Macroeconomics Concerns and Policies

Inflation:

“a sustained rise in the average price of goods over time” – since the General Price Level is determined by interaction of demand and supply, AD must rise relative to AS.

Causes

  1. Demand-Pull Inflation: AD rises and is not accompanied by an increase in AS
  2. An increase in demand in the real economy [C, I, G or X] due to increases in consumer confidence, higher wages(both D-pull and C-push), government spending, tax cuts, improved animal spirits, growing overseas demand.
  3. An increase in the Money Supply – will induce more demand in the economy
  4. Cost-Push Inflation: AS falls and hence prices rise
  5. Wage-Push: Wages rise disproportionately to productivity, may be caused by Unions
  6. Profit-Push: Monopoly firms may push up prices independent of changes in demand.

i.  Wage-Price Spiral – can be started off by a D-pull or Cost-Push

  1. Import-Price-Push: An increase in prices of imported goods, e.g. 1973 Oil Shock
  2. Tax Push – inducing WPS through an increase in tax
  3. Fall in AS caused by exhaustion of raw materials or failure of harvests
  4. Structural (Rigidity)Inflation: Imbalance in the growth of AD and AS due to lack of flexibility in the wages and prices. As the economy changes and demand and supply patterns shift, wages and prices move up but not down. Ratchet effect.
  5. Expectations can perpetuate inflation, but not trigger it. Wage Price Spiral.

Consequences – “Unanticipated Inflation”

1.  Interrupts Price Signals – Prevents prices from conveying information, as price increases may be rising in absolute terms (rising across the board) or relative terms (only for that particular good)

2.  Redistributes Incomes –

a.  Losers: Fixed Incomes, Lenders and Weak Trade Unions (or No Trade Unions).

b.  Winners: Profit Earners, Borrowers and Strong Unions

c.  Rich get richer and poor get poorer

d.  Governments may “inflate away” their debts on purpose.

3.  Affects Balance of Payments – a higher relative inflation rate makes exports look more expensive, but imports will look cheaper. This can result in a depreciating Forex rate.

4.  Uncertainty – Higher inflation is more volatile. Adds to uncertainty of doing business, discourages investment and lowers trade

5.  Employs Resources – Firms employ financial experts, buys in future markets and incurs menu costs.

However – it can also generate the money illusion, which makes people feel better off, and also encourage reallocation of labour.

Unemployment:

“those of working age who are without work, but who are available at current wage rates”
Unemp Rate = Unemp/(Work + Unemp)*100%. Seasonally Adjusted

Measure: Those who claim unemployment benefits OR Survey of those seeking employment.

Causes

Equilibrium

  1. Frictional (Search) Unemployment: Short in duration, people temporarily out of work, may not simply take the first job offered. Information problem, may be resolved through increasing the quality of information through government or private (internet) portals.
  2. Structural Unemployment: Unemployment caused by changes in patterns of demand and supply. Technological Unemployment – labour replaced by machinery. Regional Unemployment – if a mono-industrial area goes into decline. May be resolved through retraining (market) or creating jobs (interventionist), increasing labour mobility (occupational and geographical)
  3. Seasonal Unemployment: demand for labour varies with the seasons.

Disequilibrium – wage rate is above or below equilibrium point (sticky) and markets fail to clear

  1. Real-wage or Classical Unemployment – wages are driven up by unions or legislated by the government. High wages may help create more jobs since consumption will rise, but in the short term will always result in less people being employed.
  2. Demand-Deficient or Keynesian Unemployment – AD falls so people lose their jobs, a reduction in wages will reduce AD further, so solution should be to boost AD via Fiscal Policy.
  3. Growth in Labour Supply – Immigration, Baby Booms or Women joining the Labour Force (also too much of a particular kind of labour for a particular industry)

Duration: Costs of Unemployment increase exponentially with the duration of Unemployed. Unemployment = no. * duration.

Costs:

Private:

·  Financial Cost = Wage – Benefits

·  Personal Cost: Self esteem, stress, ill-health

Social:

·  Output forgone with lack of employment

·  Loss of tax receipts

·  Extra spending by the Government

·  Loss of Profits for firms from full employment

·  Loss of Opportunities for Other Workers

·  De-skilling of Unemployed

·  Externalities – Crime, Graffiti, etc.

Growth:

“monetary phenomenon measured by increases in real GDP per capita”

Actual Growth: % increase in real GDP/GNP per capita. Moving out toward the PPC. Stems from increases in AD: Consumption, Investment (D-SR, S-LR), Government Spending and Export Led (D-SR, nothing in the long run)

Potential Growth: Rate at which economy could grow. PPC itself moves outwards. In line with growth rate of productivity. Stems from increases in AS:

·  Land – reclamation, imperialism, invasion or growth triangles

·  Labour – growing population, immigration, higher participation rate

·  Capital – capital stock increased (Marginal Efficiency of Capital) – Investment (Savings), current consumption sacrificed

·  Enterprise

·  Productivity (Qualitative) – technological progress improving the quality of capital. May also depend on Actual Growth stimulating investment and confidence.

How to: ensure that AG keeps pace with PG in the Short Run (D-side), and in the Long Run ensuring an increase in the PG rate (S-Side)?

Benefits:

  1. Rising GDP means a higher standard of living in material terms
  2. Redistribution of incomes are easier when incomes are rising, redistribution hence may be more equitable (not a zero sum game)
  3. We may have more resources to pay attention to non-material things, like the environment.

Costs:

  1. Increased consumption does not = happiness
  2. Investment for growth requires sacrifice of current consumption
  3. Income may simply result in more demands
  4. Growth uses up non-renewable materials more rapidly
  5. Pursuit of materialism may leave society greedier, more selfish and less caring. Violence, crime, stress, suicide, divorce may result
  6. Higher levels of consumption usually lead to a decline in the environment.
  7. In reality distribution of income becomes more unequal (Piketty)

Balance of Payments:

All money flowing into the country is recorded as “credit” and all money flowing out is recorded as “debit”.

Current Account Balance

·  Goods Balance or Merchandise trade – Export of Goods minus Import of Goods (Balance of Trade)

·  Services Balance – Export of Services minus Import of Services: Financial Services, transport, tourism, government expenditure, entertainments and ‘wages, interest, profits and dividends”

·  Current Transfers – Private and government transfers between countries e.g. scholarships and contributions to international organizations

Capital Account

·  Capital Movements into and out of the country. Loans between countries

·  Investments – Direct Physical Investment and Portfolio Investment (shares in foreign companies).

·  Short Term flows of capital (hot money) vs Long Term flows.

Surpluses are recorded as an addition to reserves whilst deficits are paid by drawing on reserves.

Causes of BoP Disequilibrium: deficit/surplus on the Current A/C or Capital A/C

Current A/C:

·  Changes in the price of exports relative to the price of imports (terms of Trade) caused by supply or demand side factors.

·  Changes in foreign exchange rates

·  Rate of growth of domestic income relative to the world’s rate of growth

·  Trends in flows of investment income and transfers

Capital A/C:

·  In the SR ‘hot money’ flows according to current interest rates, so changes in i/r can cause an inflow (higher i/r) or outflow (lower i/r)

·  In the LR capital flows depend on political factors, government policy, world sentiment, structural changes.

Consequences of BoP Disequilibrium (on domestic and external economy): traditionally developing countries should have a deficit on Current A/C as they import capital equipment and surplus on Capital A/C as foreign firms invest, and is reversed for developed countries.

Internally:

·  Surpluses can create jobs to meet export orders, boosting output, but may lead to inflation if this generates excess demand

·  In the case of a Fixed Exchange Rate Regime, Reserves and Money Supply will increase

Externally:

·  Country may have to borrow to finance an overall deficit if there is a fixed exchange rate. Interest on loans are a liability.

·  Country may also run down reserves of foreign currency in case of a deficit

·  Under a floating regime, surpluses cause the forex to appreciate, and a deficit causes depreciation.

·  Surpluses may cause the terms of trade to improve whilst a deficit causes the terms of trade to worsen.

FOREX:

“nominal exchange rate: quoted on forex market for the currency, against the USD.”
“real exchange rate: measures the relative price of goods from different currencies when measured in a common currency”
“PPC exchange rate path is the path of the nominal exchange rate that would keep the real exchange rate constant over a period”

Singapore – “dirty” or “managed” float.

Demand for Dollar: foreigners wishing to buy local goods(visible exports) and services(invisible exports), or move capital into the country in the form of loans, direct investment or portfolio investment (capital inflows).

Supply of Dollar: locals wishing to buy foreign goods (visible imports) and services (invisible importsn) or move capital overseas in the form of loans, direct investment or portfolio investment (Capital outflows)

Fixed Exchange Rates: If Supply and Demand fluctuate, the Central Bank will buy and sell in the forex market to maintain the forex rate at a chosen level.

Floating Exchange Rates: Domestic currency is allowed to find its own level, adjusting automatically to changes in supply and demand.

Forward rates: allows importers and exporters to remove some of the uncertainty of floating rates by allowing rates to be fixed for future delivery. Hedging.

Exchange Rate Band: Fixed band in which the rate can fluctuate

Joint float: a group of countries fix their rates with regard to one another, and allows the whole band to fluctuate against the rest of the world’s currencies.

·  Unstable exchange rates generate uncertainty which drives businesses away

·  A steadily appreciating exchange rate is attractive to foreign investment

·  A steadily appreciating exchange rate is also anti-inflationary and keeps out imported inflation.

Relationships between Macroeconomic Problems:

Internal and External Value of Money:

  1. Internal value of money is determined by the price level. Hence as prices rise, the internal value of money drops. Inflation makes exports look more expensive, and imports cheaper, so the country exports less and imports more, hence resulting in a BoP deficit. If the exchange rate is floating, this will cause an increase of supply of domestic currency in the forex market, and hence cause the forex value to fall
  2. This process can also work in reverse if the forex value of the currency falls, this makes exports look cheaper and imports more expensive. Hence causing demand-pull inflation, causing prices to rise and the internal value of money to fall.

Inflation and Balance of Payment

  1. Inflation that is relatively higher than the rate of its competitors may cause an increase in imports and a fall in exports (depending on elasticities of demand), hence causing a BoP deficit.
  2. A BoP deficit may cause the forex rate to fall, making exports cheaper and imports more expensive, causing domestic inflationary pressure.

Inflation and Unemployment:

Inversely related, Phillips Curve (A.W. Phillips) Reflects the Keynesian view of the economy whereby insufficient demand causes unemployment, whereas excess demand causes inflation.

However, according to NAIRU: Inflation and Unemployment face a trade off in the SR, but in the LR the economy settles to a given level of unemployment dependent on the supply-side of the economy

Money Illusion: people think wages are rising, firms think goods are becoming popular, so AS rises with AD as people take jobs and firms step up production. However, once the illusion is broken, jobs are lost and production falls, AS falls. Hence, unemployment returns to its original level but inflation remains the same.

Conclusion:

Keynesians: Policies which are good for employment and growth cause an expansion of the economy, which may lead to inflation and a BoP problem. Conversely, policies which dampen demand and are good for inflation and BoP, may cause unemployment and reduce growth.

Monetarists: Controlling Inflation (and hence the Money Supply) is a prerequisite for achieving all the other targets.

Fiscal Policy:

“any alteration to Taxes and Government Spending with the intention of altering Aggregate Demand”

·  ST fluctuations: operating G and T counter cyclically to trade fluctuations. This is impeded by lags

·  Fundamental Disequilibria: caused by exogenous shocks e.g. AFC. With a deflationary gap, FP should be expansionary, increasing G or reducing T (to stimulate C+I). With an inflationary gap, policy should be contractionary.

Built in Stabilizers:

·  In a boom, government spending automatically falls (with reduced welfare payments) and tax receipts automatically rise with higher incomes. The budget is likely to go into a surplus and the deficit reduced.

·  The reverse happens in a slump. The effect is that fluctuations in the economy are dampened

·  Supply side effects: High Marginal Tax Rates discourage effort and initiative, whilst generous welfare payments encourage unemployment (and hence a higher rate of unemployment). Economy might be more stable, but growth may be slowed.

·  Fiscal Drag: Stabilize economy at current position, good if at full employment but will slowdown any recovery from a recession.

Discretionary Policy: Government deliberately altering levels of G and T to achieve a macro goal. Altering G will have a multiple effect on NY, whereas T will have a smaller multiplier impact.

Effectiveness:

Requirements: 1. An accurate picture of where the economy is and where its heading 2. To know the exact effect on AE of altering G & T, i.e. the size of the multiplier (and accelerator), 3. The timing of effects 4. How changes in AD will affect NY, employment, inflation and BoP, 5. Any side effects.

Problems:

  1. Difficult to ascertain the magnitude of the output gap or the multiplier. Fine-tuning is impossible, but in major recessions exact measurements become less of an issue
  2. Crowding out of the private sector. May not increase AD, merely replace it. Physical Crowding Out vs Financial Crowding Out.
  3. Barro-Ricardian Equivalence: Suggests that changing taxes to stimulate or discourage spending is futile. Solution: Tax Rebates?
  4. Lags: timing of Fiscal Policy is a problem. FP may be destabilising by the time it takes effect. Recognition Lag, Execution Lag, Impact Lag.

Side Effects: