MACROECONOMICS
Chapter 1 - A tour of the world
1.1 The crisis
Figure shows output growth rates for the
world economy, for advances economies
and emerging markets and developing
countries.
2007 signs that expansion might be coming
to an end started to appear.
Optimists believed that, lower housing
housing prices might lead to lower housing
construction and to lower spending by
consumers, the Fed could lower interest
rates to stimulate demand and avoid
recessions. Pessimists believed that decrease in interest rates might not be enough to
sustain demand and that US would go through short recession.
Housing prices continued to decline, problems were deeper. Many of the mortgages that
had been given out during the previous expansion were of poor quality. Borrowers took out
too large of a loan and couldn’t afford their monthly payments. Declining housing prices
resulted in the value of their mortgage often exceeded the price of the house, giving them
an incentive to default. Banks had often bundled and packaged these mortgages together
into new securities and then sold these securities to other banks and investors. These
securities were then repackaged into new securities and on. Value impossible to assess. This
led to the huge financial crisis. Lehman went bankrupt, effects dramatic. Lehman and other
banks links were strong therefore many other banks appeared at risk of going bankrupt as
well.
Stock prices collapsed. Hit by decrease in housing prices and collapse of stock prices, people
sharply cut their consumption. Worried about sales and uncertain future, firms sharply cut
back their investment. With housing prices dropping and many vacant homes on the
market, very few new homes were built. Fed cut interest rates all the way down to zero, US
government cut taxes and increased spending, demand decreased and so did output.
US crisis quickly became a world crisis. Other countries affected by two channels:
1. trade. US consumers and firms cut spending, part of the decrease fell on import of
foreign goods. Exports of other countries went down, so did their output.
2. Financial. US banks badly needing funds in the US, repatriated funds from other
countries, creating problems for banks in those countries as well. Lending came to a
halt, decrease in spending and output.
Governments accumulated high levels of debts and were now running large deficits.
Investors started worrying and asked higher interest rates. Governments confronted with
higher interest rates and reduced their deficit by a combination of lower spending and
higher taxes. This lead to a further decrease in demand and output.
,1.2 The United States
How big is the country from an economic point of view? level of output of country as a
whole. What is its standard of living? look at output per person.
United States:
- Output of $16.4 trillion in 2014
- 23% of world output
- output per person is $54,600.
When economists want to dig deeper and look at the state of healthy of the country, look at
3 variables:
1. Output growth – the rate of change of output
2. The unemployment rate – the proportion of workers in the economy who are not
employed and are looking for a job
3. The inflation rate – the rate at which the average price of goods in the economy is
increasing over time
US economy seems to be in decent shape. However, to make sure demand was strong
enough to sustain growth, the interest rate had to be kept very low (too low for comfort).
Productivity growth seems to have slowed down, implying mediocre growth in the future.
When crisis started, the Fed tried to limit decrease in spending by decreasing the interest
rate it controls federal funds rate. Because keeping cash in large sums is inconvenient
and dangerous, people might be willing to hold some bonds even if those pay a small
negative interest rate (clear limit to how negative the interest rate can go before people find
ways to switch cash).
- Feds stopped at zero, because the interest rate can’t be negative
o if it was 0, nobody would hold bonds. Because holding cash pays a zero
interest rate as well. zero lower bound
Low interest rates are a potential issue:
1. Low interest rates limit the ability of the Fed to respond to further negative shocks
o If demand drops further, there is little that the Fed can do to increase
demand
2. Low interest rates appear to lead to excessive risk taking by investors
o Return from holding bonds low, investors tempted to take too much risk to
increase their returns.
Even though the Fed has to worry about maintaining enough demand to achieve growth in
short run. Over longer periods of time growth is determined by other factors main one is
productivity growth.
- Without productivity growth, cannot be a sustained increase in income per person
One reason to worry: slowdown in productivity growth is happening in the context of
growing inequality. (when productivity increases, almost everyone benefits, even if
inequality increases).
- However, in US not the case. Real earnings of workers with a high school education
or less have decreased in 2010. Invert this trend by either raising productivity growth
or limit inequality, or both.
,1.3 The euro area
1957, six European countries decided to form a common European market – an economic
zone where people and goods could move freely. European union (EU), 28 countries.
In 1999, EU decided replacing national currencies with one common currency the euro.
- Official name for the group of member countries is the euro area.
- 19 countries belong to this common currency area
Euro is a strong economic power. EU as a group is too heterogeneous to be treated as a
single economic aggregate. The euro area and the rest of the EU had a double dip after
2010. EU started recovering towards the end of 2010 but growth turned negative again in
2012, and remained negative for six quarters.
Second euro area recessions goes under the name euro crisis
- associated with Greek crisis ended in partial default of the Greek public debt
Euro faces 2 main issues today:
1. How to reduce unemployment
2. Whether and how it can function efficiently as a common currency area
Can European unemployment be reduced?
How to reduce unemployment must be tailored to the specifics of each country
unemployment rate hides a lot of variation across EU countries.
High unemployment rate result of the crisis and sudden collapse in demand. Housing boom
turned to housing bust, increase in interest rates, triggered increase in unemployment in
2008 and on.
- Main problem is that European states protect workers too much
o To prevent workers from losing their jobs, they make it expensive for firms to
lay off workers unintended result it deter firms from hiring workers
increase in unemployment
o To protects workers who have become unemployment, European
governments provide generous unemployment insurance reduce incentive
for the unemployed to take jobs rapidly.
o Solution eliminate these labour market rigidities and adopt US-style labour
market institutions
What has the euro done for its members?
Euro is of symbolic importance.
Economic advantages of a common currency:
- No more changes in exchange rates for European firms to worry about
- No more need to change currencies when crossing borders
- Euro contributes to the creation of a large economic power in the world
Disadvantages:
- Each country needs to have the same monetary policy same interest. One country
needs to lower their interest rate and other increase one country will be in a
recession and the other won’t be able to slow down the booming economy.
- Loss of the exchange rate as an instrument of adjustment within the euro area if a
country has a large deficit it can’t just adjust the exchange rate, it must adjust by
decreasing prices relative to its competitors long and painful process
, Brexit is the result of two major problems in the UK:
1. Globalization and immigration: socio-economic consequences that outweighed the
UK residents economic benefits declining demand for traditional skills
2. Increasing inequality
1.4 China
Seen as one of the major economic powers in the world.
- Population enormous
- Output is only 60% of US
- Output per person $7600, 15% of US.
Two main reasons for focus on Chine:
- When comparing output per person of rich country and poor country, be careful.
Standards of living are cheaper. Purchasing power parity China is about $12100, a
fourth of US.
- China has been growing very rapidly for more than 3 decades.
Two important aspects:
- Growth barely decreased during 2008 and 2009 Chinese exports slowed during
the crisis but the adverse effect on demand was nearly fully offset by a major fiscal
expansion by the Chines government increase in public investment. Result:
sustained growth of demand and output
- Decline in growth rates from 10% before the crisis to 6.8% in 2015. How did China
maintain such high growth and are they entering a period of lower growth?
Where did growth come from? Two reasons:
1. High accumulation of capital investment ratio in China is 48%. More capital means
higher productivity and higher output.
2. Rapid technological progress: encourage foreign firms to relocate and product in
China. Encourage joint ventures between foreign and Chinese firms
