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THE
MACROECONOMICS
OF FINANCIAL
MARKETS
MACROECONOMICS ?
What is macroeconomics?
It is the study of the economy as a whole and the
variables that control it
It refers to the study of government policy meant
to control and stabilize the economy
It refers to the study of fiscal and monetary
policy
ECONOMIC GROWTH
What is economic growth?
Itis a measure of the expansion of the economy
over time
How is economic growth measured?
Over exactly the same period in the immediate
past
Such as a calendar year or quarter
Who is concerned with growth
Wage and income earners
Producers
Macro-economic planners
FINANCIAL MARKETS &
MACROECONOMICS
GDP is a measure of the level of economic
activity
GDP and its components are measured in real
terms
Thequantity of goods and services is measured
using the base year prices
09/17/2020 5
MACROECONOMICS (CONT…)
Intermediate transactions are not counted in
GDP
Take a PC manufacturer who acquires
components to make the product and
employs labour for the same
The cost of the components will not be included
The salary paid to production workers will not be
included
Because the price of the PC includes these costs
09/17/2020 6
MACROECONOMICS
What drives the GDP?
Thelevel of activity in an economy at a point in
time is determined by the aggregate demand
Spending on goods and services
The higher the aggregate demand
The more the induced production
And the higher the GDP
09/17/2020 7
AGGREGATE DEMAND
The aggregate demand can be divided into
the following sectors
Consumption
Residential investment
CAPEX on the part of firms
Government Spending
Inventories
Foreign Trade
09/17/2020 8
CONSUMPTION
It refers to the spending by the household
sector on items which are consumed
In
the US it accounts for over 60% of aggregate
demand
It can be divided into
Durables
An expected life of at least 3 years
These are extremely cyclically sensitive
Non durables
Their consumption is not very cyclical
Services
They account for over 50% of consumption in the US
09/17/2020 9
CONSUMPTION (CONT…)
Households spend out of their income
The percentage of after-tax income that is
consumed by a household depends on
Thestate of the labor market
Home prices
If property prices of owned property is high there is
less of an incentive to save
The state of the stock market
The percentage of the post-tax income not
consumed by the household sector is
The SAVINGS Rate
09/17/2020 10
RESIDENTIAL INVESTMENT
Refers to the spending of individuals on
property acquisition
Itis sensitive to interest rates
People are less likely to borrow when interest
rates are high
Expected state of the labor market
Only newly built homes are included in the
GDP
Saleof existing properties adds nothing to
economic activity
09/17/2020 11
CAPEX
Businesses spend a lot on plant and
equipment
Motor vehicles
And computers
Are big components of CAPEX in the US
09/17/2020 12
CAPEX (CONT…)
Business CAPEX is a much smaller portion of
aggregate demand as compared to
consumption and housing
But it has a disproportionate impact on changes
in GDP
It usually bears large responsibility for business
cycle fluctuations
09/17/2020 13
CAPEX (CONT…)
It is the key driver of an economy’s future
growth
For
it determines the economy’s future ability to
produce
Other growth drivers are
Spending on education and training
Like SKILL India
Government spending on infrastructure
09/17/2020 14
GOVERNMENT SPENDING
Government spending is a key economic
driver
Butdue to political pressures to present
relatively balanced annual budgets it has been
shrinking in terms of relative importance
Often it is undertaken to support aggregate
demand
Dueto declines in demand related to
consumption and CAPEX
For instance the onset of a recession will
typically stimulate government spending
09/17/2020 15
GOVERNMENT SPENDING
(CONT…)
A distinction is required between spending
on goods and services and transfer payments
Transfer payments are like social security or
welfare payments
They are not a part of aggregate demand
They simply transfer spending power (by way of
taxes) from one individual to another
09/17/2020 16
INVENTORIES
Inventories have an impact on GDP only when
there is a change
An increase in inventories will raise the GDP
The addition to inventories reflects an economic
output
A decrease in inventories will lead to a decline
It reflects spending from other sectors that did
not lead to production but to a decline in stocks
09/17/2020 17
INVENTORIES (CONT…)
Inventory accumulation foretells a future
decline in production
Although it is positive for current economic
output
Inventory usage is positive for future GDP
growth
Although it is negative for current economic
output
09/17/2020 18
INVENTORIES (CONT…)
In the case of accumulation
Was it a result of overstocking to meet sales
which never materialized
Or was it due to strong consumer spending
Overstocking will indicate a decline in future
output
Strong consumer spending does not
With the increasing importance of the
service sector as a component of GDP
Inventoriesare no longer perceived in developed
countries as an item of significance
09/17/2020 19
FOREIGN TRADE
When aggregate demand exceeds the economy’s
output
Imports will exceed exports
If aggregate demand is less than economic output
Imports will be lower than exports
Net exports stimulate economic activity
They depend on the relative price and quality of
domestic goods and services vis a vis foreign products
The level of currency exchange rates
The country’s aggregate demand relative to that of its
trading partners
09/17/2020 20
THE ROLE OF PROFITS
Firms will produce goods and services only if
the activity is profitable
If so employment will increase as will CAPEX
Sometimes the cost structure may lead to a
loss if business activity is undertaken
Ifso more demand will not translate to greater
production
There will be no increase in employment or
CAPEX
GDP will not grow
09/17/2020 21
MEASURING GDP
GDP measures the monetary value of final
goods and services produced in a country
It counts all the output generated within the
borders of a nation
It refers to the output of capital and labour
of all residents of a country
It consists of goods and services produced for
sale in the market and some non-market
items
Defence related production
Education services provided by the government
GDP VERSUS GNP
GNP counts all the output generated by the
citizens of a country regardless of where the
output is generated
So if a German company has a factory in the
US the output will be
A part of US GDP
As well as German GNP
MEASURING GDP (CONT…)
Not all productive activity is included in the
GDP
Unpaid work performed by homemakers or
volunteers is not included
Black-market activities are not included
These are difficult to accurately measure
Example: If a baker produces a loaf of bread
Itwould be counted as a part of GDP if sold to a
customer
But not if it is consumed by his family
GDP (CONT…)
GDP does not factor in the wear and tear of
machinery, buildings and other items of
capital stock
If the depreciation of such assets is
subtracted from the GDP we get the NDP
Net domestic product
GDP (CONT…)
It is important to prevent double counting to the
extent possible
That is count the market value of goods and
services only once
Exclude the following
Cost of intermediate goods and services
Market products meant not for consumption but
intended for further processing
Transfer payments
Financial transactions like buying and selling of
securities
Welfare payments
Cost of resold or second hand items
GDP (CONT…)
GDP needs to be deflated to account for
inflation
Else a perceived growth could be entirely
due to a increase in price levels
Even real GDP gives an inaccurate picture
because it excludes self-provided household
services
MEASURING GDP
There are three approaches to GDP
measurement
The production approach
The expenditure approach
The income approach
THE PRODUCTION APPROACH
It measures the value added at each stage of
production
Valueadded is equal to total sales minus the
value of intermediate inputs
Example if a baker bakes a loaf of bread
Thevalue added would be the price of bread
minus the cost of flour and other inputs
THE EXPENDITURE APPROACH
It adds up the value of purchases made by
final users
Consumption of food, durables, and medical
services by households
Investments in plant and machinery by
companies
Purchases of goods and services by the
government and foreign nationals
THE INCOME APPROACH
This approach sums up the income generated
by production
Compensation received by workers
The operating surplus of companies
REAL GDP
GDP is calculated using current or nominal
prices
Thus we cannot compare two periods without
making an adjustment for inflation
To determine the real GDP the nominal GDP
must be adjusted to take price changes into
account
Has GDP increased because more has been produced
Or is it because prices have increased
The Price or GDP deflator converts nominal
GDP to real GDP
IMPORTANCE OF GDP
It gives information about the size of an
economy
And its performance
The growth rate of real GDP is often used as
an indicator of economic health
An
increase is a sign that the economy is doing
well
If real GDP is increasing
Employment is likely to rise
And people’s disposable incomes will increase
COMPARING TWO COUNTRIES
A country’s GDP is measured in its domestic
currency
Consequently when we compare the GDPs of
two countries we need to make an
adjustment
The usual method is to convert the GDP of
each country into US dollars and then
compare
The conversion may be done
Using
market exchange rates or purchasing
power parity exchange rates
COMPARING (CONT…)
The PPP exchange rate is the rate at which
the currency of one country would have to
be converted to another to purchase the
same basket of goods and services
In Emerging Markets there is a large gap
between market and PPP exchange rates
For most EMs the ratio of market and PPP
USD exchange rates is between 2 and 4
EXAMPLE
Assume India’s GDP is 2,400,000,000,000 INR
If the market exchange rate is 60 USD-INR,
the equivalent in USD is 40,000,000,000
However if a basket of goods and services
costing $1 in the US were to cost only Rs 25
in India, the equivalent in USD is
96,000,000,000
GDP (CONT…)
GDP however cannot reveal everything
It is not a measure of the overall standard of
living of a country
GDP does not factor in important issues that
may have an impact on people
For example output may grow at the cost of the
environment
It may result in the depletion of non-renewable
natural resources
Also the overall standard of living depends on
the disparity in incomes of citizens
GDP (CONT…)
Consequently an economy may have a high
GDP
But there may be severe economic inequalities
If so the overall quality of life may be poor
To account for such factors the UN computes
a Human Development Index
Itlooks at per capita GDP
Life expectancy of citizens
Average literacy levels
School enrolment
THE OUTPUT GAP AND
INFLATION
What an economy can produce – as opposed
to what it actually produces – is termed as
Potential GDP
Itrepresents the level of output that the
economy will tend towards in the long run
Potential GDP depends on
The labor force – its experience, education, and
training
Stock of physical capital
Available natural resources
Technology and innovation
09/17/2020 39
OUTPUT GAP (CONT…)
The difference between potential and actual
GDP is the Output Gap or GDP Gap
The mandate of the government and central
bank is to narrow the gap
The wider the gap the greater will be the level
of unemployment
Labor is not being fully utilized
One way to reduce the gap is by increasing
government spending
09/17/2020 40
OUTPUT GAP (CONT…)
There is a flip side
The narrower the output gap the greater will be
the inflationary pressure
The central bank needs to take cognizance
of what impact its policies will have on
prices
This
could preclude it from taking actions to
narrow the GDP gap
09/17/2020 41
OUTPUT GAP (CONT…)
During a recession the output of an economy
will contract
In a boom period output will increase
These cyclical ups and downs is termed as the
Business Cycle
The issue for a policymaker is how close the
current output is to the economy’s long-term
potential output
Thus the issue is not just whether GDP is up or
down
Butwhether it is above or below the potential for
the economy
INFLATION
As real GDP grows more labor is required
This will tighten labor markets forcing an
increase in wages
They will lead to a higher price for goods and
services since producers will pass on their costs
Also the increase in supply may not
immediately keep pace with the growing
demand
The result is inflation
Thus the narrower the GDP gap the higher
the rate of inflation
09/17/2020 43
INFLATION (CONT…)
Inflation could influence people’s
expectations
If so it becomes self-fulfilling
Labor wages and commodity prices will be based
on expected inflation
High inflation will lead to higher expected
inflation which will lead to higher actual
inflation
This cycle will go in
And is very difficult to control in practice
09/17/2020 44
INFLATION (CONT…)
External factors could produce one-off
changes in the price level
Forinstance if crude oil prices were to rise there
could be an impact on the prices of goods and
services produced in an economy
09/17/2020 45
INFLATION (CONT…)
Why is inflation an issue of concern for policy
makers?
Business decisions are based on expected profits
Profits depend on costs of inputs and labor and
prices of outputs
During inflationary periods the decision making
process gets corrupted
Businesses postpone production and CAPEX related
decisions
Interest rates rise due to greater inflation premiums
People earning fixed incomes lose real earnings due
to inflation
09/17/2020 46
UNEMPLOYMENT
A low unemployment rate reflects a tight
labor market
This leads to higher wages
A high unemployment rate results in a
smaller increase in wages
During a recession, wages may actually decline
Wage gains will lead to price increases which
will manifest itself as higher inflation
Thus low unemployment is associated with high
inflation
09/17/2020 47
OUTPUT GAP AND
POLICYMAKING
For many central banks maintaining full
employment is a policy goal
Full employment corresponds to an output
gap of zero
Central banks seek to keep inflation under
control and the output gap is a determinant
of inflationary pressure
The output gap gauges when an economy is
underperforming or overheating
Thus it has implications for monetary policy and
fiscal policy
OUTPUT GAP AND MONETARY
POLICY
During a recession the gap will be negative
The central bank may stimulate economic
growth by lowering interest rates
This will boost demand
And prevent inflation from falling below the
target set by the bank
In a boom the gap is positive
This generates upward pressure on inflation
The bank may cool the economy by raising
interest rates
OUTPUT GAP AND FISCAL
POLICY
To reduce the output gap fiscal policy tools
may be used
If the gap is negative an expansionary policy
may be used
Raise
aggregate demand by increasing
government spending or lowering taxes
If there is a positive gap contractionary
policies may be used to reduce demand and
combat inflation
Through lower government spending
Or increasing tax rates
IMPLICATIONS FOR A GLOBAL
ECONOMY
The economies of the world are getting
increasingly integrated
Thus the global output gap may affect
domestic inflation
For instance if there is strong demand for a
product US producers will increase export
prices
However since all producers are likely to hike
their prices, the price charged for domestic
sales will also rise
THE BUSINESS CYCLE
This refers to the volatility of economic
growth and the different periods that an
economy goes through
There are various phases of the cycle
Economic growth – real output increases
Economic boom – fast economic growth which
tends to be inflationary and unsustainable
Economic downturn – the growth rate falls and
the economy heads towards a recession
Recession – period of negative economic growth
and decline in real output
CAUSES OF THE BUSINESS
CYCLE
Changes in interest rates
Ifrates are cut borrowing costs will decline
This will lead to higher spending by consumers
And greater investments by producers
The result will be economic growth
However if the central bank were to increase
interest rates to tame inflation
This will reduce consumer spending and investment
Leading to an economic downturn and recession
CAUSES (CONT…)
Changes in Property Prices
Ifproperty prices rise there is a wealth effect
Leads to higher consumer spending
Consumer and Business Confidence
Market participants are easily influenced by
external events
If there is a succession of bad news
People will cut back on investments
And a minor slowdown may magnify into a bigger
recession
CAUSES (CONT…)
Similarly if there is a string of good news
Consumers will borrow more and banks will lend
more
This will lead to economic growth
Changes in government spending
This has a multiplier effect
A cut in public spending would lead to lower
aggregate demand and a rise in unemployment
Unemployed citizens will cut back on spending
This will deepen the effects of recession
Similarly an increase in government spending can
give a big boost to economic growth
CAUSES (CONT…)
The level of investments
This depends on the rate of change of economic growth
If growth were to decline firms will cut back on
investments
Investments are highly volatile and small changes in the
growth rate can significantly influence the level of
investments
Inventory cycle
It can be argued that people buy certain luxury goods
every 4-5 years
In a booming economy people will spend on such goods,
which will lead to faster economic growth
In a recession people will not buy such products and the
slowdown will be magnified.
INTEREST RATES
Finance is all about transfer of resources
from Surplus Budget Units (SBUs) to Deficit
Budget Units (DBUs)
Interest rates equilibrate the SBUs’
willingness to extend credit and the DBUs’
need for it
Peoplewho save are paid interest to forego
current consumption and lend
That is they are paid for waiting to spend
By borrowers who cannot wait and whose current
needs exceed the available capital
09/17/2020 57
INTEREST RATES (CONT…)
If the GDP gap is substantial and there is major
unemployment people tend to save more
Firms see less profitability in expansion and
tend to borrow less
Obviously interest rates will decline
When the GDP gap is narrow households will
save less
Businesses will borrow more aggressively
Interest rates will rise
Inflationary expectations will rise
This will further push up interest rates
09/17/2020 58
INTEREST RATES (CONT…)
Thus when the GDP gap is narrow interest
rates will tend to accelerate
When the gap widens interest rates will
decelerate
09/17/2020 59
FISCAL DEFICITS
Budgets have fiscal deficits when
Government expenditure exceeds income
Obviously the Government needs more funds
For this the Government will borrow
Sources of funds for the GOI
Borrow within India
Or from other countries
Or supranational organizations like the IMF
The money borrowed by a country’s
government is called the Public Debt
09/17/2020 60
FISCAL DEFICITS (CONT…)
To pay interest on the debt the Government
has three options
Increase tax rates
Stimulate economic growth so that tax revenues
automatically increase
Print more money to pay back the debt – debt
monetization
Debt monetization will trigger inflation
Rising taxes may lead to declining economic
activity
09/17/2020 61
FISCAL DEFICITS (CONT…)
Deficits as a percentage of GDP may
decrease during economic booms
Increase in tax revenues
Lower unemployment – leading to reduced
welfare payments
How can a country counter a deficit?
Stimulate economic growth
Reduce government expenditure
Increase taxes
09/17/2020 62
FISCAL DEFICITS (CONT…)
Governments issue bonds to finance their
deficits
Issue of Treasury securities
T-bills, notes and bonds
Countries like the US have a unique
advantage
The USD is a global currency
Thus the US can run larger deficits than other
countries
09/17/2020 63
FISCAL DEFICITS (CONT…)
Every year the deficit adds to the country’s
sovereign debt
As the debt grows it increases the deficit in
two ways
Interest has to be paid on a larger base
This increases spending without any
accompanying benefits
Second high debt levels may make it difficult for
a government to borrow
Borrowers will demand greater interest to
counter this risk
09/17/2020 64
FISCAL DEFICITS (CONT…)
Rising debts can lead to a debt trap
Countries need to issue more debt to repay
interest and principal on existing debt
At some stage interest rates may skyrocket
If the trend continues a country may default
09/17/2020 65
IMPACT OF OIL PRICES
Demand for oil is relatively price-inelastic in
the short run
Ifoil prices were to increase cutting back on
consumption immediately is not feasible
Nor is it easy to switch to alternative sources of
energy
Thus higher oil prices mean greater imports
This will lead to a greater trade deficit
There will be a decline in domestic demand
This will push up the unemployment rate
09/17/2020 66
OIL (CONT…)
The drop in GDP will reduce oil demand
This will lead to lower oil consumption
Rising oil prices will push up the prices of all
goods since
They are transported using vehicles using petrol
Or else in some cases they use oil as an input
Due to a higher cost of living labour may
demand higher wages
Businesses may respond by hiking prices
There could be an inflationary spiral
09/17/2020 67
QUANTITATIVE EASING
In response to the financial crisis of 2008,
central banks of developed countries loosened
monetary policy
Quantitative Easing is such a mechanism
Itrefers to the purchase of financial assets using
central bank money
In response to the crisis the BOE cut interest
rates sharply
By 4½%
But this was perceived as insufficient
So the BOE announced the acquisition of public
and private assets using central bank money
QE (CONT…)
How does QE work?
The central bank electronically creates new money and uses it to
purchase gilts from private investors such as pension funds and
insurance companies.
These investors typically do not want to hold on to this money,
because it yields a low return.
So they tend to use it to purchase other assets, such as corporate
bonds and shares.
That lowers longer-term borrowing costs and encourages the
issuance of new equities and bonds and that should stimulate
spending.
The policy was designed to help businesses raise finance without
needing to borrow from banks.
And also to lower interest rates for all households and
businesses.
09/17/2020 69
QE (CONT…)
The BOE originally purchased medium to long
dated gilts
These securities amounted to 30% of the gilts
held by the private sector and 14% of annual
nominal GDP
The British Government also authorised the
BOE to purchase commercial paper and
corporate bonds
QE (CONT…)
How do asset purchases affect spending an
inflation?
Purchases of financial assets by the BOE will initially
increase money holdings; push up asset prices; and
stimulate expenditure by lowering borrowing costs
QE pushes up the price of assets and leads to money
in the hands of sellers
Money is usually not a substitute for securities
So sellers will rebalance their portfolios by buying
other assets
This will raise the prices of assets till investors are
willing to hold the overall supplies of assets and
money
QE (CONT…)
Higher asset prices mean lower yields
And lower borrowing costs for firms and
households
This will stimulate spending
Spending is also stimulated by the fact the
higher prices mean more wealth for holders
The BOE purchases were targeted at long-term
assets held by non-bank institutions
Such as insurance companies and pension funds
This would encourage these institutions to invest in
riskier assets such as corporate bonds and equities
QE (CONT…)
Before QE began gilts were primarily held by
non-bank institutions and overseas investors
Overseas investors may be inclined to invest
in foreign securities
Thus they may convert the sale proceeds back to
their domestic currencies
The supply of sterling would cause it to
depreciate relative to the USD and the Euro
In the UK Gilt yields came down by 100 bp
QE (CONT…)
If QE were to taper off, interest rates in the
US will rise
There will be a reversal of FII into India
There will be a fall in Indian equity prices
due to less demand from FIIs
Less demand for the rupee will lead to
depreciation of the rupee
Companies with unhedged Forex exposure
could suffer
09/17/2020 74
QE (CONT…)
Slow down of capital inflows could hurt
investments
This will lead to a lower than expected
growth in GDP
A weakening rupee would mean rising
exports
This will lead to inflationary pressure
09/17/2020 75
BOND MARKETS &
MACROECONOMICS
Bond markets are affected by the following
factors
The unemployment rate
The inflation rate
The budget deficit
The foreign trade deficit
Cyclical changes in the economy have
implications for the performance of bonds
BONDS (CONT…)
Economic changes affect bonds in two ways
The first is with respect to credit risk
If the national economy is doing badly it affects
governments, federal, national, and local, as well as
corporations
If the credit risk were to be perceived as having
increased, yields will increase and consequently
bond prices will decline
Similarly if a foreign economy were to perform
poorly
Bonds issued by entities in that country will be
impacted
BONDS (CONT…)
Secondly a change in the interest rate
structure of a country will affect bonds
Thus it is imperative that we understand the
factors that lead to shifts in the interest rate
structure
The role of the federal government is to
sustain growth and control inflation
Growth is measured by GDP
Inflation is captured by various indices
CPI; PPI; GDP Deflator
BONDS (CONT…)
Any increase in inflation has a negative
impact on people earning fixed incomes
In addition to managing GDP growth and the
level of inflation the government needs to
control the budget deficit and the current
account deficit
The primary tools available to the
government are fiscal and monetary policies
FISCAL POLICY
The term refers to the use of government
spending and/or taxation to influence the
demand for goods and services by
Consumers
Investors
The government
EXPANSIONARY FISCAL POLICY
If an economy is in recession the government
may cut tax rates
This will put more money in the hands of
consumers who will spend a portion of it
This increased economic spending is likely to
percolate down the economy increasing
aggregate demand
It should be understood that one person’s
expenditure is another’s income
Thusputting more money in the hands of
consumers has a multiplier effect
EXPANSIONARY (CONT…)
An alternative policy is to increase
government spending
This will directly stimulate aggregate
demand
And it too will have a multiplier effect
CONTRACTIONARY FISCAL
POLICY
If the economy is booming and there is
excess demand the government can increase
tax rates
This will take away money from the hands of
the consumers and lead to a contraction in
demand and a lower rate of inflation
The alternative is to reduce government
spending which will bring down aggregate
demand
ISSUES WITH FISCAL POLICY
If the government is confronted with a
burgeoning budget deficit, fiscal policy may
not offer much of an option
A deficit indicates a higher level of spending
To stimulate an economy in recession the
government has to spend more and/or
reduce tax rates
Both these actions will exacerbate the deficit
Thus in such situations monetary policy
offers an alternative
MONETARY POLICY
Monetary policy is implemented by
controlling money supply and short-term
interest rates
Itis administered by the central bank
Monetary policy attempts to control inflation and
remove its distortionary economic effects
This is expected to lead to stable growth in the
medium to long term
POLICY TOOLS
There are three monetary policy tools
available to a central bank such as the
Federal Reserve
Reserve requirements
Open market operations
The discount rate
RESERVE REQUIREMENTS
Changing the reserve requirements directly
influences the ability of banks to create
credit
To stimulate recovery the central bank can
lower the reserve ratio
This will increase the amount of loanable
funds which will circulate in the economy
If the ratio were to be increased loanable
funds will be pulled out of the economy
which will lead to a reduction in the level of
economic activity.
OPEN MARKET OPERATIONS
These involve purchases and sales of government
securities to inject or remove funds from the
banking system
These transactions normally target a desired fed
funds rate
Therate at which banks make overnight loans to one
another
The fed funds rate is a short term rate
By influencing it the Fed hopes to ultimately influence
long term rates and the level of economic activity
This is the FED’s primary tool for implementing
monetary policy
OMO (CONT…)
If the central bank wishes to slow down the
economy it will sell Treasury securities
This will reduce the level of reserves in the
banking system
The reduction in money supply will exert
upward pressure on the Fed Funds rate
This will cause a slowdown in economic
activity
Becauseboth consumers and businesses will face
higher borrowing costs
OMO (CONT…)
If the central bank wishes to stimulate the
economy it will acquire Treasury securities
from dealers
This will increase the amount of reserves in
the banking system
The increase in money supply will lead to a
reduced Fed Funds rate and will stimulate
economic activity
Asbusinesses and consumers react to lower
borrowing costs
THE DISCOUNT RATE
This is the rate charged by the central bank
on loans to depository institutions
By altering the discount rate the central
bank can influence monetary policy
However borrowing from the central bank is
not a normal practice for most banks
Thus changes in the discount rate are largely
symbolic
Ifthe central bank wants to signal that it desires
lower interest rates it will reduce the discount
rate
BUDGET DEFICITS
A budget deficit occurs when government
expenditure is higher than the revenue
received in the form of taxes and other
sources
This shortfall has to be covered by public
borrowing
The sum of all budget deficits over time is
the National Debt
Itis the total of all funds borrowed and owed to
the investing public
BUDGET DEFICITS (CONT…)
There is no limit in principle as to how much
the country can borrow for the federal
government can print money as and when
required
However excessive spending, which
consequently leads to printing of money, can
have severe inflationary effects
There are three negative facets of budget
deficits
The Crowding-Out Effect
Reliance on External Debt
Displacement of Capital
CROWDING OUT EFFECT
One manifestation of this is increased
competition for a given pool of funds
When the federal government steps in to
borrow from the public it is effectively
competing with companies
This could lead to rising interest rates which
could cause projects to become unviable
Thus federal government borrowing crowds
out private investment
CROWING OUT EFFECT (CONT…)
The crowding out effect also shows up as
tighter monetary policy
Budget deficits effectively leads to an
increase in aggregate demand and economic
growth
The central bank may judge this as
inflationary and hike interest rates
The higher cost of capital will discourage
consumer spending and corporate borrowing
And result in a slowdown in the economy
RELIANCE ON EXTERNAL DEBT
External debt is created when a nation
borrows from people who are not its own
citizens
When this debt is repaid there will be dollars
in the hands of foreigners
If
these investors choose to sell the dollars it
would result in the dollar getting devalued
If foreign bondholders choose to sell their
holdings prices will fall and interest rates
will rise
DISPLACEMENT OF CAPITAL
As government deficits mount investors will
be left holding large quantities of
government bonds
This means that corporations can raise less by
way of debt and equity
This could lead to a decline in economic growth
and quality of life
CURRENT ACCOUNT DEFICIT
CAD is the amount by which national
investment exceeds national savings
It can be divided into three parts
Balance of trade
Income
Transfers
BALANCE OF TRADE
This the difference between imports and
exports of goods and services
If imports are more than exports there is a
trade deficit else there is a trade surplus
INCOME ACCOUNT
This records income received from foreigners
versus payments made to foreigners
The major component of income is the
interest payment on debt held by foreigners
as well as interest earned on foreign assets
held by the country’s citizens
TRANSFERS
This records transfer payments to and from a
country
One of the major components for the US is
the aid that it gives to various countries
around the globe
CONTROLLING CAD
The major impact of a rising CAD is on the
exchange rate
A high deficit would mean that imports
exceed exports which would lead to large
balances of the USD in foreign hands
If this were to be liquidated the dollar will
depreciate
One way to address a trade imbalance is by
devaluing the domestic currency
Thiswill lead to a reduction in imports and an
increase in exports
INFLATION
Inflation is usually categorized into two
causal groups
Demand Pull Inflation
Cost Push Inflation
DEMAND PULL INFLATION
This occurs when aggregate demand rises
more rapidly than what firms producing
goods and services can supply
Thus too much demand is chasing too little
supply
Because of the relative scarcity prices will be
pushed upwards
In such a situation wages and salaries will also
increase
This is because to meet the growing demand
producers will be compelled to recruit
This will further exacerbate inflationary pressure
DEMAND PULL (CONT…)
An event such as war can trigger off a bout
of inflation
High government spending on defence
related products will push up aggregate
demand
If supply cannot keep pace, the consequence
will be inflation
COST PUSH INFLATION
Inflation can rear its head at a time when
demand is low and unemployment is high
This is termed as cost push inflation
This has little to do with demand
In involves an increase in the cost of the factors
or production
Both raw materials and wages
Producersin such situations will pass on the
increased costs to the consumers
COST PUSH INFLATION
In the 70s and early 80s countries like the US
experienced Stagflation
Highunemployment
And High inflation
This can be explained using the theory of
cost push inflation
During this period there was a steep increase in
the price of crude oil which pushed up the prices
of all products
INFLATION (CONT…)
Market power inflation is a type of cost push
inflation
It is also known as profit-push inflation
It refers to the ability of monopolist
producers to set prices at a high level and
force consumers to absorb them
Wage-price spiral inflation refers to
situations where unions cause an increase in
worker wages which causes a hike in prices
and in inflation
INFLATION (CONT…)
Expectation inflation is caused by an
inflationary psychosis
It refers to a crippling fear of inflation that
forces consumers and producers to take
actions that lead to higher prices
Full employment inflation is caused when
demand is strong and all available resources
are fully engaged
Cateringto this demand will lead to greater
costs and prices
FULL EMPLOYMENT INFLATION
Causes
Producers are forced to use inferior resources
and less competent labour
Producers are forced to pay over-time
Factories are over-utilized leading to a higher
rate of machine depreciation
Workers are over-stretched leading to lower
productivity
Producers need to pay more to retain efficient
workers