Chapter II: Macroeconomics
and the global economy
A. Macroeconomic consistency
B. Consistency in a market economy
C. The role of money
D. International linkages
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What is
macroeconomics?
“Keynes’ cross”
S, I
S(Y)
I(r1)
I(r2)
Y
r
Investment
r2
r1
r
IS curve
I(r)
I(r2) I(r1)
I
Y2 Y1
Y
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Essence of macroeconomics

Traditional textbooks are geared
toward macroeconomic policy making,
not to decision making of the firm
Policy
MACRO
MODEL
Outcome
Feedback
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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
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Total production and claims



Gross national product (GDP) usually
limits the “size of the cake”
Do we still know what GDP measures?
Let’s make a little test (anonymous):
Which of the four following definitions
is not GDP?
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Quiz: Which definition
of GDP is wrong?
The value of gross production
minus the value of inputs
B. The value of private consumption,
public consumption, investment,
and net exports
C. The sum of gross profits, gross wages,
net indirect taxes and depreciation
D. The sum of private consumption,
public consumption, investment,
and net imports
A.
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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
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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
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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,
public consumption, investment,
and net exports
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The production account
It records the transformation of goods and services
(inputs) by using factors of production (labor, capital)
Purchases
of inputs
NVP
= GDP
Depreciation
Factor income
Indirect taxes
Sales to other
economic agents
(+ change of inventories
of own products and
self-produced fixed assets)
GVP
(Gross value of production)
(Net value of production)
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Production: special problems

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Non-marketed services
Non-profit organizations
Government services
Compulsory military service
Exploitation of natural resources
Repairing ecological damages
Transactions of existing assets
Financial transactions
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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
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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) *)
Net wages
Net profits
Direct taxes
Indirect taxes
Depreciation
Gross
social product
(GSP)
GDP
Net foreign
factor income
*) “National income”
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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
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Redistribution
and “behavioral” change


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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
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“Circular” redistribution
Definitions
Y
C
G
I
Ti
Td
Tr
S
= GDP
= Private consumption
= Government consumption
= Investment (IP private; IG government)
= Indirect taxes
= Direct taxes
= Transfers
= Private saving (SP) + Public saving (SG)
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Macro consistency and
redistribution of resource flows
Td
Private
households
Tr
Government
SG
CP
Ynet
Enterprises
SP
Ti
Net
wealth
CG=G
IP+G
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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
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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
=
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Macroeconomic consistency...
... which, in a closed economy, is
established through “hard budget
constraints”, i.e. definitional
relationships
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Compare this...

Latest survey shows that 3 out of 4 people
make up 75% of the world's population!
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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
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Consistency through
market allocations (micro level)

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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
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Example:
Exchange equilibrium
Ben has 2 bottles of milk
Susan 2 boxes of popcorn
What will happen?
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Marginal rates of substitution

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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
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The market and arbitrage
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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?”
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Multiplier effects

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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
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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
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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
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Second-round effects are often overlooked30
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United States:
Related party trade
Source : US Department of Commerce
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Efficiency

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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
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Maximization of social welfare
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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”
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Is the market fair?
Mary may be a happy girl,
but she has nothing to trade
Do you know a
popcorn trader?
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Market fairness

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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
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Government intervention
and social justice
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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
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What is not GDP? Results
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What is the role of money?


Microeconomics does not need money:
any good can function as “numéraire”
Earlier theories link the general price level
to the quantity of money (gold)
 If gold is the numéraire, 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
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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”
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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
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How is the economy linked
to the “rest of the world”?
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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
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The current balance
and its financing

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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
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The main macro linkages...
... work through
 Aggregate exports and imports
of goods and services
 Aggregate financial flows
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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
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Example: The trade
balance of the United States

The US trade account has deteriorated:
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Global capital flows
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Global capital flows
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What is
the “global economy”?
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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
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Global output growth
and trade
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Global economy and
monetary anchoring
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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
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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)
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“Moore’s Law”,
and telecommunication costs
Source: Intel
Source: Economist
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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
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Enhanced prospects
for arbitrage (1)

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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
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Enhanced prospects
for arbitrage (2)
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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
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Globalization
and human rights
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UN Human Rights Commission
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Should we
control globalization?
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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 !
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Example: Protectionism
and the Great Depression
The Smoot-Hawley Act and its impact on US trade
January
December
1929
February
1930
1931
November
March
1932
1933
April
October
May
September
August
July
June
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Market liberalization
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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
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Closure and opening
of international trade
Average level of customs duties in the United States (1821-1993)
Smoot-Hawley(1930)
60
50
Walker
(1846)
40
McKinley
(1890)
30
20
10
Kennedy R.
(1967)
Tokyo R.
(1979)
Tariffs of
abominations
(1826)
Morrill & War tariffs
(1861-1864)
Uruguay R.
(1993)
Source : US Department of Commerce, 1994
1821
1850
1900
1930
1950 1967
1993
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“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
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Protectionism is
always obstructive

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Protectionism grants
extra economic rents
These invite “arbitrage”

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Contraband
Illicit counterfeiting
Substitution effects
Global shifts in production
and consumption
 Telework
 Invention of new products
and technologies
STAGNATION
CRIME
INNOVATION
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Reading
Reading 2-2
“Topsy turfy world: How long will
emerging economies continue
to finance America's spendthrift habits?”
The Economist, Sept 14, 2006
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What micro links offers
the global economy?

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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”)
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Impact on national policies

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
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
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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
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Information technology
and financial markets

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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
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Who reigns
the global economy?

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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 
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Three big carmakers:
Turnover
2004
GM

DaimlerChrysler
GDP of
India
$550 bill.
Ford
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The largest firms
Source: Forbes
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Large firms: Europe
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Large companies:
North America
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Large firms: Asia
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But in the global economy
network...

...it is hard to identify a
“power center”
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So ...

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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.)
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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
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Reading
Reading 2-3
“Locust, pocus”
The Economist, May 5th 2005
(optional, just to see how other
countries react to German politics)
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Is the global economy fair?

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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
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Income inequality is often a
problem “within countries”
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Discussion 2:
Globalization: Who wins, and who fails?


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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?
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