Macroeconomics CONT.

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MACROECONOMICS CONTINUED

ENDOGENOUS GROWTH (GROWTH THEORY PART 3)

Concerns with basic Solow swan

• Output growth determined by productivity growth which is taken

as exogenous, and hence unexplained

• Strong implications for convergence in output, hard to reconcile

with cross-country evidence

AK model gives simple theory of endogenous growth

• Growth rate depends on saving/investment in physical capital

• Relies crucially on the lack of diminishing returns to physical

capital

• But similar implications follow by allowing for a broader range of

capital inputs

PRODUCTIVITY

Expropriation Risk - Correlation between expropriation risk and residual GDP growth (i.e., the

unexplained component)

Corruption and contract enforceability - correlation with level of GDP per person

FACTOR INCOMES

Openness in goods and financial markets

(1) Openness in goods markets. Restrictions on trade include tariffs

and quotas

(2) Openness in financial markets. Capital controls can place

restrictions on ownership of foreign assets and foreign ownership of

domestic assets

(3) Openness in factor markets. The ability of firms to choose where to

locate operations and workers to choose where to work

With technological change, many more goods and services become

tradeable — offshoring is not a new phenomenon

Australia’s sensitivity to world commodity prices is not a new phenomenon either.

In 2012, some 85% of Australian exports were agricultural and mining commodities.

80% of imports were manufactures.

Countries like Singapore and Hong Kong have export/GDP ratios in excess of 100

because they import a lot of intermediate goods and then re-export them. But only

final goods are counted in GDP. Other things equal, countries have high export

intensities when they are small and/or geographically close to large markets

Nominal exchange rate is the relative price of domestic currency in terms of foreign

currency.

Close co-movement of nominal and real exchange rates is typical for countries with

low and stable inflation

Again, close co-movement of nominal and real multilateral exchange rates.

Bilateral real exchange rate ε = EP/P∗

, the price of Australia goods in terms of US

goods - An increase in the relative price of domestic goods in terms of foreign goods

is a real appreciation, an increase in ε. A decrease in the relative price of domestic

goods in terms of foreign goods is a real depreciation, a decrease in ε.

The goods market is in equilibrium when production Y is equal to the demand for

domestic goods Z. At the equilibrium level of output, trade balance may be in

deficit or surplus.

Games Countries Play

Increases in demand, both domestic and foreign, lead to increases

in output. But they have opposite effects on trade balances

Increase in foreign demand is often preferred to an increase in

domestic demand because it leads to an improvement in the trade

balance (why?)

In a recession, countries with high trade deficits may wait for

foreign demand to stimulate their economy ⇒ may be difficult to achieve coordinated fiscal policy responses to

global recession

Exchange Rates - Main Points

In the long run, the economy reaches the same real exchange rate and the same level of output, whether it operates under fixed or flexible exchange rates.

Under fixed exchange rates, the adjustment takes place through the price level rather than through the nominal exchange rate

For a devalued exchange rate

- with a fixed exchange rate, a devaluation (decrease in the nominal exchange rate) leads to a real depreciation (a decrease in the real exchange rate), and a short run increase in output

- a devaluation of the correct size can return an economy in recession back to the natural level of output

Against a devalued exchange rate

- in practice it is difficult to achieve the "correct" devaluation

- initial effects of a depreciation may be contractionary

- price of imported goods increases, making consumers worse off. This may lead to workers asking for higher nominal wages, and firms to increase their prices as well.

Exchange rate crises under fixed exchange rate

- higher domestic prices may lead to steady real appreciation, a worsening of trade position, lower net exports which reduce aggregate demand and reduce output.

- But if the country were to instead devalue (or float exchange rate), the real appreciation could be mitigated, cushioning the effects on aggregate demand.

- financial markets may come to expect a devaluation soon to resolve the growing problem

exceptions

- if countries are tightly integrated (eg. experience similar real shocks, have high factor mobility between them etc)

- central bank cannot credibly control domestic inflation