ECON672 Global Economy Lecture 10 Review PDF

ECON672 Global Economy 2nd edition Lecture 10 Final Review Dr. Siri Chutikamoltham 1  Lecture 1 Global Economic Environments Dr. Siri Chutikamoltham 2  Areas to Master in the Review ◼ Areas to Master refers to t...

ECON672 Global Economy 2nd edition Lecture 10 Final Review Dr. Siri Chutikamoltham 1  Lecture 1 Global Economic Environments Dr. Siri Chutikamoltham 2  Areas to Master in the Review ◼ Areas to Master refers to those that students are expected to have an excellent understanding, and able to answer related questions, qualitatively and quantitatively. ◼ It does not mean that areas not highlighted here are not important or will not be tested. ◼ The final exam covers all materials of the course, whether highlighted or not. ◼ To prepare for the exam: ◼ Study all materials: lecture notes, reading, assignments ◼ Pay special attention to the Areas to Master ◼ Get help from me before the exam if you have doubt about any issue Dr. Siri Chutikamoltham 3  Lecture 1: Areas to Master ◼ Economic gain from trade ◼ Comparative advantage ◼ What the theories say ◼ Measurement of comparative advantage ◼ Measurement of gain from trade ◼ Opposition to trade ◼ Reasons or excuses not to trade ◼ Is there a justification? Dr. Siri Chutikamoltham 4  Why Trade? ◼ 1. Comparative Advantage ◼ 2. Imperfect market ◼ 3. Product cycle ◼ 4. Search for inputs ◼ 5. Minimize costs Dr. Siri Chutikamoltham 5 Comparative Advantage: Benefits from Trade Eurasia vs. Oceania ◼ Without Trade: ◼ Eurasia: produces and consume 5 kg. coffee and 2.5 m. cloth ◼ Oceania: produces and consume 5 kg. coffee and 10 m. cloth ◼ Trade: Oceania trades 5 m. cloth for 5 kg. coffee ◼ With Trade: ◼ Eurasia: produces 10 kg. coffee, consumes 5 kg. coffee and 5 cloth ◼ Oceania: produces 20 cloth, consume 5 kg. coffee and 15 cloth. ◼ Does trade create benefits? For whom? ◼ Trade benefits both trade partners. Each has more to consume. Dr. Siri Chutikamoltham 6  Measure Comparative Advantage ◼ Revealed Comparative Advantage Formula* ◼ RCAj = (Xj/Xwj) / (XT/XW) ◼Xj = country export of commodity j ◼ Xwj = world export of commodity j ◼ XT = total country exports (of all items) ◼ Xw = total world exports (of all items) ◼ When RCAj > 1, the country has comparative advantage in commodity j *Bela Balassa and Mark Nolan, 1965 7 Dr. Siri Chutikamoltham  Measure Comparative Advantage (cont) ◼ Revealed Comparative Advantage Formula* ◼ Example: ◼ In 2017, total wheat export of the world was worth $24 Bln while total world exports of all items was $18,000 Bln ◼ Country M exported wheat valued $6 Bln, while its total export was $228 Bln. ◼ Country M’s RCA for wheat = (6/24) / (228/18000) = 19.73 ◼ Country M exported 19.73 times wheat more than its fair share, so it must have comparative advantage in wheat ◼ RCA values over the years can tell the improvement or deterioration of the comparative advantage of a country for that commodity over time *Bela Balassa and Mark Nolan, 1965 8 Dr. Siri Chutikamoltham  Terms of Trade ◼ Ratio of the price of a country’s exports to the price of a country’s imports ◼ Terms of Trade: coffee:cloth = 1:1 ◼ Mutually beneficial terms of trade ◼ Relative price in Eurasia: 1 coffee:1/2 cloth ◼ Relative price in Oceania:1coffee:2 cloth ◼ Terms of Trade: 1 coffee for ½ to 2 cloth ◼ Gains from trade rise with terms of trade ◼ Eurasia benefits more from trade the closer to 1 coffee: 2 cloth ◼ Oceania benefits more from trade the closer to 1 coffee:1/2 cloth Dr. Siri Chutikamoltham 9  Summary of Reasons for Trade and Globalization ◼ International business is justified by these key theories. ◼ Comparative Advantage: a country should produce items that it has comparative advantage in, export them in exchange for items it does not have comparative advantage in ◼ Imperfect markets theory:that factors of production cannot move freely, thus, giving a country comparative advantage is a certain production. The country to use the advantage to produce exports ◼ Product cycle theory:a product may be initially produced to serve the domestic market. But when the market becomes saturated, good to export and expand the business to new markets Dr. Siri Chutikamoltham 10  Summary of Reasons for Trade and Globalization ◼ International business is justified by these key theories. ◼ Search for input: International trade enables a country to get inputs that it does not have, or cheaper input for production ◼ Minimize cost: A country can benefit from comparative advantage, and buying cheaper input when it trades with others. This minimizes its cost of production Dr. Siri Chutikamoltham 11  Reasons for Opposition to Trade and Globalization ◼ Some reasons used to oppose trade include: ◼ Trade worsens income distribution ◼ Trade is a zero-sum game ◼ Trade equalizes wages ◼ Trade in strategic items should be prohibited Dr. Siri Chutikamoltham 12  Lecture 2 Enter the Global Economy 2nd edition and Country Analysis Dr. Siri Chutikamoltham 13  Lecture 2 Areas to Master ◼ International Trade, Balance of Payment and Country Analysis Methods to go international. International strategies Framework for country analysis Balance of payment and the health of an economy: o A. Current account is about exports and imports. ▪ Current account surplus means capital inflows into the country o B. Capital account is about the ownership of international assets. ▪ Capital account surplus means capital outflows from the country o C. Error &Omission o Overall balance = A – B +C ▪ Positive Overall balance means increasing the Official Reserves ▪ Negative Overall balance means a drawdown of the Official Reserves; thus, it becomes smaller. ▪ When the Overall balance becomes very small (such as can only buy a few weeks of imports), the country faces a Balance of Payment crisis, needing to get more capital inflows such as from the IMF ▪ Note: Must be clear about the Capital Sub-AC vs Capital AC 14 Dr. Siri Chutikamoltham  Methods to Expand Globally ◼ 1. International trade ◼ 2. Licensing ◼ A firm provides technology, trade name for the use of another company for a fee ◼ 3. Franchising ◼ A firm provides technology, trade name, business services, and/or initial capital for the use of another company for a fee/profit sharing ◼ 4. Joint Ventures ◼ 5. Acquisitions of existing operations ◼ 6. Establishing new foreign subsidiaries Dr. Siri Chutikamoltham 15  Pros and Cons of methods to expand globally Type Pros Cons International trade Simple, small K, any product Trade barriers, market differences, a lot of competition Licensing Fast expansion, small K, IP stolen, Quality Control licensing fees, low risk Franchising Fast expansion, moderate K, IP stolen, Quality Control better management control than licensing Joint Venture Shared resources, local Moderate K, Conflicts with partner’s knowledge, contacts partners, good partners are hard to find Acquire an Good control, synergy High K, regulatory existing operation constraints, conflicts of new and old management New subsidiary Bring business to the new High K, high costs, managers market, start clean, HQ has full may not have local knowledge control, tax benefitsDr. Siri Chutikamoltham 16  What strategy to expand globally? ◼ Global expansion strategy ◼ 1. Multi-domestic ◼ 2. Mega-national ◼ 3. Trans-national Dr. Siri Chutikamoltham 17  Main Characteristics of Global Strategy Multi-domestic Mega-national Trans-national Products customized similar Both, same-same but different Corporate Bottom up Top down Both Decisions Advantages Meet local needs, Econ of scale, QC Best of both worlds capture local Exchange of ideas opportunities (HQ +Local), Disadvantages Costly to customize, Not customized to Coordination lack econ of scale, local needs, supply needed, complex HQ may not have chain must run good control smoothly When to use Customers are Need to lower cost, Standardization + diverse standardized localized Dr. Siri Chutikamoltham 18  Which Country to Expand to? Country Analysis ◼ To understand opportunities and risks that a business may encounter in a country ◼ 1. Framework for Country Analysis ◼ 2. Country Risk Analysis ◼ Political Risk ◼ Financial Risk ◼ 3. Balance of Payment Analysis ◼ One indicator of economic health: Reserve Assets ◼ One predictor of the local currency movement Dr. Siri Chutikamoltham 19  1. Framework for Country Analysis Objective = to analyze a country in a holistic manner that integrates 3 main components: Economic Country Political Strategy Social Economic Context Political Social Performance Economic Political Social Dr. Siri Chutikamoltham 20  2. Country Risk Analysis ◼ Country risk is the potentially adverse impact of a country’s environment on an MNC’s cash flows. ◼ What kinds of risks? ◼ 1. Political Risk ◼ 2. Financial Risk Dr. Siri Chutikamoltham 21  3. Balance of Payment Analysis (cont) Trades in goods Balance of Trade and services A. Current AC Net Transfer Balance Overall of wages, interest Balance of Payment = Capital Sub-AC B. Capital A-B+C Financial AC AC =(Change in) Balance Reserves C.Errors and omissions Assets Dr. Siri Chutikamoltham 22  3. Balance of Payment Analysis (cont) ◼ BP has to balance, by definition ◼ Current A/C – (Capital and Financial A/C) + E&O = Overall Balance ◼ Overall Balance = Changes in Reserves ◼ What happens to Reserves if a country has a Current A/C Surplus and a Capital A/C Deficit? ◼ Ans: Reserves increase ◼ What happens to Reserves if the Current A/C Surplus > Capital A/C Surplus? ◼ Ans: Reserves increase ◼ What happens to Reserves if the Current A/C Surplus < Capital A/C Surplus? ◼ Ans: Reserves decrease ◼ What happens to Reserves if a country has a Current A/C Deficit and a Capital A/C Surplus? ◼ Ans: Reserves decrease ◼ What may happen to a country that consistently has Current A/C Deficit and a Capital A/C Surplus? ◼ Ans: Reserves decrease, needs to borrow more, if can no longer borrow B/P crisis, need to borrow from lenders of the last resort (e.g.,IMF) Dr. Siri Chutikamoltham 23  3. Balance of Payment Analysis (cont) ◼ Balance of payment position and exchange rate ◼ Current AC surplus: ◼ the country sells more exports than buy imports ◼ Earnings from the exports will usually be converted into the country’s local currency, thus, demand for local currency rises ◼ More demand for local currency make it appreciate (more expensive relative to foreign currencies), other things remain the same ◼ Consistent current AC surpluses can lead to the appreciation of the local currency, other things remain the same Dr. Siri Chutikamoltham 24  3. Balance of Payment Analysis (cont) ◼ Balance of payment position and exchange rate ◼ Capital AC Deficit ◼ Foreigners own more assets in the country than its citizens own foreign assets ◼ Foreigners need to pay to buy assets in the country, thus, more demand for local currency ◼ More demand for local currency make it appreciate (more expensive relative to foreign currencies), other things remain the same ◼ Consistent Capital AC deficits can lead to the appreciation of the local currency, other things remain the same Dr. Siri Chutikamoltham 25  Lecture 3 Wealth of a Nation GDP Dr. Siri Chutikamoltham 26  Lecture 3 Areas to Master Accounting for GDP: what is included or excluded What GDP tells What it does not tell about the wealth, standard of living, well-being Various wealth measurements: the differences, the calculation, when to use Nominal GDP Real GDP GNI Dr. Siri Chutikamoltham 27  Measuring GDP ◼ 1. Value- Added Approach ◼ GDP measures the value-added produced in an economy ◼ Value-added = the difference between the value of output sold and the costs of intermediate inputs. ◼ 2. Income Approach ◼ GDP measures income earned by capital and labor within the geographical boundary of an economy ◼ 3. Expenditures Approach ◼ GDP consists of expenditures on final products for consumption, investment, government spending and net export. ◼ Usefulness of GDP information: a gauge of national income, purchasing power Dr. Siri Chutikamoltham 28  Measuring Domestic Output or GDP Expenditure Approach C + I+G + X = Y + M or Y = C+I+G+(X-M) ◼ Domestic output or GDP (Y) ◼ Household consumption (C) ◼ Business sector investment (I) ◼ Export (X) ◼ Foreign imports (M) Dr. Siri Chutikamoltham 29  Converting Nominal GDP to Real GDP Singapore GDP ◼ GDP Nominal =quantity x price in a certain year Deflator 2007 98.1 ◼ Convert GDP Nominal to Real GDP by adjusting 2008 96.6 Nominal GDP with GDP Deflator: the price 2009 100 index for all goods in a country, used to measure 2010 100 (Base Year) the cost of current production relative to the cost 2011 101.2 of the production in the base year. 2012 101.8 ◼ = an economic index that measures inflation over 2013 101.6 time 2014 101.3 2015 104.9 2016 104.9 ◼ Real GDP = Nominal GDP x 100 2017 105.8 GDP Deflator 2018 107.0 2019 106.7 Dr. Siri Chutikamoltham 30 2020 103.8  Problems with Real GDP as a Measurement for Well-being ◼ 1.Does not include the values of services that are not marketed. ◼ 2.Does not value leisure time. ◼ 3.Does not distinguish the importance of different goods and services. ◼ 4.Does not consider the impact on environment etc. ◼ 5.Does not include underground economy ◼ 6.Does not take into account the population size. (Remedy: use Real GDP per capita ). ◼ 7. Does not measure inequality. ◼ 8. Does not count used items that are sold in the economy. Dr. Siri Chutikamoltham 31  GDP and GNI ◼ GDP ◼ Output produced within a geographic location (US, Italy, etc.) ◼ GNI (Gross National Income) or GNP (Gross National Product) ◼ Output produced by citizen of a country ( Americans, Italians, etc.) ◼ Value must be remitted back to the country ◼ GNI or GNP= GDP + Factor Payments from abroad - Factor Payments to abroad ◼ Use GDP or GNI? ◼ GDP and GNI of most countries are similar ◼ Exceptions are countries with many citizens working abroad and sending money back home ◼ GDP is more accurate in measuring the ability of a country to generate its own wealth (output), thus, more widely used Dr. Siri Chutikamoltham 32  Lecture 4 Economic Growth: Supply Side Dr.Siri Chutikamoltham 33  Lecture 4 Areas to Master ◼ Cobb-Douglas Production function Formulae of MPK, MPL of a Cobb-Douglas Function Diminishing return of MPK, MPL, thus, countries cannot rely on K and L to grow the economy indefinitely TFP is the sustainable growth factor Managers must pay attention to TFP growth of the country that they do business in Workers’ wages depend on their productivity and the value of their output Relationship between MPL and Labor Productivity: MPL = (1-a) Labor Productivity Relationship between MPL and wages: Wages = MPL x Price of output Dr. Siri Chutikamoltham 34  What can make a country poorer or richer? Growth Factors : Supply Side Capital Total Factor (buildings, Productivity Output (GDP) (efficiency, infrastructure, technical machines) knowledge) Labor (Hours worked) Dr.Siri Chutikamoltham 35  A Cobb-Douglas Production Function Output = TFP  Capital Stocka  Labor Hours(1-a) Parameter “a” Real GDP (0 < a < 1) Tells the contribution of growth Total Factor Productivity in K to growth in Output Dr.Siri Chutikamoltham 36  Cobb-Douglas Production Function Implications: 1. More inputs ( TFP, K,L) means more output (Y) double capital and double labor , you get double the output TFP x (2K)0.6 x (2L)0.4 = TFP x (20.6 x K 0.6) x (20.4x L0.4 ) = 2 x (TFP x K0.6 x L0.4) 2. Take the logarithm to calculate the change or growth: gY = gTFP + agK + (1-a) gL Growth in TFP, K, and L all lead to real GDP growth. 1% growth in TFP alone leads to 1% real GDP growth 1% growth in K alone leads to a % real GDP growth 1% growth in L alone leads to (1-a) % real GDP growth Does each factor have the same impact on growth? No, TFP gives a constant growth, while K and L give diminishing growth 37 Dr.Siri Chutikamoltham  Marginal Products of Inputs and their Compensation The marginal product of capital is the increase in output that one further unit of machinery generates – keeping unchanged the level of hours worked and TFP. Take first derivative of the Production function with respect to inputs to find their marginal products. (1-a) MPK = a TFP(L/K) The marginal product of labor is the increase in output that results from adding one further unit of labor – keeping unchanged the capital stock and TFP. a MPL = (1-a) TFP (K/L) If input markets are competitive, inputs should be paid the value of their marginal products. 38 Dr.Siri Chutikamoltham Growth Supply Side : Implications for businesses and countries: 1. More capital, more labor, more growth but up to a point due to diminishing return 2. To slow down diminishing return: Add labor to a fixed amount of capital: more hiring, allow immigration Add capital to a fixed amount of labor: more investment, more FDI 3. For sustainable growth, must improve TFP 39 Dr.Siri Chutikamoltham  Labor productivity Output or GDP = TFP  Capital Stocka  Labor Hours(1-a) a GDP  Capital  = TFP    Labor Hours  Labor Hours  Labor Productivity Log ( GDP/L) = Log (TFP) + a Log ( K/L) Growth (Labor Productivity) = Growth (TFP) + a x Growth ( Capital per labor) Dr.Siri Chutikamoltham 40  Relationship Between Labor Productivity and MPL MPL = (1-a) x TFP x (K/L)a Labor productivity = TFP x (K/L)a MPL = (1-a) x Labor productivity If labor market is efficient, labor earns its MPL (Wage =MPL x price of output that the labor creates) Labor productivity is key to the income of workers – More productive workers are paid more – The higher value that a worker can create, the more he gets paid Standard of living – Depends on our ability to produce goods and services – Higher wages in an economy are associated with higher standard of living. Dr.Siri Chutikamoltham 41  Lecture 5 Economic Growth: Demand Side Consumption Dr. Siri Chutikamoltham 42  Lecture 5 Areas to Master Factors that determine consumption: main points, conclusions, insights for management o Current income o Permanent income o Interest rate o Demographic pattern Modern trends in consumption Dr.Siri Chutikamoltham 43  What Determines Consumption 1.The Keynesian Model 2.The Permanent Income Model 3.The Interest Rate Factor 4.The Life Cycle Model Dr. Siri Chutikamoltham 44  Summary of Theories on Consumption Consumption can be explained by several theories. – Keynes Model: Consumption is a function of current income – Permanent Income Model: Consumption is a function of life- time income – Interest Rate Model: Consumption has an inverse relationship to interest rate – Life Cycle Model: Consumption at the macro level is affected by demographic pattern and changes Younger economy: consumes more, borrows more to spend Middle-aged economy: stable consumption, more savings Older economy: consumes less, withdraws savings to consume Dr. Siri Chutikamoltham 45  Implications of Theories on Business Keynes Model: Consumption is a function of current income – More income injected into an economy (such as fiscal spending), more consumption, more GDP (through the multiplier) – Business should pay attention to fiscal policy direction (expansionary or contractionary, where more fiscal spendings will be, etc) Dr. Siri Chutikamoltham 46 Implications of Theories on Business (cont) Permanent Income Model: Consumption is a function of life- time income 1. Expectations about future income may change consumption patterns today. – 1. Higher consumption, lower savings during economic boom when the consumers are optimistic about the future. – 2. Consumer segments that expect to have higher future income (young, well-educated, with good jobs) tend to consumer more. Good for lending business. – 3. Consumer segments that expect to have lower future income (middle-aged to old) tend to consumer less. Good for savings business. Dr. Siri Chutikamoltham 47  Implications of Theories on Business (cont) Permanent Income Model: Consumption is a function of life- time income 2.A temporary income change has less impact on consumption than a permanent income change. – 1. Government incentives (one-time) may not have a large impact on consumption. – 2. Government incentives (on-going) have larger impact on consumption. – 3. Job creation is better on consumption than government temporary handouts. – Business sector benefits more when employment is generated Dr. Siri Chutikamoltham 48 Implications of Theories on Business (cont) Interest Rate Model: Consumption has an inverse relationship to interest rate – Interest rate rises Saving becomes more lucrative, consumption becomes more expensive Results = less consumption, more savings Dr. Siri Chutikamoltham 49  Implications of Theories on Business (cont) Life Cycle Model: Consumption at the macro level is affected by demographic pattern and changes – 1. Older society has less savings, less investment, less growth. 1. Expect the economy to slow down when the population gets older 2. Businesses in older society are not likely to be as vibrant as in younger societies. – 2. Older society needs less durable goods, less housing and eventually excess accumulation 1. Less business opportunity for durable goods and big-ticket items (like housing) in aging society 2. Opportunities in getting rid of stuffs (like recycling) Dr. Siri Chutikamoltham 50  Major Consumption Trends 1. Aging population in several mature economies – Less consumption – Less laborforce ( unless allowed migration) – Potentially less growth 2. Increase life expectancy – More withdrawal of savings to support old age – Less saving pool for investment – More public assistance and budget Dr. Siri Chutikamoltham 51  Major Consumption Trends (cont) 3. Middle-class consumers – More consumption – More demand for public services – Foundation for Consumption-led-growth – Rising in developing countries, declining in more mature economies – Shifting purchasing power from West to East – Demand “good enough” quality, not “ the best quality” – Not environmental conscious 4. Sustainability concerns Dr. Siri Chutikamoltham 52  Major Consumption Trends (cont) 5. Collaborative consumption – Non-ownership, easy access to the temporary use, often based on digital platform – “Living more with less”, “sustainability” 6. Consumption “experience” more than “quantity” or “quality” – Beliefs: “Having more materials does not make one happier”, “ Happiness comes from experiences”, “YOLO”, “Bucket list” – Socialization: product/service reviews, ask the community, sharing photos – Consumers need more control, ditch the customer service 7. Technology embedded from start to finish in consumption decision – Social media influence – Instant gratification : online purchase, fast delivery Dr. Siri Chutikamoltham 53  Lecture 6 Aggregate Demand, Supply and Business Cycle Dr.Siri Chutikamoltham 54  Lecture 6 Areas to Master Business cycles Main characteristics Factors that affect AD to cause it to shift. Factors that affect AS cause it to shift. When AD and/or AS shift, what change may happen in the business cycle. Practice AD-AS model to show a change in the business cycle. BC-Sensitive management Dr.Siri Chutikamoltham 55  Business Cycle Periodic fluctuations in macroeconomic variables, particularly GDP. The fluctuations are seldom predictable. A regular economic phenomenon Managers must be able to foresee the up-coming business cycle to prepare for the changes Characteristics of a Business Cycle – 1.Co-movement in macro variables – 2.Longer expansion than recession – 3.Same cycle across regions and countries – 4.Wider volatility in developing countries Dr.Siri Chutikamoltham 56  What Causes Business Cycle? Short run fluctuations in economic activities around the trend are caused by “changes” in 1. Aggregate Demand 2. Aggregate Supply “Changes” in demand and supply means a “shift” of the curve: at the same price level, there is more or there is less demand or supply Dr.Siri Chutikamoltham 57  A Shift in AD Price Level AD = C + I + G + X - M P1 P0 Y0 Y1 Real GDP Dr.Siri Chutikamoltham 58  Factors that may shift AD to RH Side C I G X,M GDP growth expectation GDP growth Recession Global GDP growth expectation expectation expectation More employment More investment Gov stimulus More global opportunities employment More buyers (more X, More buyers (more Gov deficits increase, More buyers (more more population) X, more population) Gov prints more population, money urbanization) Better consumer Better consumer , Election year Better global sentiments producer consumer , producer sentiments sentiments Lower interest rate Lower interest rate Lower interest rate Lower interest rate 59  An Increase in AS (A Shift of AS to Right-hand Side) AD = C + I + G + (X – M) Price Level AS = production P0 P1 Y0 Y1 Real GDP Dr.Siri Chutikamoltham 60  Factors that may shift AS to RH Side AS shifts to the right: more outputs at the same price levels Some factors: – Increase in the quantity of inputs: labor, capital, TFP improvement – Lower input costs – Tech innovation – Better productivity – Better profitability: tax cut, etc. – Outcomes = increases in output and decreases in price How much can AS increase with changes in the factors that determine AS depends on elasticity of supply Dr.Siri Chutikamoltham 61  Example Trump’s Government Tax Cut AD shifts from personal income tax cut + fiscal expansion AS shifts from corporate income tax cut Price Level AD = C + I + G + (X – M) AS P3 The economy experiences economic boom with little inflation P0 because supply can still increase. P2 AD Y0 Y2 Real GDP Dr.Siri Chutikamoltham 62  Example Trump’s Government Tax Cut AD shifts from personal income tax cut + fiscal expansion AS shifts from corporate income tax cut AS Price Level P3 P0 AD The economy experiences overheating with high inflation because supply has limited ability to increase Y0 Y3 Real GDP Dr.Siri Chutikamoltham 63  Manage Your Business during Booms and Busts Apply BC-sensitive management principles – Production: Plan production and inventory to match the expected cycle – Marketing: Raise prices during booms, cut prices during busts, change product mix to match cycle, counter-cyclical advertisement to build up customer base. – HR: minimize lay-offs of best talents during busts, cherry-pick more talents at recovery. – Investment: counter cyclical capital expenditure – M&A: counter cyclical acquisition to get good price, eliminate weaker competitors. – Risk management across all cycles: diversify, outsource to reduce BC risk, use hedging to minimize price volatility, FX risks, develop new products for new opportunities. Dr.Siri Chutikamoltham 64  Lecture 7 Stabilization Policies: Fiscal Policy Dr.Siri Chutikamoltham 65  Lecture 7 Areas to Master Concepts of expansionary, contractionary fiscal policy, Multiplier How an expansionary (or contractionary) fiscal measure affects economic activity. Ways to fund a fiscal deficit and their potential side effects. o Raise taxation ▪ Economic distortion ▪ Economic growth reduction o Government borrowing ▪ Crowding out ▪ Intergenerational redistribution o Print Money ▪ Inflation, hyperinflation, destruction of the currency ▪ Conditions that fiscal policy may or may not be effective Dr.Siri Chutikamoltham 66  Fiscal Policy Fiscal Policy = Government actions related to government revenue (taxes) and spending (G) that can be used to stimulate or restrain the economy. Government spending (G) can be: – Consumption of goods and services Ex. wages for government employees, materials and supplies – Public investment Ex. Infrastructure – Transfers Ex. unemployment benefit, stimulus payment – Debt service and payment. Expansionary fiscal policy components – 1. Increase government spending – 2. Cut taxes – 3. Combinations of both. Contractionary fiscal policy – Same components, in the opposite direction. 67 Dr.Siri Chutikamoltham  Why Fiscal Policy? Keynesian Model: A Decline in Economic Activity Note: I0 is less than I* Y Planned Output C + I*+ G* C+I0+G* Decrease in unplanned inventories Y0 Y* Actual Output Dr.Siri Chutikamoltham 68  Potential Stabilizing Effect of an Increase in G Note: G** is greater than G* Y Planned Output C + I0 + G** C+I0+G* +G Y0 Y1 Actual Output Dr.Siri Chutikamoltham 69  The Keynesian Model Y=C+G+I C= f (Y)= a+ bY where parameter “a” is the min. consumption required Y = (a + bY)+ G + I (a + G + I) Y= 1-b Dr. Siri Chutikamoltham 70  1 The Keynesian Multiplier, 1-b 1 1 = 1-b 1 - MPC A unit change in parameter a (in C function) , G, or I leads to an increase in GDP by the magnitude of the multiplier. Increase in MPC leads to an increase in multiplier Example – MPC = 0.8 yields a multiplier of 5 – Extra $100 in the min. consumption of a, or G, or I produces an extra $100 x 5 = $500 in GDP. Dr. Siri Chutikamoltham 71  3.How to finance budget deficits? 1. Tax revenues 2. Borrowings – Government sells government bonds 3. Print money Dr.Siri Chutikamoltham 72  3.1 Impact of financing fiscal spending with taxation 1.Economic Distortion – Taxation = gap between the price a buyer pays and the income the seller gets. – Demand and supply are affected by taxes. – Individual income taxes distort supply of labor, employment – Corporate income tax distorts investment – Taxes on capital gain, investment income distort savings – Sales taxes distort demand for goods, and supply of labor. Dr.Siri Chutikamoltham 73  3.1 Impact of financing fiscal spending with taxation (cont) 2. Economic Growth – Taxes reduce expected profits – Negative for entrepreneurship, investment, growth – I = function of {expected profits; t} – t   expected profits  investment – t   people may spend energy in tax avoidance instead of in more productive activities – investment  & efficiency   growth  Dr.Siri Chutikamoltham 74  3.2 Impact of financing fiscal spending with borrowing 1. Crowding out effect – Increase deficit leads to more government borrowing – Competition for loans with the private sector leads to higher interest rates. – Higher interest rates lower private consumption and investment demand. – Government spending to stimulate growth (through running deficit) will not be effective as the drop in private sector demand “crowds out” the government effort. Dr.Siri Chutikamoltham 75  Impact of financing fiscal spending with borrowing (cont) 2.Intergenerational Redistribution – Net taxes = PV (Lifetime tax payments – Lifetime receipts of benefits from government spending) – (such as unemployment benefits, pension, education, medical care) – Net taxes refer to the entire life span, so it’s the present value of the net taxes till death. – If fiscal budgets are balanced consistently, net taxes are about the same for people of different age groups. Dr.Siri Chutikamoltham 76  Impact of financing fiscal spending with borrowing (cont) 3. Compromised ability to manage international relations if borrow a lot from foreigners Dr.Siri Chutikamoltham 77  Fiscal Policy Effectiveness Effective? – Factors that may enable the effectiveness of fiscal policy Targeted Timely No crowding out Good implementation: efficient, non-corrupted – What economic condition(s) that fiscal policy can be more effective than other policies? Liquidity trap – Caveats of fiscal policy Long lag time Confused with other kinds of policy Political influence 78  Lecture 8 Money, Inflation and Monetary Policy Dr.Siri Chutikamoltham 79  Lecture 8 Areas to Master Money creation and money supply Causes of inflation o Monetary School: Quantity of money o Fiscal School: Seignorage Calculate inflation rate Relationship between Nominal Interest rate, Real Interest rate and Inflation rate Impacts of high inflation on the economy, society, population Monetary policy tools to control inflation: what they are, what to use, when, and how they work o Traditional tools: ▪ Open market operations ▪ Discount window. ▪ Reserves Requirement o Non-traditional tools ▪ Quantitative easing ▪ Helicopter money, etc. 80 Dr.Siri Chutikamoltham  What is Money? Definition of Money Legal tender as defined by a government. Money is synonymous with cash and negotiable instruments such as checks, based on bank balances. Dictionary of Finance and Investment Terms Role of money – Store of value – Medium of exchange – Unit of account Kinds of money – Commodity – Commodity-backed – Fiat Currency “Fiat” = let it be done (Latin), a command to create something Dr.Siri Chutikamoltham 81  Money Creation Process How is money supply created? The money multiplier calculates the amount of money banks make by loaning money they are not required to keep on reserve. Let Reserve Requirement = RR Money multiplier = 1/RR Ex. A reserve requirement of 5% means a Money multiplier = 1/0.05 = 20 Assumes banks don’t hold excess reserves Assumes loans make it back to bank deposits Assumes currency doesn’t leave country 82 Dr.Siri Chutikamoltham  Inflation The rate of change in the price levels from one period to the next expressed in % Inflation during 2022 = CPI on Jan 1, 23 – CPI on Jan 1, 22 CPI on Jan 1, 22 Inflation Measurement – Consumer Price Index (CPI) – Producers’ Price Index (PPI) – GDP Deflator – Ratio of Nominal GDP to Real GDP Dr.Siri Chutikamoltham 83  What Cause Inflation? 1. Monetary School: Quantity Theory of Money 2. Fiscal School: Seignorage Dr.Siri Chutikamoltham 84  Cause of Inflation 1. Quantity Theory of Money “Inflation is always and everywhere a monetary phenomenon”, Milton Friedman Money supply growth causes inflation Inflation = too much money chasing too few goods Links inflation rate to the growth rate of money supply Dr.Siri Chutikamoltham 85  Quantity of Money and Inflation Equation MV = PY M = money supply, P = price level, V = velocity Y = real GDP %M + %V = %P + %Y gM + gV = gP + gY If velocity is constant (implies gV = 0 ) then inflation ( gP ) is determined by the growth rate of money: gP = gM - gY Velocity of Money(V): the rate at which money circulates in an economy. It tells the number of times on average a dollar changes hand in a given time period. Ex. If total money supply is $100 trillion, and there are $300 trillion worth of transactions in a year, then the velocity of money is 3.0. Dr.Siri Chutikamoltham 86  Cause of Inflation 2. Seignorage Seignorage = growth in the supply of currency = the net revenue raised by the government by printing money 2 ways to create seignorage: – 1.Direct – print money to spend – 2.Indirect – print money, then use the money to buy and hold government debt(that the government itself issues). Dr.Siri Chutikamoltham 87  Potential Consequence of Seignorage Decline in value of cash holdings due to inflation Inflation tax Growth Seignorage in Money Supply Inflation Dr.Siri Chutikamoltham 88  Seignorage and Inflation tax After 10% inflation, a $10 bill is worth only $9 in real purchasing power Reduction in the purchasing power is like the government has taken a $1 from your pocket = inflation tax of $1. Thus, Inflation tax is closely related to seignorage. Does this mean that a government can increase its revenue from inflation tax by growing the money supply forever? Dr.Siri Chutikamoltham 89  Real Seignorage Real Seignorage = the purchasing power the government gets from printing money Real Seignorage in period t = (Mt – Mt-1 )/Pt = M/P = (M/M)(M/P) = gM (M/P) If the increase in M causes higher P, then real seignorage drops. If P rises faster than gM, government must print more and more money to create same purchasing power. Hyperinflation may result. Slippery Slope of Seignorage! Dr.Siri Chutikamoltham 90  Why worry about Inflation? Impact of Inflation 1.Inflation Tax 2.Interest Rate 3.Economic Growth Dr.Siri Chutikamoltham 91  Impact of Inflation on Inflation Tax A decline in purchasing power of money Affects everyone who holds money equally Non-progressive tax Disincentives for savings Implications of inflation tax for business – 1. Consumers lose purchasing power, they may cut down on spending, especially non-essential items – 2. Producers pay inflation tax when they buy inputs for production. Costs of production rise – 3. Real value of profits decline – 4. Less savings, less funding for investment Dr.Siri Chutikamoltham 92  Impact of Inflation on Interest Rates i = r +  OR r = i -  Set nominal interest rate (i) to expected real rate (r) plus the expected inflation rate() Actual real interest rate that lender receives equals contracted nominal rate minus the actual inflation rate. Higher expected inflation raised nominal interest rate. Implications for business managers? – 1. Higher cost of capital, less profits – 2. Fewer profitable investment projects Higher cost of capital, higher discount rate, lower NPV, if cashflows remain the same – 3. Lower value of stocks Dr.Siri Chutikamoltham 93 Slide 5 Dr.Siri Chutikamoltham Mankiw:Macroeconomics, 4/e © by Worth Publishers, 94Inc.  Impact of Inflation on Economic Growth Shoe leather costs ▪ Implications for business – Time and effort to counter ▪ Higher costs to do effects of inflation business in countries with Menu costs higher inflation – Transactions costs ▪ Less economic growth, associated with less market growth changing prices ▪ Managers must consider Money avoidance inflation when select Price uncertainty countries to do business in Deters savings Lets see the evidence ….. Changes what people do! Dr.Siri Chutikamoltham 95  Stabilization Policy Monetary Policy A major stabilizing policy to manage the volatility of economic activities Monetary policy: the control over the money supply by the central bank Central banks: government authority whose main purpose is to promote stable prices and growth through monetary policy actions. Country Central Bank Country Central Bank US The Federal Reserves Malaysia Bank Negara Malaysia (BNM) System(FED) Japan Bank of Japan Indonesia Bank Indonesia (BoJ-Nichigin) China People’s Bank of China India Reserve Bank of India (RBI) (PBC) Singapore Monetary Authority of Australia Reserve Bank of Australia Singapore (MAS) (RBA) Dr.Siri Chutikamoltham 96  Ultimate Goals of Monetary Policy Monetary policy : the control over the money supply, hence interest rates, by the central bank. Main Goals: Price stability Low unemployment Real GDP growth Policy Goals Dr.Siri Chutikamoltham 97  Conventional Monetary Policy Tools 1.Open market operations – Buys and sells government securities (T-bills, T- bonds) to control the Target interest rate – overnight rate for excess reserves= main monetary policy instrument 2.Discount window and Discount rate (lender of last resort) – Discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their Central Bank's lending facility--the discount window. 3.Reserve requirements – Sets the reserve requirement for bank deposits (US, average 8% of checking account deposits, Singapore 3%) Dr.Siri Chutikamoltham 98  Potential Impacts of Monetary Policy Discount window Open market operations Reserve requirements Interest Rates Money growth Price Stability Unemployment Real Growth 99 Dr.Siri Chutikamoltham  Is conventional monetary policy effective? Monetary policy is effective when: – An increase in the money supply lowers interest rate – Lower interest rate stimulate aggregate demand (I, C, X) – Larger AD creates growth, employment, etc. But when the interest rate is already very low, more money supply cannot bring it down further Interest rates can go to at most zero, but Pessimism discourages investment, consumption liquidity trap Time lag to see result But it is more flexible policy tool than others such as Fiscal policy Dr.Siri Chutikamoltham 100  Unconventional Monetary Policy Definition of non-standard monetary policy or unconventional monetary policy – A tool used by a central bank or other monetary authority that falls out of line with traditional measures – In general, this kind of tool is not often used during economic volatility that is deemed normal When to use? – During extreme economic crisis, when traditional monetary policy tools may not be effective Dr.Siri Chutikamoltham 101  Is unconventional monetary policy effective? Recent experiences in US, UK, Japan – Effective in: 1. Restored the confidence and functioning of financial markets 2. Added monetary policy accommodation when interest rates already reached zero 3. Reduced the risks for worsening recession – But: 1. Inconclusive impacts on growth and price stability 2. Created side effects globally: rising asset prices (bubbles?); unproductive activities of speculation; risks of sudden reversal of money flows 3. Risks and dissatisfaction of the economy when unwind the excess liquidity 4. Prolonged the solutions to the real economic problems: the need to restructure the economy, fiscal deficits etc. Dr.Siri Chutikamoltham 102  Plan Ahead Review all course materials for the final exam Contact me when you need help or clarification Prepare a Cheat Sheet (A4 size, may type or write, or draw on both sides, no downloading, not even from the lecture note). Bring your laptop, a calculator + your own Cheat Sheet to the exam hall Good luck! Dr.Siri Chutikamoltham 103