THE GLOBAL BUSINESS ENVIRONMENT: INTERNATIONAL MACROECONOMICS AND FINANCE
Professor DiamondClass Notes: 1
INTRODUCTION AND MEASURING ECONOMIC PERFORMANCE IN THE GLOBAL ECONOMY
NOMINAL VS. REAL VALUES
Virtually all prices of goods and services in our economy are measured in terms of current (nominal) market values. At a given moment of time this enables a comparison of prices of competing goods as well as a summation of different types of goods and services.
However, when we need to compare the value of key macroeconomic variables over time we need to convert the nominal data into real values in order to eliminate the impact of inflation. Nominal values are measured in current dollars not adjusted for inflation. Real values are measured in constant dollars adjusted for inflation.
To convert nominal data to real values we utilize a price index. A price index (deflator) is a measure of the average level of prices of a specified set of goods and services relative to their prices in a given base period.
THE CONSUMER PRICE INDEX AND THE PRODUCER PRICE INDEX
The most utilized measure of inflation is the Consumer Price Index (CPI). It measures the cost of living for urban households. The CPI is published monthly by the U.S. Department of Labor’s Bureau of Labor Statistics (BLS). It provides information for the nation as a whole and the major metropolitan areas. Utilizing sampling techniques, data is collected for major categories of goods and services e.g. energy, housing, food, medical services, etc. Since the 1973 OPEC oil boycott the BLS also computes a core rate CPI. The core rate is the total for all items minus the volatile areas of energy and food.
The Producer Price Index (PPI) measures the changes in prices at the producer’s (wholesale) level. Data is published monthly for finished, intermediate and raw material goods. Like the CPI, the BLS also provides a core rate PPI. The base periods for the two indices are roughly the same: CPI 1982-84 = 100 and PPI 1982 = 100. However, the CPI registers a higher rate of inflation than the PPI. For example, at the end of 1999 the CPI was 168.3 vs. 135.0 for the PPI. The principle reason for the difference is that the PPI does not include the cost of services, which has been a major source of the rise in consumer prices. It is interesting to note that the PPI, for which we have fairly reliable data back to the U.S. colonial period, shows no increase in trend values from the late 1700’s to 1940. During these 150 years periods of inflation were offset by periods of deflation due to a boom and bust business cycle. Since 1940, however, the PPI and the CPI trend values have been rising.
THE GDP DEFLATOR AND THE CHAIN WEIGHTED GDP PRICE INDEX
Gross Domestic Product (GDP) is usually expressed in real terms. Unless indicated to the contrary, GDP is stated in real terms in these class notes. Real GDP is derived by dividing nominal (dollar) GDP by the GDP deflator, which is often referred to as the Implicit GDP Deflator. Real GDP is a measure of the physical volume of an economy’s production.
Both the CPI and PPI are fixed weight price indices. Each month the BLS collects the current prices of a fixed list or market basket of goods and services. The index is calculated by dividing the current cost of the items by their cost in the base period.
The GDP deflator until 1995 was determined utilizing a variable weight index. In any given year the GDP deflator is defined as the value of the final goods and services in a given base year prices. However, the rapid introduction of a new products in recent years e.g. computers, VCRs and cell phones made the use of the fixed base year increasingly irrelevant. To deal with this problem in 1995 the U.S. Department of Commerce, Bureau of Economic Analysis which publishes GDP and other national product and income data began to utilize a chain-weighted price index. This index uses a moving base year, which is always the year prior to the current year.
Although the variable and particularly the chain-weighted indices are conceptually more accurate than the fixed weighted indices, empirical data indicates that neither is clearly superior. When the prices of different goods are changing by different amounts a fixed weighted index tends to overstate the cost of living since it fails to take into account that consumers can substitute less expensive goods. Conversely, under these conditions the variable weighted indices tend to understate the increase in the cost of living since although it allows for the substitution of alternate goods it fails to reflect the reduction comparison of the original GDP deflator and the new chain weighted GDP price index also indicates that there is no significant difference between the two measures.
THE NATIONAL INCOME AND PRODUCT ACCOUNTS (NIPA)
The NIPA is the official U.S. government accounting system that collects and publishes data on the nation’s output of goods and services. Gross Domestic Product (GDP) is the total expenditure on domestically produced goods and services. It is also the total income earned domestically form both U.S. and foreign owned factors of production.
The National Income Accounts Identity is the equation showing that the sum of consumption, investment, government purchases and net exports equals GDP. These data are published by the U.S. Department of Commerce’s Bureau of Economic Analysis.
Thus, if we let Y = GDP
Y = C+I+G+NX
where Y = Gross Domestic Product expressed in real terms
C = Consumption
I = Investment
G = Government Spending
NX = Net exports of goods and services
A statement of the National Income Identity which includes NX is referred to as an open economy. It is an economy that sells goods and services to other nations, buys imports form them and has significant financial flows to and from foreign nations. A closedeconomy is a nation that has little or no trade in goods, services or financial (capital) flows with other countries. The United States was viewed as essentially a closed economy for most of its history despite the fact we have always been a coastal nation with a sizable foreign trade. However, as late as the immediate post-World War II decades of the 1940’s and 1950’international trade accounted for only about 5 percent of GDP, exchange rates were fixed and financial flows to and from other nations were restricted. This is no longer the case. Changing geopolitical, economic and technology factors have increasingly transformed the U.S. into a more open economy. Imports now constitute 13 percent of GDP. The exchange rate of the dollar has been floated since 1973 and international financial flows are massive. No longer can U.S. macroeconomic policies be viewed solely in terms of their impact on the domestic economy. The Federal Reserve, for example, in determining its monetary policies must take into account the impact of interest rate changes on both the domestic and international economies. U.S. inflation in the 1970’s was primarily a function of the policies of the international oil cartel, OPEC. The impact of sizable U.S. government budget deficits in the 1980-1995 period on private domestic investment was eased by substantial capital flows from abroad. The 1997-98 Asian financial crises impacted the U.S. positively by substantially reducing the price of imports while at the same time threatening the prolonged prosperity of the 1990’s. Moreover, some economists regard the persistent and growing U.S. trade deficit as one of the major problems facing the U.S. economy. It should be noted that no major or minor economy in the world today is totally open or closed. In the case of the U.S., which is increasingly an open economy and a champion of free trade, it still retains some tariffs and import quotas as well as restrictions on the flow of foreign labor.
Despite the open economy status of the U.S., for analytical and modeling purposes we still find it useful to use the closed economy expression of the national income identity for analytical purposes. Let us restate the national income identity in terms of a closed economy i.e. no net exports:
Y = C+I+G
We can also observe that the income generated by GDP can be allocated as follows:
Y = C+S+T
where Y = Gross National Income
C = Consumption
S = Saving (that portion of income which is not allocated to consumption or taxes)
T = Taxes
Setting the two equations equal yields:
C+I+G = C+S+T
If we cancel C from both sides then:
I+G = S+T
AndI = S+ (T-G)
Investment is equal to savings where S is private saving and T-G (taxes minus government purchases) is government or public saving. As we shall discover the equality of saving and investment is critically important to our understanding of long and short run equilibrium in our economy.
We can also observe that saving equals investment by rearranging our expenditure expressions of GDP in the closed economy:
Y = C+I+G
Recognizing that all government expenditures are viewed in the NIPA as consumption spending then:
Y-C-G = I
where Y-C-G is the value of the output that remains after the needs of consumers and government have been met, and thus is national saving or simple saving. As we have noted earlier national saving is comprised of private (personal and business) saving and government (public) saving.
A further simplification of the national income identity is to eliminate the government sector (G and T) in the national income identity, then:
Y = C+I and
Y = C+S
Equating total national spending with total national income:
C+I = C+S
and once again S = I
We will find this form of the identity useful in developing our models of economic growth.
NATURAL GDP
Before leaving the subject of the NIPA we need to introduce the concept of the natural level of GDP. It is the level of national output/income towards which ht economy gravitates in the long run. It is the level of GDP which results from the full utilization of the available factors of production in a given time period. It is also sometimes referred to as the full employment GDP or the non-accelerating inflation rate of unemployment (NAIRU) GDP. We let equal natural GDP. As a result of economic growth changes over time.
THE OPEN ECONOMY
Let us return to the open economy expression of the national income identity and examine it in more detail.
We begin by observing that some output is sold domestically and some abroad, thus:
Y =
where are consumption, investment and government spending on domestic goods and services and EX is foreign spending on domestic goods and services.
Furthermore:
C =
I =
G =
Where total consumption, investment and government expenditures are respectively the sums of domestic and foreign purchases of goods and services, we can substitute this into the open economy equation as follows:
Y =
Rearranging we find:
Y = C+I+G+EX-
We observe that is expenditures on imports (IM) and thus the national income identity is now:
Y = C+I+G+EX-IM
and if we let (EX-IM) equal net exports (NX) we arrive at:
Y = C+I+G+NX
This statement of the national income identity states that expenditures on domestic output is the sum of consumption, investments, governments purchases and net exports, and:
NX = Y-(C+I+G)
Net exports equals output minus domestic spending on domestic and foreign goods and investments. If output exceeds domestic spending, net exports are positive and the nation has a trade surplus. If output is less than domestic spending, net exports are negative and the nation ahs a trade deficit. Now we again express the national income identity in terms of saving and investment.
SinceY = C+I+G+NX
ThenY-C-G = I-NX
And since Y-C-G is national saving S, then:
S = I+NX or
S-I = NX
Furthermore, as in the case of the closed economy, we can divide national saving into private and public saving by setting the national income identity equal to the alternative ways hat national income may be allocated:
C+I+G+NX = C+S+T
Eliminating C from both sides of the equation yields:
I+G+NX = S+T
Combining government purchases and taxes we arrive at:
I+NX = S+(T-G)
when S is private saving and the difference between taxes and government spending is public saving. If tax revenues exceed government expenditures, a surplus is generated and there is positive public saving. If taxes are less than government spending there is a budget deficit and negative public saving. Rewriting the equation:
S+(T-G)-I = NX
where private plus public saving (national saving) minus domestic investment equals net exports.
As in the closed economy model the relationship between saving and investment is important S-I is net foreign investment. It is the excess of domestic saving over domestic investment. It is equal to the amount that domestic residents are lending abroad minus the amount that foreigners are lending to the domestic economy. NX is the trade balance. It can be positive and the nation has a trade surplus or negative and the nation has a trade deficit. As we shall discern the positive or negative nature of the trade account largely determines the nature of the current account in the balance of payments.
Net foreign investment always equals the trade balance. Any nation that generates a trade deficit must cover this difference by being a net borrower in world financial markets. Nations that experience a trade surplus are net lenders to the rest of the world. Thus, this form of the national income identity shows that the international flow of goods and services (trade) and the international flow of funds to finance capital accumulations are two sides of the same equation. If a nation’s investments exceeds its saving, the extra investment funds must be secured by borrowing from abroad. These funds are necessary so that the trade deficit nation can cover the difference between the value of its imports and exports. Conversely, if a nation’s saving exceeds its investments, the saving that is not invested domestically is lent to foreigners so that they can pay for the difference between the value of their imports and exports.
Note that the international flow of capital can take a variety of forms. For example, a trade deficit nation like the U.S. can borrow abroad by selling bonds issued by the U.S. government or private corporations. Alternatively it can take the form of a direct investment when a foreign corporation constructs a plant or other physical facilities in the U.S. It can also take the form of foreign purchases of existing U.S. capital stock such as factories, office buildings, hotels, and recreational properties such as golf courses. In all of the above, foreigners end up with either a claim to the future returns to domestic capital or ownership of a portion of the domestic capital stock. The net foreign investment of the domestic economy is reduced. Moreover, if a domestic economy like the U.S. experiences sizeable trade deficits over an extended period of time foreign claims on its capital stock may grow to a level where foreign lenders are no longer willing to purchase additional claims at the current interest rate level, or in reaction to a negative shock to either their own economy or that of the deficit nation may decide to cash in a sizeable proportion of their claims. This could cause serious financial and economic problems for the borrowing (debtor) nation.
THE LONG AND SHORT RUN: ECONOMIC GROWTH, BUSINESS CYCLE, UNEMPLOYMENT AND INFLATION
We have already used the term “long run” in our discussion of GDP. The distinction between the long and short run is critical to the understanding of macroeconomic theory. It is also important to make this distinction in analyzing macroeconomic problems. The long run is an extended time period usually lasting at least a decade thus allowing for significant changes in key economic variables. The short run is a limited time period where there is insufficient time for economic variables to fully adjust to changes.
Most macroeconomic theories can be divided into long run and short run theories. The former focuses on economic growth and the latter on economic stability - the business cycle. Moreover long run theories postulate prices to be flexible and thus respond to changes in supply and demand. In contrast short run theories view most prices as sticky at some predetermined level.
Classic economic theory focuses on the long run. In so doing it has developed the concept of the classical dichotomy. This concept enables economists to simplify economic theory by ignoring nominal variables and concentrate on real variables. For example, in discussing economic growth we can ignore changes in the money supply since they do not influence real variables. In contrast, neo-Keynesian theories focus on the short run. A frequently quoted Keynesian observation is – why worry about the long run since we will all be dead.
It should also be noted that the impact of a given economic factor may vary in the long vs. the short run. For example, a high national saving rate is a most positive element promoting economic growth. However, a high saving rate during the contraction phase of a business cycle can be a significant negative force in preventing an economy from returning to prosperity.
ECONOMIC GROWTH
As indicated economic growth theories focus on the long run. They seek to explain why some countries grow while others do not. At the same time economic growth is reported in a short run context. The U.S. Department of Commerce Bureau of Economic Analysis publishes annual rates of changes in real GDP as well as quarterly data expressed as an annual rate.
In the long run context the measurement of economic growth needs to take population growth into account. The goal of economic growth is to increase the standard of living for all individuals. For example, if a nation during a 25 year period were to double both the size of its population and its annual real GDP, it would have experienced significant growth in the total output of goods and services. However, the average citizen’s level of living would be unchanged. Thus, the appropriate measure of long-term economic growth is real GDP divided by the size of the population - per capita GDP.