1. How Does an Economy Work? The Macro-Economics of European Economies MSc in Economic Policy Studies John FitzGerald, January 2015

2. Course Outline 1.How does an economy work? JF 16-1-2015 2.The genesis of macroeconomics AM 23-1-2015 3.Modern macroeconomics AM 30-1-2015 4.Banks and financial markets AM 6-2-2015 5.The recent crisis AM 13-2-2015 6.The labour market JF 20-2-2015 7.Fiscal Policy and forecasting JF 6-3-2015 8.Trade JF 13-3-2015 9.The economics of global warming JF 20-3-2015 10.The future of the Irish economy AM and JF 27-3-2015

3. Outline of Lecture Theory Different “markets” A model of the economy Equilibrium and Disequilibrium Market “Imperfections”, Expectations, Behaviour Applied - examples from 2000-15 The EU and the US economies Disequilibria in EU economies How economies adjust

4. Different Markets Useful to consider the economy as a series of markets The Goods (and Services) market Money / Financial Markets Labour Market Housing Market Government sector These markets are interlinked – a “model” of the economy For equilibrium in the economy the markets must be consistent

5. The Goods market - 1 Demand for Goods (and Services) C+I+G : Closed economy C+I+G+X : Open economy C=Private Consumption; I= Investment; G= Government consumption; X=Exports Supply of Goods (and Services) Y : Closed economy Y+M : open Economy Y = Domestic Output; M=Imports Disequilibrium? Inflation, Current account of the balance of payments Imperfections?

6. The Goods market - 2

7. The Goods market - 3 S=Y-C-T S= Savings Y=C+I+G+(X-M) Y-C-T=S=I+(X-M)+(G-T) S+(T-G)=I+(X-M) Total savings equals investment plus the current account surplus What happens if people want to save more?

8. The Goods market - 4 Growth? Output is a function of inputs and productivity Inputs: labour, capital, materials Investment increases capital and hence the productive potential of economy Investment in human capital (education) increases productivity of labour Investment in R&D may raise productivity of all factors Q= Y = a function of K,L,M, productivity The stock of capital labour and materials determines potential output However, how much will it be profitable to produce?

9. The Goods market - 5 Profits=P*Q-W*L-P k *K-P m *M where firms maximise profits P= price of output; W= price of labour; L= employment; P k = price of capital; K= capital stock; M = materials; P m = price of materials This means that output doesn’t automatically adjust to meet demand Open economy: is it profitable to produce in Ireland? If it is, how much labour, capital and materials will you need? Competitiveness matters In the long run it is through raising output that living standards rise. Raising demand on its own may not lead to increased output. e.g. Irish government policy in 1977-1979 Imperfections?

10. Money / Financial markets Demand for Money Need money to buy and sell Affected by cost - credit Supply of Money Central Bank can create money Banks extend credit based on their stock of money Disequilibrium? e.g. inflows on financial account of the balance of payments Imperfections? e.g. Expectations – drive bubbles

11. The Labour market Labour Demand How profitable are firms – what happens to output Cost in home country relative to foreign determines share of world output Price of labour (labour costs), price of capital, price of materials Openness of economy affects behaviour Labour Supply Demographics, Wage Rates, Costs of working, Value of leisure, Culture Openness of economy affects behaviour - migration Equilibrium – Disequilibrium Unemployment rate, rate of wage inflation Imperfections?

12. The Housing market Demand – factors driving demand Demographics – natural increase Income / wealth Cost – user cost, a function of interest rates, expected prices Supply – factors driving supply Profitability of building – price relative to costs Costs – labour, materials, land Disequilibrium How to measure it? Rate of price increase? Imperfections?

13. Government Sector Revenue and Expenditure Revenue Economic costs of taxation Economic impact of taxation Other Revenue Expenditure Government Consumption Government Transfers Subsidies Investment Measure of imbalance – Deficit or Surplus Debt - sustainability

14. A model of the economy An equilibrium solution for economy requires equilibrium in all markets Markets are interlinked. Linked by many variables: Interest rates, wage rates, prices, etc. etc. How will economy adjust to exogenous changes? e.g. changes in budget, changes in oil prices, changes in monetary policy How can governments influence growth? Importance of the supply side

15. Equilibrium, Disequilibrium May be out of long-term equilibrium. e.g. Running an increasing current account deficit – demand > output Inflation high and rising (prices and wages) Unemployment high Will economy return to equilibrium of its own accord? Possibility of multiple equilibria What is the role of government? Adjustment takes time Time to invest, to change output, to change expectations Never actually in equilibrium

16. Market Imperfections, Expectations, Behaviour Market imperfections e.g.: Monopolies / oligopolies: make more from lower output Adjustment takes time e.g. investment SME’s cannot finance themselves because of financial sector difficulties Unions and employer cartels may affect wage bargaining Restrictions on supply of building land may affect housing supply Can Government improve the situation? Expectations e.g. People have economic “models” in their heads. These models may or may not be correct Consumption affected by lifetime income – what is lifetime income? Expect a rise in house prices – get on the property ladder! Behaviour In chemistry H 2 O always combine like that. No such certainties with human behaviour. History rarely repeats itself.

17. Applied Europe and the US 2007 Goods market – Current account of the balance of payments and inflation Money market – interest rates, nominal and real Labour Market – unemployment and wage inflation Housing Market – was there a housing market Europe and the US 2015 Goods market – Current account of the balance of payments and inflation Money market – the “zero lower bound” Labour market – out of equilibrium – will it return to full employment? Housing market – EU economies and the US The investment question

18. Current account of Balance of Payments - 1

19. Long-term real interest rates - 1

20. Rate of inflation - 1

21. House Price Inflation - 1

22. Government Borrowing - 1

23. Debt – GDP ratio - 1

24. Current account of Balance of Payments - 2

25. Long-term real interest rates - 2

26. Rate of inflation - 2

27. Government Borrowing - 2

28. Debt – GDP ratio - 2

29. Individual Countries in EU Look at 3 examples of problems and adjustment Latvia Spain UK

30. Latvia – current account of BOP

31. Latvia – rate of inflation Consumer prices, nominal wages and house prices.

32. Latvia – real interest rate

33. Latvia – Investment share of GDP Housing, building and construction and total

34. Latvia – exports share of GDP

35. Relative wage rates Wage rates in a common currency to base 2000=100: Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

36. Latvia – unemployment rate

37. Latvia – government borrowing as % of GDP

38. Latvia – Debt as % of GDP

39. Latvia – Conclusions?

40. Spain – current account of BOP

41. Spain – rate of inflation Consumer prices, nominal wages and house prices.

42. Spain – real interest rate

43. Spain – Investment share of GDP Housing, building and construction and total

44. Spain – exports share of GDP

45. Relative wage rates Wage rates in a common currency to base 2000=100: Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

46. Spain – unemployment rate

47. Spain – government borrowing as % of GDP

48. Spain – Debt as % of GDP

49. Spain – Conclusions?

50. UK – current account of BOP

51. UK – rate of inflation Consumer prices, nominal wages and house prices.

52. UK – real interest rate

53. UK – Investment share of GDP Housing, building and construction and total

54. UK – exports share of GDP

55. Relative wage rates Wage rates in a common currency to base 2000=100: Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

56. UK – unemployment rate

57. UK – government borrowing as % of GDP

58. UK – Debt as % of GDP

59. UK – Conclusions?

60. AMECO Database Many annual variables for EU economies, US, Japan etc. Don’t assume that the data are always right! Where available, runs from 1960. Includes EU forecasts to 2016 Be careful that 2014 onwards are EU forecasts! Three approaches to accessing it: 1.Online: http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfmhttp://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfm 2.Excel File: AMECONov14.xlsx plus list_of_variables.pdf 3.Excel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheet House prices from BIS datatbase: Online: http://www.bis.org/statistics/pp_detailed.htm#selectedhttp://www.bis.org/statistics/pp_detailed.htm#selected

61. Future Presentations 1.The origins and resolution of the current crisis in Estonia, Bulgaria, Greece and Spain (20 th February) What were the origins? How is it resolving? Look at disequilibria in markets 2.The origins and resolution of the current crisis in Latvia, Portugal, Spain and Italy (20 th February) What were the origins? How is it resolving? Look at disequilibria in markets 3.The crisis in Scandinavia (Finland, Sweden, Denmark) 1988-1995 (6 th March) What were the origins? How was it resolved? Look at disequilibria in markets

62. Reading for this lecture Basic text: “Macroeconomics a European Perspective”, Blanchard, Amighini and Giavazzi. Probably more theory than you need, but provides the basics Chapters 3-6 The rest of the reading discusses real economic situations. The objective is to evaluate whether economies are out of equilibrium and if so why? How are they adjusting or how have they adjusted? What are the problems? FitzGerald, J., 2013 “Financial crisis, economic adjustment and a return to growth in the EU”, Revue de l’OFCE - Debates and policies, No.127 pp. 277-302 http://www.ofce.sciences-po.fr/pdf/revue/127/revue-127.pdfhttp://www.ofce.sciences-po.fr/pdf/revue/127/revue-127.pdf Look at one or two of these publications for the EU and its component economies IMF World Economic Outlook, October 2014. http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/text.pdfhttp://www.imf.org/external/pubs/ft/weo/2014/02/pdf/text.pdf OECD Economic Outlook, November 2014, http://www.oecd.org/eco/outlook/General-assessment-of-the-macroeconomic- situation.pdfhttp://www.oecd.org/eco/outlook/General-assessment-of-the-macroeconomic- situation.pdf National Institute Economic Review, November 2014, http://ner.sagepub.com/content/230/1.tochttp://ner.sagepub.com/content/230/1.toc European Commission: European Economic Forecast, Winter 2014 http://ec.europa.eu/economy_finance/publications/european_economy/2014/pdf/ee2_en.pdf http://ec.europa.eu/economy_finance/publications/european_economy/2014/pdf/ee2_en.pdf

63. Reading for this lecture Possible additional reading for projects OECD country surveys http://www.oecd.org/eco/surveys/http://www.oecd.org/eco/surveys/ Zsolt Darvas, A TALE OF THREE COUNTRIES: RECOVERY AFTER BANKING CRISES, Bruegel Policy Contribution ISSUE 2011/19, DECEMBER 2011 http://ec.europa.eu/economy_finance/publications/publication13551_en.pdf and http://ec.europa.eu/economy_finance/publications/publication692_en.pdf compares Finland and Sweden in the 1990 crisis http://ec.europa.eu/economy_finance/publications/publication13551_en.pdf http://ec.europa.eu/economy_finance/publications/publication692_en.pdf