Macro Economics (Part-1)

Question 1: Write down the importance of macroeconomics.

Ans.:  The study of macroeconomic variables is indispensable for understanding the working of the economy. Our main economic problems are related to the behavior of total income, output, employment and the general price level in the economy. The variables are statistically measurable thereby facilitating the possibilities of analyzing the effects on the functioning of the economy. It gives a bird eye view of the economic world.

1. Explaining the factors                                                                                                                           It explains the factors which determine the level of national income and employment in as economic.

2. Explaining circular flow                                                                                                                        It explains the circular flow of national income in an economy like the household or individual, firms, factor market, goods market, government and rest of the world or net export.

3. Explaining the problem of unemployment

It explains the problem of unemployment which is a main problem of developing countries. It helps in calculating the unemployment rate on the following way where:

          

       U= (TU/LE)*t                 Here, TU= Total Unemployment

         = ((LE-TE)/LE)*t                    LE= Labor Employment

                                                          TE= Total Employment

4. Explaining about international trade

It explains the various aspects of international trade such as terms of trade balance of payments, foreign exchange etc.

5. Introducing business cycle
It studies the causes of fluctuations in the business cycle where exists peak, trough, recession, recover and to control inflation and deflation.

6. Analyzing economic determinates

It analyze the main determinates of economic development, various stages and process of economic growth.

7. Formulation of policy

For the formulation of useful economic policies for the nation, macro-analysis is of the utmost significance; economic polices can not be obviously based on the basis of the fortunes of a single firm or even a single industry or the price of individual commodity.

8. Regulating overall entities

It is helpful in understanding the functioning of macro economics system. It is for more fruitful to regulate aggregate employment and national income and to work out a national wage policy. Macroeconomics has special significance in studying in causes, effects and remedies of general unemployment.

9. Evaluation of overall performance

The study of macroeconomics is very important for the evaluation of overall performance of the economy in terms of national income. National income data helps in forecasting the levels of economics activity and to understand the distribution of income among different groups of people in the economy.

10. Analyzing monetary problems

It is in terms of macroeconomics that monetary problems can be analyzed and understood property. Frequent changes in the value of money, inflation or deflation, affect the economy adversely. Adopting monetary, fiscal and direct control measures for the economy as a whole can counteract them.

We may conclude that macroeconomics enriches out knowledge of the functioning of an economy by studying the behavior of national income, output investment, saving and consumption. Moreover, it throws much light in solving the problems of unemployment, inflation, economic instability and economic growth.

Question 2: What is the subject matter of macroeconomics?

Ans.:  Macroeconomics deals with some huge elements. The subject matters of macroeconomics are explained below-

Macroeconomic variables

The very first subject matter of macroeconomics is macroeconomic variables like- national income, total investment, total consumption expenditure, total savings, aggregate demand and supply etc. the mutual relationship among these variables and the matter of determining the equilibrium value of them are subject matter of macroeconomics.

Market

Macroeconomics explains labor market, goods market and money market. Generally, employment level depends on the active demand in an economy. Active demand depends on the function of aggregate demand and supply. So macroeconomics deals with the reasons of employment and unemployment, results and the way to remove them.

Theory of national income

Some macro analysts commence analysis of the different aspect of the activities of a nation on the basis of the national income. Later on, to describe the country’s economic activity and the flow of distributing income among different classes of society, the information of national income is considered as the most important in macroeconomics.

Economic growth

Economic growth is an important subject in macroeconomics. Different model of national income analyze the way of keeping the growth rate of a country. The conditions of continuous growth are explained in detail in different economic model.

Business cycle

Macroeconomics deals with different aspect of business cycle as well. Here it deals with monetary policy, fiscal policy, wage policy etc.

Question 3: What are the limitations of macroeconomics?

Ans.:   Though the importance of macroeconomics is proved, there are some limitations of it, like-

1. Gathering of dissimilar components

There are many active elements in macroeconomics like, consumption, savings, investment, income, rate of interest etc. they all are different from one another. So it is difficult to assume a general environment from dissimilar matters.

2. Individual is ignored

In macroeconomics, individual is ignored altogether. It is individual welfare which is the main aim of economics. Increasing national saving at the expense of individual welfare is not a wise policy.

3. Emphasize on aggregation

It is general to have an effect of aggregation in macroeconomics. When we emphasize more on aggregation, sometimes it will result in worthless. Macroeconomics is a combination of dissimilar components. So it is difficult to make all of them work in a similar manner.

4. Difference inside aggregation

Under the considered aggregation of macroeconomics, the existences of elements don’t get enough importance. For example, if a country’s national income is increased at 20% under a 5 year planning, it will be difficult to understand weather the real income of individual is increased or not. 

5. Aggregate decision on the basis of individual behavior

Individual behavior is not totally ignored in the aggregate concept of macroeconomics. But it will be a mistake when applying individual decision and experience in case of entire economy.

6. Emphasize on money

In macroeconomics money is considered as an important element. But the value of money is always changing. So it will be difficult to determine the economic situation after emphasizing on money.

Question 4: What is business cycle? Describe the different steps of business cycle.

Ans.: 

Business Cycle: The term business cycle refers to the recurrent ups and downs in the level of economic activity extending over several years. Individual business cycles vary substantially in duration and intensity.

1. Peak:

A peak at which business activity has reached a temporary maximum, such as the middle peak her economy is at full employment and the domestic output is also at or very close to capacity. The price level is likely to rise during this phase.

2. Recession

The peak is followed by a recession-“a period of decline in total output, income, employment and trade”, lasting six months or longer. This downturn is marked by wide spread contractions of business is many sectors of the economy. Because many prices are downwardly inflexible, “the price level is likely to fall only if the recession is severe and prolonged” –that is if a depression occurs.

3. Trough

The trough of the recession or depression is where output and employment “bottom out” at their lowest levels. The trough phase of the cycle may be short lived or quite long.

4. Recovery

In the recovery phase, output and employment expand toward full employment. As recovery intensifies, the price level may begin to rise before there is full employment and full capacity production.

         

Despite common phases, business cycle varies greatly in duration and intensity. Some economists prefer to talk of business “fluctuations” rather than “cycles”, because cycles imply regularity while fluctuations do not.

Question 5: What are the effects of inflation on economy? Is inflation always harmful?

Ans.:  Inflation means a considerable and persistent raising the general level of prices over a long period of time.

According to Kemmer define inflation as, “A state in which the value of money is falling prices are rising the general spirit of this definition inflation is a situation in which supply of money increases at a rate much faster than the supply of output.”

A high rate of inflation makes the life of the poor very miserable. It is, therefore, described as anti-poor. It redistributes income and wealth in favor of same and greatly harms others. By making the rich, richer and poor, poorer, it militates against sociality. Besides, inflation lowers national output and employment and impedes long run economic growth, especially in developing country like Bangladesh. We shall discuss below effects of inflation.

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can have positive and negative effects on an economy. Negative effects of inflation include: loss in stability in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.

Today, most mainstream economists favor a low steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

 

Effects of inflation:

General:

An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services. The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.

Increases in the price level (inflation) erodes the real value of money (the functional currency) and other items with an underlying monetary nature, that are priced in terms of money (e.g. loans, bonds, fixed pension payments). However, inflation has no effect on the real value of non-monetary items, items without a fixed price in terms of money (e.g. goods and commodities, like cars, gold, real estate).

Negative:

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.

With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Cost-push inflation:

Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral. In a sense, inflation begets further inflationary expectations.

Hoarding:

People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.

Hyperinflation:

If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

Allocative efficiency:

A change in the supply or demand for a good will normally cause its price to change, signaling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost:

High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

Menu costs:

With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.

Business cycles:

According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.

Positive

Labor-market adjustments:

Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.

Debt relief:

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate.

Room to maneuver:

The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

Tobin effect:

The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects.

Question 6: What is monetary policy? What are the instruments of monetary policy?

Ans.:  A central bank changing of the money supplies to influence interest rate and assists the economy in achieving full employment non inflationary level of total output. Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.

Monetary policy is referred to as either being an expansionary policy, or a contraction policy, where an expansionary policy increases the total supply of money in the economy, and a contraction policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contraction policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Tools of Monetary Policy:

The Fed has three monetary policy tools—open market operations, reserve requirements and discount window lending.

• Open Market Operations
• Reserve Requirements
• Discount Window Lending

Open Market Operation:

Open market operations are the most important and active tool of monetary policy that the Fed uses. These operations consist of the Fed buying and selling previously issued U.S. government securities, or IOUs of the federal government. Interest rates affect the level of activity in the economy. When rates are low, people find it easier to buy cars and homes, and businesses are more inclined to invest in new machinery and buildings. And when the rates are high the opposite occurs as the Fed tries to curtail inflation and maintain economic growth.

Open market operations typically are conducted several times a week. A majority of the open market operations are not intended to carry out changes in monetary policy. Rather, they are conducted to prevent some technical, temporary forces from pushing money and credit conditions in some undesired direction.

The public’s demand for cash varies, depending on the season, the day of the month and even the day of the week. When people hold more cash, the reserves of the bank go down. And that could push short-term interest rates up, if the Fed did not use open market operations to offset the increase.

The Fed has to be watchful, not only for any signs of impending inflation or recession, but also for how technical factors may be affecting the supply of money and credit in the economy.

Cash Reserve Ratio:

Reserve requirements are the percentages of certain types of deposits that banks must keep on hand in their own vaults or on deposit at a Federal Reserve Bank. The Fed has the authority to set reserve requirements on checking accounts and certain types of savings accounts.

Reserve requirement Raised Lowered

Impact on Bank lending Reduce lending Increase lending

The Fed rarely changes the reserve requirements. The last change made to the reserve requirement was in April 1992, when they lowered the rate from 12% to 10% of transaction deposits.

Changes in the reserve requirement make planning difficult for lenders, and any increase imposes a cost on them. The Fed generally does not change the reserve requirement when there is an alternative way of achieving the same policy result.

Bank Discount Rate:

Discount rate, another tool of monetary policy, is the interest rate that the central bank charges banks for short-term loans. Changes in the discount rate typically occur in conjunction with changes in the federal funds rate.

Through the discount window, Central Bank lends funds to depository institutions. All depository institutions that maintain transaction accounts or non-personal time deposits subject to reserve requirements are entitled to borrow at the discount window.

Discount Rate Raised Lowered

Impact on Economic Activity Slows economic activity Stimulates economic activity

Policy Check inflation Economic growth

Increases in the discount rate generally reflect the Federal Reserve's concern over inflationary pressures, while decreases often reflect a concern over economic weakness.

Question 7: What is full employment?

Ans.:   In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so. It is defined either as 0% unemployment, literally, no unemployment (the rate of unemployment is the fraction of the work force unable to find work), as by James Tobin, or as the level of employment rates when there is no cyclical unemployment. It is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of unemployment. Unemployment above 0% is advocated as necessary to control inflation, which has brought about the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU); the majority of mainstream economists mean NAIRU when speaking of "full" employment.

According to Classical Economist,

“Full employment is a situation when there is no involuntary unemployment, though there may be voluntary, casual, seasonal, structural, technological & frictional unemployment.”

According to the Economic & Social Council of the UN,

The purpose of such a standard is to provide full employment which is consistent with the smallest amount of unemployment that a country can reasonably be expected to have, after a minimum allowance is made for seasonal & frictional unemployment.

Finally, Full employment means there is zero unemployment. The demand for labor is equal to the supply of labor that means natural rate of unemployment.