Macro-Economics?

Micro economics indicates economy working at individual market and business level (at consumer, investor and worker).

Macro-economic indicates how national economy performs on 2 fronts:-

Sustained growth rate and stability in general price level.

It is important to understand macroeconomics as it impacts every individual life. Better understanding of macroeconomics can have significant impact on the way of our thinking and take day to day personal and business decisions in better way.

Interest rate, consumer confidence, unemployment rate, exchange rate, inflation, currency fluctuation in some part of the world can have potential impact on our life.

Business is no longer regional focus, we all are part of the world economics and every change in any part of the world can have impact in some way.

So to understand macroeconomics, can give potential knowledge to make better decisions in everyday life.

Major Macroeconomics Problem/key challenge areas?

1.) Rate of economic growtha. Rate of economic growth of the country is typically measured/indicated by GDP (Gross

Domestic Product). b. GDP can be defined as total market value of all final goods and services produced in the

economy in a given time period. c. GDP can be measured in multiple ways:

i. Flow of cost/income approach1. All income received by people in the country

a. Wages (Salary), Rent amount, Interest earned, Profit/benefits earned in any other form by everyone in the country ( wages + rent + interest earned+ profits/benefits)

ii. Flow of product/expenditure approach1. GDP = Consumption + Investment + Government Spending + Net Export

a. GDP = C + I + G + (X-M)d. Real vs Nominal GDP

i. Real GDP is the nominal GDP value adjusted for inflation. Real GDP should be watched closely than Nominal GDP for getting true picture of the current economy status.

ii. Real/Nominal GDP calculation:-1. Real GDP is calculated against base year – Current year Quantity*Price

of base year.2. Nominal GDP is price of current year * current year quantity.

1. Real GDP = Nominal GDP – inflationa. If Year X, Nominal GDP is 8 and inflation

is 6i. Real GDP = 2

b. If year X, Nominal GDP is 7 and inflation is 3

i. Real GDP = 4ii. The GDP forecasted in budget generally are Real GDP

( inflation adjusted)e. GDP Equation Interpretations

i. GDP(Y) = C+I+G+(X-M)ii. (Y-C) – G – (X-M) = I

1. Savings = Investmenta. Level of saving in the economy is equal to investments made in

the country. b. High saving will give option for government and private

institutes to have more money for investment.iii. (Y-C-G)-I = (X-M)

1. Savings – Investment = CA Deficita. (Y-C-G)-I = CAb. More investment than saving indicates that country is spending

more than it should be doing – higher imports than exports.f. India GDP

2.) Inflation a. What is Inflation

i. Upward movement of prices from one year to next year (change in price index).[Prince (2016)-Price (2015)/Prince (2015)] %

ii. There are 3 Inflation indicators generally used, all need to be used to know about economy trend:-

1. CPIa. Consumer price index indicates the change in the price level on

consumer front. All consumption of goods and services at retail price level including imports is considered.

b. Major items in the bucket having highest weightage are food groups, housing, services and misc. consumption items.

c. Taking base year as reference and calculating the fixed quantity weights, CPI is calculated to indicate the price increase for consumer.

d. CPI = (Current Price * Base year quantity) / (Base year Price * Base year quantity)

2. WPIa. Wholesale Price index indicates the change in the price level on

the larger basket of goods including intermediate goods ( but no service) at wholesale price.

b. Major items in the bucket havig the highest weightage are manufactured goods, fuels etc.

c. Taking base year as reference and calculating the fixed quantity weights, WPI is calculated to indicate the price increase for consumer.

d. WPI = (Current Price * Base year quantity) / (Base year Price * Base year quantity)

3. GDP Deflator (Nominal GDP / (Nominal GDP – Inflation))a. GDP deflator indicates the change in the price level for all

domestically produced final goods and services (no import items).

b. Economic metric, which shows how economy GDP is growing by removing the effect of inflation (rising prices) - indicates changes in consumption of goods and services currently present. It is not based on the any fixed basket of goods like CPI. Any new addition of goods and services in the economy also gets added and thus provides much better metric framework for economic growth indicator.

c. As quantity of goods and services produced is known at the end of the year, GDP deflator value has 1 year lag.

India’s CPI

iii. Which one to refer:-1. CPI and WPI are mostly used as the inflation indicator in the economy.2. As both have different bucket and weightage of items in the bucket,

they provide data points useful to understand economy at different level.

a. CPI will most likely tell about price change (demand growth) faced by the common people who buy food items, and avail services.

b. WPI will most likely tell about the price change (demand growth) faced by the manufacturers (producers).

iv. Inflation eats into the money value, impact savings value in future. Interest rate is influenced by the current inflation and expected inflation.

v. Due to inflation, borrowers can benefit and lenders can suffer – As inflation rises value of money returned by borrower under fixed interest lending decreases for lender.

3.) Unemploymenta. There are different kinds of unemployment that can occur in the economy.

i. Frictional1. Job switching can create unemployment.

ii. Cyclical 1. Economy dips into recession, which is cyclical as indicated in the past

century. Whenever economy enters into recession, it leads to unemployment.

iii. Structural1. These by far are toughest and has seen rising in the past few decades.

Technological revolution results in making many current jobs irrelevant and leads to unemployment.

b. Unemployment indictor is quarterly data. GDP output and unemployment are closely related – GDP output increase leads to decrease in unemployment and vice-versa.

c. India Unemployment data

Different school of economics and evolution of economics study groups in World

1.) Classical economics

Classical economics played central role and provided guiding principle which worked for most of the 18th century till early 19th century – Adam Smith and Riccardo were the so called classical economics defining fathers. Their belief and principal were:-

a. Economy is self-correcting , no need for government or external agency to participate ( Popularly names as Laissez Fair)

b. Unemployment is part of business cycle, as business cycle is cyclic there are phase when unemployment happens but economy self-correcting mechanism addresses the unemployment issue. This is how it may work:-

c. When business starts with some resources, due to economy of scale and wages increase overtime leads to business not being so profitable. Thus wages need to again go back to the correct level. Unemployment happens, more people available to take job, wages decrease, expense of running business decreases and thus business start making profit again with more jobs being created. Classical economics based on 2 basic principles:

d. Says Law - Supply creates its own demand. Supply of goods and services in the economy produced will have its corresponding demand.

e. MV=PQ f. This equation indicates that keeping velocity of money supply constant and quantity

stable, increase in Money supply will result in increase in Price.g. What happened during Great Depressionh. Stock market crash in 1929i. GDP fell one third between 1929 and 1933j. 25% unemploymentk. Business investment fell from 16M to 1 M in 1933l. Great depression was caused due to classical economics view that economy self corrects

without the involvement of government institute.m. But this did not happen, and when sentiments went down economy moved into deeper

recession.

2.) Keynesian Economicsa. It rejected the classical economics view of economy self-correcting itself.b. When economy goes into recession and sentiments are down, economic pump by the

government is necessary to revive the economy,c. Before price adjustment takes place, it is preceded by the income adjustment behavior –

During great depression people and business behavior changed quickly on the basis of recession and reducing level of income. Thus large expenditure by the government is important.

d. Thus Role of Fiscal policy is important for the economy.e. Fiscal Policy focus is towards tax policy and government spending.

f. Philosophy was based on – when economy is in recession it causes high unemployment and people do not spend (demand goes down). When economy is booming it causes high employment and people spend more causing inflation.

g. Unemployment and inflation is inversely related. Both cannot coexist at the same time.

h. What happened during 1970’s i. Just like during classical economics, led to great depression which forced economist to

look for other options, Keynesian usage was followed with another economic problem – Stagflation.

j. Stagflation is – high unemployment with high inflation. This was unknown scenario before 1970’s.

k. It was caused primarily because of:-l. Huge Tax cuts by the government as part of fiscal policy at the start of 1970’s.m. Vietnam War at the same time – which increased the spending to support war.n. As money supply in the economy increased, caused demand pull inflation in the

economy.o. As war ended, with economy/business cycle going down, unreasonable money supply

and short spike in business during small phase led to increase of unemployment with high inflation in the economy at the same time – causing stagflation.

3.) Monetarist School of economicsa. Believe that macro-economic problems of inflation and unemployment/Recession

happens in the economy due to b. Rate of growth of money supplyc. Inflation happens when government prints excessive moneyd. Recession happens when government prints less moneye. Keynesian policy to drive the unemployment below the lowest sustainable

unemployment rate, which used to move economy into uncertainty zone, causing inflation.

f. Natural rate of unemployment is an important concept brought by the Monetarist economist

g. Also called as lowest sustainable unemployment rate ( LSUR)h. Lowest level of unemployment without putting upward pressure of inflationi. Going below LSUR, can lead to short term growth in the economy. But in long term it

leads to the prices/wages increase thus causing the inflation.j. To bring down the inflation, then need to increase the level of unemployment (inducing

recession) in the economy. Inducing recession brings in increase in interest rate to very high level.

4.) Supply side economicsa. Government focus on addressing supply side based on the following philosophy without

inducing inflation:-b. Increase government expenditure – government pump into expanding production and

support in building infrastructure to help in production and accelerate economic growth.

c. Cut taxesd. Tax cut though will cause inflation in short term. But long term, people get incentive to

earn more and work more, which leads to increased productivity and employment. Business incentive and people incentive to supply more increases; AS Curve shifts right thus reducing the inflation in long term.

e. But there is potential risk of increasing the budget/fiscal deficit, which may lead to gradually build up trade deficit (twin deficit).

AS-AD Model (Supply and Demand Market Model to understand and analyze the state of economy)

1.) How prices and GDP output works in the economy. AS – Supply curve

Supply of goods/service in the economy is captured using AS curve With Price on Y-Axis and GDP output(efficiency) on X –Axis AS curve- As Price of goods increases, gives business incentive to grow;

suppliers will be able to create more goods/services which will increase the GDP output.

AS – Shift of AS Curve Determinants of AS curve depends on factors:-

o Input prices

GDP Output

Price

AS

o Technologyo Productivityo Legal institution like tax

If cost of import resource like oil rises, production cost increases – shift AS curve on the left - prices increases and output decreases – this is called Cost push inflation.

If productivity increases due to technological shift, average production cost will fall, AS curve shift rightwards – Prices fall and output also increases.

If sales tax/excise tax falls – decrease production cost, AS curve shifts rightwards – prices will fall and GDP output will increase.

AD – Demand Curve Demand of goods and services in the economy is captured as AD curve With Price on Y-Axis and GDP output (efficiency) on X-Axis AD curve- as prices goes down purchasing power of people increases,

thus demand of the goods or service will go up. To meet increased demand output needs to grow thus GDP output rises thus increasing the GDP output negatively.

Also, as prices goes down interest rate reduces, thus investment/spending increases in the economy which leads to the increase of the GDP output.

Shift of AD curveo Determinants of AD curve depends on 4 factors:-

Consumption Govt. Spending Investment Net Export

o Demand increase moves the curve to the right, and decrease in demand moves the curve to the left.

Suppose Stock market dips 2000 points in a week, how will it impact AD curve

GDP Output

Price AD

Consumer wealth goes down, AD shifts leftwards

News of possible recession will impact Consumer expectation will fall, less consumption and

curve shifts leftwards During government expansionary policy, spending

increases with rise in the pays of the government employees and others. Increase in money supply in the market will lead to increase in the demand. AD curve shifts to the right.

AS-AD curve Supply and demand curve intersection provides the macro-economic

equilibrium of price and GDP of the economy. Intersect point of AS and AD curve– P1, is the Price equilibrium, and Q1

is the GDP equilibrium of the economy.

2.) Types of Inflation and how Inflation builds up in the economy 2 types of inflation arises in the economy

Demand Pull inflationo Too much money chasing too few goodso More money in the economy- purchasing power of people

increases or more number of people have money. This leads to people demanding more goods and services in the economy – AD curve shifts to the right. If economy is not in position to supply the demand, it leads to inflation.

AS

AD

GDP Output

Price Q1

P1

AD1

AS

AD

Price

P1

Supply side Inflationo Cost of doing business/product cost increases

Rapid increase in the production cost/wages/raw material cost pushes the product cost

Any other supply side shock like drought/war can also push the cost

o As cost of doing business increases, supply goes down – AS curve shifts leftwards.

Price increases but GDP output decreases. Economy faces Inflation along with recession

(Stagflation)

AS1

AS

AD

GDP Output

Price

Q1

P1

If expansionary policy is used, unemployment will decrease, money supply increases; AD curve shifts rightwards. GDP increases but it leads to more price increases (more inflation).

If Contractionary policy is used, money supply decreases, inflation comes down; AD curve shifts leftwards, Prices come down but GDP output also decreases.

Supply side economics is challenging as it is difficult to correct prices and output. Need to bring back AS1 to AS, factors which moves AS need to be closely monitored. Business cost to be controlled so that AS curve does not shift drastically to leftward to cause supply side inflation.

AD1

AS1

AS

AD

GDP Output

Price

Q1

P1

AD1

AS1

AS

AD

GDP Output

Price

Q1

P1

AS curve shift rightward is the most ideal situation –in this case prices fall and GDP output increases.

Macro-Economic Policy tools

There are primarily two governing bodies in most of the economic country worldwide – Democratic government and central bank.

Both play a very important role in defining the guidelines, rules and policy required for the economy to function properly and efficiently.

1.) Fiscal Policy

Government lays down the fiscal policy of the country, which primarily focuses on the government spending and tax related policies.

2.) Monetary Policy

Central bank of the country lays down the monetary policy of the country, which primarily focuses on the money supply control in the economy.

Both policy have to be in sync to make economy stable and control the growth of the economy.

Understanding of some key macroeconomics terminology influencing fiscal policies

1.) Autonomous consumptiona. Even if income is 0, consumption that is still required is called as Autonomous

consumption.b. It helps to get an idea about discretionary income (money left after autonomous

consumption).Growth of discretionary income indicates growing economy.2.) 4 major components that define the GDP of the economy:-

a. Consumption (C) b. Govt. expenditure (G)c. Investment (I)d. Net export ( X-M)

3.) Consumption – It is one of the major contributors of the GDP growth component.a. One major factor that derives the consumption level in the economy is Propensity of the

people to save or spend. This micro economics indicator is critical to formulate the consumption estimate and future GDP growth. It also helps to formulate fiscal policy with numbers – to help in knowing how much govt. has to spend/tax cut/print money

i. MPC – Marginal Propensity of consumptionii. Marginal Propensity to Save(MPS) = 1- MPC

iii. Consumption forecast = Current consumption + MPC * Disposable income1. For India, Marginal propensity to consume is considered to be 0.6.2. If MPC of economy is 0.6, current consumption is Re 8 and disposal

income increases by Re 10.a. MPS = 1-0.6 = 0.4b. Forecast Consumption = 8 + 0.6*10 = 14

3. Future expectation of the Level of consumption can give indication of an average home expenditure.

4.) Investmenta. It comprises of events like :- Buying real estate/goods + Industry spending on plants and

infrastructureb. It depends on the interest rate and expectations/business sentiments

5.) Net exporta. Export – Importb. More import will lead to:-

i. Increase in dollar demand which will have multi fold impact:-1. Reduction in GDP growth 2. Trade deficit 3. Weak Currency

6.) Government expenditurea. Defined in the fiscal policy – where agents like tax rates, government spending,

subsidies etc. formulates government expenditure plan.i. Government total expenditure = Revenue Expenditure(Consumption+ Interest

payments+ Transfer payments) + Capital Expenditure(Infrastructure expenditure like on roads)

ii. Government Own Receipts = Revenue Receipts ( Direct and indirect Tax + non-tax revenue) + Capital receipts ( Recovery of loan + Public sector disinvestment)

iii. Fiscal deficit = Government Receipts - Government expenditure

7.) Fiscal or Expenditure Multiplier – When government tries to bring up extra money in economy circle by means of tax cuts or government spending, the actual money flow in the economy grows by level of multiplier.

a. Multiplier = 1/MPS = 1/(1-MPC)i. Govt. spends 100b$ on defense projects, what is the impact on the GDP?

1. MPC = 2/3(0.6), then multiplier will be = 1/(1-2/3) = 32. Increase the economy by 3*100 = 300Billion

ii. Recessionary gap of 100b$, how much tax cut required?1. MPC= 0.8, multiplier = 5 ( =1/(1-0.8))2. Government spending – 100/5 = 20 B$3. For tax multiplier- (as tax cuts is not spend all)

a. MPC*expenditure multiplier = 0.8*5 = 4

4. 100/5 times = 25b$5. 25b$ of tax cut required to close recessionary economic gap of 100b in

the economy.

iii. Inflationary gap – 60b$1. MPC = 0.752. Multiplier = 1/1-0.75 = 43. Need to pull out 15b$ money from the economy either by

a. Reduce Government spending by 15 b$ Orb. Raise tax collection by 20b$

8.) Fiscal/Budget Deficit a. Fiscal deficit = Government Receipts - Government expenditure b. Fiscal deficit can be broken into 2 sub-components:-

i. Structural deficit1. Due to existing tax structure and paying schemes.

ii. Cyclical deficit1. Caused due to recession as automatic stabilizers policy – fiscal policy

like subsidies, compensations etc.2. Automatic stabilizers

a. Unemployment rate increases - spending more and tax is also less

b. Inflation also impacts government spending.c. Deficit can be financed by government in following ways:-

i. Raise taxes1. Unpopular step

ii. Borrow money1. From central bank thus pulling out money from the system

a. T-Bonds , G-Securities(selling government securities to central bank)

i. Can lead to Crowding out can be problemii. Crowding out will not have impact during recession or

cyclical deficits.iii. Raise Interest ratesiv. Borrow from international market – import of goods and services from abroad

1. Import > export, thus trade deficit starts increasing can lead to twin deficit ( trade deficit and fiscal deficit)

2. But if import items are used for productive use, and able to generate GDP growth it will help economy revive.

3. Borrowing from abroad, can lead to fluctuation of the currency in the international market. Investment and trading can get affected due to currency fluctuation.

v. Print money1. Central buys Government Bonds and prints new money

a. Can cause of inflationd. Budget Deficit pros and Cons

i. Cons1. High deficit, high interest rate, crowding out, higher interest rate foreign

investment pours in, Must exchange currency with dollars, dollar value increases due to high demand, stronger US dollar impacts exports while imports still high thus leading to trade deficit.

2. For trade deficit – need to sell assets to foreign investors, this may lead to reduce country growth and real income for citizens.

3. Debt to external has increased.4. Paying interest on external debt impacts money supply5. Foreign debt exposes political issues.6. Internal debt is also not good7. Payment of interest, interest of payment means tax payers money going

to wealthy people who buys government bonds, money otherwise could have been spend on other government improvement schemes like education, accumulation of large debt puts pressure on future generations

ii. Pros1. Most of debt in internal debt, borrowed from citizens2. Debt today is used for investment which will benefit future generations.3. Private investment depends on the country infrastructure and human

resource capability.4. Govt. spending on Too many wasteful programs should be controlled –

like war, subsidies, welfare programs etc..5. Public investment is less productive than private investment

Problem with Economy following only Fiscal policy (i.e. Government policy to push spending in the economy to fuel growth)

1.) Crowding out of the private market players.a. As Keynesian primary tool is fiscal policy, government spending can lead to crowding out

– which means government will pick money from the market and thus money for private players will not be available.

2.) Government spending can potentially lead to Fiscal deficit in long run. Large Fiscal deficit will lead to increase in the interest rate.

3.) It ignores monetary policy and inflation.4.) Also, does not account for AS-AD model which depends on GDP and Price.

Central Bank and Monetary Policy

1.) Type of Moneya. Commodity money

i. Bank moneyii. Paper money

2.) Feature of moneya. Medium of exchange

i. It indicates the goods and services that are exchanged in the economyb. Unit of account – rate at which goods are exchangedc. Store value ( hold money for a year and spend next year)

3.) How money got created:-a. Started with gold standard couple of century ago.

i. Asked goldsmith to store gold and in issue receipt to the people. For any transaction need to go to goldsmith, get gold for transaction.

ii. But it lead to 3 basic concepts which led to the formulation of basis of money market:-

1. Paper receipt can be used directly for transaction2. Goldsmith competition can lead to additional benefits to depositors –

interest rate on gold storage.3. Fractional reserves – Goldsmith can issue multiple gold receipts to the

people based on the assumption that all people will not come back for their gold at the same time – thus expanding the money supply.

iii. Above 3 points form the basis of today’s banking system also.a. Currency notes are used directly for transactionb. Banks provide various interest rates as benefit to customers for

keeping money with banksc. Fractional reserve, banks issue currency in the market based on

the below ratio guidelines:-i. Cash Reserve ratio (CRR) - The amount of money Bank

need to hold to at any given point of time for safeguarding liquidity.

ii. Money Multiplier = 1/RRiii. Thus Re 100 deposit in the bank, with RR of 0.1 will

increase the money supply by 100*10= 1000.1. Money supply is multiple of money multiplier.

iv. Central banks provides the money to the banking systems.

4.) Interest Ratea. It is define as the Price of the money.b. Value of money, which is considered as commodity, follows the same AS-AD rules.c. Demand and supply of money drivers the interest rate. More money supply in the

market can push interest rate down and vice versa.

d. Inflation and interest rate can be considered as the 2 sides of the coin.e. Real interest rate = nominal interest rate – inflation

i. There are various interest rates terms:-1. Policy Repo Rate : 6.50%

a. Rate at which commercial bank can borrow money from RBI2. Reverse Repo Rate : 6.00%

a. Rate at which RBI can borrow money from commercial bank3. Marginal Standing Facility Rate : 7.00%

a. Rate at which banks can borrow money from RBI4. Bank Rate : 7.00%

a. Rate at which commercial bank loan money from the RBI on short term. It is different from repo rate.

5. Base Rate : 9.30% - 9.70%a. Minimum rate set by RBI, below this rate banks cannot loan

money to the consumers.

5.) Central Bank is responsible for:-a. Issue currencyb. Lender of last resortc. Regulate financial institutionsd. Provide banking system to the governmente. Provide financial systems to the nation banksf. Conduct monetary policy

6.) Monetary policy(defined by central bank) focus points can be:-a. Promote economic growth in-line with potential economic b. High level of employmentc. Insure stable prices ( control inflation level)d. Moderate long term interest ratese. Insure exchange rate prices ( control currency value in the global market)

7.) Money supply in the economy has impact on 3 major economic factors:-a. Interest rates, Assets prices, Exchange rates.b. These factors influence consumption spending and investment, thus impacting the GDP

of the economy.i. For example, more money supply in the economy may lead to more investment

in bonds. Bond prices can go up thus yield comes down – Interest rate comes down.

8.) Major policy instruments with Central bank to influence the money supply in the economy:-a. Setting reserve ratio – Impacts the money multiplier

i. CRR : 4%1. Bank need to hold certain % with RBI for ensuring liquidity at all times.2. Use case of CRR – if Rs 100 is injected in the economy the impact on the

money supply will bea. Money supply = 100/0.04 = 2500

b. With Rs 100, economy money supply becomes Rs 2500.ii. SLR : 21.25%

1. Bank need to hold certain % in the form of government security.b. Discount rate ( Interest rate)c. Open market operation

i. Buying and selling government security bonds (Treasury bills)a. Central bank Monetary policy use case (open market

operation):-i. Inflation (demand pull inflation) in the economy – this

will need some contractionary policy to be in place - Sell treasury bills

ii. Open market operations steps:-iii. Sell treasury bills to Brokers/Dealers who sell to

commercial banks, Big corporations, Financial institutions and Individuals perhaps

iv. Buyers buy bonds by writing checks to the Fed drawn from some commercial bank

v. Fed presents the check to the bank, payment happens by reducing the bank reserve with Fed/Central bank reserves.

vi. This reduction in the reserves leads to reducing the money supply in the economy.

vii. Reserve is down , money supply contracts, interest goes up, Investment, consumption and net exports decreases, AD down ( real GDP and inflation goes down)

Where to use Monetary and Fiscal Policy

i. If size of recessionary gap and multiplier is known then better fiscal policy can be laid.

ii. Believe fiscal policy is better tools, Monetary policy is good only for fine tuning the economy when not in recession or inflation stage

Unemployment

1.) One of the parameters or indicator of Growth of the economy is the unemployment. This indicator is not yet published for India recently, the last data is for 2013 which stands at 4.9%.Highest being in 2010 as 9.4% in last decade.

2.) Unemployed data is gathered using the sample data. 3.) It does not contain non-working group4.) Working group( Or labor force) consists of:-

a. Employedb. Not employedc. Employed/Labor force

5.) For every 2% drop of GDP, unemployment raises by 1%.

6.) Actual GDP should be close to potential GDP to keep unemployment rate constant.7.) Unemployment and Inflation

a. Wages fall when unemployment is high and vice versab. Natural rate of unemployment is the minimal level of unemployment without putting

upward pressure on inflation8.) Expansionary policy to keep unemployment below the lowest rate will ease initial

unemployment level but in long run will result in inflationary spiral.9.) Should control/cut wages and prices to bring down inflation

What is Twin Deficit?

Fiscal deficit and Trade deficito GDP = C+I+G+(X-M)

GDP – C –G –(X-m) = I, where GDP – Consumption will leave Savings + tax. Saving + (Tax – Government spending) + (Import - Export) = Investment

o Tax – Government - > Indicates Fiscal Deficito Import – Export -> Indicates Trade deficito If economy has burden of huge fiscal deficit ( Government spending is more than the

government money collection), then following events may happen:- Saving needs to go up (citizens to save more), interest rates need to go up. Import and export gap should increase ( more import than export) With possible increase of interest rates, Investment will go down.

o IF fiscal deficit increases It may result in increase in interest rate to give incentive for people to save more. But

increase in interest rate will hamper growth as loan will become expensive. To reduce the fiscal deficit, government may depend on borrowing from international

market,

Summary of Leading Economic indicators

GDP = C+I+G+(X-M)o GDP – ECRI leading index, stock market, yield curve speedo C – consumer confidence, retail/house saleso I – Manufacturing index

CPI/WPI – Inflation indicators ( RBI may rate interest rate to control inflation)o G – Treasury Reporto (x-m) – Trade report

Impacts GDP And impacts Investment

Recent World Events

US economy grew by 3.5% average from 1947 till 2001. From 2001 till 2011 it grew by 1.6%. In 2007, saw massive financial crisis in US market especially Real estate and Banking sector which led

to Downturn, massive fiscal stimulus and monetary stimulus till date. To bring up the economy to good growth and increase the GDP, countries like US initiated

expansionary policy not seen earlier in the world – term in economics known as Quantitative easing. Quantitative easing-

o Central bank buys massive amount of bonds – increase bond price , lower bond yield and interest rate

o Lower interest rate helps in investment as money borrowing required to create jobso Helps to devalue the currency and help export of the country.

But this has not helped to solve the ground problem in many countries till now. And the reason seems to be tied with structural problem and effect of world trade.

o China joins WTO 2001, which eventually led to GDP fall for many countries around the globe. It can be understood on the basis of following points of the change happened for world economies.

Large trade deficits (X-M) with many countries around globe As X-M increases, GDP goes down ( massive imports from China to other

countries in the world) Massive reduction in the Investment

Companies around the globe start putting up factories and manufacturing units in China, thus Investment in respective countries has gone down.

Structural emergence of low growing GDP economies Increase in the Government expenditure has not helped economy and GDP to grow.

o Even with low interest rates, economy has not picked up in the developed countries. This can be attributed to the following reasons as to why quantitative easing and low

interest rates not able to pick up economy growth:- Aging population in the developed nation With real estate and stock crash in the past few years worldwide has led to

belief that huge risk is not advisable. Thus major population in the developed nation now have inclination for

saving instead of consumption. With inclination to save more and low interest rate, it creates environment

where people intend to save more and more to cover up market risks, support aging needs and more money required in future.

o Thus US/Europe QE did not affect the growth as structural issue of chronic trade imbalance was not addressed

o Thus Recession in Europe/US along with less consumption need led to weak import from China weak import for commodity country (Canada/Australia/Russia – provide natural resources to china). This cycle has led to world growth to go on decline in the past few years.

There are possible three major problem statements that different school of economist consider as the most challenging:-

What causes instability in the economy Keynesians view

o Change in investment and consumption shift AD curveo Adverse supply side shock (Natural disaster causing surge in high oil prices)

shift AS curve Monetarist

o Relies on the market processes to gauge economy – thus they believe instability is due to Bad Government policy

o Prices and wage demand in competitive market causes fluctuations in Demand

wages cannot adjust because of government policies and monopoly protections

o MV=PQ Change in M( Money supply in the economy) leads to inflation

( velocity stable and Q is not related to price) Supply side

o Agree supply side shocks lead to instabilityo Agree government failure can lead to instabilityo View high tax rates and regulations that reduce supply incentives.

Is Economy self-correcting and if so how quickly it corrects Monetarist view

o Market adapts and self-correcto AD (Demand curve) shifts right, Price moves up and GDP output (Q) moves

right.o Normal wages will rise, increase supply costo AS shift lefto Price rises and economy return to full employment levelo Adaptive expectations – gradually change expectations. It takes longer.o Few believe rational expectations – changes faster.

Keynesians o Rational expectation is not correct, it takes long for market to self-correct.

Thus requires fiscal and monetary policy to interfere.o Agree with supply side shocks impact.

Government involvement in fiscal and monetary policy can lead to:

Influencing Aggregate demand in the economyo Due to money supply perhaps not in line with output increase ratioo Due to Rational expectation which may occur whenever central bank increases the

money supply, which can offset the money supply to control prices.

Causing instability in the economy due to Government Failureo Government induce huge fiscal deficito Crowding out can happen leading to no private investments in the country

Understanding the Factors which influence growth of the economy of a country (GDP growth factors)

1.) Human resources a. Quality of labor inputs

i. Improvement in education, health etc.2.) Natural resource

a. Arable land, water, gas, forest etc.3.) Capital formation

a. Roads, power plant etc.4.) Technology

a. Changes in production Processesb. New product or services

5.) 2 other factors influence economy growtha. Demand factor – nation must employ growing supply of resources for full utilization,

thus demand should growb. Efficiency factor –

i. To reach production potential, must reach productive efficiency, by using existing and new resources in least costly way.

ii. Allocative efficiency – goods and services allocation should be able to maximize efficiency.

Natural and human resource as such does not seem to contribute much in economic growth after certain point. The reason for it can be understood by:

o Law of diminishing returns Marginal product of labor decreases as population increases and land is area remains

more or less constant. Thus population pressure drives the economy output slowly if there is resource

constraint. Technological and capital investment overcome law of diminishing returns

o New industry and increase in the productivity efficiency helped drive the economy

What should be focus areas to realize economic growth?

o Capital investment More rail roads and highways More computers and infrastructure More farms machinery and irrigation facilities

o Technological and R&D investment New industry creation helps to drive the economy Technological change is required for good economic growth

Processes New product goods and services

o Education/labor quality Labor productivity plays the most important role in economy growth.

Technological advances contributes most in improving the labor productivity.

How government can use public policy to simulate growth

Demand side policyo Inadequate aggregate demand can lead to recessionary gap

Monetary policy – low interest rate Fiscal policy – eliminate fiscal deficit can reinforce easy money policy

Supply side policyoCapital-labor ratio

Productivity increases with capital to labor ratio increase Investment in new plants/machinery Lower business tax rates Tax credits etc. policies

oHuman capital Improve labor force quality

Tuition tax credits, student loan, learning programs and platforms for learning new skills

oTechnological change More goods and services from given amount of resources Tax incentives, R&D benefits

oRaise level investment in infrastructure Increase in domestic saving rate, as it provides investment financials.

Trade model - Why do nations trade and how nations decide what to import/export.

Absolute advantageo Country that can produce goods at lower cost than any other countryo Saudi Arabia – oil, US – cheap food.

Comparative advantageo Each country will benefit if it specializes in the export of goods which it can produce at

relatively low cost.o Each country will benefit if it specialized in the import of goods which it can produce at

relatively high cost.

Items\Country (Labor -hours)

Country A Country B Comparative Advantage

1 unit of Food 1 (hr to produce 1 unit) 3 Country A1 unit of Clothes 2 4 Country B

In Country A:-

1 unit of food = ½ of cost of clothing

1 unit of cloth = 2X cost of food

In Country B:-

1 unit of food =3/4 of cost of clothing

1 unit of cloth = 4/3 of cost of food

Example:-

150 unit of food in country B can be traded for 300 unit of food from country A. If produced in country B only, country B could have produced maximum 200(150*4/3) unit of clothing. So trade is beneficial.

2 country engage in unrestricted free trade, follow principles of comparative advantage, both can gain from free trade.

About Trade deficit

Trade deficit (Current account deficit) is calculated with respect to particular country. Two component of trade deficit used for calculations are

o Current account Merchandise trade balance Fees for services Net investment income

o Capital account Foreign purchases of assets in country Country purchases of assets outside country Reserve changes

Large current account trade deficit will get offset by selling country assets to foreign (inflows of money).

US chronic Trade Deficito With so large trade deficit, it should have led to US dollar weakening demand and thus

devalue of US dollar (depreciate US dollar). This should have led to US export getting attractive (lower price for export) and higher price of import. Which should have encouraged more exports and thus balancing the trade deficit.

o Large Trade deficit occurred due to:- Large budget deficit since 1980’s , which led to increasing the interest rate(money

supply in economy is low so increase the interest rate high to indicate scarcity of dollar money). Large interest rate increased the dollar demand, led to dollar appreciation, which made exports expensive and imports cheaper. And this led to large trade deficit.

Decline saving rate, and investment being more or less stable with little increase – and the money for this flowed into the country from foreign investment. Demand of dollar increased thus appreciating the dollar value again.

In country A GDP (A) goes down, income goes down, import items goes down, impact Country B export, income goes down and GDP falls for country B. Cyclic notion or chain of causality.

Fiscal policy of one country can impact other country economy.o Country B fiscal policy can be structured to take expansionary policy route so that country B

can have imports from country A and country B currency appreciates. More imports from country A will help balance trade deficit also.

Monetary policy impact on exchange rate:-o US raises interest rate, investors sell euro and buy dollars, demand for dollar increases,

dollar appreciates, and euro depreciates, it increases euro net export and raises net income.o Side-effect, US interest rate increase tend to increase European interest rate, thus

investment falls and income falls.

About Exchange rate

One nation currency can be traded with the currency of other country. Demand-supply of currency controls the exchange rate between countries. Currency that gains in value in relative to another currency – appreciates.

o Demand is more for the currency compared to other currency leads to increase in the value.o 1 dollar == Rs 60 , but later 1 dollar == Rs 65, this means dollar appreciates or rupee

depreciates.o Depreciate means :-

Export/outsourcing benefits ( with 1 dollar can buy more rupees service) Why exchange rate changes:-

o Differing rate of GDP growth rate between country Example- increase of GDP can lead to increase in the income – which can lead to

perhaps increasing the demand of some currency.o Differing rate of inflation between country

Real inflation adjusted prices should be same, thus impacting exchange rate – Law of one Price

o Change in relative interest rates between country

Raise of interest rate in one country, will lead to more investment in the country. Thus value of currency of some country will appreciate compared to the other nation.

If US raises interest rate, investors will pull money from India market and invest in US. They will sell rupees, rupees supply will increase and dollar demand will increase. US dollar will appreciate compared to Rupee.

o Change in tasteso And purely Speculation

There are potentially 2 kinds of exchange rateso Floating

Exchange rate changes based on demand/supply of the currency.o Fixed exchange rate.

Will peg value of it is currency with other currency or with basket of currencies Country will take necessary steps to maintain the peg value

How exchange rate evolved from ancient gold standardo Currency issued by each country had to be in gold or redeemable in goldo Currency on the country thereafter would be convertible into fixed amount of goldo Fixed exchange rate

If country has trade deficit, then it has to use its gold reserve to buy currency to prevent value of currency falling. Value of currency will fall due to more currency used to payout for excess import leading to fall in the currency circulation in the country.(that is country will need to lose gold reserves).

If trade surplus, more export will help to accumulate more gold reserves and country will have more currency circulation in the economy.

o During WW1, many countries abandoned gold standard to support war. This lead to those countries increasing the money supply in respective economy which finally led to differing rate of inflation in countries. Post war gold exchange rate implementation became a challenge-

Country which had undervalued currency, gained as export increased and thus increasing gold reserves.

Country which had overvalued currency, had to depend on import – which led to gold reserves to go down.

o Gold standard got abandoned in 1933, with US and Britain dropping the gold standard.o With no standard, countries started to devalue their currency to able to create more jobs and make

exports competitive.o This devaluation by all countries to outpace other countries led to destabilize the economy.

Countries increased money supply which triggered increase of inflation in most of the countries. And this economic breakage build political pressure which finally helped to trigger WW2. Rise of inflation in Germany is considered to be the most important reason of the rise of Hitler and causing WW2.

New international monetary system (1944)o Partially fixed or adjustable peg system.o Replaced gold standard with US Dollar standard, thus identified as global currency.

o All currencies were valued against Gold and dollar – and exchange rate between currencies was defined.

o It was partial fixed exchange rate – periodically currency will be adjusted to reflect the current currency values.

o Stability of gold system fixed rate with benefits of adaptability of exchange rate overtime.o US economy boomed in 1950’s, dollar lend to Europe and US industry being setup for

Europe to import US goods. Overtime, US exports fell, with still strong economy, global investors were pushing money in US, US dollar was overvalued and impacted export sector. This led to increase in Trade deficit and with Vietnam war current deficit also increased.

o US dollar surplus increased outside US, and US plan to devalue dollar price, which led to selling of US dollars and get gold. With so much dollars in the market now, and no demand dollar value plunged and US gold reserves also went down.

o US dropped dollar standard and 1970’s dollar value fell.

Today’s Hybrid systemo Flow managed based (demand/supply based). Different countries though tool various

options to work in today’s world. Few countries have floating exchange rate. Market decide the value and no

intervention. Other countries (like Canada and Japan) – flexible exchange rate. Country buys/sells

currency to maintain the volatile fluctuations, Systematic intervention. Small currencies – Peg with other currency (Swiss Franc). Currency bloc – Euro – flexible currency model.

o Government intervention is minimal in today’s system. Central bank plays more important role in maintaining stable exchange rate.

Central Bank Buys rupees with Dollars. Appreciate the rupee compared to the dollar. India dollar reserve in the past 5 years has grown primarily due to declining

oil market and oil import cost.

If trade deficit is larger (import more than export), then currency demand will fall and thus depreciate. Once depreciate, export will become cheaper and trade balance will try to get restored with increasing export.

G-7 nations bought larger amount of US dollars in 1980’s, to help US dollar from falling further as this could have led to US export getting attractive and thus impacting the trade export for all other countries. Thus by buying more dollars, G-7 nation increased the dollar demand and thus appreciate the dollar value in comparison to their.

Some Country/Zone economic knowhow

Euro monetary systemo 1970’s, EU countries went for fixed exchange rate peg against German currency so that

deliberate devaluation of currency by individual country does not happen.o 1990, west and east Germany reunification – lead to large budget deficit as east Germany

industries were subsidized to support uplifting the industry in-line with rest.o More subsidies lead to more money supply in the economy, which build pressure for the

inflation. To target anticipatory inflation, Germany raised interest rates.o As German raises interest rate, this could have led to German currency in demand

compared to other neighboring countries and other currency could have depreciated against German currency.

o Euro system crashed as interest rate were high and unrealistic exchange rate value.o Country cannot have fixed exchange rate, open capital markets and independent monetary

system.o And it gave way for the birth of common currency – EURO.o Global cooperation is important:-

Lowering trade barriers Joint monetary policy expansion

Tightening fiscal policy to increase savings and investment

Definition of developing country

Low per capital incomeo Poor health, low literacy, short life expectancy and suffer from malnutrition.o Factors of development growth

Human resources Quality

o Population grows faster in developing countries, so as GDP may rise so does population.

o Need to control population growth – but before control it is important to reach a stage of high income and good education system in place. This will lead to increase expenses for more children and people would have received old age safety net from saving/government schemes – which will make idea of more children for support go away.

Quality o Education, training, improve public safety and healtho Workers need to use technology, less sick leaves, use capital more

effectively. Natural resources

Arable labo Much of the population of the developing nation is employed in farming –

thus good use of land with right technology, fertilizers will help nation output.

o Some countries like US have been able to use the natural resources to build industrial revolution and expand the economy.

o Other countries have not been able to make use of resources efficiently due to lack of political will and corruption – Nigeria and Zaire are good examples.

o Land ownership with farmers create better ecosystem for farmers to have strong incentive to increase the land yield. In developing country, small percentage of people hold major portion of land which does not help the agriculture growth.

o Capital resources

TO build nation capital resource reserves is important, countries should try to avoid use of current capital reserves to accumulate capital.

When nation is poor, it is difficult to abstain from not using the current resources. Growth countries invest around 20% of nation output in capital formation, whereas

developing nation save around 5% , most of the saving is spend in providing housing and other benefits for the poor people.

Technology Developing countries can benefit from the technological invention done in other

countries – adaptation of foreign technology can benefit developing nation.

o But without quality human resources, capital and entrepreneurs it will not result in any benefit.

Some developing nation prosper while many other do not o Cycle of poverty

Rapid population growth Low per capital income low level of saving and low level of demand low level of investment in physical and human capital low level of productivity Low per capital income.

Poverty is accompanied by low level of education, skills and literacy. This in turn leads to low adoption of new technology.

o Need multiple steps to be taken at the same time to break the virtuous cycle of poverty:- Invest more Education and health improvement Develop skills Curb population growth

o Policies that can help break the cycle:- Industrialization vs Agriculture

Industrialization if capital intensive, leads to crowded cities, and high level of unemployment

Raising productivity in farms may require less capital, while providing productive employment for labor surplus.

State vs Market economy Market oriented economy

o Outward orientation in trade policy, low tariffs and few quantitative trade restrictions, promotion of small business and fostering competition.

o Markets work well in stable macro-economic condition, taxes are stable and inflation is low.

Growth and openness Import vs domestic production, improving efficiency and competitiveness and low

trade barriers.o Policies summary:-

Establishing Rule of Law Openness to international trade Controlling population growth Encouraging FDI Building human capital Making peace with neighbors Independent central banks Realistic exchange rate policy Privatizing state industries