Macroeconomics for a Sustainable Planet

This is a summary of the course ‘Macroeconomics for a Sustainable Planet,’ offered by the SDG Academy. The course explains many of the basics of macroeconomics, particularly in the context of sustainable development.

1. Introduction to Macroeconomics
   1. Introduction to Macroeconomics
   2. Macroeconomic Pathologies
   3. 21st Century Perspectives on Macroeconomics
   4. International Comparisons of Income (PPP)
   5. GDP & Well-Being
2. Output Determination & Employment
   1. The Full-Employment Economy
   2. Deriving GDP
   3. Labour and Saving
   4. Economic growth
   5. Partial employment economy
   6. Focus on business cycles
   7. The basics of aggregate demand management
   8. The three big problems with aggregate demand policies
   9. Output determination in the IS-LM model
3. Labour markets
   1. Labour Markets, Concepts, Definitions & Groups
   2. Labour Market Institutions: Minimum Wages, Unionisation & Contracts
   3. Costs of Unemployment, Digitization of Labour Markets, Informality & Underemployment
4. Money & Central Banking
   1. Money vs Barter: History and Concepts
   2. Money Demand
   3. Money Supply and the Role of the Central Bank
   4. The Central Bank & New Approaches to Monetary Policy
5. Exchange rate themes
   1. Exchange Rate Arrangements
   2. PPP & Interest Rate Arbitrage
   3. The Real Exchange Rate & the Role of Non-Traded Goods
   4. Monetary Policy Under Fixed & Floating Exchange Rates
   5. Currency Crisis
6. Financial markets and Financial Crises
   1. Bank Runs and Panics
   2. How to prevent Bank Runs
   3. Bubbles & Crashes
   4. Managing Insolvencies
   5. What Happens When Governments Go Broke?
7. Inflation, unemployment and stabilisation
   1. Inflation, the Fiscal Deficit & Seigniorage
   2. The Costs of Inflation
   3. Inflation, Unemployment & the Phillips Curve
   4. Stabilisation Themes
8. Consumption, Saving and Investment
   1. Consumption, Saving & the Intertemporal Budget Constraint
   2. The Permanent Income Consumption Theory
   3. The Life Cycle Model of Consumption and Saving
   4. Investment
   5. The Basic Theory of Business Investment
9. Fiscal Policies and Institutions
   1. The Budget, Public Revenues & Expenditures
   2. Saving, Investment the Fiscal Deficit & the Management of Public Debt
   3. Interactions Between the Private and Public Sectors
   4. Fiscal Institutions and Policies
10. Open Economy Issues
    1. The Aggregate Demand in an Open Economy
    2. Aggregate Demand with a Flexible Exchange Rate
    3. Aggregate Demand with a Fixed Exchange Rate
    4. The Current Account & External Indebtedness
    5. The Intertemporal Budget Constraint of a Country
11. Economic Growth
    1. Economic Growth in History, Patterns & Sectors
    2. Sources of Economic Growth
    3. Solow’s Growth Convergence Model
    4. Growth and Inequality
    5. Growth Traps
12. Globalisation
    1. What is Globalisation?
    2. Development of the Global Economic System
    3. Globalisation of Population Systems
    4. Crisis of Poverty and Inequality
    5. The Challenge of Sustainable Development

Introduction to Macroeconomics

Introduction to Macroeconomics

The concepts that you study when looking at the macro-economy:

1. Output and income
2. Employment and unemployment
3. Long-term growth
4. Inflation
5. Income: consumption, saving and investment
6. Capital
7. Debt
8. Inequality

Macroeconomic Pathologies

A well-functioning economy:

• is achieving economic progress—the standards of living, live expectancy and health conditions are improving;
• has relatively stable prices;
• keeps the income gap limited and;
• debt is manageable.

Since the field of macroeconomics started to develop in the 1930’s, it’s been pre-occupied with understanding and dealing with crises or de-stabling effects on the economy—pathologies. A key figure is Maynard Keynes who investigated the astronomical inflation rates in the 1920’s, followed by the great depression in the 1930’s. The main economic pathologies are:

1. High and persistent unemployment
2. Poverty and growth traps (where a poor or middle-income country is not making progress and poverty is persisting or worsening)
3. High inflation
4. Financial crisis
5. Sovereign (national government) default (can no longer pay debts)
6. Massive inequality (of income)
7. Resource depletion

21st Century Perspectives on Macroeconomics

There are eight perspectives the lecturer wants to highlight in this course:

1. A closed economy is an economy without its relations to the rest of the world. If we want to understand how macroeconomics works in any place, we have to take into account that the majority of economies aren’t closed.
2. We should also look at the institutional environment of an economy. Macroeconomies have some common features, such as a private, government & banking sector, and a labour market. However, when we zoom in, we see differences; various political systems, currencies and monetary unions. Similarly there are differences in the labour markets, such as the share of workers who are member of a labour union or the tax collection system. There are also differences in the interaction between the various macroeconomic institutions. Who pays for health-care and how is this arranged between the private and government sector? This has effect on pricing and employment in that specific sector.
3. We will also focus on the economic structures; the question of how the major sectors of the economy, the total output, can be divided among the primary sectors (agriculture, mining), secondary sectors (manufacturing, construction & utility sector) and tertiary sectors (wholesale and retail trade, transport, professional services, entertainment).
4. A fourth relevant aspect is the clinical economics. Being able to perform a good diagnosis of what drives the different pathologies of an economy and what effective cures could possibly be.
5. Next, a healthy relationship and balance between the private and public sector is the fifth relevant aspect. Here we look at a good division of responsibilities, how government revenues should be allocated and how sovereign default can be avoided.
6. Sixth, looking at the government as a macro-economic problem solver.
7. A seventh perspective relates to the fact that macro-economics needs to keep an eye on the natural capital.
8. Also, the role of technology and advances in technology is important, as it constitutes the toolkit of the economy. Apart from its impact on production, it also determines much of the change of the economy over time.

International Comparisons of Income (PPP)

Often when we compare the economy across different countries, we use the Gross Domestic Product (GDP). Though it may give us some insights on an economy’s performance, there are some things to keep in mind. Most importantly, prices, particularly for services (non-traded goods), vary greatly across different countries’ economies. For the same service in the U.S. you’d pay much more as for that service in Ghana. The reason this is particularly relevant for services is that it does not work very well to make arbitrage; the profit earned from purchasing an asset at a lower price and selling it at a higher price in a different market. Looking at GDP would tell us that Ghana is not producing much goods and services, while in reality they do, just for a substantially lower price.

You can correct for this issue by having a fixed set of prices for specific goods and services. Calculating the GDP with this purchasing power parity (PPP) adjustment means that you multiply the amount of goods and services produced with a universal price. So instead of using the market price of a service in Ghana, you take the market price of the U.S. for that same service and multiply this with the number of services produced. The total that you then find makes for a valid comparison between the relative size of the two economies, using the GDP per capita PPP.

GDP & Well-Being

The GDP is not a very good measure of well-being. It does not account for our health, distribution amongst the society (it’s an average), water and air quality, safety and many other non-material factors. In addition to the PP adjustment, we should also recognise the difference between the total GDP, and the GDP per person to correct for population size. Some alternative measures include:

• Life expectancy at birth: how old do people get?
• Human Development Index (HDI): indicator from the United Nations (UN) taking into account health and education.
• Happiness Index (HI): life satisfaction measure that basically asks people how they feel about their life.
• Sustainable Development Goals (SDG) index: considers a wide variety of indicators such as health, environmental conditions, equality, education and more.

As we can see in the table that shows the index for different countries, GDP correlates with, but does not predict, well-being.

Output Determination & Employment

The Full-Employment Economy

Full employment economy: an economy where all the people in the economy that would like to work are at work.

In macroeconomics we often thing in different timescales:

• Short-term: 3 months - a year
• Medium-term: 1 - 10 years
• Long-term: 25 - 100+ years

Business cycles are short-term cycles of economic activity that consist of expansions and contractions occurring at about the same time in many economic activities.

Changes in cycles often follow from certain shocks in the economy, between which a distinction can be made:

• Supply-side shocks: affect the capacity of the economy to supply goods and services (e.g. a flooding or an earthquake).
• Demand-side shocks: associated with changes in the desire of businesses or government or households to buy goods and services.

To understand a full employment economy we should look at the production function: a relationship between the main inputs into production and the amount of output that one gets. The Aggregate Production Function links all of the inputs into production in an economy with the total output measured by the GDP. There are two inputs to the production:

• What the workers contribute in their jobs (labour input) and;
• the capital stock (infrastructure, building stock, machinery, computers, etc.) that we work with in order to produce (capital input).

Since the capital stock slowly builds up over the years, is mainly the labour input that relates to short-term changes.

If we relate the amount of employment to the level of output we get a positive relationship: more workers, more output. If we know the number of workers in an economy, we can the GDP consistent with full employment.

Deriving GDP

For GDP, macroeconomists virtually always look at market transactions to determine output, that is the actual purchase of products in the economy during a particular period. We can look at the GDP in three distinctive ways:

• Output that is produced by the different sectors of the economy.
• Income that is earned by the workers, owners or investors.
• Direct and future (investment) uses of outputs by both households (private) and governments (public), plus export minus import sales.

These are three different measurement techniques that should yield the same GDP value.

To provide some perspective from the U.S. macroeconomy: There are 325 Americans of which 150 million are employed and 7.9 million unemployed. Through 28 million businesses they produce a USD18 trillion GDP, roughly USD60,000 per person. From the production side, we can divide that output into three sectors (the first perspective):

• Primary & secondary (the goods producing sector), e.g. agriculture and mining: USD3.4 trillion
• Tertiary sector (services), e.g. entertainment, wholesale, health and transport services: USD12.3 trillion
• Government, e.g. building roads, national defence, public administration and prisons: USD2.3 trillion

Looking at the same country from the income perspective:

• Employee compensation: USD9.7 trillion
• Rent and proprietor’s income: USD2 trillion
• Corporate profits: USD2.1 trillion
• Capital consumption (using up of existing capital base): USD2.8 trillion
• Taxes: USD1.2 trillion
• Other: USD0.6 trillion

This actually equals a USD18.4 trillion GDP, and this is because we need to correct for earnings abroad. The USD18.4 trillion is the Gross National Product (GNP), which is the sum of the GDP and the earnings of Americans abroad minus the earnings of foreigners in America.

And lastly the uses-perspective:

• Private consumption: USD12.2 trillion $C$
• Investment: USD3.1 trillion $I$
• Government purchase: USD3.2 trillion $GP$
• Exports: USD2.3 trillion $X$
• Imports: USD2.8 trillion $M$

This is in balance with the $GDP$ through $GDP = C + I + GP + X - M$

The gross investment rate is found by dividing the total investments by the total GDP, in the case of the US 16% (3.1/18).

In addition to the three previous perspectives provided on the GDP, we also need to understand the difference between the output in an economy and the dollar, or current-price value. It provides a contrast between the price value and the physical volume of goods and services produced.

To illustrate, as we look at the 2009-2016 period for the US, we see that measured in dollar value, the GDP increased by 30%. While when we look at it in terms of the physical change this is only 16%. We find that 11% of the increase can be attributed attributed to changes in price. This is a useful insight when talking about inflation later in the course.

Labour and Saving

The real wage is the wage relative to the average price level. We use this to get a sense of the purchasing power of earnings. The real wage is a major determinant of how many people want do do how much work. Generally, is the real wage is higher people want to do more work.

Business perspective focuses on the bottom line. If it raises profits they will hire more workers, and if it doesn’t they won’t. Here, if the wage is high, it becomes increasingly costly to hire new workers. We can combine these perspectives in a general wage/labour-curve (shown below).

We see how the point where these lines meet represents the wage and labour where the number of workers that businesses want is equal to the amount of work that workers want to offer at that wage. From it, we can find the number of workers and the real wage for a full employment economy. We can use this labour indicator, or the number of workers, in our previous aggregate production function.

This full employment output that we find in our aggregate production function is also called potential GDP. It’s the level of output that’s potentially available when all who want to work are employed by firms who want to hire them. Often however, this is not the case, and the number of workers is larger than the demand. When there is a sudden drop on the aggregate production function moving away from the potential GDP, this is called a business cycle downturn or economic recession.

The next question is how our capital stock is spent; investment vs direct consumption.

By putting aside some of our capital stocks now, we can have higher output in the future, a question of delayed gratification. Saving is conceptually turning present capital into future capital.

Between saving and consumption there is also some kind of balance. This balance helps us to determine consumption and saving on the one side, and the interest rate on the other. The interest rate measures the costs of borrowing between today and the future, or the value of saving in terms of money in the bank that that bank is lending to investors to build new capital. So here, too, there are two variables; the amount that households want to save and the amount that businesses want to invest. Our goal again is to find the balance between these two.

The balance has a number of determining variables. For consumers this is the interest rate (higher is more saving) and for businesses or investors in businesses this is the (loan) interest rate. If this is high there will be less investments that will yield such high returns that after paying back the loan there will be profits left. Consequently we find a similar graph:

Here, the balance is the balance of desired saving and desired use of that saving by businesses for investing in the future. From it, we can derive the amount of saving and investment that gets made in a year, answering our previous question. For the U.S. this saving/consumption balance is about 20/80.

Economic growth

Building up the capital stock of an economy is an important part of long-term economic development, similar as to an increasing population increases the production. Capital accumulation is a 3-variable process:

• Today’s capital stock $K_{t}$
• Depreciation of today’s capital (the wearing out of existing capital stock) $dK_{t}$
• New investments $I_{t}$

Where the formula for future capital $K_{t + 1}$ is $K_{t+1} = K_{t} + I_{t} - dK_{t}$

There are different kinds of capital that all need specific types of capital investment. Here are the six primary ones:

• Business capital: what the private business sector owns, e.g. factories and shops
• Infrastructure: typically owned and managed by government, e.g. roads, power lines and sewerage
• Human capital: the knowledge and skills of the workforce, based on education, health and vitality
• Intellectual capital: the fruits of research and developments, the knowledge of an economy
• Natural capital: maintains our capacity to produce food, clean air, water, and a safe environment. This kind of capital is often depleted or destroyed for exploitation
• Social capital: trust in government and in each other, the ability to cooperate

All forms of capital are needed for a prospering economy.

Partial employment economy

In the economic downturn of the 1930’s there was no shortage or direct decline in any of the previous capital stocks described. So how could soaring unemployment rates as in the great depression have occurred?

For this we look at another curve similar to the ones we have seen before. We again have a line for businesses and consumers, but this time concerning the price level and total output. When prices are higher, businesses can hire more workers and increase the total output (positive relationship). However, when prices are higher this reduces the purchasing power for people if the wage remains fixed, meaning that higher prices lead to lesser sales. Again, there is an equilibrium where the lines cross, in this case this is where we find the ‘actual’ GDP.

John Maynard Keynes realised that the actual GDP can be (much) lower than the potential GDP of a fully-employed economy. He also had the insight that there are policy tools to raise the level of demand in an economy. An example of this is that the central bank increases the money supply in the economy. This would shift the total aggregate demand curve to the right (consumers have more money to spend).

Keynes also saw that in a well-performing economy operating near the potential output level, people can get pessimistic or businesses hesitant because of uncertainty about the future. This is reflected by a similar shift as indicated above, but instead to the left. The effect is unemployment and recession; the pessimism about the future becomes a self-fulfilling prophecy. This was Keynes interpretation of the great depression.

Focus on business cycles

As discussed previously, business cycles are the regular ups and downs of the economy. These cycles can have various causes, such as movements of optimism or pessimism in society, government policies or supply shocks. It’s important to understand, however, that these fluctuations appear on top of a growth curve that’s been happening over the past two centuries. When studying business cycles there are three important questions:

1. What causes business cycles?
2. Can these fluctuations be stabilised?
3. Are short-term stabilisation practices effective in the long-term

The basics of aggregate demand management

Before, we derived the equation for the GDP of an economy: $GDP = C + I + GP + X - M$. When an economy in in a recession, the aggregate demand curve shifts to the right (see figure below). Taking these two as given, we can conclude that when an economy is in a recession, we need to find methods to increase $C$, $I$, $GP$ or $X - M$, This is what stabilisation policies attempt to achieve, or stimulus: measures taken by governments in order to raise aggregate demand. Government has several tools available to do so:

1. Government consumption: hiring more people
2. Tax policy: tax cut
3. Government investment spending: build more infrastructure
4. Monterey policy
5. Exchange rate policy to increase exports

The three big problems with aggregate demand policies

Many economists also point out a range of problems with the kinds of stimulus policies previously mentioned, the three main ones are:

1. ‘It’s not that simple’. E.g. when taxes are cut, this should stimulate consumer spending but this doesn’t necessarily need to happen. Or, when governments spend more, consumers might see this as a problem for later and become more pessimistic and spend less again.
2. When employment is already at a high level, a government-induced increase of aggregate demand may only cause inflation: the prices go up, but output remains the same.
3. The short-term effort may not be in line with long-term stability. Increased government spending may increase employment in the short-term, but the government debt does go up.

Output determination in the IS-LM model

The IS-LM model was developed by John Hicks to help explicate Keynes’s thinking on aggregate demand management. It can be summarised by yet another supply/demand-curve, but now for money. On the vertical axis we find the interest rate and on the horizontal axis the level of output, or aggregate demand. The IS curve depicts the set of all levels of interest rates and output (GDP) at which total investment (I) equals total saving (S). At lower interest rates, investment is higher, which translates into more total output (GDP), so the IS curve slopes downward and to the right.

The LM curve depicts the set of all levels of income (GDP) and interest rates at which money supply equals money (liquidity) demand. The LM curve slopes upward because higher levels of income (GDP) induce increased demand to hold money balances for transactions, which requires a higher interest rate to keep money supply and liquidity demand in equilibrium.

The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance.

Government spending, again as economy stabilising mechanism, means that the aggregate demand goes up, which moves the IS curve to the right. Consequence: interest rates and output go up.

If instead the central bank increases the money supply, the LM curve shifts to the right, again increasing output, but lowering the interest rate.

Both are illustrated below.

Labour markets

Labour Markets, Concepts, Definitions & Groups

Working age population: everyone older than a certain age (usually 15).

Labour force: those of working age who are part of the labour supply (both employed or unemployed)

Unemployed: are (1) without work, (2) currently available for work and (3) are seeking work.

This rate is often used to compare different societal groups, e.g. men and women:

Another important concept is the Beveridge curve, which shows the relation between the vacancy and employment rate. It suggest that a high vacancy rate correlates with low unemployment, and vice versa.

Labour Market Institutions: Minimum Wages, Unionisation & Contracts

Labour market performance in different countries comes from differences in institutions. For example, collective wage bargaining, unionisation and the degree of government intervention and the duration and generosity of unemployment benefits all affect the wage level and unemployment rate.

The unionisation is the number of workers who are unionised over the total number of workers of the country’s labour force. It has been declining over the past couple of decades; from 35% in 1980 to 15% in 2014. Bargaining can happen at various levels, such as company, industry, sector or country. Industrialised countries often move to more decentralised bargaining levels. There’s variety between countries when it comes to government intervention in these processes, where it is usually lower for countries with more decentralised bargaining levels.

Collective wage bargaining comprises negotiations by labour force representatives (unions), pertaining to employment conditions like wages and working conditions.

There are also several laws to protect the employed:

• Severance payments: the cost of dismissal of a worker paid to the employee
• Notice period: advance notice for a worker who is going to be dismissed
• Minimum wage: lowest wage that employers are legally obliged to pay to their employees

Costs of Unemployment, Digitization of Labour Markets, Informality & Underemployment

To estimate the cost of unemployment we have to distinguish between cyclical and structural unemployment. The latter is also known as the natural rate of unemployment: full-employment unemployment rate when the total output of the economy as at its potential level. Cyclical employment on the other hand is whenever output is below the potential level. Costs of cyclical unemployment:

• Unemployed don’t get paid
• Government has lower revenues
• Companies have lower profits

Digitisation also has effects on the labour markets. Digitisation is the process of converting analogue information to a digital format. As a social process it is the transformation of techno-economic environments and social institutional operations through digital communications and applications. Digitisation leads to a (small) reduction in the unemployment rate. However, this is unevenly spread amongst society: high-skilled workers benefit while low-skilled workers lose out.

The unemployment rate is not the only indicator about the labour market. Informality and self-employment, varying widely across countries, need to be considered as well. Someone who is informally employed is active in the production or sales of legal goods and services that are not regulated or protected by the state. These are often characterised by a lack of social security and contracts and include self-employed workers. Underemployment is different, it is when someone is working but not working the hours they would like to work (time-related underemployment), or working a function for which they are overqualified (skill-related underemployment).

Money & Central Banking

Money vs Barter: History and Concepts

One of the toolkits used by the US Central bank to avoid a recession after the 2008 financial crisis was quantitative easing, which is the introduction of new money into the money supply by a central bank, usually through buying treasury securities.

Before money became the currency of the economy, trade, or bartering, was used to attain goods or services. Later, various currencies were used in parallel, such as gold, coins or life-stock.

The government introduced paper money to replace these goods only in the 19th century. At that time, this paper money could be exchanged for fixed amount of silver or gold, the money was ‘backed,’ so to say, by precious metals.

Nowadays, countries issue unbacked money, also known as fiduciary money. This means that the money is not backed by precious metals, but backed by trust of the issuer. The trust in the institution that issues the money, that prints it, that makes people accept it as common currency.

Money has three functions:

1. Means of exchange; people are willing to accept money in exchange for their goods or services since they know others will also accept this money for theirs.
2. Unit of account; because price is expressed in numerical values it allows for accounting.
3. A store of value (given that inflation remains low)

It also has two necessary characteristics:

1. Should maintain its physical value (else the last condition as store of value cannot be guaranteed)
2. Should be cheap and practical to store

Gresham’s law: bad money replaces good money. So if your currency is ‘number of cows’ you will pay first with your worst cows. ‘Bad cows’ will become the currency.

The currency that you see in circulation is the most liquid form of money. Together with other forms of money, this becomes a monetary aggregate.

The monetary base, or the high-powered money is equal to the currency in circulation plus reserve balances held by commercial banks. Another concept, M1, is the currency in circulation plus the demand deposits in the commercial banking system. M2 is than M1 plus saving deposits, time deposits and money market mutual funds. Lastly, M3 is the sum of M2, repurchase agreements, money market fund shares or units, and debt securities of up to two years.

These concepts are used to calculate a county’s monetary deepness. For example

Money Demand

When a household receives income, it can decide how that income is held. It may wish to hold some income as money (high liquidity, no interest), or other financial assets (that do pay interest). William Baumol and James Tobin showed how to get the optimate choice of money demand (money over price):

Where income pushes up money demand, and the interest rate pushes down money demand.

The quantity theory of money is expressed through:

Where $M$ is the monetary base, $V$ the circulation velocity and the total output of the economy (Price level $P$, times output $Q$). The velocity is the number of times that money circulates in the economy for a given period of time, it is the rate at which money changes hands.

Money Supply and the Role of the Central Bank

Most countries have their own central bank. These banks use the short-term interest rate as instrument of monetary policies. They regulate the monetary base in a way such that the market interest rate is aligned with a guiding interest rate.

In the US this is the federal funds rate, i.e. the interest rate at which depository institutions (banks and credit unions) lend balances to other depository institutions.

Beyond the base money, so M1 and M2, the supply is also determined by individuals, families, companies and the banking sector.

The central bank has three operations that affect the monetary base:

1. Open Market Operations: purchase/sale of financial instruments by the central bank leading to an increase/decrease in the monetary base
2. Discount Window Operations: granting loans to provide resources for private financial institutions
3. Foreign Currency Operations: buying/selling foreign currency in exchange of national currency

The money multiplier is used to understand the increase in monetary aggregates, say M1, after an increase in the monetary base. There are two basic elements that are determinants of this multiplier.

1. The coefficient (c) that measures the preference for cash in relation to deposits. $c = C/D$ Where $C$ is the money kept in cash and $D$ the money deposited.
2. The reserve deposit ratio (r) which reflects the share of the deposits maintained by the central bank. $r = R/D$ Where $R$ is the reserves held and $D$ the deposits made.

The money multiplier than is calculated by:

The Central Bank & New Approaches to Monetary Policy

Not every central bank controls the same variable. While some control a monetary aggregate, most control the interest rate.

John Taylor developed an equation that could fairly accurately predict the central bank’s interest rate. He argued that apart from the actual interest rate, the central bank also considers economic growth and unemployment.

This yields the Taylor rule: the central bank should decrease the interest rate when productive capacity is underutilised and vice versa.

There are different ‘anchors’ for monetary policy that can help the inflation rate stay at the desired level. The different options used by the different members of the International Monetary Fund (IMF) are:

1. Exchange rate (45.5%)
2. Inflation-targeting framework/scheme (18.8%)
3. Monetary aggregate target (13.1%)
4. Other (22.5%)

Newer and unconventional tools have emerged, especially in response to the 2008 financial crisis.

Exchange rate themes

Exchange Rate Arrangements

A currency crisis takes place when the central bank runs out of international funds. The countries currency may be devalued by as much as 900% in three-months time (Argentina, 1989).

A more recent example is a drop in exchange rate of the ruble (Russia) by over 50% due to the collapse of oil prices (Russia’s main export product). Similarly, the UK pound depreciated by 15% in two-weeks time after the Brexit option won the referendum.

There are three types of exchange arrangements:

1. Floating arrangements: a floating exchange rate is a type of exchange rate regime in which a currency’s value is allowed to fluctuate in response to foreign exchange market events.
   1. Clean float: the central bank does not intervene in the foreign exchange market.
   2. Managed float: the exchange rate is mainly determined by the market but the central bank has the opportunity and uses it to intervene in the foreign exchange market (by buying or selling).
2. Fixed arrangement: the central bank is committed to maintain the exchange rate at a certain level.
   1. Hard peg: irrevocable (cannot be cancelled)
   2. Soft/conventional peg: revocable (can be cancelled)
3. Intermediate arrangement: the central bank pegs the exchange rate to a foreign currency or a set of currencies, allowing some degree of flexibility according to market forces.
   1. Exchange rate band: the exchange rate can move between a floor and a ceiling and the central bank intervenes only when the exchange rate reaches the floor or the ceiling.

PPP & Interest Rate Arbitrage

The law of one price dictates that a good must cost the same everywhere when it is expressed in a common currency.

Where $P_{i}$ is the price of good $i$, $E$ the exchange rate and $P_{i}’$ the price of the good in another country.

In reality, this law doesn’t hold, partly due to transport costs, trade barriers, governmental regulations and non-tradable inputs. Also, we’ve seen that the price of the good can be universal, but if there’s many services (the price of which is variable over countries or places) applied in making the good this will affect the eventual price.

The Price Power Parity (PPP) discussed before it an extension of this law, only applied to a basket of products.

Where $P$ is the local price level, $E$ the exchange rate, and $P’$ the foreign price level of a basket of consumer goods. There are four conditions to be met for this equation to hold:

1. There are no transport costs
2. There are no artificial barriers (trade tariffs or import quota’s)
3. The goods are internationally tradable
4. The local price index must have the same basket of goods

Because the global industry is so interconnected, capital will naturally flow to areas where higher returns can be achieved. E.g., when the risk in two places is similar, investors will invest in places where they find a higher interest rate.

For example, when $i$ is the interest rate in country A, $i’$ the interest rate in country B, and $E$ the exchange rate (currency A over B), I can compare the investment in country A:

$1+i$

with an investment in country B, in the currency of country A:

From it, we arrive at the Uncovered Arbitrage Condition:

uncovered because no market was used to cover against exchange risk. Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge against exchange rate risk.

This uses the forward premium: percent change of the forward exchange rate market divided by the current exchange rate:

such that

The forward exchange rate market allows for the buying and selling of currency for future delivery. You can use the forward market to sell foreign currency at a particular date and know precisely what you will get.

When you would sell a product in another currency directly, you sell it via the spot exchange rate market: the current market with no premium to protect against exchange rates in the future.

The Real Exchange Rate & the Role of Non-Traded Goods

The real exchange rate ($R$) is a measure of a country’s competitiveness defined in a very simple equation:

$E$ is then the nominal exchange rate and $P’$ and $P$ the foreign and local price level respectively.

The real exchange rate increases when a nominal depreciation is not offset by an increase in all the prices of your inputs. Foreign prices (also for your products) increase relative to nominal prices, making your business more competitive (as exporter).

The real exchange rate in relation to the equilibrium exchange rate $R’$ tells us something about a currency’s valuation. Is the real exchange rate lower; the currency is overvalued, is the real exchange rate higher; the currency is undervalued.

To derive this equilibrium value, we may use the Big Mac Index (yes really), which compares the prices of the Big Mac all over the world, using the US as base. To convert prices of the Big Mac Index to USD you use the market exchange rate. You can than calculate the over-or-undervaluation with respect to the USD. It gives you an indication of how cheap or expensive a country is.

We’ve talked about tradable and non-tradable goods. There are two factors that influence a good’s tradability:

1. Protectionism: the economic policy of restraining trade between countries through tariffs, regulations, imports, etc.
2. The transportability/transport cost

The higher these both factor, the less tradable a product is.

Monetary Policy Under Fixed & Floating Exchange Rates

When a central bank increases the monetary base by purchasing bonds this has the following effects:

1. Those selling the bonds increase their capital
2. The demand for foreign currency increases as the domestic interest rate goes down
3. Part of this capital is used to buy foreign bonds to make foreign investments
4. To correct (under fixed exchange rate), the central bank will have to sell foreign reserves

In the end, an increase in the money supply by a central bank under fixed exchange rate arrangement causes a loss of international reserves, but there is no effect on the stock of money and the exchange rate. A central bank can only do this al long as it has international reserves.

Under floating explain rates (clean float), again the central bank purchases bonds and:

1. Those selling the bonds increase their capital
2. The demand for foreign currency increases as the domestic interest rate goes down
3. Part of this capital is used to buy foreign bonds to make foreign investments
4. The exchange rate starts depreciating (it increases).
5. The prices of imports increases
6. The domestic price level increases
7. Inflation rate goes up

In this case though, there is no change of international reserves.

When the exchange rate depreciates, it’s very hard to stop inflation.

Currency Crisis

There are three types of models that help us understand why a currency crisis may occur:

1. First-generation models: explain how a currency crisis occurs when macroeconomic policies are inconsistent with a fixed exchange rate. These models emphasize that if you have a fiscal deficit (the condition when the expenditure of the government exceeds its revenue in a year) you cannot maintain a fixed exchange rate.
2. Second-generation models: explain how a currency crisis can occur without a macroeconomic fundamental problem. Expectations play an important role.
   1. A self-fulfilling crisis is when people will believe a crisis will happen and because of their according behaviour it happens.
   2. Expectations crisis is the former but without any anomalies in the economies fundamentals.
3. Third-generation models: analyse the interaction between a currency crisis and a banking crisis.

It’s important to realise that even when an economy is healthy, a crisis at one of its neighbours can have a contagious effect.

Financial markets and Financial Crises

Bank Runs and Panics

Commercial banks make their profit by taking (short-term) deposits against an interest rate and than using these deposits to provide (long-term) loans against a higher interest rate. This is called maturity transformation: where financial intermediaries like banks use short-term liabilities (like deposits) to fund long-term assets.

Fractional reserve banking: only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal.

Interbank loans: when banks borrow money from other banks for a specified period of time.

This structure however doesn’t always work. When many depositors want to withdraw their money in a short time period (for example they think other depositors are taking their money out of the bank) they cause a ‘bank run;’ a run on the bank where depositors in a massive number, suddenly demand their money back from the bank because they fear that all the other depositors are doing the same thing.

This is called a rational panic, because if you are an individual who has normal confidence in the bank but you see everyone else panicking, the only rational response is jump in the line and try to get your money out, too.

Since the great depression of the 1930’s the US had for 70 years not seen a bank run happen.

The bank run of 2008 was different. It was not a panic of bank depositors in commercial banks, but a panic involving investment banks: banks that borrow money from other banks to make onward loans.

When Lehman Brothers, one of these investment banks, were pushed into bankruptcy because of risky lending that couldn’t be repaid, banks started to withdraw money from investment banks and within hours, banks all over the world stopped lending to other banks.

This and consecutive events could’ve lead to another great depression, but this time the federal reserve didn’t just stand by and lend money to these banks so they could continue to lend money to businesses and investment banks.

How to prevent Bank Runs

There are four steps to preventing a bank panic:

1. Capital adequacy; having a sufficient share of bank owners’ capital in the bank provides both a cushion and an incentive. Capital adequacy standards were tightened after 2008.
2. Reserve adequacy; a prudential standard requires the bank to have higher reserves, required reserves against their deposits.
3. Deposit insurances provided by the government for capital up to a regulated threshold. This can help break a panic flood; you don’t have to collect your deposits because you are insured by government capital.
4. Central bank as the lender of last resort. Lending from this lender of last resort comes at a price; oversight regulation, stress testing and due diligence of the commercial and investment banks.

With this knowledge however, bank runs still remain an actual concern (see Greece in 2015). This can have various causes:

1. Poor regulation
2. Lack of reserves, or reserves that were perceived liquid became illiquid in times of crisis.
3. Lack of deposit insurance
4. Failure of the lender of last resort

Bubbles & Crashes

A financial bubble occurs when a financial asset deviates from its fundamental value. Usually the financial market would prevent bubbles from occurring as they shouldn’t invest in vastly overvalued assets. However, investors may think that whatever caused the price of the asset to rise will continue to do so in the future.

Investors could say, we count on the recent momentum of price increases to continue at least for a while, and I’m going to ride this thing up a little bit more and get out before the crash occurs.

Rational bubble: bubbles in which the investors are not making a wild mistake but they are making a probabilistic assumption that the price increases could continue for a while at a certain probability, and yet they are aware that the price might crash and revert to its fundamental level.

What can be said about financial bubbles and crashes:

1. They are somewhat rare but definitely exist
2. they can have elements of rationality to them even though the collective behaviour of the financial market is irrational; it’s irrational in the sense that the price deviates over a sustained period of time from reasonable calculations of fundamental values.
3. Bubbles misallocate resources; in a housing bubble, resources are spent on houses while there may be no demand (houses are held by investors as asset rather than as a living quarter).

Managing Insolvencies

Insolvency is one’s inability to pay one’s debt. The worth of this company is, in a sense, negative, because the debts on the books are greater than a reasonable calculation of the present discounted value of future operational earnings.

Most countries have bankruptcy laws in place to manage insolvency. When one of the creditors to an insolvent company demands its money through court, the lender is forced to pay off its assets in order to satisfy the claim. When this is not satisfactory, as it often is when the lender is forced to pay off all creditors, they might all want to lay claim on company assets. This is also called a creditor run. This is undesirable however, specifically if the company manages to make a profit (just not enough to pay off its creditors).

Bankruptcy law in the United States argues that a company can be worth more as an ongoing operation than in liquidation. If companies are worth more over the long run the law gives them two pathways:

1. Liquidation and distribution of the benefits, not to one but all of the creditors.
2. The company continues operation. But then, the existing owners of the company, those who own the shares, lose all their claims on the company, and the debtors of the company become the owners of the new company. In a way the debt is written off the balance sheet and it’s converted into equity of the creditors. This company is than under chapter 11 of the bankruptcy law.

What Happens When Governments Go Broke?

On the government balance sheet we find:

• Taxes ($T$)
• Public debt ($D$)
• Interest on debt ($r \times D$), determined by the interest rate $r$
• Government spending ($G$)
• Government outlays, or spending on goods and services, consumption and investment, plus the spending on servicing the outstanding stock of public debt ($G + r \times D$)

The government has a budget deficit when:

$G + r \times D - T > 0$

Accordingly, the government will have to borrow money, such that the debt in the next year ($D_{t+1}$) would equal:

$D_{t} + G + r \times D - T$

For a government debt to stay at a constant level, the interest on the debt will have to be paid:

$T - G = r \times D$

The primary surplus is equal to $T - G$, and $r \times D$ is the interest servicing on the debt (interest due debt).

When a government doesn’t seem to be able to create a primary surplus and is in debt, wit is driven to lay off workers in the public sector or abandon necessary infrastructure investments. Secondly, it can induce a collapse of social order; general strikes, unrest, epidemics, dangers to the water supply. Thirdly, a massive banking crisis with the effects discussed before. And lastly, radicalisation of the society

Inflation, unemployment and stabilisation

Inflation, the Fiscal Deficit & Seigniorage

Hyperinflation is defined as the monthly rate of inflation of 50% or more (13,000% annually).

Inflation has at its root the fiscal deficit of a government. These deficits can be reduced by cutting government spending and increasing taxes, but both are undesirable and can only be taken thus far. The government can lend from markets to reduce its deficit, but the markets too will only do so when they expect to be paid back eventually.

Say that these endeavours are no longer sufficiently effective, in that case, the government will have to go to the lender of last resort, i.e. the central bank. Adding money to the supply base by buying government securities can have several consequences, depending on the exchange rate arrangement:

1. Fixed exchange rate: no initial increase of inflation, but international reserve are lost.
2. Flexible exchange rate: the exchange rate depreciates, triggering an increase in inflation, it’s the inflation that’s eventually financing the fiscal deficit.

To understand the idea of inflation as a tax we need to understand the concept of seigniorage: revenue obtained by printing money, virtually without any cost. It is the difference between the cost of producing something (say a 100-dollar bill) and its worth (100 dollars). This seigniorage is collected by the central bank.

Inflation tax has a base and a rate. The base is the money balances held by the public, and the rate of the inflation tax is the inflation rate.

The advantage of inflation tax is that it requires no institutional capacity to collect, it ‘goes automatically.’

The Costs of Inflation

When inflation occurs, you have a efficiency loss in the holding of money: higher expected inflation leads to higher interest rates and thus a higher opportunity cost of holding money. This leads to inefficient spending in the economy, as people purchase different financial assets and other durable goods to protect themselves against further inflation, not necessarily assets they need.

Menu prices are another kind of cost to inflation. Changing prices isn’t free, e.g. you have to reprinting restaurant menus and catalogues, and reconfigure prices in your vending machines. These costs have declined from digitisation.

Bracket creep effect: inflation pushes income into higher tax brackets; people’s income taxes increase with no increase in their real income or purchasing power.

The poor and most vulnerable people in a society pay the largest portion of their income as inflation tax.

The prior are effects that occur from expected inflation, the complementary effects of unexpected inflation are different.

A first effect would be wealth redistribution. For example, when a creditor facilitates a loan against a 5% interest rate, and the inflation rate is 5%, the debtor effectively repays the loan at a 0% interest rate. Wealth is redistributed from creditors to debtors.

A second effect is income redistribution. When a labourer signs a contract for a certain pay, the labourer’s real income will decline because of inflation. Some contracts include a reconfiguration of the wage when inflation exceeds a certain level. Again, when a contract is set at minimum wage, the most vulnerable in society are hit the hardest.

Another is regressive tax: a tax that takes a larger portion of income from low-income earners than from high-income earners.

Finally, the effect of unexpected inflation is that producers make wrong production decisions: when a product’s prices rise unexpectedly, the producer can interpret this as an increase of demand. In this case, increasing production would seem like a good idea when in reality it is not.

Inflation, Unemployment & the Phillips Curve

There is a trade-off between inflation and unemployment; when you get less unemployment, inflation will increase, whereas if you get higher inflation, unemployment will decrease.

As a worker, when you sign a contract, you make some assumptions about the future; about aggregate demand, the price level, output and the real wage.

Okun’s law: the level of output is closely related to the unemployment rate:

Where $U_{n}$ is the natural rate of unemployment, $Q’$ the potential output, and $b$ the response in unemployment to a reduction in the output gap.

The Philips curve that explains that there is an inverse relationship between unemployment and inflation:

Where $i_{e}$ is the expected inflation, $u_{N}$ is the natural rate of unemployment and $h$ a fixed positive coefficient.

The relationship broke in the 70s after the oil shock, but nonetheless gave countries the motivation to use inflation to reduce unemployment. This can be particularly useful when you, s a politician, have an election coming up. However, the trade-off is only valid for the short-term. When new contracts are signed they will adjust for these inflation rates.

There are three different kinds of expectation formation mechanisms:

1. Static; the inflation will be the same as in the recent year(s)
2. Adaptive; the inflation is a weighted average between current and last periods
3. Rational; workers, companies and all economic agents have a ‘model’ that incorporates government information and all available information to form their expectations.

Stabilisation Themes

Stabilisation is the process of reducing inflation to a low/moderate/target level. There are several tools that ought to be understood for stabilisations

1. Simple rules: stabilise the exchange rate
2. Roots of the problem: reduce or eliminate the fiscal deficit
3. Stop inflationary inertia: inflation in the current period responds to inflation in the previous period.

A way to rank how efficient stabilisation is by using the sacrifice ratio: measures how much unemployment must be necessary to reduce inflation to a target rate. It is the accumulated excess of unemployment above the natural level divided by the percentage points of reduction in inflation. A 1.5% sacrifice ratio means that for for every one percentage point of reduction in inflation, the unemployment rate grows by 1.5%. Naturally, a low sacrifice ratio corresponds to a more efficient stabilisation policy.

One way to reduce the costs of stabilisation is to have independent institutions that monitor and help in this process. The central bank, for example, has the credibility to carry out such a stabilisation programme and is not intertwined with business or government affairs.

A last point on stabilisation is that it is more difficult to stabilise inflation that comes from supply shocks than from demand shocks. Examples of the former are adverse weather (crop damage-induced price increase of produce), collective wage bargaining for waged beyond productivity, increase of fuel prices.

Consumption, Saving and Investment

Consumption, Saving & the Intertemporal Budget Constraint

We should think about household consumption and saving in a inter-temporal framework, meaning ‘over-time.’ Here, a two-period framework, considering the present and the future, is useful.

The basic idea of household decision making is that households want a relatively smooth path of consumption; consumption smoothing. As an example, you could have an income of USD1000 this year, and no income in the next. In that case, you could smooth your consumption by spending USD500 this year and saving the other USD500, and in the next year dis-save the other USD500.

When there’s an interest rate of, say, 10%, a household can spend USD524 in the first year and USD524 in the next. This is what the graph shown below helps us do.

Rate of time discount: psychological degree to which households give less value to future consumption.

Present Value (PV): amount of money that you have to put in a bank today to get a certain amount of money in the future, the future value (FV).

Where r is the interest rate.

Inter-temporal budget constraint: the sum of consumption over several years in present value terms has to equal the sum of income of the same years in present value terms.

The Permanent Income Consumption Theory

Let’s assume a household with USD780 and USD220 income in the present and future time respectively ($r$ = 10%).

1. If the household wants to spend all of it today, it can spend the USD780 plus a loan of USD200 that it will pay back next year ($(1 + 0.1) \times 200$), so USD980 in total.
2. If the household doesn’t want to spend anything, it can save the USD780 and in the next year spend USD200 + USD780 + USD78 = USD1078 in the next year.
3. If the household wants smooth consumption, we can use the graph to find the intersection with the 45-degree line and the consumption possibility line at USD513.

Permanent income: sum of the present values of earnings equals the present value of the actual flow of earnings (so in this case USD513 per year).

We find that the smooth spending equals:

Of course, this approach is not only valid for households, but also applies to countries. It’s specifically relevant for countries with material reserves in times of high and low prices for that material.

When a government in the previous situation proposes a USD40 tax cut this year, this will be paired with a USD44 tax increase next year. Hence, the disposable income goes to USD820 in year one (NPV) but also USD176 in year 2 (NPV). The permanent income stays the same.

The Life Cycle Model of Consumption and Saving

The life cycle model of consumption and saving has a hump-shape: early years, one would spend more than it makes, later it will make more than it spends, and at last one makes nothing an lives of his retirement reserves.

There are two ways that wealth may be transferred from the older to the younger generation:

• Voluntary bequest
• Involuntary bequest (e.g. when someone passes away unexpectedly)

Annuity: a form of investment that pays the investor a fixed return annually for the duration of the investors life.

The composition of a nation’s people decided largely whether a country is saving or dis-saving. When there is primarily young people, the country will automatically save, while if there are primarily old people, the country will dis-save.

Investment

There are different kinds of capital goods and consequently several kinds of investment.

1. Business capital; overwhelmingly financed by the private sector
2. Infrastructure capital; overwhelmingly financed by the public sector
   1. Fast-growing/emerging economies: 5-10% national income
   2. Mature, slower-growing economies: 2-3% national income
3. Human capital; built-up skill and health and physical productivity of people, has both a ‘human,’ political and economic dimension.
4. Intellectual capital; originates from investment in R&D. This is a tricky one, because an idea that you invest in might spread rapidly across the world. Patents are a solution to this, often exploited by the private sector.
5. Natural capital; exploited by the private sector and thus (should be) heavily regulated by the public sector.
6. Social capital; trust in each other, safety. This requires investment that slinks the gap between rich and poor and other ends of society.

Tragedy of the commons: when a shared resource is used by individuals motivated by private self interest and exploited to the extent that it is depleted and rendered unavailable to all.

The Basic Theory of Business Investment

The starting point if one wants to know how to maximize the value of a business, is to ask what  the value of a business is. Broadly speaking this is the discounted flow of earnings of that business.

Investors buy shares of a business based on the expected future profitability of the business.

With $V$ the market value, $E_{1}$ the earnings today, $I_{1}$ the investments (of the business itself) today and $E_{2}$ the future (expected) earnings.

In order to study the potential of an investment, we need to first understand how the future stock of a company ($K_{2}$) changes based on the stock depreciation ($1 - d$). This is given through:

with $d$ the depreciation rate.

To account for the new investments made we have $I_{1}$ such that

Marginal Product of Capital (MPK): the contribution of each additional unit of capital to an additional unit of output.

So if $Y_{1}$ is the capital stock, we find that $Y_{2}$ equals the MPK times the units of capital invested.

Combine these equations, next years earnings can be defined as:

To know if a higher level of investment today raises the value of a firm we simply need to satisfy:

$MPK - d > r$

with $r$ the market interest rate.

The Cost of Capital is the rate of return required for an investor to make an investment.

Fiscal Policies and Institutions

The Budget, Public Revenues & Expenditures

In 1992, in the Maastricht Treaty was signed by countries of the EU. One particular part of the treaty concerns the ceiling put on fiscal deficits at 3% of GDP, and on public debt at 60% of GDP. Particularly after the 2009 financial crisis, only few countries met this criterion.

Since the balance is an important evaluation of a country’s financial health, the budget is a crucial part of policy for any government. Here, the fiscal balance is the difference between public revenues and public expenditures.

Taxes; the most important resource of revenue

• direct; applied directly to individuals or businesses. E.g. income tax, wealth tax, inheritance tax.
• indirect; apply to goods and services; e.g. value-added tax (VAT), sales tax or import tariffs. Higher development countries collect relatively more revenue from direct taxes than from indirect taxes, since the latter are easier to collect and don’t collect sophisticated institutions.

Expenditures

• current expenditures; salaries, consumption of goods and services, interest payments and transfers to the private sector made by the government (~90%). Wages and salaries, and social security being most significant.
• capital expenditures; public capital investments and transfers to the private sector or other entities for investment purposes (~10%).

Saving, Investment the Fiscal Deficit & the Management of Public Debt

Total domestic saving is equal to the sum of public and private saving, and total investment is equal to the domestic saving and external saving. The current account balance is equal to the public sector balances plus the private sector balances. When the current account balance is negative, this almost always indicates a public sector deficit.

An increase in the fiscal deficit reduces public saving. This generally increases domestic interest rate and reduces private investment. This phenomenon is known as crowding out; high government spending increases interest rate which leads to a reduction in private investment.

A relationship for the sustainable level of public debt is given by:

Where $g$ is the rate of economic growth, $D$ is the public debt, $G$ is the government consumption, $I$ is the investment, $r$ is the interest rate on public debt, $T$ is the revenue from taxes and $Q$ is the level of output.

The condition states basically that if the interest rate paid by the government is higher than the growth rate of the economy, ‘g’ the country will need to generate a fiscal surplus; which is what we have on the left hand side in order to have a sustainable debt.

On the other hand sustainability is compatible with the fiscal deficit, if the growth rate of the economy is higher than the rate of interest, the real rate of interest paid on government debt.

Interactions Between the Private and Public Sectors

Political business cycle: results from manipulation of policy tools by governments in office trying to boost the economy prior to an election to improve their re-election chances.

An opportunistic business cycle is that governments try to boost an economy close to elections, and try to put through costly adjustments when elections are distant. Some further observations:

• When the turnover of the governing party is high, they will spend more. This is because when in power, the debt is only for the next coalition to deal with.
• Coalitions with a big number of political parties tend to have high government spending.

The interaction doesn’t always have to be opportunistic, so-called ideological political-business cycles.

• Governments to the right of the political spectrum will apply adjustment programs which are tougher than governments to the left at the beginning of an administration. And then maybe not when they are coming to the next election.

The tax rate does not set the government revenue. It’s the interaction of the incentives that are set by that tax rate and the decisions of the public, the decisions of private agents that will determine government revenue.

When a government increases the tax rate, first revenues will rise. But as the tax rate is further increased, it creates a negative incentive to work. After a while, a further increase leads not to an increase but a decrease of government revenues. This concept is captured in the Laffer Curve.

Fiscal Institutions and Policies

To understand whether a government deficit is the consequence of economic conditions or government responsibilities we can use the structural balance. The structural balance shows the fiscal balance that would occur when an economy is growing at its potential level.

If your country derives a lot of its income internationally, by exports from commodities the fiscal revenue is likely to be highly dependent on the price of that commodity and then subject to the volatility of that price in world markets.

Structural fiscal rules, e.g. adjusting government spending based on a commodity price such as copper (case of Chile), make for counter-cyclical fiscal policy.

The Dutch Disease: a booming natural resource appreciates the real exchange rate and reduces competitiveness of other exports. This makes for a skewed distribution of revenues which on a local scale may be undesirable.

Middle-income trap: the inability of a country to move beyond middle-income level.

To escape this trap means to have strong fiscal institutions, particularly for countries with natural resources. Fiscal institutions include:

• Fiscal rules; spending set according to structural revenues
• Sovereign funds; state-owned investment funds that invests in real & financial assets (real estate, precious metals, stocks, bonds).
• An independent autonomous fiscal advisory council

Open Economy Issues

The Aggregate Demand in an Open Economy

Aggregate demand is the total desired purchases of goods and services.

When we look closer at the imports and exports of the total consumption we can further elaborate on $X$ and $M$:

Where $P$ corresponds to the price, and $X$ and $M$ to the volume of exports and imports respectively. In the context of the aggregate demand:

To find the cost of a foreign product one must multiply the foreign cost of the good with the exchange rate.

When the exchange rate goes up, and consequently a foreign good becomes more expensive, you say that your currency is depreciating in an open market where the exchange rate is allowed to fluctuate (floating rate). In an open economy with a fixed exchange rate this means the currency is devalued or is weakened with respect to another currency.

Aggregate Demand with a Flexible Exchange Rate

Imagine if a government decides to boost its economy by increasing government spending (fiscal policy). In a closed economy, this would yield higher aggregate demand but also an increase of the interest rates. In an open market, this means that the interest rates becomes higher (relatively) than in other countries. Consequently, foreigners want to buy domestic currency. Consequently, the exchange rate is appreciated (for a floating exchange rate), it has strengthened ($E$ goes down). This means that, the export balance will decrease; more imports and fewer exports. This can almost entirely offset government spending.

When a central bank increases the money supply, this leads to higher output and lower interest rates. However, because the interest rates decline, the exchange rate goes up; domestic investors move their capital abroad. Imported goods become more expensive, exported goods cheaper; the export minus imports will increase. So, monetary policy might not increase domestic investment but increase net exports instead due to a weaker currency.

Aggregate Demand with a Fixed Exchange Rate

In the foreign exchange market, the central bank can stabilize the price. It can buy foreign exchange when the domestic currency is tending to strengthen, it can sell for in exchange when the domestic currency is tending to depreciate and thereby peg the exchange rate.

Lets consider a similar example that the government wants to increase aggregate demand by increasing government spending. Similarly, the interest rate would go up and investors would want to buy domestic currency which would appreciate the exchange rate ($E$ goes down). In this case however, the central bank would buy foreign currency equal to the amount of investments made from that foreign country. The effect is that now the aggregate demand has increased. In this case the net exports won’t change. So, under a fixed exchange rate, the fiscal policy is effective.

The converse case, again monetary policy increasing the monetary base, and interest rates go down. In this case, the central bank sells its foreign reserves to the domestic investors that otherwise would have bought this from the foreign exchange. So, in turn, the money added is bought back in exchange for foreign reserves. Monetary policy in ineffective.

In all previous examples, we implicitly presume a high degree of capital mobility: the ability and right to buy and sell domestic financial assets in order to buy or sell foreign denominated and overseas financial assets.

The Current Account & External Indebtedness

In an open economy, domestic saving does not necessarily equal domestic investment. Investors might be driven to invest domestic savings into foreign assets.

Current Account Balance: excess of saving over investment, the net accumulation of assets abroad. It can be measured in three different ways, looking at:

1. Trade flows; $Y = C + I + G + (X - M)$
2. Spending and output; balance of trade in goods and services: $Y - (C + I + G) = (X - M)$
3. Savings and investment; saving ($S$) is $Y - (C + G)$ so that $S - I = (X - M)$

We can see in the investments/saving-curve how, in an open market, savings and investments don’t need to be the same. This will only happen is the world interest rate is at the point where the two lines cross. A high world interest rate would mean high saving and low investment, while a low world interest rate means the exact opposite.

Shocks can disrupt the current account balance. For example, if a country is selling more of a product by discovering a new reserve, the income will be above the permanent income, shifting the savings-curve to the right. Since the world interest rate doesn’t change, this means there will be more saving than investing.

The Intertemporal Budget Constraint of a Country

The current account surplus tells us:

• A country is borrowing from abroad; current account deficit
• A country is lending abroad; current account surplus

Over the long term, the net exports today plus the present value of net exports in the future has to be equal.

Economic Growth

Economic Growth in History, Patterns & Sectors

The rule of 70 states that a doubling of the economy occurs roughly at 70 divided by the growth rate (%) years. So If an economy has a 7% growth rate, a doubling of that economy will occur in 10 (70/7) years time.

Angus Maddison divided the past two millennia up into four different stages or times:

1. Agrarianism: 500-1500AD: no division of labour, no specialisation and very little technical progress. No population or per capita income growth.
2. Advanced Agrarianism: 1500-1700AD: a little bit of population growth and virtually no increase in income per capita.
3. Merchant Capitalism 1700-1820AD: A lot of trade, population grew a little more, and per capita income below 0.1%.
4. Capitalism 1820AD-present, explosive increase of population and per capita income, driven by the industrial evolution. Specialisation became more common. Urbanisation grew.

Urbanisation: increase in the proportion of people living in urban areas.

This is a drive of people out of agriculture, a consequence of increased productivity on land, and more concentrated work in the urban centres.

As an economy develops, the demand for services grows.

Sources of Economic Growth

The Solow’s Growth Accounting Framework says that there are three main sources of economic growth:

1. Capital accumulation (transpiration) $K$
2. Labour accumulation (transpiration) $L$
3. Improving productivity, technological change (inspiration) $T$

The production function argues that a change in production (i.e. economic growth) is determined by a change in technical progress plus the accumulation of labour—multiplied by the share of labour , and the accumulation of capital—multiplied by the share of capital in the economy’s output.

We’ve already seen that total output can also be expressed as he sum of consumption plus investment plus government spending plus exports minus imports.

Furthermore, we can define total output as that accumulating from labour (wages and salaries) or capital (interest payments, profits)

Solow’s Growth Convergence Model

Capital stock: stock of residential structures, machines and equipment that exist at a certain moment and contribute to production.

Investment: spending in goods and services used to maintain or increase the capital stock of the economy.

Again, when we consider $p$ as the rate of depreciation, than $p$ times the capital stock $K$ is the total depreciation. Subtracting this from the gross investment $I$ gives us the net investment, or change in capital stock.

Recall that we had $Q = T \times F(K, L)$. Not considering the technological state gives $Q = F(K, L)$, with $K$ the capital and $L$ the labour.

We can redefine this as the output per worker: $q = f(k)$, with $q = Q/L$. This line can also be drawn in a production function as well:

the line shows us the Marginal Productivity of Capital: a decreasing function of the capital labour ratio. An increase in the stock of capital relative to labour makes output per worker rise at a decreasing rate. The number of workers you add to one machine yields a decreasing growth of production.

The change in stock of capital per owner $\Delta k = i - pk - nk$ where $n$ is the workforce population growth.

The saving function says that you save a given fraction of the output: $S = sQ$ with $s$ the saving rate. If you than consider that saving is equal to investment you get $sQ = I$.

With that, we can define the fundamental equation of capital accumulation: $\Delta k = sq - (n + p)k$. If we now draw the $q$-line, the $sq$-line and the $(n + p)k$-curve. We find where the $sq(k)$ and $(n + p)k$-line (point A), you get the long-term equilibrium point of sustained growth on the production function or $q(k)$-line.

At Point A, we have that $sq = (n + p)k$, which means that the change of $k$ is zero, meaning that the capital stock per worker is at a steady state. Before the equilibrium, the output per capita grows slower than the capital labour increase. At point A, this growth is exactly the same. Poorer countries are often on the left side of the curve. Poor countries thus grow faster than developed countries, so they will be able to catch up. Or at least, that’s what the Solow model.

Growth and Inequality

The Kuznets Curve (Simon Kuznets) suggests that when a nation’s income per capita grows, inequality increases. However, after a while the income inequality will reach a plateau and go down again; an inverse u-shaped curve. The reason for the initial growth of inequality is that the owners of scarce capital have very high returns; labour is cheap and demand is high. Later, capital becomes abundant and labour becomes scares; equality declines.

Recent research also argues that, as more growth reduces inequality, reduced inequality may also stimulate growth by reducing social conflicts, improved overall education and health, and reducing political instability.

Growth Traps

A Growth Trap is a problem that doesn’t let a country go all the way to development. The Poverty Trap entails the restrictions that make economic growth slower for poor countries; such as the lack of infrastructure, illness, weak institutions, and low incentives to invest in human and physical capital. Countries where people own very little capital also lacks the means for investment; if you don’t have much money it’s unlikely for you to save.

The Middle Income Trap is an economic development situation where a country attains middle-income level but cannot move beyond. Here too, a lack of productivity is the main cause. Inequality can be a cause as it makes politics vulnerable to elite capture, economic entrenchment, clientelism and populism. Investment in education, industrial upgrading and diversification lead to higher economic growth.

The Curse of Natural Resources observes that countries with high natural reserves tend to grow slower than countries that don’t have natural reserves. There are several explanations for this ‘curse:’

• Dependence on oil and minerals is correlated with civil war, creating instability, migration and capital flight.
• Resource-rich countries are subject to the volatility of commodity prices and large cyclical fluctuations; associated with less investment and consequently lower growth.
• The political class has incentives to capture the ownership of the resources.

The last growth trap is Environmental Degradation: deterioration of the environment through depletion of resources such as water, soil and air. There may also be a Kuznets curve for environmental damage; at initial development stages, the environmental damage increases, but when a certain income level is attained (USD30,000 per capita), it starts to decline again.

Globalisation

What is Globalisation?

Globalisation is the interconnection of the world economy, happening in various different ways, such as trade (goods & services), financial flows for investment (borrowing and lending), information, knowledge and technology, and migration.

There are 5 big epochs/waves of globalisation:

1. Dispersion of humanity
2. Old world globalisation; trade between the continental empires
3. Age of (re)discovery; sea routes between America, Europe and India
4. Age of industrialisation
5. Information revolution

Development of the Global Economic System

The globalisation of industrialisation can be divided usefully in three phases:

1. 1800s-1914: dominance of European powers
2. 1914-1945: world war I, instability of the 1920’s, 1930 great depression, world war II.
3. 1950-200’s: our construct of globalisation, expansion of global trade, global institutions.

In the third phase, there was already a sense of three worlds:

• First world; U.S, Post-war Europe, Japan, South Korea, Australia, New Zealand
• Second world; Soviet Union, China, Central Asia, Mongolia
• Third world; Latin America, Africa, Middle East, South Asia

Many countries after decolonisation became Autarkic: without external assistance or international trade, building up behind a protective barrier.

How did we move to a more global world, from these three distinctive world types?

1. Opening of the Republic of China to the rest of the world by Deng Xiaoping after Mao Zedong. This sparked tremendous growth in the economy, growing 32 times its initial size from 1978 to 2010-15.
2. Collapse of the Soviet Union in 1991 into many sovereign states desiring to join the market economy.
3. Uruguay round; initiation of the the world trade organisation. Setting broad trade rules, facilitating an open trading system with convertible currencies and financial institutions.
4. Technology revolution; a revolution of computing, information and transmission to greatly boost globalisation of production, design, shipments, assembly and logistics.

Globalisation of Population Systems

Major trade routes often don’t include Africa and Latin America, making them less integrated in global supply chains and the economy.

Crisis of Poverty and Inequality

Two of the main challenges of our time in globalisation are that of inequality and poverty. Extreme poverty has come down sharply during the age of industrial globalisation. However, roughly 1 billion people still struggle for their daily survival, but roughly 10 percent of the global population still live in extreme poverty (as of 2015). Under the SDGs, extreme poverty is to be ended by 2030.

Inequality in our global society is high and is generally perceived to be rising. The Gini Coefficient is a statistical measure for this degree of inequality (0 complete equality, 1 complete inequality). Complete inequality in that context would mean that one person in a country has all the income and the rest has nothing. As of now, the Gini coefficient ranges between 0.25 and 0.6.

Multiple factors in income inequality are given:

1. Technological advancement; tends to favour those with higher skills and education
2. International trade; a sector can be competed away by foreign sectors producing the same things
3. Public policy; can correct for market failures that cause inequality
4. Globalisation has made it harder to tax the high-earners, s they can move their money or properties to tax havens

The Challenge of Sustainable Development

The challenge of our time is that of sustainable development. We need to create economies that are:

• Smart; productive, using modern technologies, adopting the benefits of the information revolution
• Fair; keeping the Gini coefficient down, reducing income inequality, ensuring access to ass basic needs
• Sustainable; addressing the environmental challenges that have come to be

This is very similar to the Triple Bottom Line that societies need to keep in balance:

1. Economic
2. Social
3. Environmental

The idea of planetary boundaries argues that the human species needs to know and keep its limits in order to keep the physical system safe.

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