02

Chapter II: Macroeconomics
and the global economy

A. Macroeconomic consistency
B. Consistency in a market economy
C. The role of money
D. International linkages
Goethe Business School
What is
macroeconomics?
Keynes cross
S, I
S(Y)
I(r1)
I(r2)
Y
Investment
r2
r1
IS curve
I(r)
I(r2I(r
) 1)
Y2 Y1
2
Essence of macroeconomics
Traditional textbooks are geared

toward macroeconomic policy making,
not to decision making of the firm
Policy
MACRO
MODEL
Outcome
Feedback
3
Aggregate thinking
Macroeconomics aggregates individual

agents decisions
Why?
To achieve consistency within macroeconomic
constraints: Total production limits aggregate claims
To link real activities to financial constraints:
Monetary policy affects price levels and interest rates
To link the economy to the rest of the world

To analyze the impact of government policies
4
Total production and claims
Gross national product (GDP) usually

limits the size of the cake
Do we still know what GDP measures?
Lets make a little test (anonymous):
Which of the four following definitions
is not GDP?
5
Quiz: Which definition

of GDP is wrong?
A.
B.
C.
D.
The value of gross production

minus the value of inputs
The value of private consumption,
public consumption, investment,
and net exports
The sum of gross profits, gross wages,
net indirect taxes and depreciation
The sum of private consumption,
and net imports
6
Think
Reading
Abel, Bernanke, Croushore, Chapter 2
(only 2.1 through 2.3, without Application)
For participants needing to brush up GDP
definitions and components: Full assignment
For other participants: Only Box 2.1
8
What is GDP?
There are various perspectives

to look at GDP:
From the production side
From the perspective of income earners
by groups (wages, profits, indirect taxes, etc.)
From the perspective of income usage
(consumption, investment, etc.)
All three definitions are equivalent

9
The three definitions of GDP
Production
GDP = Gross value of production
minus value of inputs
Income distribution
GDP = Gross profits, gross wages,
net indirect taxes and depreciation
Usage of income
GDP = Private consumption,
and net exports
10
The production account
It records the transformation of goods and services

(inputs) by using factors of production (labor, capita
Purchases
of inputs
NVP
= GDP
Depreciation
Factor income
Indirect taxes
Sales to other
economic agents
(+ change of inventories
of own products and
GVP
self-produced fixed assets)
(Gross value of production)
(Net value of production)

11
Production: special problems
Non-marketed services
Non-profit organizations
Government services
Compulsory military service
Exploitation of natural resources
Repairing ecological damages
Transactions of existing assets
Financial transactions
12
Reading
On differences in measuring GDP

Reading 2-1
Europe's work in progress:
Why does Europe's productivity growth
lag so far behind America's?
The Economist, November 14, 2002
13
Primary income distribution
Net social product

(at market prices)
The account shows the distribution of GDP

onto factors of production and the state
Net social product
(at factor costs) *) Gross
Net wages
social product
Net profits
(GSP)
Direct taxes
Indirect taxes
Depreciation
GDP
Net foreign
factor income
*) National income
14
Secondary redistribution
of national income
The public sector contributes to GDP

via public consumption and investment,
which is valued at input costs
Government changes the original income
distribution through taxes and transfers
Does this affect the level of GDP?
No, if simply redirecting circular flows
Yes, if this leads to behavioral changes
15
Redistribution
and behavioral change
Redistributing income through taxes and

transfers may affect aggregate economic
behavior
For instance income might be transferred
from high savers to high consumers
This could reduce investment and
increase consumption and affect growth
16
Circular redistribution
Definitions
Y
C
G
I
= GDP
= Private consumption
= Government consumption
= Investment (IP private; IG government)
Ti
= Indirect taxes
Td
= Direct taxes
Tr
S
= Transfers
= Private saving (SP) + Public saving (SG)
17
Macro consistency and

redistribution of resource flows
Td
Private
households
Tr
Government
SG
CP
Ynet
Enterprises
SP
Ti
CG=G
Net
wealth
IP+G
18
Consistency within a
closed economy
Enterprises:
GDP = Ynet + Ti = C + G + I gross
Households:
Ynet - Td +Tr = C + SP
= Disposable income
Government:
Td + Ti - Tr = G + SG
19
I=S
The various resources flows are rendered

consistent, for the closed economy, but we
shall focus on the fundamental identity:
I = S, or
InvestmentGross = SavingPrivate + Public
=
20
Macroeconomic consistency...
... which, in a closed economy, is
established through hard budget
constraints, i.e. definitional
relationships
21
Compare this...
Latest survey shows that 3 out of 4 people

make up 75% of the world's population!
22
Can a market economy

achieve macro consistency?
It is a truism that macroeconomic

consistency is always achieved by definition
ex post, the contentious question is whether
a market economy can achieve consistency
through micro planning ex ante
The debate created a deep rift in economic
thinking for most of the 20th century
23
Consistency through
market allocations (micro level)
Microeconomic theory demonstrates

that general equilibrium can be achieved
through competitive markets under certain
conditions (Walras model)
Generalized consistency of real activities
of individual agents (consumers and
producers) is called general equilibrium
Government only sets the framework;
there is no need for direct intervention
24
Example:
Exchange equilibrium
Ben has 2 bottles of milk
Susan 2 boxes of popcorn
What will happen?

25
Marginal rates of substitution
In economic language, Ben and Susan

compare marginal rates of substitution
Ben evaluates the marginal utilities of getting
popcorn for sacrificing milk
Susan evaluates the marginal utilities of getting
milk for sacrificing popcorn
If U(popcorn)/ U(milk)Ben > U(popcorn)/U(milk)Susan
the two kids will start trading voluntarily until the
marginal rates of substitution become equal
26
The market and arbitrage
Economists call the process triggered by

comparing marginal rates of substitution
arbitrage. This drives market transactions
It is akin to the 2nd Law of Thermodynamics
What is this Law?
In a nutshell it answers the question:
You have two adjacent rooms:
one heated, the other cold
What happens if you open the insulating
door between the rooms?
27
Multiplier effects
The comparison of arbitrage with thermodynamics is incomplete however

In economics, energy is not simply
dissolved, it triggers multiplier effects
These interact with the energy source
creating positive feedbacks
Dissipating income comes back, partly,
through growth and import demand
28
Income flows and

the import multiplier
Income transferred from one country to another

spurs export production (and creates income)
through import demand by the recipient
Country A
Country B
Income
Income growth
Imports
29
Other international
macro linkages
Induced imports by faster growing countries

may explain the growth
of exports of countries with stagnating
or declining domestic demand
Other international macro linkages work in
favor of country A through
Benefits for consumers from cheap imports
Remittances of migrant workers
Related party trade for direct investments
Second-round effects are often overlooked 30

United States:
Related party trade
Source : US Department of Commerce
31
Efficiency
In the real world arbitrage will not work

directly, but works through relative prices
With free competition and full information,
relative prices will reflect marginal rates of
substitution for consumers and producers
So the price mechanism renders the
allocation of resources efficient
32
Maximization of social welfare
As relative prices will adjust to arbitraging in a

market economy, there is no scope for market
disequilibria (i.e. excess supply or demand)
Moreover, general welfare is maximized in an
economy as long as the price mechanism works
without restrictions
Everybody wins, but the outcome may not
please those who do not have any assets
The market can not deal with justice
33
Is the market fair?

Mary may be a happy girl,
but she has nothing to trade
Do you know a
popcorn trader?
34
Market fairness
However the market is fair in that

it gives a choice and allows an exit
This limits economic rents and political
arbitrariness
It can be fairer than state administered
allocations of resources
It also limits the power of bureaucracy and
acts against corruption
35
Government intervention
and social justice
Social justice or fairness are important reasons

for government intervention in a market economy:
the redistributive function of government
Redistribution is not only a moral issue,
it also stabilizes the political environment
by reducing social conflict potentials,
and it may even promote growth
Yet could be other reasons for government
intervention as is discussed later
These interventions fall into two categories:
the stabilization and allocation functions
36
What is not GDP? Results
37
What is the role of money?
Microeconomics does not need money:

any good can function as numraire
Earlier theories link the general price level
to the quantity of money (gold)
If gold is the numraire, all other prices are measured
in units of gold (weight = pound, peso, livre, lira)
The quantity of gold (and its velocity of circulation)
determine the general price level of GDP
The quantity theory completes Walras model

38
A theoretical dichotomy:
allocation and monetary anchoring
Walras Model:
Quantity theory:
General equilibrium is
achieved through
relative prices in free
markets
M , the gold price
Neutral
Transmission into
monetary prices
plays the role of a monetary

anchor
39
Quantity theory of money:

Watch out!
The quantity theory of money is naive

in that it uses a very simple transmission model:
M V = P Y, where
M = the money stock ($)
V = is the velocity of circulation (constant / time)
P = the general price level
Y = GDP (or transaction volume: $ / time)
In reality the transmission process has to

account for credit money, which is more complex
40
How is the economy linked

to the rest of the world?
Net exports is a key component of GDP

If we add net foreign transfers to net
exports, the current balance CB is
obtained
CB = (Net exports + Trforeign), so
GDP + Trforeign = C + G + Igross + CB
A = Absorption
(GDP - A + Trforeign) = CB = National saving
41
The current balance

and its financing
A negative CB appears to imply a softening

of the hard budget constraint
National absorption can exceed production
But a negative CB has to be financed by
foreign capital: the country borrows abroad
- CB = + Crforeign
A positive CB (national saving) signals
an accumulation of net wealth abroad
42
The main macro linkages...

... work through
Aggregate exports and imports
of goods and services
Aggregate financial flows
How are deficit countries constrained

through international capital markets?
Are surplus countries unconstrained?
We shall have to analyze global financial
flows to answer these questions
43
Example: The trade

balance of the United States
The US trade account has deteriorated:
44
Global capital flows
45
Global capital flows
46
What is
the global economy?
The global economy

is not only measured
in terms of trade
Merchandise trade as a
percentage of GDP was
comparable even before
World War I
But there is a massive
structural change in trade
What is different are new
opportunities for arbitrage
and monetary anchoring
Source: Economist
47
Global output growth

and trade
48
Global economy and

monetary anchoring
The global economy

allows new anchoring
of net wealth
positions and trade
This can be used to
hedge risks, but also
for speculation
We also have to
examine those risks
49
Dimensions of globalization
Factors driving the global economy are:

Technical progress
(telecommunication, computers)
Common knowledge base
Information products and procedures
Interdependence of markets
Economic and cultural rapprochement
(global village)
Integration of national economies
(EU, NAFTA)
50
Moores Law,
and telecommunication costs
Source: Intel
Source: Economist
51
The impact of technology
Technical progress has dramatically

enhanced the prospects for arbitrage
at a world scale
Ben and Susan can now compare across
continents
52
Enhanced prospects
for arbitrage (1)
We can compare prices of standard goods

and services across countries
Moreover some high-value-adding
services have become tradable
We can compare labor standards and
wages, which induces new migration
We compare investment opportunities and
rates of return, which drives the allocation
of capital at the world scale
53
Enhanced prospects
for arbitrage (2)
The comparison extends well beyond economic

activities and also affects general policies and
culture (Globalization of values)
While it is possible to erect barriers to trade,
migration and financing, this is more difficult for
cultural values
Globalization could therefore provoke cultural
clash and conflicts, but also expand human
rights
54
Globalization
and human rights
55
UN Human Rights Commission
56
Should we
control globalization?
We can control trade through customs

duties, quota, and outright bans
Can we use these to control globalization?
The answer is no!
Trade barriers are typically used to protect
singular interest
For the economy as a whole it is profitable
to avoid such barriers
Protection is a sure recipe for losing out !
57
Example: Protectionism
and the Great Depression
The Smoot-Hawley Act and its impact on US trade
January
December
1929
February
1930
November
1931
March
1932
1933
April
October
May
September
August
July
June
58
Market liberalization
The damaging effects of such barriers are

increasingly being recognized
There are international institutions that
stand for for the liberalization of markets
These organizations also survey the
observance of established global rules
The WTO is responsible for securing free
trade under fair conditions
59
Closure and opening

of international trade
Average level of customs duties in the United States (1821-19

Smoot-Hawley(1930)
60
50
Walker
(1846)
40
McKinley
(1890)
30
Kennedy R.
(1967)
Tokyo R.
(1979)
Tariffs of
abominations
20
(1826)
Morrill & War tariffs
(1861-1864)
Uruguay R.
(1993)
10
Source : US Department of Commerce, 1994
1821
1850
1900
1930
1950 1967
1993
60
Hidden protectionism
Of course protectionism is still

with us, only in subtler forms:
Standardization of products
Regulation of markets
Non market practices in general
(subsidization, administered prices)
Manipulated exchange rates
Security relevant (defense)
Ecological rules
Sanitary rules
61
Protectionism is
always obstructive
Protectionism grants
extra economic rents
These invite arbitrage
Contraband
Illicit counterfeiting
Substitution effects
Global shifts in production
and consumption
Telework
Invention of new products
and technologies
STAGNATION
CRIME
INNOVATION
62
Reading
Reading 2-2
Topsy turfy world: How long will
emerging economies continue
to finance America's spendthrift habits?
The Economist, Sept 14, 2006
63
What micro links offers

the global economy?
Global markets are characterized by

competition for factors of production,
in particular skilled labor and know how
Know how often goes with capital
investments, leading to competition
among economic systems and
government regulations to attract investors
Under such pressures whole economic
systems may collapse (communism)
64
Impact on national policies
The global economy is characterized by

thinking in terms of share holder value and
highest return
It puts pressures on government policies
National frontiers will become less
important through
the integration of markets,
standardization of products and procedures
and the adaptation of harmonized policies
65
Exploiting international
micro linkages
Economic transactions in a global economy are

fostered through
New means of telecommunication
and transportation, cut in costs
Information processing technologies
Advances in management techniques
Advances in logistics
and outsourcing (dismemberment of the value chain)
Improved risk management
Deregulation and liberalization of markets
66
Information technology
and financial markets
Financial markets have particularly

benefited from globalization
Today trade of information products is
ubiquitous and almost instantaneous
Controlling international finance would
lead to exclusion and segmentation
So negative consequences of controlling
financial flows are felt immediately
67
Who reigns
the global economy?
The old capitalism

critique makes multinationals responsible for
dominating economies
and governments
Turnover data are
compared with national
GDP and used as a
dependency criterion
For instance
68
Three big carmakers:

Turnover
2004
GM
DaimlerChrysler
GDP of
India
$550 bill.
Ford
69
The largest firms
Source: Forbes
70
Large firms: Europe
71
Large companies:
North America
72
Large firms: Asia
73
But in the global economy

network...
...it is hard to identify a

power center
74
So ...
even large companies are under

global competitive pressures (Ford, GM)
Those firms failing to adapt are likely
to lose in the globalizing economy:
Countries, firms, even individuals
And never compare
turnover with income figures !
(Profits of the three car makers were $10bill.)
75
A new capitalism debate:

..swarm of locusts
The new capitalism debate recognizes

global micro links that impose constraints
onto the firms decisions, but
It attempts to contain some of those links
(labor markets, capital holdings, taxation)
It appeals to moral values and patriotism
to counter arbitraging
Such protectionist strategies are futile,

inconsistent, and damaging in the long run
76
Reading
Reading 2-3
Locust, pocus
The Economist, May 5th 2005
(optional, just to see how other
countries react to German politics)
77
Is the global economy fair?
Again, a market economy cannot be

expected to bear justice
But global economics appears to play
in favor of some of the more dynamic
developing economies
They draw on the global knowledge base
as they open up for competition
Economies still based on raw materials
and rent seeking are falling behind
78
Income inequality is often a

problem within countries
79
Discussion 2:
Globalization: Who wins, and who fails?
What are the principal advantages

and disadvantages of globalization?
What should poorer countries do to benefit from
the global economy?
What strategies should firms adopt toward
nations that fail to adjust to the global economy?
80

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Chapter II: Macroeconomics

and the global economy

Traditional textbooks are geared

Macroeconomics aggregates individual

To link the economy to the rest of the world

Total production and claims

Gross national product (GDP) usually

Quiz: Which definition

The value of gross production

There are various perspectives

All three definitions are equivalent

The three definitions of GDP

The production account

It records the transformation of goods and services

(Gross value of production)

(Net value of production)

Production: special problems

On differences in measuring GDP

Primary income distribution

Net social product

The account shows the distribution of GDP

Goethe Business School

The public sector contributes to GDP

Redistributing income through taxes and

Macro consistency and

The various resources flows are rendered

Latest survey shows that 3 out of 4 people

Can a market economy

It is a truism that macroeconomic

Microeconomic theory demonstrates

Susan 2 boxes of popcorn

What will happen?

Marginal rates of substitution

In economic language, Ben and Susan

The market and arbitrage

Economists call the process triggered by

The comparison of arbitrage with thermodynamics is incomplete however

Income flows and

Income transferred from one country to another

Induced imports by faster growing countries

Second-round effects are often overlooked 30

Source : US Department of Commerce

In the real world arbitrage will not work

Maximization of social welfare

As relative prices will adjust to arbitraging in a

Is the market fair?

However the market is fair in that

Social justice or fairness are important reasons

What is not GDP? Results

What is the role of money?

Microeconomics does not need money:

The quantity theory completes Walras model

M , the gold price

plays the role of a monetary

Quantity theory of money:

The quantity theory of money is naive

In reality the transmission process has to

How is the economy linked

Net exports is a key component of GDP

The current balance

A negative CB appears to imply a softening

The main macro linkages...

How are deficit countries constrained

Example: The trade