Global economic environment notes Chapter 1 and 2 PDF

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Global economic environment notes with Teresa Cantero...

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Global economic environment CHAPTER 1: What is the Economic Environment?............................................................2 1. 2.

A Good Business Environment..........................................................................................2 Toolbox for Analysis: Key Economic Indicators, Concepts and Analytical Framework........2 a. b.

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Toolbox for Analysis: Economic Information.....................................................................3 a. b. c. d. e. f. g. h.

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Macro Language: Key Indicators..............................................................................................2 Key Economic Indicators..........................................................................................................2 To assess the performance of a country´s economy we need:...............................................3 Formal Information..................................................................................................................4 Sources of Information............................................................................................................4 Sources of Economic Data.......................................................................................................4 Complexity of using Economic Data........................................................................................4 Dealing with complexity..........................................................................................................5 Distinguish Nominal / Real.......................................................................................................5 Nominal / Real GDP.................................................................................................................5

Toolbox for Analysis: Statistics (Index, growth rates)........................................................6 Toolbox for Analysis: Theoretical Framework....................................................................6 a. b. c. d. e. f. g. h. i. j. k. l. m.

Basic Analytical Framework.....................................................................................................6 Analytical framework: Basic Model.........................................................................................6 Analytical Framework: Basic Macroeconomic model..............................................................6 Aggregate Demand Curve (AD)................................................................................................7 AD: Key relationships...............................................................................................................7 AD Negative Slope...................................................................................................................7 Aggregate Supply CURVE (AS)..................................................................................................7 Long Run AS (LAS)....................................................................................................................7 Short Run AS (SAS)...................................................................................................................8 Changes in AD (Shifts AD Curve)..............................................................................................8 Changes in LAS (Shifts AS Curve).............................................................................................8 Changes in SAS (Shifts AS Curve).............................................................................................8 Impact of Demand Shifts and AS Slope...................................................................................9

CHAPTER 2: Business Cycles.............................................................................................9 1. 2.

What are business cycles?.................................................................................................9 Tracing the cycle (where does the economy stand?).......................................................10 a. b.

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Are cycles good or bad....................................................................................................11 Causes of business cycles................................................................................................12 a. b. c.

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Potential (trend) Output........................................................................................................10 Output gap.............................................................................................................................11

Real business cycle school.....................................................................................................12 Keynesian school...................................................................................................................12 A pragmatic view (short-term focus).....................................................................................13

Are there any remedies? The case for macro stabilization..............................................13

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CHAPTER 1: What is the Economic Environment? Session 1 -

The complete collection of factors external to the company, exogenous to its decision making that condition business performance Wide ranging list of aspects with different degrees of influence Dynamic factors that change over time whose changes should be monitored

1. A Good Business Environment -

Stable and dynamic growth Stable and moderate inflation Low interest rates Stable and competitive exchange rate Flexible labor market Sound public finances Predictable macro policies Low taxes Cheap energy High education levels Good infrastructure Fair competition Sound financial system Political stability

Session 2 2. Toolbox for Analysis: Key Economic Indicators, Concepts and Analytical Framework a. Macro Language: Key Indicators -

To assess economic performance we will be looking at:  Output/Income/Demand (GDP: growth and productivity)  Employment (level, rate of growth, rate over lf)  Inflation (prices)  Interest rates  Exchange rates  Government finances (debt, deficit)  External balances (trade and current account)

b. Key Economic Indicators     

Output/Income/Expenditure (size of the economy) – Total goods and services produced in a country in a given period in volume terms (real GDP) Wealth and wellbeing of a country depend on the output it is able to produce (but wealth is stock, output is flow) Key measures  Productivity = Output/total hours worked  Growth rate: g = (GDPt – GDPt-1)/GDPt-1 Employment – Is the total number of persons working (ideally all those that want to work but often not the case) Unemployed – individuals actively looking for a job

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Labor force (population really available for work) = employed + unemployed Unemployment rate = unemployed divided by labor force (times 100) Inflation – rate of growth of the price level  Key question, how to measure aggregate prices (CPI, GDP deflator, …) o Consumer Price Inflation – rate of change of the Consumer Price Index o GDP Underlying inflation – rate of growth of the GDP deflator  Inflation high and low (fast and slow growth of prices)  Accelerating or decelerating inflation (increasing rates of growth or decreasing rates of growth)  Some inflation numbers (annual most recent rates)  US 1.7%, Euro Zone 1.1%, Spain 1.5%, China 2.1%

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Interest rates - price of lending or borrowing money (cost to the borrower and payback to the lender) o The less finance available (or more finance demanded) the higher the rates o Large variety of interest rates (sovereign, corporate, regulated, free market, short term, long term…) all related o Interest rate changes will tell us a lot about the state of the economy, about macro polices and about expected trends in both of them  Some official interest rates: US Fed 0.54%, ECB 0.0%, Japan -0.1%, Brazil 13%, Mexico 5.75% Exchange rates – price of a given currency in terms of other currencies  The more expensive the Euro, the more expensive products from the Euro Zone  Exchange rates can be fixed by governments, be set by the markets or (most often) some combination of both  Changes in exchanges rates also tell us much about the state of the economy and its prospects Government finances – (like family finances) healthy finances are those with low debt and small or no deficit (is better a surplus/saving?)  Indicators: public debt, budget deficit  Bad economic performance always deteriorates public finances  Sound finances are necessary to be able to smooth the impact of deep recessions or help accelerate recovery External balances – Net of a country´s exchanges of commodities, services and capital with others (net need for foreign currency)  If net entry of foreign currency for all concepts in our country is positive, then our country is lending income outside, if it is negative, our country is borrowing income from outside  The result of borrowing is debt accumulation  If external debt is too large or negative balances perceived as unsustainable, the exchange rate sharply looses value (depreciation)  Large and rapid withdrawal of foreign funds from a country can cause serious exchange rate and financial crises (South Korea 1997, Brazil 1999)

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Session 3 3. Toolbox for Analysis: Economic Information a. To assess the performance of a country´s economy we need: -

A theoretical framework – basic understanding of how the economy works Economic data/Indicators – make empirical use of the theory Experts´ analysis /assessment – see how others use the theory and what are their views Follow up on events – take everything into account

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Lots of common sense – look at fundamentals, take a broad view and stick to your judgment

c. Formal Information -

Not all data/information available is equally acceptable Online resources imply access to massive amounts of information The challenge for economists twenty years ago was to find information, the challenge today is to find the right information Formal/serious work requires formal/reliable information You should use formal information for your Country Report Assignment

d. Sources of Information -

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What is formal information for the three main types of resources? Some unwritten rules:  Data – best are primary sources which are the ones producing/elaborating the data. Generally national statistical agencies or ministries; secondary institutional sources feeding from primary sources are also valid resources (for instance international organizations)  Reports /analysis – Reputed and well known public and private institutions (Ministries, Central banks, International organizations, large private banks, research institutions/bureaus, universities, etc.)  Press/News (national and international well known and reputed journals and magazines, preferably specialized in finance and economic news) Key characteristics of reliable sources  Producer of information is known  Producer has an institutional origin (institutions are committed to respect methodological principles, they have a reputation at stake)  The institutional producer (public or private) is well known and widely respected  Information is issued with regularity/periodicity and constantly updated

e. Sources of Economic Data -

Statistical Databases – are collections of series of economic data, covering long periods of time, organized by subject, easy to access and user-friendly for extracting information There are many databases available for economic analysis of all countries  National  Public o Official Statistical Bureau http://www.insee.fr/fr/bases-de-donnees/ o Central Bank http://www.bde.es/bde/es/areas/estadis/ o Ministry of economy http://www.bea.gov/ o Other (Min Labor, Finance, … ) http://www.mof.gov.cn/index.htm  Private http://www.bloomberg.com/markets/  International o Eurostat http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_databa se o ECB http://sdw.ecb.europa.eu/ o Fed Reserve B of Saint Luis http://research.stlouisfed.org/fred2/ o IMF http://www.imf.org/external/data.htm o OECD http://stats.oecd.org/ o World Bank http://wdi.worldbank.org/tables o UN http://data.un.org/

f. Complexity of using Economic Data

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Most macro aggregates are not directly observable (output/activity, prices, labor costs, trade balance, money supply) Even when observable (unemployment, exchange rate, interest rates, public spending) often there are several ways to measure them Observed behavior of macro variables is very sensitive to their definition and measure (GDP vs GNP, CPI vs DGDP, Registered vs Survey Unemployment) Statisticians work hard to provide good estimates (often alternative measures are produced)

g. Dealing with complexity -

Some recommendations:  Keep in mind that most data are estimates  Try to understand the information really contained in an estimated economic indicator  Keep in mind its limitations (there are always assumptions made and statistical errors) debates on growth over decimal points are mostly silly  When possible, look at alternative proxies/indicators for a variable  Always look at several consecutive time observations to detect unusual behavior  Use long term average values as a reference  Trends and growth rates (seasonally adjusted) are the most useful and reliable information

h. Distinguish Nominal / Real -

The distinction between nominal and real (value versus volume) is important in economics  You can increase sales or turnover for two reasons: more volume or higher price, important strategic distinction In Macro analysis is equally important but more difficult to distinguish  Progress and growth has to be measured in real terms  Separating growth in real and nominal terms requires good estimates of aggregate prices and the use of the right prices for each aggregate  Nominal increases in macroeconomics do not necessarily mean better or more (if all prices increase the same, higher nominal value does not mean more gains)

i. Nominal / Real GDP 

We need to distinguish:  Nominal GDP (NGDP) – total amount of production at prices actually paid on the market  Real GDP (RGDP) - measure of GDP that represents variation in volumes (takes out price changes) with respect to a “base” or reference year  GDP Deflator (PGDP)- the economy's aggregate price level  In terms of Growth: Growth of NGDP= Growth of RGDP + Growth of PGDP 

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Moving from nominal value measures to real values and the aggregate price level is a great challenge for statisticians  How can we provide one single estimate of what is happening to prices in the economy when there are so many different products and services?  What should we do to GDP to cancel out the impact of changes in prices of all the products and services considered?  A great deal of work and research goes on around the world to produce good estimates The solution is provided by index numbers

4. Toolbox for Analysis: Statistics (Index, growth rates)

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Index Numbers  Complexity in measuring Macroeconomic data is overcome by using Index Numbers  The value of a given Macro variable at a point in time might not have a straight interpretation but its evolution is always meaningful (examples: real GDP, GDP deflator, Consumer confidence, Money Supply)  See Campus Online folder GROWTH containing three files: Growth rates, Index Numbers, Growth exercises  Things that you need to know:  The level shows the change with respect to the base year, no economic meaning, only useful to see the trend  Main information is contained in growth rates (levels of two indexes cannot be compared, growth rates can)  Value Indext = Volume Indext * Price Indext

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Growth Rates - See Campus Online folder GROWTH  The useful meaning of most economic aggregates is found in their growth rates or ratios  Prices (inflation)  GDP growth  Aggregate Consumption  Aggregate Investment  Unemployment rate  Employment  Industrial production  Public Deficit/GDP  Public Debt/GDP  Trade deficit/GDP  Balance of Payments deficit/GDP

5. Toolbox for Analysis: Theoretical Framework a. Basic Analytical Framework   

Assessing Economic Performance is a practical exercise based on: Key Economic Indicators (GDP, r, inflation, e, …) The relationship among them -> Theoretical framework

j. Analytical framework: Basic Model Remember that:  Models are simplifying representations of real life behavior focusing on key variables and abstracting from many realistic details  Non-realistic assumptions might be necessary, and fully acceptable, as long as they contribute to understand a complex reality  Price/quantity relationship for the aggregate differs from individual behavior k. Analytical Framework: Basic Macroeconomic model We care about GDP/Activity, interest rates (r) and prices (inflation) given by - Aggregate Supply (Real GDP, Prices): Aggregate production decisions of firms depending on labor market, production function, stock of capital, natural resources - Aggregate Demand (Real GDP, Interest rates and Prices): Aggregate spending decisions . The circular flow of Income and Expenditure AD=AS AD - Negative relationship Price level – Output/GDP AS – Positive ? Relationship Price level – Output/GDP

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l. Aggregate Demand Curve (AD) -

The economy will tend to values of real GDP and P such that:  Real Expenditure demand in goods and services (GDP) by families (C), business (I), the government (G) and the external sector (X-M) are equal to total production of those goods and services (Goods Market)  The amount of Money (M) supplied by monetary authorities equals the amount of Money Demanded in real terms (M/P) (Money Market)

m. AD: Key relationships -

In Goods markets: GDP, C and I have a negative relationship with interest rates Higher r à lower C and lower I à lower GDP In Money markets: GDP and r have a positive relationship Interest rates have to increase when GDP increases to make (M/P)s=(M/P)d But if (M/P)s increases à r decreases In Foreign Exchange Markets e will be such that De = Se More demand for foreign currency depreciates the domestic currency More demand for the domestic currency appreciates the domestic currency Stronger currency à less exports and more imports Weaker currency à more exports and less imports

n. AD Negative Slope GDP and aggregate Price level negative relationship can be explained by: - The effect of P changes on aggregate Money holdings. Lower price level has (ceteris paribus) a similar effect to more money in the economy: increased (M/P)s à lower interest ratesà higher business investment and consumption à Higher AD o. Aggregate Supply CURVE (AS) -

Aggregate Supply is the relationship between the quantity of goods and services supplied and the price level in the economy The Shape of the AS curve is the most controversial issue in Macroeconomic theory, consensus view:  Vertical AS in the long-run (LAS)  Positive slope in the short-run (SAS)

p. Long Run AS (LAS) -

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Real GDP in the long run (production of Goods and Services) depends on:  Labor available  Physical capital  Natural resources  Technology LAS is vertical (Supply is unrelated to the price level) at the Natural/Potential

q. Short Run AS (SAS)

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Real GDP supply in the short-run increases with increases in the Price level Positive slope of the SAS needs explaining  Sticky wage theory – nominal wages adjust slowly to P changes  Stic...