Global Economic Environment

Session 1
Economic Environment: The complete collection of factors external to the company, exogenous
to its decision making and that have an influence in business performance.

Session 2
Key Economic Indicators:

- Output/Income (GDP growth, productivity): Total goods and services produced in a country in
a given period in volume terms (real GDP)
Key measures:
Productivity = Output / total hours worked
Growth rate: g = (GDPt GDPt-1) / GDPt-1

- Employment (level, rate of growth): Is the total number of persons working (ideally all those
that want to work but often not the case)
Unemployed individuals actively looking for a job
Key measures:
Labor force (population really available for work) = employed + unemployed
Unemployment rate = (unemployed / labor force) x 100

- Inflation: rate of growth of the price level

Consumer Price Inflation: rate of change of the Consumer Price Index

- Interest rates: price of lending or borrowing money (cost to the borrower and payback to the
lender)

- Exchange rates: price of a given currency in terms of other currencies

Exchange rates can be fixed by governments, be set by the markets or (most often) some
combination of both.

- External balances (trade and current account): Net of a countrys exchanges of commodities,
services and capital with others (key is the need of foreign currency)
If net entry of foreign currency for all concepts in our country is positive, then our country is
lending income outside, if it is negative, our country is borrowing income from outside

Session 3
Economic Models: simplified versions of real life economic events. Models are the basis for a
theory that explains aggregate economic behavior.
Equilibrium: a stable situation, out of which the economy generates an automatic process of
adjustment to return to it.
Short/Long run: the time frame consideration is key in economic analysis

- In the Short run we care about Business cycles (periodical swings in economic activity).
Cycles good or bad subject to opinion. Key for income generation

- In the Long run we care about growth potential (depends on endowments and investment).
Key for Wealth generation
Economic Policies: government measures designed to improve economic conditions or to
stabilize the economy (to dampen business cycles).

- Macroeconomic Policies:
I.

Monetary policy: (monetary instruments: interest rates, money supply)

II. Fiscal policy: (fiscal instruments: government spending, taxes)

- Structural Policies: (changes in rules and institutions)

Session 4
Basic static Macroeconomic model: AD = AS
AD -> Aggregate Demand (Real GDP, Interest
rates and Prices): Aggregate spending decisions.
The circular flow of Income and Expenditure
(Expenditure Production Income)

- Equilibrium in Goods Markets (negative

relationship GDP, r):
IS -> Y = Ep = (1/s) (Ca-cTa+Ip+G+NX)
s = marginal propensity to save s=1-c
c = marginal propensity to consume
Ca = autonomous consumption, Ta = taxes, I=investment, G = government spending,
NX = net exports

- Equilibrium in Money Markets (positive relationship GDP, r):

LM -> (M/P)s = (M/P)d and (M/P)d = hY fr
h is elasticity of money demand to income
f is responsiveness of money demand to interest rates

- Equilibrium in Foreign Exchange Markets e = exchange rate such that De = Se

Demand side policies

Supply side policies

- Basic static Keynesian model of AD - IS-LM model:

Key measures:
Marginal propensity to Consume (or save) c (s): extra money spent on private
consumption for every additional euro available.
The multiplier (k): The total impact on the economy of a change in any demand component
k= 1/(1-c) or k= 1/s

- Keynes Multiplier: Change in any component of income (C, I, G, NX) has a compounded
impact on activity equal to the multiplier:
Y = (1/s) (Ca + G + I + NX)
Where Y = Y1 - Y0
Ca is autonomous component of Consumption G is Government expenditure
I is Investment
NX is Net exports (Exports minus Imports) s is marginal propensity to save (or 1-c)
(1/s) or (1/(1-c)) is the multiplier
the larger the marginal propensity to consume the bigger the multiplier

AS -> Aggregate Supply (Real GDP, Prices): Aggregate production decisions of firms
depending on labor market, production function, stock of capital, natural resources.
(Relationship between the quantity of goods and services supplied and the price level in the
economy)

- Two Extreme views:

I.

Self-Correcting Economy Classical school; Prices and wages adjust to make AD=AS; No
need for Fiscal Policy and Monetary Policy, they are not effective

II. Failure of Self-Correction Keynesian school; There is a need to explain severe and prolonged
unemployment spells; wage rigidity explains positive slope in AS; IS can be vertical (insensitive
I and C to r) and LM can be horizontal (increased Ms cannot lower r), in both cases Monetary
policy is ineffective, only fiscal policy works

- AS has a positive slope in the short run (SAS): firms increase output at higher price levels
because wages and other input costs adjust slowly.

- AS is vertical in the long run (LAS): when wages and other input prices fully adjust to changes
in the price level, the amount firms are willing to produce depends only on production capacity.
Demand side policies (macro policies) might be useful in the short run and Supply side
policies are necessary in the long run.

Session 7
Nominal GDP: total amount of production at prices actually paid on the market
Real GDP: measure of GDP that represents variation in volumes (takes out price changes) with
respect to a base or reference year
GDP Deflator: the economy's aggregate price level
GDP Deflatort = (Nominal GDPt / Real GDPt) x 100

Session 8
Value Indext = Volume Indext x Price Indext
Why nations fail?
Session 9
Business cycles: economic fluctuations
consisting in periods of high growth followed
by periods of low or negative growth
Natural Real GDP or Potential GDP is the
level of activity that makes a reasonable
use of available resources (capital, labor,...)
and, therefore, that is compatible with stable
inflation.
Actual GDP is the one observed at a given
point in time, it might be equal, greater or
smaller than potential.

Unemployment Gap: % points difference between actual and natural rate of unemployment

 GDP Gap: % difference between actual and potential/ trend GDP

- If GDP Gap positive -> too low unemployment -> accelerating inflation
- If GDP Gap negative -> too much unemployment -> decelerating inflation
- If no GDP Gap -> stable inflation -> ideal
Two main views:

- Real Business Cycle School: cycles are the efficient response of the economy to shocks.
(Supply side: Technology shocks are the cause of business cycles -> Better technology implies
higher productivity which in turn increases investment and demand for labor (expansion)).
Keynesian School: cycles are the result of the failure of the market to adjust efficiently to
different types of shocks.
(Demand Side: The economy is driven by aggregate demand, aggregate supply is totally elastic
-> Market failures (labor markets, lack of competition, financial markets, sticky prices...) explain
why prices do not adjust to stimulate demand).

- A pragmatic view: cycles reflect periodical swings between accumulating disequilibria (during
expansions) and the eventual necessary correction of those disequilibria (during recessions).
(Relevant for business managers: identify cycle position, anticipate turning points and assess
policy needs and effects on business environment -> You have to watch for: Increasingly
widening gaps and Increasing disequilibria (public deficit, public debt, external deficit,
inflation, private debt, unemployment...)

Session 10
Economic Crises: particularly sharp cyclical downturns, in them there is a significant
deterioration in economic conditions.

- Common symptoms of economic crisis:

I.

Rising bankruptcies

II. Rising unemployment

III. Loss of real income
IV. Loss of wealth
V. Fall in investment and consumption
VI. Depreciation of the currency

Session 12
QE consists on central banks issuing new money to purchase all kinds of assets (instead of the
usual safe short term sovereign bonds)

- QE is controversial:
I.

it radically changes the balance sheet of the Central Bank

II. Its impact on real activity is not granted

III. It might fuel new bubbles in the assets markets
IV. It may end up generating high inflation
V. It has been a source of instability for emerging economies (large capital inflows first and large
capital outflows afterwards)

Session 13
Factors affecting money demand:

Aggregate real income Y (positive relationship)

The aggregate price level (positive relationship)
Nominal interest rates (negative relationship)
Wealth, new technologies, uncertainty.

Money supply is influenced by:

- The Central Bank is the government institution responsible for monetary policies
- Depositary Institutions (Banks) are privately owned banks and thrift institutions that accept
deposits from and make loans directly to the public.
Bank reserves: deposits of private banks with the Central Bank (CB)
They can be:

- required reserves are established by the CB as a ratio on deposits and they limit the amount of
credit that can be provided

- excess reserves are those above the amount required by the CB, they can be lent overnight to
other banks
The Central Bank:

- aims at influencing the interest rate on overnight reserve loans

- can lend reserves itself at the discount window at the discount rate
- can change the supply of reserves through open market operations
More reserves available, or cheaper access to them, mean lower interest rates positive stimulus
to the economy
Increasing commercial bank reserves increases Money by a multiplier:

- The money multiplier is the ratio of money supply to base money (Ms/H) or (1/e : Where e =
reserve requirement ratio)

 Generalization: same money can be used several times each year for transactions, as it goes
from one person to the other:
MV = PY or V = PY / M
V = velocity of money, the number of times each period a unit of money is in a transaction
Y = Real GDP
P = GDP deflator index
PY = Nominal GDP
Assumption of the quantity theory:

- Changes in PY could reflect changes in P (prices) or changes in Y (output)

- If M induce only changes in P (Classical school) then changes in the stock of money lead to
proportional changes in the price level (same holds for inflation)
Key measures:
If higher money growth does not translate into equal output growth, then higher money
growth
leads to higher inflation.
m+v=p+y
If velocity (V) is constant then v = 0 and m=p + y where lower case letters stand for growth
rates

Does the quantity of money theory hold?

- Not in the short run

- Yes in the medium- long run
Why to increase money if it creates inflation?

- Governments try to finance high public deficits with new printed money or to stabilize the
financial system

- When a central bank prints "fresh money" it can obtain goods and services. The amount
of goods and services that the government obtains by printing money in a given period is called
seignorage
Inflation: The rate of change in the price level

- Rate of Inflation = P(1) P(0)

P(0)
Costs of inflation:

- Discourages saving and encourages debt (inflation is bad for savers and good for debtors)
- Unpredictability of the environment (volatile inflation prevents business planning)
- Tendency to persist or accelerate. Once starts to accelerate, it is very difficult to reverse
expectations and lower inflation

- High cost of lowering inflation (deep recession, large unemployment and big loss of activity)

 Costs of deflation:

- Encourages saving and discourages consumption (bad for debtors and good for savers), bad for
stimulating demand during recessions

- Increases the burden of debt

- Tendency to persist and accelerate once expectations on deflation are built in
Hyperinflation: sometimes is described as 30% or more inflation in a year.

- Recommendations if you are in an international firm operating in a high inflation country:

I.

Streamline cash management (invest in indexed assets)

II. Reduce payment terms periods

III. Delay your nominal payments
IV. Measure financial performance in terms of a non-inflation currency (dollars/Euros)
V. Hedge your currency risk

Session 15
Monetary Policy: is determinant for the economic environment because it will influence:

Interest rates (short and long term)

Credit availability
Exchange rate
Inflation levels

Monetary Policy Challenges:

- Money is difficult to measure

- Demand for money is unstable and might not react to supply decisions in the expected way
- Monetary policy implementation depends on final impact on market interest rates and
transmission of cheaper/more expensive credit or more/less credit to the general public through
the financial system
Increasing Money Supply, in the short run

Should lower interest rate

Should increase Y (real GDP, activity)
Should increase Aggregate Demand for each price level
Might increase Prices (size depends on slope of Aggregate Supply curve)

Increasing Money Supply, in the long run

- Should increase inflation (quantity theory of money)

The formulation of Monetary policy requires the CB to take decisions regarding three elements:

- Ultimate Goals/Targets: relates to economic growth and stability

- Intermediate targets: money supply growth, inflation, unemployment and exchange rates.
- Operational Instruments: over which concrete decisions are taken. Base Money and interest
rates.

Session 18
A bond: promise of a stream of payments at specific dates in the future
Bonds are traded in secondary markets, which makes them highly liquid assets
The price of a bond :the discounted value of a stream of payments until redemption
Payments are of two types:

- Regular coupon payments

- Final payment (face value) at the redemption date
The yield of a bond: the average rate of return if it is held to maturity (it is the rate at which
discounted payments equal current market price)
Price and Yield have a negative non-linear relationship
If yield is higher, people would move money from bank deposits to bonds (price of bonds up
and return on deposits up), if it is lower people will not buy bonds (prices will have to fall
and yields will increase)
The impact of current and expected monetary policy decisions on market interest rates is
reflected in the yield curve
The slope of the yield curve:

- Upward sloping (expected increase in r -> expected recovery into the future)
- Downward sloping (expected decrease in r -> expected recession into the future) Flat or
humped with similar values at extremes (high uncertainty)
The normal shape of the Yield curve is a positive sloping line -> higher yields for longer
maturities
A negative sloping Yield curve or inverted yield curve is a rare case, always points to a
recession -> lower return on longer maturities only makes sense if interest rates and inflation
are expected to fall in the future
A flat or a humped curve is also rare -> same rates of return on 3 months and five years mean
no expected differences on monetary policy, growth and inflation
A Sound Financial System suitable for sustaining growth has to be:

- Deep -> the size of financial assets managed by Banks and traded in financial markets has to
be large in relation to the size of the economy

- Accessible -> with a structure that makes it easy to use by savers and investors
- Efficient -> profitable and able to work at minimum costs
- Stable -> able to avoid financial and banking crisis

Session 20
Fiscal policy: decisions taken by the government concerning public spending and tax revenues
FP can be:

- expansionary to stimulate the economy (increasing government spending or lowering taxes)

- contractionary to cool down the economy (lowering public spending or increasing tax
revenues)

- Neutral if policy decisions on the spending side are compensated with decisions on the revenue
side from the point of view of the final contribution to real GDP
Successive deficits accumulate as public debt:
Debtt= Debtt-1 + Deficitt
Excessive debt accumulation drives the government to insolvency and default (fiscal crisis)
Economic limits to Fiscal policy:

- Preserving government solvency

- Minimizing tax distortions
- Minimizing side effects (crowding out, transfer of debt burden to future generations)
We assess fiscal sustainability by looking at Debt/GDP trend

- d = p + y -> stable public finances

- d < p + y -> improvement in public finances d > p + y -> deterioration in public finances
Where
p + y is growth in GDP p = growth in prices
y = growth in real GDP
d = growth rate in debt

Debt grows when public spending increases faster that public revenues. A key component of
public spending are interest payments. When interest rates on sovereign debt are persistently
higher that the rate of growth of nominal GDP the government risks becoming insolvent.
Budget Deficit = Primary deficit + Interest Payments
Unsustainable debt might drive the government to default on payments

Session 22
An exchange rate states the price of a given currency (euro) in terms of another currency (dollar)
Exchange rate changes (changes of the base (euro))

- Appreciation: increase of the value of the base (more dollars per euro)
- Depreciation: decrease of the value of the base (less dollars per euro)
Nominal versus Real exchange rates

- Nominal is the market rate

- Real is the ratio of what a given amount of money buys in one country compared with what it
buys in another (domestic price of goods relative to their price in other countries)
The real exchange rate is a measure of competitiveness
Re = e x Pd / Pf
where Re = Real exchange rate
e = Nominal exchange rate
Pd = domestic price level
Pf = foreign price level

Bilateral versus Effective exchange rates.

- Bilateral rate states the value of a currency against another

- Effective exchange rate measures average performance of a currency against all other
(relevant) currencies
Effective exchange rates provide information on the overall evolution of a currency
Session 23
Theory of PPP: the price of traded goods should be the same in all countries, after adjusting for
custom duties and transport costs
Change in inflation: pf p

- positive pf >p -> PPP predicts appreciation of the domestic currency

- negative pf <p -> PPP predicts depreciation of the domestic currency
Change in interest rate = rd-rf
Where rd domestic rate rf foreign rate

- Increase in domestic interest rates -> capital inflow -> appreciate the domestic currency
(everything else constant)

- Decrease in domestic interest rates -> capital outflow -> depreciate the domestic
currency (everything else constant)

Session 24
Institutional Framework: full collection of legislation, formal provisions, administrative
procedures and organizational structure, that regulate the functioning of political, social and
economic life in a country.
(Acemoglu and Robinson) Inclusive political institutions provide the best environment for growth

- Pluralistic governments: political power is shared by broad segments of population

- Strong governments with centralized power: able to take hard decisions and undertake
difficult reforms