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MACROECONOMIC
NOTES
Contents
2 – National economy
5 – Money and interest rates

13 – Unemployment and inflation
25 – Macroeconomic policy
39 – Balance of payments and exchange rates
47 – Financial crises

Macroeconomics for Business – N11114


The National Economy

THE CIRCULAR FLOW OF INCOME

The major macroeconomic objectives are…
- High and stable economics growth
- Protection of the environment
- Low inflation
- Low unemployment
- Balance of payments
- Stable financial system

AD is the total spending on goods and services made within the country
...

- National income rises
- Inflation rises
- Imports rise

When withdrawals are more than injections in the economy national income
falls
...
The product method
- Add up the value of all goods and services produced in the country
...
The income method
- Add up all the incomes generated for households in the productions of
goods and services
...
The expenditure method
Expenditure
Production
- Add up all expenditure on final product
...


National income = Consumption of domestic goods and withdrawals

Aggregate expenditure = Consumption of domestic goods and injections










3



The Multiplier

- When injections rise or withdrawals fall, this leads to a multiplied
increase in income
...



Equations for MPW and MPC
1
𝑘=

𝑚𝑝𝑤

1
𝑘=

(1 − 𝑚𝑝𝑐)


∆𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝑚𝑝𝑐 =

∆𝐼𝑛𝑐𝑜𝑚𝑒



















4

Money and Interest Rates

The functions of money are that it is…
- Medium of exchange
- Means of storing wealth
- Means of evaluation

Money Supply

- The monetary base consists of cash in circulation outside the central
bank plus banks reserves within the central bank
...

- Bank deposits are the largest component of broad money supply
...

- Banks are in the business of deposit taking and lending
...


Banks assets include…
- Cash and reserve balances in the central bank
...
Profitability
- Profits are made by lending money out at a higher interest rate than that
paid to depositors
...
Liquidity
- The ease in which an asset can be converted into cash without loss
...


3
...


Credit creation

- Banks can expand the amount of bank deposits, and hence the money
supply, by a process called credit creation
...


1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜

To find increase in

The creation of credit is not easy to predict because…

1
...

- Banks increase their liquidity ratio if customers do not want to borrow
...
Banks may not operate a simple liquidity ratio

3
...



Change in money supply

The causes of increase in money supply are…
- Banks reducing their liquidity ratio
- Non-bank private sector choosing to hold less cash
- Inflow of funds from abroad
- Public sector deficit




6






There are two types of money supply…

1
...


2
...





Demand for money

The motives for holding money are…
- Transactions motive
- Precautionary motive
- Speculative motive

Determinants of money demand

Transactions and precautionary demand for money depends on…
- Nominal national income
- Frequency of which people are paid
- Rate of interest



7



- Seasonal
- Financial innovations



Speculative demand for money depends on…
- Rate of interest on money
- Expectations of changes in price of other assets














𝑀@ = 𝐿A + 𝐿C
𝑀@ = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑚𝑜𝑛𝑒𝑦
𝐿A = 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛𝑠 𝑎𝑛𝑑 𝑝𝑟𝑒𝑐𝑎𝑢𝑡𝑖𝑜𝑛𝑎𝑟𝑦
𝐿C = 𝑆𝑝𝑒𝑐𝑢𝑙𝑎𝑡𝑖𝑣𝑒

8

Money Market Equilibrium

- The money market equilibrium is where the demand for money meets
the supply of money
...


If the interest rate is above the equilibrium level…
- People have surplus money balances
- They would buy shares, bonds and other assets
- The prices of these assets will go up
- Interest rates will fall
- Money supply will fall and demand for money will increase until
equilibrium is reached
...



Transmission of Monetary Policy

Quantity theory of money

Relates nominal income to the quantity of money and velocity
...




The effect of changes in money supply

- If we assume that the velocity of money is constant in the short run,
then there is a predictable effect on PY
...


Interest rate mechanism

Higher money supply could increase aggregate demand through…

Interest Rate Transmission Mechanism
- Higher money supply will lead to a shift in the 𝑀R curve leading to lower
interest rates
...
In turn, the investment
will lead to the multiplier effect increasing income, higher incomes
increase aggregate demand
...

-

Problems with the money – Interest rate link
Elastic demand for money
Unstable demand for money
When central banks increased 𝑀R in an attempt to offset the credit
crunch, many banks, firms and individuals increased their liquidity and
did not buy bonds, shares, houses etc
...

-

The demand for money is unstable – Interest rate link
Inelastic investment demand
Unstable investment demand
Difficult to predict the effect of interest rates due to a change in 𝑀R
...









It may shift due to…
- Changes in foreign interest rates
- Changes in exchange rates
- Government statements of intentions of future economic policy
- Industrial news
- Newly published figures on inflation









11

Exchange rate transmission mechanism

Higher money supply could increase aggregate demand through…

Exchange Rate Transmission Mechanism
- Higher money supply leads to a shift in the 𝑀R curve leading to lower
interest rates
...
Once
the pound devalues, imports decrease and exports increase leading to
higher aggregate demand
...


Unemployment rate – Ratio of unemployed in the labour force
...


The duration of unemployment is affected by…
- The level of unemployment
...

- The phase of the business cycle
...
The curve
is…
- Upward sloping
- Relatively inelastic

The aggregate demand for labour shows the number of workers that firms
demand at each real wage rate, the curve is downwards sloping
...



13


Disequilibrium in Unemployment

Disequilibrium
unemployment – When the
real wage rate is above the
one at which AS=AD









The causes for disequilibrium unemployment are…

1
...

- It is associated with recessions
...

- The low aggregate demand
causes a too low equilibrium
output level in the goods market
to generate full employment
...
Real wage (Classical) unemployment
- Trade unions use their monopoly power to set wages above the market
clearing level
...
Growth in labour supply
- If AS rises with no corresponding increase in AD, the equilibrium real
wage falls
...

- Not as serious as demand deficient unemployment
...

- At microeconomic level supply and demand may not match i
...
there
may be vacancies in some parts of the economy but an excess of labour
in others
...


- The equilibrium level of unemployment is also known as the natural
level of unemployment
...
Frictional unemployment

- People leave jobs, are unemployed while looking for a new job
...


The remedies to this are…
- Better job information through job centres, newspapers, agencies etc
...



2
...


The causes are…
- Changing pattern of demand, lower demand in some industries
...


- Structural unemployment usually occurs in certain regions of the
country; it is referred to as regional unemployment
...

- The speed of change of demand and supply in the economy
...










16

The remedies for this are…

• Interventionist approach
- Government funded training
- Grants to firms to set up in areas of high unemployment

• Market orientated approach
- Encourage people to look more actively for jobs including in other parts
of the country
...




3
...


- The remedies are the same for structural unemployment
...


Typically, inflation refers to consumer prices such as…

• Consumer price index (CPI)
- The percentage increase in the index over the previous 12 months
...



- Inflation rates vary over time and across countries
...







17


Costs of inflation
- If people could correctly anticipate the inflation rate, and fully adjust
prices and incomes, then the costs of inflation would be small
...
Demand pull inflation
- Caused by the continuing rise of
AD
...

- The increase in prices depends on
the increase in firm’s costs due to
higher production i
...
the shape of
AS
...



2
...

- Firms respond to increasing costs
by increasing prices and reducing
output
...

- The AS curve shifts to the left, a
movement along the AD curve,
which increases unemployment
...
The interaction of demand-pull
and cost-push
- Sometimes these two can occur
together
...

- An initial cost push inflation
makes the government expand
AD to offset rises in
unemployment
...




4
...

- Both workers and firms take account of expected rate of inflation when
taking decisions
...

- Firms care about the nominal wages they pay relative to the price of the
goods that they sell




















19

Unemployment and Inflation

Short run

- The Phillips curve studies the statistical relationship between
unemployment and inflation
- It was found out that there is an inverse relationship between the two
...



Money illusion – People believe that higher nominal wages mean higher real
wages
...

- As labour became
scarce, firms had to
offer higher wages and
the position of trade
unions strengthened
...


Stagflation – Persistent high inflation combined with high unemployment
...

- The higher the rate of inflation people expect, the higher wage they
claim, the more firms increase their prices
...
𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑝𝑟𝑖𝑐𝑒𝑠)

- Its assumed that the expected inflation equals the inflation of the
previous year
...












21

Long run Phillips Curve
- As long as there are demand pull pressures (where inflation is more than
0), inflation will rise as the
expected rate of inflation
rises
...



- Expanding AD can reduce unemployment below the natural rate only in
the short run
...

- On the contrary, a policy of restraining AD will not lead to higher
unemployment in the long run
...


The implications are…
- Monetary and fiscal policy have no long-run effect on unemployment
- Can only influence the inflation rate
- Supply-side policies are necessary to reduce unemployment

New Classical Views
The assumptions are…
- Flexible prices and wages
- Rational expectations

The implications are…
- No trade-off between inflation and unemployment even in the short run
- The AS and the Phillips curve are vertical in the short run too
- All unemployment is equilibrium unemployment
- Only anticipated changes in AD can affect output and employment until
people realise their mistake and wages and prices adjust
...

- People expect a higher level of output and this optimism will cause a
higher level of output to be produced
...


- The policy implication is straining importance of a gradual but sustained
expansion in demand
...


- Persistence of unemployment after recessions of early 1980s and 1990s
...

- Reduced impact of unemployment following the 2007/8 financial crisis
due to greater labour market flexibility (flexible working hours, nominal
wage cuts)
...

- Governments are now careful not to push demand up beyond the point
where inflationary expectations will change
...

- Therefore, a horizontal Phillips curve
...































24

Macroeconomic Policy

Fiscal Policy

- Fiscal policy involves altering taxes and/or government expenditure to
affect the level of AD
...

- National debt is if the government runs persisted deficits and they
accumulate
...

- Government pays back debt and creates new debt at the same time
...


An expansionary fiscal policy is either…
- Raising an injection
- Reducing a withdrawal
These increase AD which lead to a multiplied rise in national income
...






25

Purpose of Fiscal Policy

There are 3 main purposes of fiscal policy…

1
...


2
...

- Increase government expenditure and/or lower taxes in recessions to
boost the economy
...
Influencing aggregate supply
- Increase government expenditure on infrastructure
- Tax incentives for investment

Use of Fiscal Policy

1
...

- Act instantly, as soon as AD fluctuates
...
g
...
This helps
dampen down the rise of national income
...
g
...


The disadvantages of automatic stabilisers are…

• Adverse Supply-side effects
- High tax rates might discourage effort and initiative
- High unemployment

• The problem of fiscal drag
- If the economy is in recession, as soon as the economy starts to recover,
the automatic stabilisers would act as a drag on the expansion
...
Discretionary Fiscal Policy
- Automatic stabilisers reduce but do not prevent fluctuations
- The government chooses to alter its level of expenditure and/or taxes if
there is a fundamental disequilibrium in the economy

There 2 ways of doing it are…

• Changing G
- Government spending has a direct effect on AD
...


The 2 problems with discretionary fiscal policy are…

• Magnitude of the effects
- If G or T is changed, it is not sure how much total injections or
withdrawals will change
...

- Unsure how much the change in AD will affect output and employment,
and how it will affect prices
...



The effectiveness of discretionary fiscal policy

There are two problems concerning discretionary fiscal policy…

1
...

- Size of the multiplier is unknown
- Unknown how much the change in AD will affect output, employment
and prices
...
Timing of the effects
- Don’t know how quickly the policy can be changed
...


The problem of forecasting the magnitude of the effects is the effects of
changing government expenditure…
- A rise in government expenditure leads to a rise in total injections
...

- Private investment declines reducing AD
...


Amount of crowing out depends on…
- Shape of Md curve
- Shape of Ms curve
- Responsiveness’ of I and C to changes in r
...
Effects of changes in taxes
- A temporary tax cut may lead people to save their extra disposable
income and maintain their consumption level
...
Size of the multiplier
- Difficult to predict the multiplier, households and firms base their
decisions on expectations about future prices and income
...
Random shocks


Problems of timing of the effects

Fiscal policy involves considerable lags
...

- Until effects of those changes work their way through the economy

If time lags are long, fiscal policy could be even more destabilizing

Fiscal rules and the Golden rule

- Given the magnitude and timing of problems, many governments use
fiscal rules
...
g
...



- Public sector receipts should cover all current spending averaged over
the business cycle
...

- Allows additional investment by borrowing
- Permits higher G or lower T if there is a surplus







29

MONETARY POLICY

- Monetary policy generally involves the control of interest rates
...


In the short run price stability can conflict with the goals of high employment
and interest rate stability

E
...
if the economy is expanding and unemployment is falling, the overheated
economy lead to inflation increasing
...


Central bank

The way in which a central bank conducts monetary policy depends on it’s
independence, and there are 2 types of independence…

1
...
Instrument independent
- The ability to set monetary policy instruments






30

Bank of England

Instrument independence…
- Chancellor of the Exchequer used to decide interest rates
- The 1988 Bank of England Act made the Bank independent to set
interest rates
...

- Interest rates are decided by Monetary Policy Committee

Goal independence…
- Inflation target is set by the chancellor of the exchequer
...


The 2 major sources of monetary growth are…

1
...
Public sector borrowing from the banking sector
- Restrict the size of PSNCR

Short-term monetary policy control

- Assume CB wants to tighten
monetary policy to fight inflation

They may do this in 3 ways…

1
...
Controlling interest rates
- Increase interest rates and then
manipulate money supply



31


3
...



Techniques to control money supply

1
...
Discount policy, central bank lending to banks
- Central bank changes the interest rate at which it lends to banks

3
...
g
...


Banks can resist attempts to restrict the growth in money supply

Problems with monetary base control are…
- changing liquidity ratio (Banks hold cash in excess of minimum)
...

- Size and variability of money multiplier

Problems with controlling broad money supply are…
- BoE wants to tighten monetary policy, so banks may be prepared to
reduce liquidity ratio
...

- There are potential large fluctuations in interest rates
...




32


Potentially large fluctuations in interest rates

1
...
The demand for money is unstable
- Its difficult to predict the effect of interest rates of a change in Ms
...

- If people think the inflation rate will rise, the transactions demand for
money rises
- If people expect the economy is going to grow faster, the demand for
loans increases as firms increase their investment
...


- Advocates of active monetary and fiscal policy view the economy as
inherently unstable and believe policy can be used to offset this inherent
instability
...


The resolution of this debate will depend on…
- The confidence of people in the effectiveness of either discretionary
fiscal policy or rules
- The degree of self-stabilisation of the economy (case for rules) or
conversely the degree of inherent stability (case for discretion)
...

- Politicians seeking re-election may manipulate policies for their benefit
...




- Fine tuning can be improved by better forecasting and quick-acting
policies to combat time lag
- Allows governments to respond to changing circumstances

The problems with rules are…
- It can cause sever fluctuations in interest rates and greater instability
- It is hard to know which rule to choose
- Rules may conflict
- Rules may become unsuitable


Inflation targeting

The issues with inflation targets are…
- There is a choice of target, so don’t know which one to choose
- Need to choose who sets the target
- Target may have to be changed often
- Multiple target, may take more than one objective into account







35

Demand side policy in the UK

Fiscal policy…
- Golden rule
- Sustainable investment rule
- Some flexibility

Monetary policy…
- Target of 2% CPI inflation set by govt
...


Supply side policies attempt to increase the potential level of output and shift
the LRAS curve to the right (i
...
increase output at any given level)
...






36

Unemployment

Policies to reduce unemployment are…
- Reduction of labour market imperfections
- Increasing labour mobility across occupations and regions
- Reducing union power

Inflation

Policies to reduce inflation are…
- Reducing or controlling monopoly power
- Incentives to increase productivity


Approaches to supply-side policy

1
...
Interventionist SSP

Market failure to provide adequate training, R&D and investment…
- High risks for individual firm but economically desirable
- Capital market imperfections (Investment not financed even though
privatively profitable), lack of investment, cyclical nature of investment

Forms of intervention are…
- Nationalisation
- Direct provision (infrastructure and R&D)
- Grants
- Industrial reorganisation (loans to industry, arrange and finance mergers
if felt it will lead to economies of scale)
- Assistance to small firms (grants, tax cuts, etc
...

- Investment grants may be more likely to go to high-profile projects than
to the most beneficial areas
...

- Reducing the tax burden may result in a higher return on investment,
with markets ensuring efficient allocation


















38

Balance of Payments and Exchange Rates

POLICY OBJECTIVES

- A country can have internal and external policy objectives

Internal balance – Where the economy is at the potential level of national
income
...
The BoP
records all the flows of money between residents of the country and the rest
of the world
...


Assume the economy is in a recession…
- The government expands AD through fiscal policy
- National income rise
- Demand for exports rise
- Trade deficit, BoP disequilibrium



EXCHANGE RATES

- The nominal exchange rate is the rate at which one currency trades for
another on the foreign exchange market
...

- A depreciation of the domestic currency is the reverse
...

𝑅𝐸 = 𝐸 ∗ 𝑃Z /𝑃\
RE = Real exchange rate
E = Nominal exchange rate
𝑃Z = Price index of exports
𝑃\ = Price index of imports

- If a country’s export prices rise faster than the foreign currency prices of
it’s imports (𝑃Z /𝑃\ ), it’s real exchange rate will appreciate
...


Determination of the rate of exchange

- A free floating exchange rate is determined by demand and supply
















40

Shifts in the currency demand and supply curves

- Any shift in the demand or supply curves will cause the exchange rate to
change
...


If the interest rate rises…
- Domestic assets more attractive
- Lower net capital outflow
- Currency appreciation as more people invest in the pound

If the interest rate falls…
- Domestic assets less attractive
- Higher net capital outflow
- Currency depreciation


A depreciation







41

EXCHANGE RATE REGIMES

- Free floating exchange rates should automatically correct any BoP
deficit/surplus by depreciation/appreciation
...
g
...


- Devaluation will lead to a BoP surplus in the long run due to the J-curve
affect
...
Intervention is necessary to maintain the fixed rate
...
g
...
The CB needs to…
- Sell foreign currency and buy sterling
- Buy securities (conduct OMO) and increase market supply (sterilisation)
...


Under a fixed exchange rate…
- The CB give up monetary policy as a policy instrument
- Fiscal policy becomes more effective


Exchange rate regimes & monetary policy

Flexible exchange rate…
- Monetary policy relatively effective
- Direct effect on AD
- Reinforced by a change in the exchange rate

Fixed exchange rate
...






43

Expansionary fiscal policy under flexible exchange rate

- AD shifts right due to increased G (AS diagram)
- Md shifts up to M’d due to higher national income (Money market
diagram)
- Exchange rate appreciates and lowers AD
- AD shifts to AD2 following fiscal policy expansion
...
Money supply
has to increase to bring interest rates back to previous level
...
The use of inflation or money supply targets
- Effect on exchange rates of resulting changes in interest rates

2
...


3
...
The higher the loan, the larger the probability that the high risk
borrowers do not pay back
...


What causes financial crises?

Financial crises have 3 stages…
1
...
Bank panics
3
...
A financial crisis can begin with the mismanagement of financial
liberalisation or innovation
- Elimination of restrictions (deregulation)
- Introduction of new types of loans or other financial products

- Can lead to a credit boom, where risk management may be lacking
- Eventually, loan losses accrue, and asset values fall, leading to a
reduction in capital
...

Banking funding falls too
...


2
...

- Financial institutions also see a fall in their assets, leading again to
deleveraging
...
A financial crisis can begin with a spike in interest rates or an increase in
uncertainty
- Many 19th century crises initiated with a spike in rates, due to liquidity
problems or panics
- Moral hazard increases as loan repayment becomes more uncertain
- Other periods of high uncertainty can lead to crises, such as stock
market crashes or the failure of a major financial institution
...
If sever
enough these factors can lead to a bank panic…
- Panics occur when depositors are unsure which banks are insolvent,
causing all depositors to withdraw all funds immediately
...



Stage 3 – Debt deflation

If the crisis also leads to a sharp decline in prices, debt deflation can occur
(where asset prices fall but debt levels do not adjust) increasing debt burdens…
- Debt levels are typically fixed, not indexed to asset values
...

- Economic activity remains depressed for a long time
...

- New financial products developed to further enhance and distribute risk
from mortgage lending
...


Agency problems in mortgage markets also reached new levels…
- Mortgage originators did not hold the actual mortgage, but sold the
note in the secondary market
...


Mortgage Originator – An institution or individual that works with a borrower
to complete a mortgage transaction
...


The rating agencies did not help…
- Agencies consulted with firms on structuring products to achieve the
highest rating, creating a clear conflict
- Further, the rating system was hardly designed to address the complex
nature of the structure debt designs
...


Securitisation

- Subprime mortgages were higher risks for banks
- Risk can be reduced by moving the loans off the banks’ balance sheet
- Banks bundle up packages of mortgages to sell to other investors
- They pay credit rating agencies to assess the packages and rate their
riskiness
...




49

- Having shifted a batch of mortgages off it’s balance sheet, a bank is able
to lend to more homebuyers and create more mortgages
...


Securitisation – The process of taking an illiquid asset, and through financial
engineering, transforming them into a security
...


The housing market

- Initially, the housing boom was lauded by economists and politicians as
it helped stimulate growth in the subprime market as well
...
People were clearly buying houses
they could not afford, except for the ability to sell them for a higher
price
...
He pointed to new mortgage products, relaxed lending
standards, and capital inflows as the more likely cause
...
com
crash and 9/11 passed, central banks became more concerned about
inflation and began to raise interest rates
...
25%
o The BoE began to raise rates in 2006
...




50

Financial institutions

- As mortgage defaults rose, banks and other financial institutions saw the
value of their assets fall
...

- Banks began the deleveraging process, selling assets and restricting
credit, further depressing the struggling economy
...

- With the downgrade of $10 billion on mortgage related products, short
term money markets froze
...

- Banks and firms began to horde cash
o Banks became less willing to lend to other banks, even if they had
the money to lend
o The inter-bank market tightened up

Money market funds – An open ended mutual fund that invests in short term
debt securities such as US treasury bills and commercial paper
...


Failure of major financial firms

The collapse of several high profile US investment firms only further
deteriorated confidence in the US…
- March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of it’s
value only 1 year ago
- September 2008: Both Freddie Mac and Fannie Mae put into
conservatorship after heaving subprime loses
...
Merrill Lynch sold
to Bank of America at ‘fire’ sale prices
...






51

Policy response in 2007-09

Expansionary monetary policy…
- Reduction in short-term interest rates (nominal close to 0)
- Quantitive easing

Expansionary fiscal policy…
- Bailout of banks and other firms by government
o Government loans or part nationalisation
- Stimulus packages
o Increase in government spending and tax cuts

- Proposals for more financial regulation, bank breakups, more stringent
capital requirements


Response to credit crunch in UK

Monetary policy…
- Pump liquidity and capital into banking system
- Quantitative easing

Fiscal policy…
- Fiscal stimulus put increasing pressure on budget balances
- Golden & sustainable investment rules temporarily abandoned
- ‘Temporary operating rules’ for fiscal policy



52



---