The Market for Goods and

Services: Growth in the Short-

Run

Chapter 4

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Overview

• The main trade-off of public authorities: inflation versus economic growth;

• Aggregate demand shifts and what happens when policymakers make a mistake;

• The worst economic scenario: stagflation;

• Expectations and self-fulfilling prophecies;

• The Commodities Supercycle and what happens when companies make

mistakes;
Reminder

 In the closed economy model, aggregate demand is a function of the behavior

of consumers, the government, and business: AD = C + I + G
 C: consumption by households
 I: Investment by companies in expanded capacity
 G: Government expenditure
 Chapter 4.1 From Long-Run to Short-
Run

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Market for Goods and Services: Importance of demand in the
Short-Run

Though in the long run, economic growth is determined by aggregate supply, in

the short-run, economic growth is determined by Aggregate demand. This is
because:

1. Aggregate supply factors accumulate over time, and often require successful
investment that can take years to show returns
2. Prices and wages are “sticky”, or slow to respond to variables that should
impact them
Aggregate Supply: Short-term Vs. Long-Term

Price level
 Initially: Price stickiness → more AS
horizontal Aggregate supply
curve, less susceptible to price
and wage changes
 Near Potential output: AS Curve
becomes more vertical because
Maximum potential output
cannot be exceeded (can’t use
more than all the resources
available) GDP=Y
Potential
GDP = Y*
 Aggregate supply can increase, in the long-run

Price level
AS AS’

GDP=Y
Y* Y*
 Commodities Supercycle

China’s rapid growth in the early 2000’s saw massive increases in global demand for
commodities.
In turn, this led to robust growth in resource-rich regions like Latin America, and
Australia. 180

160

140

120

100

80

60

40

20

0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
China Import Price Average Price 1990-2023
Mine production of iron ore (million metric tons gross weight).

Iron Ore Production Skyrockets during Commodities Supercycle

End of the Supercycle

As China’s demand for iron ore and other commodities tailed off, so did global
demand, which saw a sharp decrease in aggregate demand in many of these
commodity rich countries. Many of these countries saw sharp decreases in GDP
growth as a result.
Keynesian Economics: Short-run Aggregate Supply

John Maynard Keynes advanced the idea of “Effective Demand”,

which is the demand level at which people have a real intention
to pay for goods and services. Keynes’ theories were
instrumental to modern economic understandings of short-run
economic growth.
 Chapter 4.2 Aggregate Demand Shifts
and Short-Run Dynamics

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Aggregate Demand in a Growth Gap

A
S
Price Level

P
AD

Y Growth gapY* Y
Fixing a Growth-Gap

An increase in aggregate demand while an economy is in a growth gap will likely

result in stronger economic growth. Increasing aggregate demand can be done by
increasing consumption, investment, net exports, or government spending,
Ceterus paribus.
Fixing a Growth Gap
A
S
Price Level

P’
AD’
P
AD
Y
Y Y’ Y*
 Results from short-run AD Shifts to the right
Economic recovery Economic Overheating

● Economy starts in growth gap ● Economy starts at or near potential

● AD moves right GDP output
● GDP output increases, inflation ● AD Moves Right
increases slightly ● GDP output increases slightly, inflation
increases drastically
Recovery in a Growth Gap
A
S
Price Level

P’
AD’
P
AD
Y
Y Y’ Y*
Economic Overheating

A
Price Level S

P’

P AD’

AD

Y Y* Y
Case Study: The ECB’s 201 1 Rate Hike

 Following the Global Recession,  Noted Economist Paul Krugman

the European Central Bank was against this decision,
(ECB) cut interest rates to spur claiming that the Eurozone was
growth. In 201 1 , however, the still in a significant growth gap
ECB believed that recovery had  Each came to drastically
been achieved, and that different conclusions based on
eurozone countries were nearing same information
the peak of the economic cycle.
 201 1 : ECB raises interest rates
for eurozone countries
Krugman’s View Vs. The ECB’s view

Expectation on A
Future Price S
Level

ECB AD

Krugman AD

Yk YEC Y* Y
Why the Disagreement Matters

If the ECB was Right: If Krugman was Right:

 Interest rate hike slows  Interest rate hike significantly

economic growth slightly. slows economic growth.
 Lowers threat of inflation.  No real impact on already minor
 Counter-cyclical measure. inflation.
 Would further exacerbate
Eurozone’s growth gap.
 Cause a recession.
 Pro-cyclical measure.
A Look at the Numbers: Who was Right?

After the ECB’s rate hike, the EU’s Seems that Krugman was right.
annual GDP growth dropped sharply,
and the EU went into a nearly 2-year
recession.
DROP IN EU GDP GROWTH
 Chapter 4.3 Stagflation and Aggregate
Supply Shifts

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Stagflation

 Stagflation is an economic condition characterized by low or negative

economic growth and high inflation.
 One such example was the United States during the 1 970’s Oil Crisis
 Stagflation is not illustrated by a shift in aggregate demand. Instead, it is a
leftward shift in aggregate supply
Stagflation illustrated
AS’
Price Level
A
S

P’
P AD

Y’ Y Y
Stagflation by the Numbers: Oil Crisis in the USA
Annual GDP Growth Vs. CPI inflation
changes, USA, 1 971 -1 982 In October 1 973, the members of the
Year GDP growth Inflation
Organization of Petroleum Exporting
1971 4.4% 3.5%
Countries (OPEC) declared an oil
1972 6.9% 3.4% embargo.
1973 4.0% 8.5%
1974 -1.9% 12.1% By 1 974, prices of oil had quadrupled
1975 2.6% 7.3% from $3 to $1 2 a barrel.
1976 4.3% 5.0%
1977 5.0% 6.6%
1978 6.7% 8.9%
1979 1.3% 12.8%
1980 0.0% 12.6%
1981 1.3% 9.3%
1982 -1.4% 4.5%
Annual GDP Growth Vs. CPI inflation changes, USA, 1 971 -1 982

Year GDP growth Inflation Oil was a crucial factor in the

1971 4.4% 3.5% production of nearly everything in the
1972 6.9% 3.4% USA in the 70’s. As oil prices rose,
1973 4.0% 8.5%
prices of goods that needed oil to be
1974 -1.9% 12.1%
1975 2.6% 7.3% produced rose. Total goods produced
1976 4.3% 5.0% fell drastically, and the US economy
1977 5.0% 6.6% shrunk nearly 2% in 1 974.
1978 6.7% 8.9%
1979 1.3% 12.8%
By the 2nd Oil Crisis of 1 979, Oil
1980 0.0% 12.6%
1981 1.3% 9.3% prices increased 1 0x over 1 973
1982 -1.4% 4.5% prices to $39.5 a barrel
Source: Fed St Louis (2018).
 First Oil Crisis Illustrated Graphically

AS 1974 AS 1973 AS
Inflation
1972

12.1
%
8.5%
3.4% AD

-1.9% 4.0% 6.9% Growth rate

Stagflation

Aggregate Supply shocks are usually temporary. The Oil Crisis was different,
because of how crucial oil was to the productivity of the United States economy.

 During times of stagflation, short of reversing the shock, there is no full-proof

way to get back to economic stability. Nations can either aim to control
inflation and reestablish credibility, at the risk of exacerbating or causing a
recession, or aim to spur economic growth at the risk of Inflation increasing
even more drastically. In the 1 970’s and 80’s, under the direction of Paul
Volcker, the U.S.A. chose the former.
 Positive Supply Shocks

Economies can also experience

A
positive supply shocks. These Price Level S
are spawned by sudden and AS’
drastic increases in the
productivity of factors of the
economy.
P
 Ex: the Internet Revolution P’ AD
of the mid-late 1 990’s.
 Ex: Introduction of the
cotton gin to American
South, circa early 1 800s Y Y’ Y
The Internet Revolution: Positive AS Shock

U.S. GDP Growth Vs. CPI-tracked inflation, 1 994-2001

Year GDP growth Inflation

1994 3.4% 2.3%
1995 3.5% 3.0%
1996 2.6% 2.7%
1997 4.6% 2.9%
1998 4.6% 1.2%
1999 4.8% 1.7%
2000 4.2% 3.4%
2001 2.3% 3.3%
Source: Fed St Louis (2018).
 The Components of
Chapter 4.4 Aggregate Demand:
Consumption and
Investment

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Aggregate Demand’s Components

Because the economy produces at the intersection of AD and AS, the equation for
AD can be expressed as AD=AS=GDP=C+I+G+X-IM.

For now, lets look at C and I: Consumption and investment.

Consumption

Consumption is what people consume. Household consumption makes up a

significant part of all countries’ GDPs, and typically becomes a larger share of the
economy as a nation gets richer. A simple model of Aggregate consumption is
this:

C= a + b(Y-T)

Where C is Aggregate consumption, a is the fixed amount that people must

consume, b is a proportion of individuals’ disposable income, Y is economic
output, and T is total income taxes.
Consumption Continued

People either spend or save their disposable income, and b represents the
Propensity to Consume. We define s as the Propensity to Save, or the proportion
of their disposable income that individuals save.

b + s = 1.
Consumption continued

Permanent Income Hypothesis: consumption today should be based on not only

current income but future income as well.

If people were purely rational and had access to all the proper information, people
would save exactly enough money for old age. People across the world would
have similar b and s, and the only real changes would be in demographics.

This is not the case.

Propensities to Save and Consume

b and s differ across the world. They are heavily context-dependent, not only with
regards to age-demographics.

Marginal and average propensities can be affected by age, culture, inequality, and
socioeconomic status.
 Household Consumption Globally

As people become richer they tend to Household final consumption expenditure

save more at the margins, meaning (% of GDP), 2016
that poorer countries tend to have High income 60.2
higher rates of consumption than Upper middle income 50.3
developed countries. Middle income 53.3
Lower middle income 64.8
China is a notable exception to this Low income 75.6
rule, as its 30-years of strong growth United States 68.4
came in part from the significant Euro area 55.7
strength of investment as a portion of China 37.4
Source: World Bank (2018).
GDP.
Aggregate Demand: Investment

Besides consumption, another aspect Investment is a crucial contributor to

of Aggregate demand is investment. long-run economic growth, because
Investment is the purchase of goods good investments increase the
or assets that will create wealth in the productive capacity of the country,
future. Building roads is an which increase the potential GDP
investment. Constructing new fiber output.
optics lines are investment. Building
new factories, training programs for
workers, etc. are all forms of
investment.
Aggregate Investment and Interest Rates

Important things to know about Interest

Investment is a function of interest
Rates:
rates and opportunities envisioned by
companies. • Central banks can affect, through money
market operations, the target interest rate.
Interest rates influence the cost of
capital. They are, broadly speaking, • The target interest rate is closely related
the cost of borrowing (or lending) to the risk-free interest rate in the capital
money. asset pricing models (CAPM).
Investment can be shown as: • Changes in the target interest rate affect
the price of money in the national
I = I(r), where r is the real interest
economy.
rate.
How Interest Rates Affect Investment

As interest rates rise, borrowing money becomes more expensive. Less people
are likely to borrow money for potential investment (Investment decrease).

As interest rates drop, borrowing money becomes cheaper, and more people are
likely to borrow money for potential investment (Investment increase).
 Interest Rates and Investment

Real interest rate

r
'
r Aggregate
Investment

I’ I Total Investment
AD Applied: The “BRICS” New Development Bank

BRICS is an acronym that refers to Brazil, Russia, India, China, and South Africa.
These countries are the largest low-middle income emerging economies. They are
projected to be increasingly important in the global economy in the coming years.
40%

35%
BRICS share of 30%
world GDP in 25%
PPP, projected, 20%
1992-2025. 15%

10%

5%

Source: IMF. 0%
1992 1996 2000 2004 2008 2012 2016 2020 2024 2028
 BRICS
Russia, Brazil and South Africa will likely see their share of the global economy
decrease in coming years.

This is primarily due to the strength of institutions, but is also related to China and
India’s success at securing investment as a major percentage of their GDP
35%

BRICS share of 30%

world GDP in 25%

PPP, projected, 20%

1992-2025. 15%

10%

5%

Source: IMF. 0%
1992 1996 2000 2004 2008 2012 2016 2020 2024 2028

China and India Brazil, Russia and South Africa

The New Development Bank

The NDB subsidizes investment by providing loans at a lower interest rate than
would otherwise occur in the country.

Most subsidized investments go towards infrastructure.

Whether the NDB is successful is, as of yet, unclear. But the fundamental
mechanism through which they operate, is. They act to lower interest rates in
BRICS countries, in order to increase their national investment, to spur long-term
economic growth.
 Chapter 4.5 The Role of Expectations

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Expectations and Aggregate Demand

We know that consumption and investment are components of aggregate demand.

Expectations also play a huge role in affecting aggregate demand. Economic
agents are forward looking, and accounting for expectations illuminates a lot about
economic events.
Negative Expectation Shocks and “Self-Fulfilling Prophecies”

Negative expectations shocks can be caused by news breaking about

something/anything that could put a damper on economic growth or make people
less confident in the security or viability of investment. Political gridlock,
governmental scandal, important economic or monetary policy announcements,
and terror attacks are examples of events that could cause expectations shocks.

People that expect uncertainty/instability will save more and consume less.

Companies that expect uncertainty/instability will invest less.

Self-Fulfilling Prophecies

 If people/companies expect an economic downturn, they will likely save more

to prepare for it.
 This lowers both consumption and investment, lowering aggregate demand
and creating a growth-gap.
 Thus, expectations of economic downturn can, in effect, increase the
likelihood economic downturn, creating a self-fulling prophecy
Role of Expectations: A Tale of Two Presidents

When Donald Trump was elected President of the United States, there was
much uncertainty as to what his role as the head of the US government would
mean for the U.S. economy. Expectations, both positive and negative, have
played a key role in shaping the path of the economy since his election. Here
are two scenarios that people expected. Neither was entirely correct, but the
latter has been more influential in the U.S.A.’s economic growth for his first year
in office.
Negative Scenario

Negative: Donald Trump would be unqualified for office, and his outbursts and
quick temper (and his tweets) would cause so much uncertainty that the USA’s
stock market would collapse, and any policy proposals designed to spur economic
growth would be undermined by the nation’s distrust of his credentials.
Illustration of a Negative Expectations Shock
A
Price Level S

AD

AD’
Y’ YY* Y
Positive Scenario

Positive: Donald Trump’s outbursts would cause some market volatility, but his
consistent messaging of deregulation would allow for businesses to thrive. Lower
corporate taxes and less oversight could lead to higher growth. So companies
invest anticipating more favorable conditions will soon arise.
A Tale of Two Presidents, Illustrated

In the negative Scenario, AD would In the positive Scenario, AD would

Decrease, lowering inflation and GDP increase, increasing inflation and
output as expectations worsened. economic growth (to varying degrees,
depending on the initial position of
the economy) as expectations
improved.
Positive Expectation Shocks

Positive expectation shocks bring economic gains:

 People having more faith in the economy can spur growth and investment. It
can lower unemployment and bring people out of poverty.
Positive Expectation Shocks

Positive expectation shocks (strangely enough) can also bring the seeds of the
next downturn:

 Irrational Exuberance--Investor enthusiasm that is not backed by the

fundamentals of the economy, may lead to huge asset pricing bubbles that
can cause problems when they pop:
 The DotCom crash in 1 999 and 2000:
 The housing market crash in 2008 that sparked the great financial crisis.
Expectations in Economics

 Expectations are a large force behind why international economics is context-

dependent.
 Expectations are influenced by trust in institutions and governments.
 Expectations can either amplify or mitigate the efforts of policymakers,
depending on whether the policymakers are trusted.
 The success of economic policy relies on the reactions of economic agents.
 Credibility is crucial.
 Chapter 4.6 Prepping for Economic
Policy

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
The Market for Goods and Services: Representational Pros and
Cons

Pros: Cons:

 Simple, concise and clear.  Reductionary--tends to gloss

 Can represent nearly all over diverse sectors of
economic positions. consumers and corporations.
 Demonstrates (nearly universal)  Works best with discrete shifts.
tradeoff between unemployment  Good for representing economic
and inflation. changes, but less so for making
accurate assessments of current
economic position.
Sustained economic growth
AS AS’
Best possible scenario:
Price Level both AD and AS shift to
the right at the same time.
Economy grows (Y to Y’)
without inflation.

P
AD’
AD
Y
Y Y’ Y*
 Appendix Okun’s “law” and the
Phillips Curve

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Okun’s Law

Okun’s law is really more of a rule of thumb, and is rarely fully accurate

● Illustrates relationship between economic growth and unemployment

● Claims that: Change in the unemployment rate = -1 /2(change in real
output/potential output)
● Unemployment only decreases if the change real output is greater than the
change in potential output.
● A one-point increase in cyclical unemployment corresponds to a 2% negative
GDP growth
The Phillips Curve

● The Phillips Curve is another way to represent the trade-off between

employment and inflation.
● As unemployment decreases, inflation increases.
● Illustrates the fundamental issue facing policymakers.
● Shows that current inflation is a function of expected inflation, the pricing
mark-up, conditions in the labor market and the rate of unemployment.
● Tradeoff is shown explicitly rather than implicitly.
● Can supplement understanding of the Market for goods and services (MGS).
The Phillips Curve Graph

Inflation

π’

Phillips Curve
μ’ μ Unemployment
Phillips Curve Equation

Phillips Curve Equation:

Where:

● πt is the inflation rate at time t;

● πe is the expected inflation at time t;
● μ is the mark-up of firms, a measure of excess profits related to their market-
power;
● z is a ‘catch-all‘ variable referring to idiosyncrasies in the labor market that
affect the rate of unemployment (trade union power, employment legislation
etc);
● α is the elasticity of inflation to unemployment.
Why the Phillips Curve Matters

● Explicit demonstration of tradeoff between employment and inflation

● Ties labor markets more closely to current economic models
○ Changes in labor market regulations can shift the phillips curve
■ Unionization, which can make it more difficult to fire employees, can
shift the curve to the right, causing more significant consequences
for policymakers.