FW1 - Mental Imagery
Look at the map:
307 days before opening.
Macro economy studies how the national economy changes and how it increases.
Lesson: 1,5 hour
External readings: 3,5 hour
Do it yourself: 0
Total: 5 hours
The objectives of the lesson are to give you the fundamentals about:
-Gross domestic product.
-Monetary and government policies.
By the end you will be able to discuss about these topics and to relate them to your own biz project.
1-GROSS DOMESTIC PRODUCT
In most countries, the Gross domestic product (GDP) is the official measure of the economic output because it is the best basis of the well being of the citizens in a given country.
-Definition: Gross domestic product (GDP) is the total final value of all the goods and services produced in a given country, in a year.
The following clarifications are necessary:
It is a gross measurement because it includes the total amount of goods and services produced regardless the fact that some of which are simply replacing goods that have depreciated.
It only includes goods and services produced within a given country regardless of the citizenship of the people owning the companies in this given county.
So, it differs of the gross national product (GNP): For example, the US GNP includes the value of goods produced by Us citizens in China or in Brazil.
It only includes what was produced during the year. So, do not confuse GDP an wealth.
For example, you own an estate bought for $100 million which earns $10 million per year: The estate is a wealth or a stock and does not enter in the GDP calculation. The $10 million you earn each year is a production and is included in the GDP.
GDP measures the production of a nation but not its wealth. Of course the production obtained each year increases the wealth i.e. the stock accumulated since the beginning of time. In year 1 your wealth was 100 million. In year 2, supposing you had consumed none of the production obtained, your wealth would have increased to 110.
The term final production is very important:
To simplify matters, let us suppose that there is a national economy made up of 2 companies.
The first, A, manufactures steel, and has a production level of 100 $,The second, B, manufactures food tins from steel bought from A. Its production level is 150 $.
We do not add 100 and 150 $ to obtain the final production. GDP is calculated according to the diagram below:
GDP is therefore 150 $ and not 250 $. It indicates final production. It does not count intermediate production twice (in this case the steel used to make the tins).
115-Real GDP or GDP at constant prices:
Changes in GDP from one year to another reflect changes in the amount of goods but also changes in their prices. Economists use a deflator to suppress the effect of a change in price. They obtain a real GDP, or a GDP at constant prices, that only reflects the change in the output of good and services and consequently the growth or the decrease of the economic effectiveness.
12-How the GDP is used.
GDP is the final production. The national accounting shows how this final production is used.
The final production is used into four components: Consumption spending, Investment spending, Government spending, and Exports minus Imports.
121-Consumption spending (C):
It consists of consumer spending's on goods and services. It is divided into durable goods, non durable goods, and services.
Durable goods are goods used for several years such as cars, furniture's, computers, and so on.
Non durable goods are goods used for a short time such as food and clothing.
Services include all the services such as consultancy fees, medical care, travel fares and so on.
For a new biz it is interesting to focus on the sector repartition of the consumption spending (C) that is to say the household spending.
Real life example:
The repartition of the US household spending in 1900 and in 1999 at constant market prices, is shown below:
Alcohol and tobacco-----27%----------------7%
As the volume of household expenditure is, at constant market prices, 5 times higher than 1900, it does not mean that americans eat less than in 1900. It just means that the increase in income has been used to buy more services. The proportional share of food decreases and on the contrary those of services and durable goods increase.
122-Investment spending (I)
It includes the purchase of tools and equipments used in the production of others goods, such as factories, machines and the building of new homes.
It includes also the changes in the level of inventory: Suppose that a company has in its inventories of raw materials, parts, and finished goods a value of 100 at the beginning of the year and a value of 130 by the end of the year: The difference of 30 is an investment spending and enters in the calculation of I.
You have to take notice that investment must be preceded by savings.
GDP= consumption+ saving
It means that savings equal investment and that the level of investment will depend on savings.
123-Government spending (G)
It includes public consumption of goods and services such as defense, schools, police, roads and so on. It does not include transfer payments such as social security because the use of this money has already been counted in the consumption spending.
One part of this final production is exported but on the contrary we have to take in account the imports. Exports minus Import can give a negative or a positive result. Finally, we get the following equation.
13-Sector repartition of GDP
The above equation shows how the final production is used but it does not tell us from where this production is coming. For this purpose, economy is divided into sectors:
- Agriculture, forestry and fishing.
- Production and construction excluding manufacturing.
For each of these sectors, we calculate the money spent on making the goods and the money received from the sales of the goods. Then, we calculate what value is added by each sector: for example, 5% of the final production (GDP) is coming from the agricultural sector. Then we can write the following equation:
GDP= value added by agricultural sector+ value added by Manufacturing sector+ And so on
It is very important to know the sector repartition of the GDP : With technical progress, the share of agriculture and manufacturing diminishes in the total GDP, while the share of service increases: For example, agriculture accounted for 11% in US GDP by 1900. It accounts to day for only 2%.
14-The income approach
The final production has for counterpart a final income. The production enables people to earn an income rewarding the contributions they have brought. It means that GDP can be described according to the following equation:
GDP= National income
The national income is made up of the following components:
-The wages which are paid to the labor force
-The rents which are paid to those who supply the land or the natural resources.
If a stock of land with a value of 100 produces an income of 10, an extend of the value of the stock (150) will produce an income of 15 and so an increase of 5 of the GDP.
In the olden times and with the feudal system, the rent was an important revenue: landowners lent the acreage's to farmers who paid allowances. Because of this importance, the classic economists spent a lot of time to explain the mechanism of the rent.
To day few people get rent. Farmers own their acreage's. The only modern real rent is the amount of royalties paid each year to the oil people in the Middle East.
More generally natural resources and raw materials today only play a marginal role in economic growth.
Real life example:
Japan or Singapore do not posses raw materials, but their expansion was among the fastest in the world.
North Korea has raw materials (coal, hydroelectricity). South Korea has none. South Korea has benefited of high growth. North Korea is one of the poorest country in the world.
The relative proportion of raw materials involved in production is constantly decreasing. This is firstly because we can use substitutes and synthetic alternatives for raw products (such as rubber) and secondly because the aim of technical progress is to use less and less to obtain the same result.
-The interests that are paid to the persons who provides the Capital.
-The profits that reward the persons who implement and manage labor, land and capital. In fact the profit is also the final income of all the people who engage their own capital such as the farmers, craftsmen, small biz, self employment and so on. As for the rent, the distinction between interest and profit is quite academic in the modern world .
-The taxes which are paid to the government.
Finally we obtain the following equation:
GDP= Wages+ Rent+ Interest+ Profit+ taxes
In adding rent, interest and profit under the sole category of profit we can write:
GDP= Wages + Profit + Taxes
Finally, with the different approaches, we get three equations:
-How final production is used:
GDP= Consumption +Investment + Government + Ex-Im
-Where final production comes from:
GDP = Value added by the main sectors
-What incomes have been earned to get this final production:
GDP= wages + Profit + Taxes.
The last equation is interesting because it relates the terms with the resources and factors of production: Labor force, Land and natural resources, Capital (equipment and tools). We shall use this equation when we shall explain the mechanisms of economic growth.
The next drawing 2 shows the circular flow of GDP as we have just described it:
15-GDP per capita
GDP measures the power of a nation but it in no way measures the well being of individuals living in this nation:
-Definition: GDP per capita measures the amount of goods and service each person can enjoy.
It is given by the following ratio:
GDP per capita= GDP of the country/Population of the country.
If GDP grows and if the population grows faster, each person is going to be impoverished instead of doing well.
For example: Let' suppose 2 countries A and B with the same GDP of 1000. If one has a population of 100 and the other 10, GDP per capita ( or per head) is as follows:
People living in country B have ten times as much production and are 10 times better off than those living in country A. It means that we have to divide the GDP by the population to get a real measure of the well being of individuals living in a country.
Real life example:
Regarding GDP per capita, there are huge differences:
-Between regions inside a same country.
-Between individuals inside a same region. In the same town a professor could get $140,000, and an unskilled worker $14,000! GDP per capita is just an average but it gives a good indication about the well being of people in different countries.
-Definition: Economic growth results from an increase in the GDP. The growth of the GDP is measured by its annual percentage increase: the growth rate.
21-The growth rate
Let 'suppose that the GDP follows these figures:
Year 1: 7500; Year 2: 8000; Year 3: 8400; Year 4: 9000.
The growth rates are 6,7% in year 2, 5% in year 3 and 7,1% in year 4. Now you have to take in account the change in price: Let' suppose that the price rises by 1% every year. Then the growth rate of the real GDP at constant prices are 5,7%, 4% and 6,1%. The average growth rate over this period is:
5,7 + 4 + 6,1 / 3 = 5,3.
With such a growth rate, the GDP of 7500 in year 1 will amount 15000 in year 13, 30000 in year 26, 60000 in year 39, 120000 in year 52, 240000 in year 65, 480000 in year 78, 960000 in year 91, 1920000 in year 104!!! In supposing this growth rate constant it means that in 104 years the initial GDP (7500) will increase 256 fold!
It looks incredible but it's right! We always underestimate the power of the compounding rates over a long period.
You can calculate how long it takes GDP to double by dividing the growth rate into the number 70: If growth rate is 2%, the GDP will double every 35 years: 70/2=35.
It means that the average rate of growth is the most important thing in economy for improving well being.
Real life example
During 25 years (from 1960 until 1985) the GDP of Japan grew at a rate of 5,8%. Today, the GDP of China increases by a rate of 9%. Of course, it is difficult to maintain such growth rates over a long period but most developed countries have increased five or tenfold their GDP from 1900 until 2000.
On the contrary, many countries do not benefit of any growth rate. For example, thanks to the marxist economy, the GDP of North korea registers negative growth rates: -26% in 1994, -17% in 1995, -17% in 1996! As a result the GDP falls in four year from $20 billions to $10 billion!
North korea is not the sole case: As a result inequalities between countries are rising at exponential rate.
We have to explain the cause of the level of the growth rate.
22-The causes of the growth rate
Recall from FW4 the production possibility frontier (PPF). The PPF is obtained when all the resources are optimized. In this situation there is no margin for growth. To get growth the PPF must increase.
The increase of the PPF has only two possible causes: The available resources increase or/and the technology changes significantly. The growth is said extensive when the resources increase, and intensive when the technology advances.
221-The labor force
It grows with a high birth rate and a lower mortality. Without a doubt, production increases by the growth of the active population and the consequent increase in the amount of work done.
Nevertheless, Recall that when only one factor grows, you are rapidly exposed to the law of diminishing returns. In the real life, when the labor force increases without any increase in capital, the labor productivity is exposed to decrease. It means that the rise of population is a poor lever.
What is more, the real growth per capita will fall when the growth rate of the GDP is inferior to the growth rate of the population. If the number of slices of a cake increases more rapidly than the size of the cake itself, your share will be smaller and smaller.
This situation is experienced by many undeveloped countries. The countries with the lowest increase of GDP per capita are those with the highest birth rate.
222-The capital increases with the investments:
Economists agree on the fact that Well being (rise of GDP per capita) mainly depends on the extend of capital and the productivity.
To improve the growth of your business focus mainly on productivity in first and then on the extend of capital (investment). Add an unit of labor force only when the next extend of capital is exposed to the law of diminishing returns.
In fact, as technology is always improving, a new unit of capital rises the labor productivity and avoid to recruit more unit of labor force: For example suppose you have two trucks with two drivers. Improvement in truck technology will allow you to have only one bigger truck and only one driver for a growing output.
Others things being equal the growth rate is also related to the yield of investment what is to say the capital output ratio. This ratio depends from the sectors.
Let's suppose a GDP made up as follows: 80 for C and 20 for I. Let's suppose that we know the breakdown of I (S in the graph) between the different sectors:
If we know the average rate of yield applied to each category of investment, we can calculate the likely growth rate of GDP.
The total is therefore: 2.8
In year 2 GDP has grown to 102.8.
We discover the fact that the breakdown of investment and its capital output ratio are more important than its total amount: An investment of 10 instead of 20 concentrated on services would have resulted in a growth rate of 5%, retaining the yield hypotheses below.
It means that you have to carefully evaluate the capital output ratio of any investment and that you have to invest in the sectors that bring the higher yields.
The next drawing 3 summarizes the growth process as we have just described it.
3-THE BUSINESS CYCLE
GDP never increases in a linear, continuous way. It grows like that:
GDP is the result of a complex balance between aggregate supply and aggregate demand, investment, savings etc. All these elements influence each other, but not at the same time. Short-term fluctuations such as inflation and recession are unpredictable, and never end.
When the aggregate demand is higher than the available supply, inflation occurs.
-Definition: Inflation is an increase in the general price level. It has two causes: costs and excess of money.
-Costs of production: When all the costs of production go up, the companies are under constraint to rise their selling prices. A general cost increase may come from a rise of wages, from higher taxes or mostly from a sudden rise in some raw materials such as crude oil.
When you are expecting a rise of raw material, it's wise to purchase them in advance and to increase your inventories.
-Excess of money: When the amount of money grows faster than the growth of the supply, there is an excess demand and prices will go up.
For example, investments which are not financed by savings can boost the inflation because it always exists a certain time before a factory becomes productive. Wages paid to build the factory are spent immediately, but the extra production will only appear later, for instance in a years time. Consequently the demand grows faster than supply. Inflation often appears at the end of a fast expansion of the economic activity.
32-Recession and unemployment
When the aggregate supply is higher than the demand, a recession occurs. It means that consumers save more and that the savings are not used to invest. Companies then have too much production capacity, which means they fire personnel and stop recruiting.
As a result the wages should diminish. In fact, trade unions and government want to maintain the level of the wages. As a result a surplus occurs as we have seen in the microeconomics: unemployment increases.
The lack of flexibility is the cause of unemployment in the short run and the lack of competencies in the long run: With technical progress, the companies do not need any more unskilled workers in our developed countries. As a result a lot of people with low capacities cannot be employed and only received a public help for a living.
It means that Public education systems have not been able to forecast this evolution and to find new ways in order to help these people to expand their capacities.
Recession offers a good opportunity to clean the staff: Fire ineffective people. On the contrary, keep the employees who have accumulated human capital. It's not compassion, it's just sound management. A recession is short and even if these persons are under employed, it's better to keep them than to recruit new people when the expansion is coming again.
Do not wait the boom to recruit: You should pay higher wages than at the beginning of the expansion cycle. Anyway, lift the qualifications to increase the human capital in your enterprise.
The Phillips curve is a relationship which says that when inflation rises, unemployment diminishes and vice versa. This curve should justify the Keynesian idea that the increase of demand with supply of money and low interest rates is the best way to fight recession.
Unfortunately in the 1970s we got both a high level of inflation and unemployment. The main explanation of this phenomenon was certainly in the growing share of the structural unemployment (see above)
Keynesian have focused on the multiplier of investment as a tool to fight the recession.
Definition: An increase in investment has a multiplier effect which is calculated as follow:
Initial investment * output multiplier = Final output
The output multiplier is defined as:
1 / (1-Marginal propensity to consume).
If people used to save 20% of their income, the marginal propensity to consume is 0,80. In this case the output multiplier is equal to:
1 / (1- 0,80) = 1 / 0,20 = 5
For example, let's suppose the government decides to finance an investment of 500 million. The workers earn 500 and they spend 80% that is to say 400 in shopping. This spending of 400 is an income for the retailers. In turn the retailers spend 80% (320) in dining out. The 320 become income for the owners of restaurant who spend 80% (240) in movie and so on. When all the effects are summed up, output spending in retail, restaurant, movie and so on will amount 2500 according to the formula.
Initial investment: 500 * Output multiplier: 5 = 2500.
It's looks magic but in fact we shall see the same phenomenon with the velocity of money: (See further). Nevertheless, the multiplier is a good tool when there are both idle resources and a low propensity to import.
Go to www.royalbank.com . Click on "starting a business" and then on "business cycles" . This site provides advices for new biz and notably how to face the business cycles.
Some business are very exposed to business cycles: household furniture's, motor cycle vehicles, appliances and so on because it is always possible to postpone the purchases. On the contrary, The activities in education, insurances, medical drugs and food are not correlated with the business cycle.
Money is the medium of exchange to buy and sell goods and services. Money is not just cash. When economists speak about measuring the money supply they also mean checking account balances and money market funds.
41-The money equation.
Changes in money supply cause direct changes in GDP: The amount of money available affects the size of the economy, according to the following formula:
GDP is determined by the money supply multiplied by its velocity. Velocity is the number of times the money supply circulates through the economy. For instance, the US money supply is $1 trillion and this $1 trillion circulates through the economy eight times a year. Since $1 trillion multiplied by eight is $8 trillion, GDP would be equal to $8 trillion.
A nations central bank is a "bank for banks". The Central Bank influences the economy in three main ways:
421-By changing interest rates
Banks borrow money from the central bank at a discount rate and lend it to their customers at higher rates. If the discount rate is lowered, the difference between the banks loan rate and the price they get from the central bank is higher. This in turn encourages banks to make more loans to businesses and to consumers. The more loans there are, the higher the money supply in the economy.
Companies borrow to invest. When interest rates rise, new investments must be more profitable than the increase in interest rates for the profit expected from them to remain the same. A rise in interest rates therefore decreases investments and, as a consequence, the aggregate demand. When interest rates rise, consumers are also encouraged to save instead of spending. This also helps decrease demand.
Rising interest rates are therefore the sign of a recession in the next few months. Lowering interest rates has the opposite effect and therefore suggests a coming expansion.
422-By buying and selling government securities
The central bank trades government securities on the financial markets, buying and selling the governments own Treasury bonds. These trading transactions are called open market operations. When the central bank purchases government securities from the public, it places more money in the hands of the public who sold them; money supply increases. When investors buy government securities sold by the central bank, money supply decreases.
423-By changing the reserve requirement of financial institutions.
The central bank requires financial institutions such as banks and brokers to keep on hand a set percentage of the cash deposited by customers. This cash is called a reserve. When Central Bank requires a higher level of reserves, banks cannot loan as much money; and money supply decreases.
When interest rates start to rise: Reduce your investments, do not try to increase production. Ruthlessly track down all your expenditures. In the next 6 months to 1 year, your company will go through turbulence's. Sales are going to drop and you will only be able to maintain current profit levels by reducing costs immediately.
When interest rates start to drop: It's the right time to invest, to recruit sales staff and to advertise etc. In the next few months, the economy is going to enter a phase of expansion. Make sure you are ready to make the most of it.
You should constantly be on the look out for changes in interest rates. Rates are published daily in financial newspapers. Make a note of any changes every 2 weeks so that you don't wake up once it's already too late.
The Central Bank uses all the means at its disposal to increase or decrease the amount of money in circulation in the economy. Economists all agree on the two points below:
Inflation, i.e. a general increase in prices, can be predicted by means of the following equation ( measures the percentage of increase):
For example, if M increases by 10 %, GDP by 3 % and velocity by 1 %, inflation will be:
10% - 3% + 1% = 8%
We must modify the GDP equation once again to include Government expenditure or, more generally, public sector expenditure, G.
GDP can be definitively expressed as follows:
Overall, G levies taxes on households (tax, compulsory contributions etc) and takes out loans (the National debt).
With these revenues, the Government:
51-The increasing role of the State
In the course of the 20th century, the proportion of State expenditure as a percentage of GDP increased substantially in all industrialized countries.
In the USA, the State's proportion represented 10 % of GDP before the First World War. Today, the figure has increased to 35 %. In some countries, it well exceeds 50%.
There are three reasons for this increase:
52-The State as manager of kingly services
It is logical for the State to pay the civil servants who perform tasks for the State that private employees cannot carry out. A State needs judges, a police force and soldiers to ensure the countrys internal and external security.
It would even be desirable for those carrying out difficult or arduous tasks to be better paid. On the other hand, some services such as education or health could probably be performed more efficiently if they were managed by the private sector.
53-The State distributes social revenues
The State levies taxes from people with medium and high incomes to distribute to the poorest inhabitants, thus guaranteeing them a minimum revenue. Nevertheless this policy is limited because the Laffer curve shows that when taxes are too much increased, their receipts fall rapidly.
Redistribution is also practiced by the State in an even more harmful way in favor of groups of marginal producers:
Subsidies are distributed to companies which would disappear if we let the normal market rules prevail: Certain categories of farmers, fishermen and some industries . The cost of these subsidies is levied from the taxpayers.
Some companies in Europe are specialized in the search of public grants and subsidies. They often recruit executives who only have to look for them in using their relations. What is more, some companies are just created to benefit of a public grant and when they have gotten it , they just disappear!
Do not try to copy these people! They can do that because they have close relations with some policy makers and high civil servants: This monkey business functions like a a circular flow of corruption: corruption----subsidies---more corruption and so on!
Avoid the economic sector where these sharks are operating. As they are fueled with subsidies, you cannot compete with them.
54-The State as an Investor
It is logical to invest in domains such as bridges, roads, military equipment. All these investments have positive externalities for the economic players.
It is also necessary:
These two conditions are not a matter of economics but politics:
To invest, the government must borrow: The total amount of borrowing is called the national debt and its percentage to the GDP is the debt ratio.
55-The State and its regulatory function
Generally speaking, the State puts laws into practice once they have been voted. This is done in the legal framework in which all economic activity belongs.
The Government's regulatory function is also very important. A Government has the authority to set certain prices. For instance, it sets a minimum wage level and can also set floor and ceiling prices in certain cases.
It prescribes countless regulations that interfere in the life of companies and households: Rules on pollution, on competition, on whether or not to allow foreign products to enter the country (quotas), on trade unions.
No more! no more, please! When regulations increase too much (notably the labor regulations or the taxes) the only way is to lock out the biz and to fly away! Thanks to globalization ( next lesson) it's nowadays easy to move the capital. Once again, do not be stuck. Be always prepared to move.
domestic product is the total final value of goods and services produced
in a given country in a year. To get this final production you have to
remunerate the factors of production with wages, interests, and profit.
The total income distributed equals in a year the total production. The
growth of GDP occurs when the factors of production are better used (productivity)
or when they are extended (investment in capital). Productivity
and investment are the main tools to improve GDP per capita. The
GDP never increases in a linear way. It registers fluctuations which cause
inflation or unemployment. The monetary policy enables to limit these
fluctuations. On the other hand these fluctuations can be amplified or
balanced according to the government policy. DO
IT YOURSELF Use
the knowledge's you have just gotten to clarify your vision: -Are
you in a sector which is likely to expand? -Have
you put enough knowledge and creativity into your project? -Is
the economic situation in your country friendly to business? -Have
you begun to think about the administrative and legal hurdles? Periodically,
read and read again the down-earth advices. They must be
printed in your mind and in your subconscious. AUTHOR Click
Gross domestic product is the total final value of goods and services produced in a given country in a year. To get this final production you have to remunerate the factors of production with wages, interests, and profit. The total income distributed equals in a year the total production.
The growth of GDP occurs when the factors of production are better used (productivity) or when they are extended (investment in capital). Productivity and investment are the main tools to improve GDP per capita.
The GDP never increases in a linear way. It registers fluctuations which cause inflation or unemployment. The monetary policy enables to limit these fluctuations. On the other hand these fluctuations can be amplified or balanced according to the government policy.
DO IT YOURSELF
Use the knowledge's you have just gotten to clarify your vision:
-Are you in a sector which is likely to expand?
-Have you put enough knowledge and creativity into your project?
-Is the economic situation in your country friendly to business?
-Have you begun to think about the administrative and legal hurdles?
Periodically, read and read again the down-earth advices. They must be printed in your mind and in your subconscious.
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