How Does an Economy Work? The Macro-Economics of European Economies MSc in Economic Policy Studies John FitzGerald, January 2015

Course Outline 1.How does an economy work? JF The genesis of macroeconomics AM Modern macroeconomics AM Banks and financial markets AM The recent crisis AM The labour market JF Fiscal Policy and forecasting JF Trade JF The economics of global warming JF The future of the Irish economy AM and JF

Outline of Lecture Theory Different “markets” A model of the economy Equilibrium and Disequilibrium Market “Imperfections”, Expectations, Behaviour Applied - examples from The EU and the US economies Disequilibria in EU economies How economies adjust

Different Markets Useful to consider the economy as a series of markets The Goods (and Services) market Money / Financial Markets Labour Market Housing Market Government sector These markets are interlinked – a “model” of the economy For equilibrium in the economy the markets must be consistent

The Goods market - 1 Demand for Goods (and Services) C+I+G : Closed economy C+I+G+X : Open economy C=Private Consumption; I= Investment; G= Government consumption; X=Exports Supply of Goods (and Services) Y : Closed economy Y+M : open Economy Y = Domestic Output; M=Imports Disequilibrium? Inflation, Current account of the balance of payments Imperfections?

The Goods market - 2

The Goods market - 3 S=Y-C-T S= Savings Y=C+I+G+(X-M) Y-C-T=S=I+(X-M)+(G-T) S+(T-G)=I+(X-M) Total savings equals investment plus the current account surplus What happens if people want to save more?

The Goods market - 4 Growth? Output is a function of inputs and productivity Inputs: labour, capital, materials Investment increases capital and hence the productive potential of economy Investment in human capital (education) increases productivity of labour Investment in R&D may raise productivity of all factors Q= Y = a function of K,L,M, productivity The stock of capital labour and materials determines potential output However, how much will it be profitable to produce?

The Goods market - 5 Profits=P*Q-W*L-P k *K-P m *M where firms maximise profits P= price of output; W= price of labour; L= employment; P k = price of capital; K= capital stock; M = materials; P m = price of materials This means that output doesn’t automatically adjust to meet demand Open economy: is it profitable to produce in Ireland? If it is, how much labour, capital and materials will you need? Competitiveness matters In the long run it is through raising output that living standards rise. Raising demand on its own may not lead to increased output. e.g. Irish government policy in Imperfections?

Money / Financial markets Demand for Money Need money to buy and sell Affected by cost - credit Supply of Money Central Bank can create money Banks extend credit based on their stock of money Disequilibrium? e.g. inflows on financial account of the balance of payments Imperfections? e.g. Expectations – drive bubbles

The Labour market Labour Demand How profitable are firms – what happens to output Cost in home country relative to foreign determines share of world output Price of labour (labour costs), price of capital, price of materials Openness of economy affects behaviour Labour Supply Demographics, Wage Rates, Costs of working, Value of leisure, Culture Openness of economy affects behaviour - migration Equilibrium – Disequilibrium Unemployment rate, rate of wage inflation Imperfections?

The Housing market Demand – factors driving demand Demographics – natural increase Income / wealth Cost – user cost, a function of interest rates, expected prices Supply – factors driving supply Profitability of building – price relative to costs Costs – labour, materials, land Disequilibrium How to measure it? Rate of price increase? Imperfections?

Government Sector Revenue and Expenditure Revenue Economic costs of taxation Economic impact of taxation Other Revenue Expenditure Government Consumption Government Transfers Subsidies Investment Measure of imbalance – Deficit or Surplus Debt - sustainability

A model of the economy An equilibrium solution for economy requires equilibrium in all markets Markets are interlinked. Linked by many variables: Interest rates, wage rates, prices, etc. etc. How will economy adjust to exogenous changes? e.g. changes in budget, changes in oil prices, changes in monetary policy How can governments influence growth? Importance of the supply side

Equilibrium, Disequilibrium May be out of long-term equilibrium. e.g. Running an increasing current account deficit – demand > output Inflation high and rising (prices and wages) Unemployment high Will economy return to equilibrium of its own accord? Possibility of multiple equilibria What is the role of government? Adjustment takes time Time to invest, to change output, to change expectations Never actually in equilibrium

Market Imperfections, Expectations, Behaviour Market imperfections e.g.: Monopolies / oligopolies: make more from lower output Adjustment takes time e.g. investment SME’s cannot finance themselves because of financial sector difficulties Unions and employer cartels may affect wage bargaining Restrictions on supply of building land may affect housing supply Can Government improve the situation? Expectations e.g. People have economic “models” in their heads. These models may or may not be correct Consumption affected by lifetime income – what is lifetime income? Expect a rise in house prices – get on the property ladder! Behaviour In chemistry H 2 O always combine like that. No such certainties with human behaviour. History rarely repeats itself.

Applied Europe and the US 2007 Goods market – Current account of the balance of payments and inflation Money market – interest rates, nominal and real Labour Market – unemployment and wage inflation Housing Market – was there a housing market Europe and the US 2015 Goods market – Current account of the balance of payments and inflation Money market – the “zero lower bound” Labour market – out of equilibrium – will it return to full employment? Housing market – EU economies and the US The investment question

Current account of Balance of Payments - 1

Long-term real interest rates - 1

Rate of inflation - 1

House Price Inflation - 1

Government Borrowing - 1

Debt – GDP ratio - 1

Current account of Balance of Payments - 2

Long-term real interest rates - 2

Rate of inflation - 2

Government Borrowing - 2

Debt – GDP ratio - 2

Individual Countries in EU Look at 3 examples of problems and adjustment Latvia Spain UK

Latvia – current account of BOP

Latvia – rate of inflation Consumer prices, nominal wages and house prices.

Latvia – real interest rate

Latvia – Investment share of GDP Housing, building and construction and total

Latvia – exports share of GDP

Relative wage rates Wage rates in a common currency to base 2000=100: Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

Latvia – unemployment rate

Latvia – government borrowing as % of GDP

Latvia – Debt as % of GDP

Latvia – Conclusions?

Spain – current account of BOP

Spain – rate of inflation Consumer prices, nominal wages and house prices.

Spain – real interest rate

Spain – Investment share of GDP Housing, building and construction and total

Spain – exports share of GDP

Relative wage rates Wage rates in a common currency to base 2000=100: Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

Spain – unemployment rate

Spain – government borrowing as % of GDP

Spain – Debt as % of GDP

Spain – Conclusions?

UK – current account of BOP

UK – rate of inflation Consumer prices, nominal wages and house prices.

UK – real interest rate

UK – Investment share of GDP Housing, building and construction and total

UK – exports share of GDP

Relative wage rates Wage rates in a common currency to base 2000=100: Latvia, Spain, Germany, Ireland, UK, Portugal, EU28

UK – unemployment rate

UK – government borrowing as % of GDP

UK – Debt as % of GDP

UK – Conclusions?

AMECO Database Many annual variables for EU economies, US, Japan etc. Don’t assume that the data are always right! Where available, runs from Includes EU forecasts to 2016 Be careful that 2014 onwards are EU forecasts! Three approaches to accessing it: 1.Online: 2.Excel File: AMECONov14.xlsx plus list_of_variables.pdf 3.Excel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheet House prices from BIS datatbase: Online:

Future Presentations 1.The origins and resolution of the current crisis in Estonia, Bulgaria, Greece and Spain (20 th February) What were the origins? How is it resolving? Look at disequilibria in markets 2.The origins and resolution of the current crisis in Latvia, Portugal, Spain and Italy (20 th February) What were the origins? How is it resolving? Look at disequilibria in markets 3.The crisis in Scandinavia (Finland, Sweden, Denmark) (6 th March) What were the origins? How was it resolved? Look at disequilibria in markets

Reading for this lecture Basic text: “Macroeconomics a European Perspective”, Blanchard, Amighini and Giavazzi. Probably more theory than you need, but provides the basics Chapters 3-6 The rest of the reading discusses real economic situations. The objective is to evaluate whether economies are out of equilibrium and if so why? How are they adjusting or how have they adjusted? What are the problems? FitzGerald, J., 2013 “Financial crisis, economic adjustment and a return to growth in the EU”, Revue de l’OFCE - Debates and policies, No.127 pp Look at one or two of these publications for the EU and its component economies IMF World Economic Outlook, October OECD Economic Outlook, November 2014, situation.pdfhttp:// situation.pdf National Institute Economic Review, November 2014, European Commission: European Economic Forecast, Winter

Reading for this lecture Possible additional reading for projects OECD country surveys Zsolt Darvas, A TALE OF THREE COUNTRIES: RECOVERY AFTER BANKING CRISES, Bruegel Policy Contribution ISSUE 2011/19, DECEMBER and compares Finland and Sweden in the 1990 crisis