Macroeconomics, the study of the economy as a whole, encompasses a broad range of factors. Understanding its core components is crucial for investors, policymakers, and anyone seeking to grasp the forces that shape our economic landscape. This guide offers a concise review of key macroeconomic concepts, providing a foundation for further exploration.
I.1 Output
Output is fundamental because ultimately, output per capita, not just money per capita, determines a country’s wealth. The primary measure of output is Gross Domestic Product (GDP), typically calculated using the expenditure method: GDP = Consumption + Investment + Government Spending + Net Exports (CIGNx). A negative Net Export (NX) value indicates that a country is importing more than it exports, leading to borrowing from abroad.
Alt: GDP formula represented as CIGNx equals Consumption plus Investment plus Government spending plus Net Exports.
Output increases with growth in labor, capital, or Total Factor Productivity (TFP). Two primary approaches exist for fostering economic growth:
A. Supply-side economics (or “trickle-down” economics) emphasizes the role of producers in driving economic growth. This approach focuses on increasing output, often through measures like tax cuts to incentivize investment and R&D, ultimately boosting TFP.
B. Keynesian economics advocates for “managing demand” through government expenditure and lower taxes, utilizing both monetary and fiscal policy. Keynesians believe recessions occur due to sticky prices and wages in the short run, coupled with economic shocks.
I.2 Money
The “price” of money is manifested in three key ways: interest rates, exchange rates, and the aggregate price level of goods and services (inflation). An increase in the money supply generally leads to lower interest rates, currency depreciation, and higher inflation.
The interplay between these factors is critical. For example, real GDP increases when output rises, while nominal GDP increases when both output and prices rise. While an increased money supply might lower nominal interest rates, inflationary expectations can push them back up, creating ambiguity.
“Money illusion” describes the tendency for people to focus on nominal increases in income without fully accounting for the effects of inflation.
Central banks manage the money supply through various tools: adjusting the discount rate (the rate at which banks can borrow from each other), altering the reserve requirement (the fraction of deposits banks must hold in reserve), and, most frequently, through open market operations (buying and selling government bonds).
I.3 Expectations
Expectations can significantly influence economic reality. For example, if people expect inflation to rise, they may demand higher wages and raise prices, leading to a self-fulfilling prophecy. Similarly, negative expectations about the future can lead to increased saving and reduced consumption, causing GDP to fall below optimal levels, resulting in a GDP gap.
A solution to managing expectation is:
- Monetary policy: One issue is the liquidity trap, where interest rates are near zero, reducing the incentive to convert money into financial assets and increasing the demand for cash. In this situation, increased money supply does not lower rates.
- Fiscal policy: increasing government spending (G in CIGNx). While this can increase the deficit, caution is needed at full employment as it may exacerbate inflation. At low employment levels, fiscal policy can boost both output and prices.
II.1 US Monetary History
The gold standard was theoretically self-regulating: rising inflation led to rising prices, increased imports, gold outflows, and, eventually, falling inflation. However, a key issue was the wild fluctuation of interest rates with seasonal demand for money.
II.2 GDP Accounting
The expenditure method (CIGNx) is generally preferred for calculating GDP. Net Domestic Product (NDP) is GDP less depreciation, but measuring depreciation is practically challenging. Gross National Product (GNP) measures the output of a country’s residents regardless of location, while GDP measures output within the country’s borders.
II.3 Reading Balance of Payments (BOP) Statements
The Balance of Payments (BOP) is an account of cross-border transactions.
Alt: Structure of the Balance of Payments statement with emphasis on the financial account line item under the capital account.
The financial account is a key line item within the capital account. Omissions, often referred to as “plugs,” can reveal covert capital outflows, indicating that individuals with inside information are discreetly moving assets out of the country. The BOP operates on a double-entry system. Credits represent sources of foreign exchange (FX), or an increase in liabilities or a decrease in assets. Debits represent uses of FX, or increases in assets or decreases in liabilities.
II.4 Foreign Exchange (FX)
A current account surplus indicates higher demand by foreigners for a country’s goods and services. Rising inflation typically leads to long-term currency depreciation. Rising interest rates, however, increase demand for a country’s currency as foreigners seek higher returns on financial assets.
II.5 Connecting Output with Expectations and Money
Money supply influences inflation, interest rates, and exchange rates. Macroeconomics focuses on managing the money supply. For example, an increase in the money supply can increase nominal GDP, but real GDP (measured in constant currency) may not increase proportionally as it measures output, not price increases due to inflation. Macroeconomics also deals with policies aimed at shaping expectations, which can ultimately drive economic reality.
