C: 80 S: 16 C: 64 S: 12.8 C: 51.2 ……. Final dY 100/(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 = output Consumption function is:C = 0.8 Y + 50 Autonomous 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 = output Consumption function is:C = 0.8 Y + 50 Autonomous 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 = 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) 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 Aggregate Demand (AD) Income, output (Y) 45° C = 0.8 Y + 50 b I = = 50 / (1-0.8)

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 = 1000 With: C = 0.8 (1-t) I = 100 G = t x 1000 We obtain: t = 25% We can observe that: Tax receipts = 250   C = 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) 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 = G =  = + 30 þTotal impact on AG = + 30 x 5 = 150 The 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 SAVING Demand for money Financial market Financial intermediairies Financial intermediairies banks, insurance firms Pension funds... Sight deposits,time deposits Insurance policies,... Credits, seed capital,… Listed assets : shares, bonds,... money Financial assets Provide information Create liquidity Consumption, saving & investment Prof. Patrick GOUGEON, ESCP-EAP

Official Settlements Adjustment Understanding the balance of payments Current accounts Goods Services Investment income Transfers Capital account Direct investment Portfolio investment Others ItemsBalance Trade balance Balance of goods and services Current accounts balance 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 depreciation Stabilisation supply 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 EuropeJapan Exchange rate 1 € = 125 Yens Inflation 4% 1% Evolution of 100 € purchasing power if the exchange rate if fixed Beginning of the year……… € ………………………….…12500 Yens End of the year ……….. 100/1.04 € ………………………...…12500/1.01 Yens (- 4%) (-1%) Purchasing power of 100 € in Japan = 12136/1.01 Yens That is: 1201 (-4%, as in Europe) ADJUSTEMENT devaluation of 3% 100 € = 12500/1.03 = 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 rateInterest rate An increase in interest rate is expected to attract capital flows and limit the risk of a devaluation Inflation rate Anticipated inflation is included in the interest rate Purchasing Power Parity theory: high inflation is likely to weaken the currency Conclusion if 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 Increase decrease Deficit reduced Assumed automatic correctionAnd real life ! The globalisation trend: a European perspective