1. Go Global !
Global Economic Environment :
The Effect of Government
Macroeconomic Policy on Business
By
Stephen Ong
Edinburgh Napier University Business School
chong@mail.tarc.edu.my
Visiting Professor, College of Management, Shenzhen
University
4 August 2012
2. Learning Objectives
To identify the fiscal policy instruments of
Government to manage the economy
To critically assess the effectiveness of
fiscal policy
To identify the principal instruments of
monetary policy
To evaluate the nature and effectiveness
of monetary policy
20. 3.2 Expansionary Fiscal Policy
Recessions
Decrease
$5 Billion Aggregate
Additional Demand
Spending
AS
Price Level
Full $20 Billion
P1 Increase in
Aggregate Demand
AD1
AD2
20 $490 $510
Real Domestic Output, GDP
21. 3.3 Contractionary Fiscal Policy
Reduce
Demand Pull $5 Billion
Inflation Initial Decrease
In Spending
AS
Price Level
Full $20 Billion
P1 Decrease in
Aggregate Demand
AD4
AD3
21 $510 $522
Real Domestic Output, GDP
22. 3.4 Built-In Stability
• Automatic stabilizers
• Taxes and transfers
• Economic importance
• Tax progressivity
• Progressive tax system
• Proportional tax system
22 • Regressive tax system
23. 3.5 Built-In Stability
T
Government Expenses, G
and Tax Revenues, T
Surplus
G
Deficit
23 GDP1 GDP2 GDP3
Real Domestic Output, GDP
24. 3.6 Evaluating Fiscal Policy
• Standardized budget
• Full-employment budget
• Cyclical deficit
• Recent U.S. fiscal policy
• Budget deficits and
projections
24 • Social security considerations
25. 3.6.1 Evaluating Fiscal Policy
T
Cyclical deficit
Fiscal policy
Government Expenses, G
neutral
and Tax Revenues, T
b a
$500 G
$450
c
25 GDP2 GDP1
(Year 2) (Year 1)
Real Domestic Output, GDP
26. 3.6.2 Evaluating Fiscal Policy
Standardized deficit T1
Expansionary fiscal T2
policy
Government Expenses, G
and Tax Revenues, T
e d
$500 G
$475
h
$450
f
$425 g
26 GDP4 GDP3
(Year 4) (Year 3)
Real Domestic Output, GDP
27. 4. Fiscal Policy Issues
Problems, Criticisms, and Complications
• Problems of timing
• Recognition lag
• Administrative lag
• Operational lag
• Political considerations
• Future policy reversals
• Offsetting state and local finance
• Crowding-out effect
• Current thinking on fiscal policy
27
29. 4.2 Standardized Budget Balance
Percentage of Potential GDP, 2007
Deficits Surpluses
-6 -4 -2 0 2 4 6
Denmark
New Zealand
Ireland
Canada
Norway
France
United States
United Kingdom
29 Japan
Source: Organization for Economic Cooperation and Development
30. 4.3 Federal Budget Balance
Actual and Projected, Fiscal 1994-2014
Actual Projected (as of March 2008)
$300
Budget Deficit (-) or Surplus, Billions
200
100
0
-100
-200
-300
-400
-500
30 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Congressional Budget Office
31. 4.4 The Public Debt
• National or public debt $9.01
trillion
• Ownership
• U.S. securities
• 53% owned by federal
government and Federal Reserve
• 47% held outside the federal
government and Federal Reserve
31
32. 4.5 The Public Debt
Debt Held Outside
The Federal Debt Held by the
Other, Including
Government State and Local Federal Government
and Federal Governments and Federal
Reserve (47%) Reserve (53%)
U.S. Banks
And other 8% 7%
Financial
9%
Institutions
Federal
25% Reserve
Foreign
Ownership
44%
7%
U.S.
Government
U.S.
32 Individuals
Agencies
Source: U.S. Treasury
Total Debt: $9.01 trillion
33. 4.6 Debt and GDP
Federal debt held by the public, percentage of GDP
50
45
40
35
Percent of GDP
30
25
20
15
10
5
0
1970 1975 1980 1985 1990 1995 2000 2005
Year
33
Source: Economic Report of the President, 2006
34. 4.7 Debt and GDP
Publicly Held Debt: International Comparisons
As a Percentage of GDP, 2007
0 20 40 60 80 100
Italy
Japan
Belgium
Hungary
Germany
United States
United Kingdom
France
Netherlands
Canada
Spain
34 Poland
Source: Organization for Economic Cooperation and Development
35. 4.8 Debt and GDP
• Interest charges
• Primary burden
• 1.7% of GDP 2007
• False concerns
• Bankruptcy
• Refinancing
• Taxation
•35Burdening future
generations
36. 4.9 Debt and GDP
• Substantive issues
• Income distribution
• Incentives
• Foreign-owned public debt
• Crowding-out effect revisited
• Burden on future generations
• Public investment as an offset
36
• Graphically
37. 4.10 Crowding Out
A Large Public Debt to Finance Public Investment Will Cause…
16
If Public Spending
14 Spurs More Private
Investment Will
Real Interest Rate (Percent)
12
Increase to ID2
b c
10
8
a
6
Interest Rate Crowding-
4 Rise Will Out Effect
Decrease
ID 2
2 Investment
a to b ID 1
0 5 10 15 20 25 30 35 40
37
Investment (Billions of Dollars)
38. 4.11 The Leading Indicators
1. Average workweek
2. Initial claims for
unemployment insurance
3. New orders for consumer
goods
4. Vendor performance
5. New orders for capital goods
6. Building permits for houses
7. Stock prices
8. Money supply
38 9. Interest-rate spread
10.Consumer expectations Source: The Conference Board
39. Monetary Policy
Money
The Central Banker : FRS
The Banking System
Monetary Policy
The US Subprime Crisis
40. 1. Functions of Money
• Medium of exchange
• Used to buy/sell goods
• Unit of account
• Goods valued in dollars
• Store of value
• Hold some wealth in money
form
• Money is liquid
31-40
42. 1.2 Money Defined
• M2
• M1 plus near-monies
• Savings deposits including
money market deposit
accounts (MMDA)
• Small time deposits
• Money market mutual funds
(MMMF)
31-42
43. 1.3 Money Defined
M1 M2
January 2008 Currency + 56%
M1
Checkable Deposits + 44% 18%
Small Time Deposits + 16%
Money Market Mutual 14%
Funds Held By Individuals +
Savings Deposits, 52%
Including Money Market +
Deposit Accounts
Totals $1,365 $7,499
Source: Federal Reserve System Billion Billion
31-43
44. 1.4 Money Supply
• Are credit cards money?
• What “backs” the money
supply?
• Nothing!
• Why is money valuable?
• Acceptability
• Legal tender
• Relative scarcity 31-44
45. 1.5 Money and Prices
• Prices affect purchasing power
of money
• Hyperinflation renders money
unacceptable
• Stabilizing money’s purchasing
power
• Intelligent management of the
money supply – monetary policy
• Appropriate fiscal policy 31-45
46. 2. Federal Reserve System
• Historical background
• Board of Governors
• 12 Federal Reserve Banks
• Serve as the central bank
• Quasi-public banks
• Banker’s bank
31-46
47. 2.1 Federal Reserve System
Board of Governors
Federal Open Market Committee
12 Federal Reserve Banks
Thrift Institutions
(Savings and Loan Associations,
Commercial Banks Mutual Savings Banks,
Credit Unions)
The Public
(Households and
Businesses)
31-47
48. 2.2 Federal Reserve System
The 12 Federal Reserve Banks
Source: Federal Reserve Bulletin
31-48
49. 2.3 Federal Reserve System
• Federal Open Market Committee
• Aids Board of Governors in setting
monetary policy
• Conducts open market operations
• Commercial banks and thrifts
• 7,300 commercial banks
• 11,000 thrifts
31-49
50. 2.4 Federal Reserve Functions
• Issue currency
• Set reserve requirements
• Lend money to banks
• Set discount rate
• Check collection
• Fiscal agent for U.S. government
• Supervise banks
• Control the money supply
31-50
51. 2.5 Federal Reserve System
• Federal Reserve independence
• Recent developments
• Relative decline of banks and
thrifts
• Consolidation
• Convergence of services provided
by financial institutions
• Globalization of financial markets
• Electronic payments
31-51
52. 2.6 Financial Institutions
World’s 12 Largest Financial Institutions, 2007
Assets (Billions of U.S. Dollars)
0 1,300,000 1,600,000 1,900,000
Barclays (UK)
BNP Paribas (France
Citigroup (USA)
HSBC Group (UK)
UBS (Switzerland)
Royal Bank of Scotland (UK)
ING Group (Netherlands)
Mitsubishi UFJ (Japan)
Deutsche Bank Group (Ger)
Bank of America (US)
Allianz Worldwide (Ger)
JPMorgan Chase (USA)
Source: Organization for Economic Cooperation and Development
31-52
54. 2.8 The Global Greenback
• U.S. currency circulating abroad
• Russia $80 billion
• Argentina $50 billion
• $450 billion total
• 60% of total US currency
• U.S. profits from dollars leaving
• Black markets and illegal activities
• Dollar offers stable purchasing power
• Exchange rate risk
31-54
55. 3. Fractional Reserve Banking
• The Goldsmiths
• Stored gold and gave a receipt
• Receipts used as money by public
• Made loans by issuing receipts
• Characteristics
• Banks create money through
lending
• Banks are subject to “panics”
32-55
56. 3.1 Fractional Reserve System
• Balance sheet
• Assets = Liabilities + Net
Worth
• Both sides balance
• Necessary transactions
• Create a bank
• Accept deposits
• Lend excess reserves
32-56
57. 3.2 Creating a Bank
• Transaction #1
• Vault cash: cash held by the
bank
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets Liabilities and Net Worth
Cash $250,000 Stock Shares $250,000
32-57
58. 3.2.1 Creating a Bank
• Transaction #2
• Acquiring property & equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets Liabilities and Net Worth
Cash $10,000 Stock Shares $250,000
Property 240,000
32-58
59. 3.2.2 Creating a Bank
• Transaction #3
• Commercial bank
functions
• Accepting deposits
• Making loans Deposits
Accepting
Balance Sheet 3: Wahoo Bank
Assets Liabilities and Net Worth
Cash $110,000 Checkable
Deposits $100,000
Property 240,000
Stock Shares 250,000
32-59
60. 3.2.3 Creating a Bank
• Transaction #4
• Depositing reserves in a
Federal Reserve bank
• Required reserves
• Reserve ratio
Commercial bank’s
Reserve Required reserves
ratio =
Commercial bank’s
Checkable-deposit liabilities
32-60
61. 3.2.4 Reserve Requirements
Current Statutory
Type of Deposit Requirement Limits
Checkable deposits:
$0-$9.8 Million 0% 3%
$9.3-$43.9 Million 3 3
Over $43.9 Million 10 8-14
Noncheckable nonpersonal
savings and time deposits 0 0-9
• Fed can establish and vary reserve
ratio within limits set by Congress
• Required reserves help Fed control
lending abilities of commercial banks
32-61
62. 3.2.5 Creating a Bank
• Transaction #4
• Assume the bank deposits all
cash on reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets Liabilities and Net Worth
Cash $0 Checkable
Reserves 110,000 Deposits $100,000
Property 240,000 Stock Shares 250,000
32-62
63. 3.2.6 Reserve Requirements
• Excess reserves
• Actual reserves - required
reserves
• Required reserves
• Checkable deposits x reserve ratio
• Example:
• Checkable deposits $100,000
• Reserve ratio 20% 32-63
64. 3.2.7 Creating a Bank
• Transaction #5
• Clearing a check
• $50,000 check reduces reserves
and checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets Liabilities and Net Worth
Checkable
Reserves $60,000 Deposits $50,000
Property 240,000 Stock Shares 250,000
32-64
65. 3.3 Money Creating Transactions
• Transaction #6a
• Granting a loan
• $50,000 loan deposited to
checking a Loan is Negotiated
When
Balance Sheet 6a: Wahoo Bank
Assets Liabilities and Net Worth
Reserves $60,000 Checkable
Loans 50,000 Deposits $100,000
Property 240,000 Stock Shares 250,000
32-65
66. 3.3.1 Money Creating Transactions
• Transaction #6b
• Using the loan
• $50,000 loan cashed
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Assets Liabilities and Net Worth
Reserves $10,000 Checkable
Loans 50,000 Deposits $50,000
Property 240,000 Stock Shares 250,000
A single bank can only lend an amount
equal to their preloan excess reserves 32-66
67. 3.3.2 Money Creating Transactions
• Transaction #7
• Bank buys government
securities from dealer
• Deposits payment into
checking Government Securities
Buying
Balance Sheet 7: Wahoo Bank
Assets Liabilities and Net Worth
Reserves $60,000 Checkable
Securities 50,000 Deposits $100,000
Property 240,000 Stock Shares 250,000
New money is created 32-67
68. 3.4 Commercial Banks
• Conflicting goals
• Earn profit
• Make loans to earn interest
• Buy securities to earn interest
• Maintain liquidity
• Alternative?
• Overnight bank loans
• Federal funds rate
32-68
69. 3.5 The Banking System
• Multiple-deposit expansion
• Assumptions:
• 20% required reserves
• All banks “loaned up”
• Banks lend all of excess reserves
• A $100 bill is found and
deposited
• Multiple deposits can be created 32-69
70. 3.6 The Banking System
(1) (3) (4)
Acquired (2) Excess Amount Bank Can
Reserves Required Reserves Lend; New Money
Bank and Deposits Reserves (1)-(2) Created = (3)
Bank A $100 $20 $80 $80
Bank B $80 $16 $64 $64
Bank C $64 $12.80 $51.20 $51.20
Bank D $51.20 $10.24 $40.96 $40.96
The process will continue…
32-70
71. 3.6.1 The Banking System
(2)
(1) Required (3) (4)
Acquired Reserves Excess Amount Bank Can
Reserves (Reserve Reserves Lend; New Money
Bank and Deposits Ratio = .2) (1)-(2) Created = (3)
Bank A $100.00 $20.00 $80.00 $80.00
Bank B 80.00 16.00 64.00 64.00
Bank C 64.00 12.80 51.20 51.20
Bank D 51.20 10.24 40.96 40.96
Bank E 40.96 8.19 32.77 32.77
Bank F 32.77 6.55 26.21 26.21
Bank G 26.21 5.24 20.97 20.97
Bank H 20.97 4.20 16.78 16.78
Bank I 16.78 3.36 13.42 13.42
Bank J 13.42 2.68 10.74 10.74
Bank K 10.74 2.15 8.59 8.59
Bank L 8.59 1.72 6.87 6.87
Bank M 6.87 1.37 5.50 5.50
Bank N 5.50 1.10 4.40 4.40
Other Banks 21.99 4.40 17.59 17.59
$400.00 32-71
72. 3.7 The Monetary Multiplier
Monetary 1 1
multiplier = required reserve ratio
=
R
Graphic New Reserves
$100
Example $80 $20
Excess Required
Reserves Reserves
$100
$400
Initial
Bank System Lending
Deposit
Money Created
32-72
73. 3.7.1 The Monetary Multiplier
• Maximum amount of new
money created by single
dollar of excess reserves
• Higher R, lower m
• Reversibility
• Making loans creates money
• Loan repayment destroys
money 32-73
74. 3.8 Bank Panics of 1930-1933
• Before deposit insurance
• Bank failure led to mass withdrawals
• Forced loan reduction
• 25-33% decline in money supply
• 1933 national bank holiday to
evaluate all banks
• Contributed to the Great Depression
• Regulation protects the system today
32-74
75. 4. Interest Rates
• Price paid for the use of
money
• Many different interest rates
• Speak as if only one interest
rate
• Determined by money supply
and money demand
33-75
76. 4.1 Demand for Money
• Why hold money?
• Transactions demand, D1
• Determined by nominal GDP
• Independent of the interest rate
• Asset demand, D2
• Money as a store of value
• Varies inversely with the interest
rate
• Total money demand, Dm 33-76
77. 4.1.1Demand for Money
(c)
(a) (b) Total
Transactions Asset demand for
demand for demand for money, Dm
money, Dt money, Da and supply
Rate of interest, i percent
10
Sm
7.5
5 + =5
2.5
0
Dt Da Dm
50 100 150 200 50 100 150 200 50 100 150 200 250 300
Amount of money Amount of money Amount of money
demanded demanded demanded and supplied
(billions of dollars) (billions of dollars) (billions of dollars)
33-77
78. 4.2 Interest Rates
• Equilibrium interest rate
• Changes with shifts in money
supply and money demand
• Interest rates and bond
prices
• Inversely related
• Bond pays fixed annual
interest payment
• Lower bond price will raise the
interest rate 33-78
79. 4.3 Federal Reserve Balance Sheet
• Assets
• Securities
• Loans to commercial banks
• Liabilities
• Reserves of commercial banks
• Treasury deposits
• Federal Reserve Notes
outstanding
33-79
80. 4.3.1 Federal Reserve Balance Sheet
February 14, 2008 (in Millions)
Assets Liabilities and Net Worth
Securities $713,369 Reserves of Commercial
Loans to Commercial Banks $ 11,312
Banks 60,039 Treasury Deposits 4,979
All Other Assets 111,689 Federal Reserve Notes
(Outstanding) 778,937
All Other Liabilities and 89,869
Net Worth
Total $885,097 Total $885,097
Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008
33-80
81. 4.4 Central Banks
Selected Nations
Australia: Reserve Bank of Australia (RBA)
Canada: Bank of Canada
Euro Zone: European Central Bank (ECB)
Japan: Bank of Japan (BOJ)
Mexico: Banco de Mexico (Mex Bank)
Russia Central Bank of Russia
Sweden: Sveriges Riksbank
United Kingdom: Bank of England
United States: Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)
Malaysia : Bank Negara Malaysia
33-81
82. 4.5 Tools of Monetary Policy
• Open market operations
• Buying and selling of government
securities (or bonds)
• Commercial banks and the
general public
• Used to influence the money
supply
• When the Fed sells securities,
commercial bank reserves are
reduced
33-82
83. 4.5.1 Open Market Operations
Fed buys $1,000 bond from a commercial
bank
New Reserves
$1000
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
33-83
84. 4.5.2 Open Market Operations
Fed buys $1,000 bond from the public
Check is Deposited
New Reserves
$1000
$800 $200
Excess Required
Reserves Reserves
$1000
$4000 Initial
Bank System Lending Checkable
Deposit
Total Increase in the Money Supply, ($5000)
33-84
85. 4.6 Tools of Monetary Policy
• The reserve ratio
• Changes the money multiplier
• The discount rate
• The Fed as lender of last resort
• Short term loans
• Term auction facility
• Introduced December 2007
• Banks bid for the right to borrow
reserves 33-85
86. 4.6.1 Tools of Monetary Policy
• Open market operations most
important
• Reserve ratio last changed 1992
• Discount rate was a passive tool
• Term auction facility is new
• Guaranteed amount lent by the
Fed
• Anonymous 33-86
87. 4.7 The Federal Funds Rate
• Rate charged by banks on
overnight loans
• Targeted by the Federal Reserve
• FOMC conducts open market
operations to achieve the target
• Demand curve for Federal funds
• Supply curve for Federal funds
33-87
88. 4.7.1 The Federal Funds Rate
Using Open Market Operations
Federal Funds Rate, Percent
4.5 Sf3
4.0 Sf1
3.5 Sf2
Df
Qf3 Qf1 Qf2
Quantity of Reserves
33-88
89. 4.8 Monetary Policy
• Expansionary monetary
policy
• Economy faces a recession
• Lower target for federal funds rate
• Fed buys securities
• Expanded money supply
• Downward pressure on other interest rates
• Contractionary monetary
policy 33-89
90. 4.9 Taylor Rule
• Rule of thumb for tracking actual
monetary policy
• Fed has 2% target inflation rate
• If real GDP = potential GDP and
inflation is 2% then target
federal funds rate is 4%
• Target varies as inflation and
real GDP vary 33-90
91. 4.10 Monetary Policy
• Affect on real GDP and price
level
• Cause-effect chain
• Market for money
• Investment and the interest rate
• Investment and aggregate demand
• Real GDP and prices
• Expansionary monetary policy
• Restrictive monetary policy 33-91
92. 4.11 Monetary Policy and GDP
(c)
(a) (b) Equilibrium real
The market Investment GDP and the
for money demand Price level
Rate of Interest, i (Percent)
Sm1 Sm2 Sm3 AS
10 P3
Price Level
AD3
8 P2 I=$25
Dm AD2
6 ID I=$20
AD1
0 I=$15
$125 $150 $175 $15 $20 $25 Q1 Qf Q3
Amount of money Amount of investment Real GDP
demanded and (billions of dollars) (billions of dollars)
supplied
(billions of dollars)
33-92
93. 4.12 Expansionary Monetary Policy
Problem: unemployment and recession
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
E E S UA C
Aggregate demand increases
Real GDP rises
33-93
-
94. 4.13 Restrictive Monetary Policy
Problem: inflation
Fed sells bonds, increases reserve ratio, increases
the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
E E S UA C
Aggregate demand decreases
Inflation declines
33-94
-
95. 4.14 Monetary Policy
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Recent U.S. monetary policy
• Problems and complications
• Recognition lag
• Operational lag
• Cyclical asymmetry 33-95
96. 4.15 The Big Picture
Input Consumption
Resources (C a )
With Prices
Levels of
Investment
Aggregate
Output,
Aggregate
(I g )
Employment,
Supply Demand
Productivity Income, and
Prices
Sources
Net Export
Spending
(X n )
Legal-
Institutional
Environment Government
Spending
(G)
33-96
97. 4.16 The Mortgage Debt Crisis
• Home mortgage default 2007
• Banks write off bad loans
• Reserves reduced
• Fed as lender of last resort
• Term auction facility
• Fed lowered federal funds rate
• Mortgage backed securities as a
new innovation
• Bad incentives 33-97
98. 5. The US Subprime Crisis
Video : Capitalism : A Love
Story
“Over all history, money has
oppressed people in one of
two ways: either it has been
abundant and very unreliable,
or reliable and very scarce.”
John Kenneth Galbraith, The Age of Uncertainty
(1977)
99. Conclusion
“Understanding the forces that affect
aggregate demand, including
government fiscal and monetary
policies, can help economists and
policymakers smooth out the cycle
of boom and bust.”
Paul Samuelson
100. Casestudy : IKEA
1. Read and prepare the
Casestudy on IKEA
(Johnson, Whittington &
Scholes (2011)) for
discussion and presentation
next week.
2. Identify and evaluate the
challenges facing IKEA
during the global recession,
by conducting External
Environment, Industry,
Competitor analysis and
SWOT.
101. Core Reading
Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global
Environment, Napier University Edinburgh
Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International
Business: Environments and Operations. 14th edition, Pearson
Samuelson, P.A. and Nordhaus, W. D. (2010)“Economics”
Irwin/McGraw-Hill, 19th Edition
Porter, Michael E. (2004)“Competitive Strategy – Techniques for Analyzing
Industries and Competitors” Free Press
The Learning Objectives for Chapter 1 are To define globalization and international business and show how they affect each other To understand why companies engage in international business and why international business growth has accelerated To discuss globalization’s future and the major criticisms of globalization To become familiar with different ways in which a company can accomplish its global objectives To apply social science disciplines to understanding the differences between international and domestic business