A Concise Guide to Understanding Macroeconomics

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What is macroeconomics?

Macroeconomics is a branch of economics other than microeconomics. Different from microeconomics, it studies the economy as a whole. It addresses demand, supply, price, but in the aggregate.

In it, you will learn concepts such as how to measure aggregate economic activity? How does it fluctuate in the short term? The ups and downs will have a huge impact on our lives. It affects economic growth, unemployment, and inflation.

Here, you will also explore what determines economic growth? For example, why can a resource-poor country, such as South Korea, become a developed country?

In addition to the real sector, you will also learn about money, but again in the aggregate. You can find it in the monetary section.

Macroeconomics also deals with how countries interact with each other. Why can a crisis in one country spread to another? It is becoming more and more relevant with globalization. International trade and capital flows have been steadily increasing. These transactions, trade and capital, you will find in the balance of payments section.

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Guide To Understanding Economics

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What are the topics in macroeconomics?

Measuring economic activity

Economists measure the activity of economic actors in the aggregate. They grouped economic actors into four groups:

1. Household sector
2. Business sector
3. Government sector
4. External sector (or foreign sector)

The household sector and the business sector make up the private sector. Both play a significant role in a free market economy, but not in a command economy.

Furthermore, the external sector also consists of three other sectors (households, business, and government). But, it only exists in an open economy, not in a closed economy.

Interaction between economic actors

Economists introduce a circular flow model – also known as a circular flow diagram or circular flow of income. It illustrates the relationships and flows of income, expenditure, output (goods and services) among economic actors. Money facilitates these transactions.

The model becomes fundamentally important when you study macroeconomics. You will know why aggregate expenditure equals aggregate output and aggregate income.

The simplest model uses households and businesses as representations.

• Households spend $100 to buy goods. It becomes income for the business.
• Businesses use $80 for input spending in factor markets. The rest, $20, is a profit for the business owner.
• Input suppliers and business owners are households. So, $100, in the end, becomes household income.

What is being measured?

Economists focus on three variables:

• Output→ aggregate output
• Expenditure→ aggregate expenditure
• Revenue → aggregate income

Aggregate output is the total final goods and services produced by an economy for a given period, say one year.

Aggregate income is the sum of the income received by the suppliers of factors of production in the same period. It includes:

• Employee compensation
• Rent
• Interest
• Profit

Aggregate expenditure is the sum of all expenditures by economic actors for aggregate output. It consists of:

• Consumption
• Investment
• Government spending
• Net exports (exports minus imports)

Indicators to measure economic activity

Economists propose the gross domestic product (GDP) to measure the total output in an economy, regardless of who produces it (citizens or foreigners). It also represents a measure of an economy’s aggregate income and expenditure.

Gross national product (GNP) is an alternative. It represents the aggregate output produced by residents of a country, regardless of where they produce, whether domestically or abroad.

Two measures of GDP:

• Nominal GDP, also known as GDP at current prices
• Real GDP, also known as GDP at constant prices

Nominal GDP represents the monetary value of the economy’s total output, measured at current prices. Prices may vary in each measurement period. Thus, the change represents a change in output and a price change.

Nominal GDP = Output in year t x Price in year t

Meanwhile, real GDP measures the same output but uses base-year prices. Prices are constant over time. Hence, the change represents a change in output.

Real GDP = Output in year t x Base year price

Of these two indicators, economists introduce the GDP deflator. It is equal to nominal GDP divided by real GDP. Thus, the changes represent changes in the prices of all goods and services in the economy.

GDP deflator = (Nominal GDP / Real GDP) x 100

Then, another indicator is GDP per capita. GDP per capita measures average output per inhabitant:

Since GDP also represents income and expenditure, real GDP per capita is usually used to evaluate the average standard of living in a country. It must be adjusted for purchasing power parity (PPP) to eliminate the effect of exchange rate variations, so it is more comparable.

Calculating GDP

Three approaches to calculating GDP:

• Output approach
• Expenditure approach
• Income approach

Theoretically, the three approaches yield an equivalent figure. But, in practice, that may not be the case. The reason could be due to differences in data sources or calculation methods. For this reason, a statistical discrepancy entry is made to balance the three approaches above.

Output approach

The value-of-final-output approach adds up the value of final goods and services. However, it excludes the value of the semi-finished goods because their added value during the production process is reflected in the final goods’ selling price.

• If you keep calculating the value of the semi-finished goods, it will result in double counting. The same goods are counted multiple times as they go into multiple production processes.

The value-added approach is an alternative calculation. It sums up the added value at each stage of the production and distribution process. That would be equivalent to the value-of-final-output approach.

• Value added is equal to the output price minus the price of the materials to make it.

Expenditure approach

The expenditure approach adds up all expenditures on final domestic goods and services. They consist of consumption, investment, government spending, and net exports.

GDP = Consumption + Investment + Government spending + Net exports

Consumption represents the total amount spent by households on final goods and services. It includes spending on durable goods, nondurable goods, and services.

Investment includes capital goods investment and inventory investment. Also known as gross private domestic investment.

• Capital goods investment is to purchase items such as production equipment and machinery or to build factories. That is a gross investment, namely, investment to increase production capacity (net investment) plus investment to compensate for the depreciation of capital goods.
• Inventory investment is another name for inventory changes. Unlike other components, it is the most volatile component.

Government spending includes routine expenditures and public investments such as roads, airports, power plants, school buildings, and hospitals.

Net exports are exports minus imports. Exports represent the expenditures of foreign economic actors for domestic output. Meanwhile, imports represent purchases by domestic economic actors for goods and services produced abroad.

• Because GDP measures the value of final domestic output, imports reduce its value (negative sign).
• For an economy, imports represent leakage, and exports represent injection.

Income approach

The income approach adds up all payments received by the household, business, and government sectors in an economy. It is equal to national income plus capital consumption.

GDP = National income + Capital consumption

National income represents the total income received by all factors of production to generate GDP. It equals wages plus rent, interest, profit, and the difference between indirect tax and subsidy.

National Income = Wages + Rent + Interest + Profit + (Indirect Tax – Subsidy)

Why do we add indirect tax and subtract subsidy?

• The prices consumers pay for products are not fully reflected in producer profits due to indirect taxes. It goes into government revenue. So, it is summed back when calculating national income.
• Subsidies are payments to companies by the government. That reduces production costs than they should. So, without subsidies, company profits should be lower. Thus, the subsidy is deducted from the calculation.

Next, back to the GDP formula, why is it necessary to add capital consumption to national income?

What is capital consumption? Capital consumption or capital consumption allowance is an economic term for the depreciation of capital goods. It represents the expenditure required to maintain the current production capacity.

• Depreciation is recorded as an expense and reduces the company’s profit in the financial statements.
• Thus, it is added back to the national income to reflect the actual value of the profit received by the business.

National savings

National savings is national income unspent on goods and services. It equals private savings plus public savings, representing the total loanable funds provided by the domestic economy without having to borrow abroad.

National savings = Private savings + Public savings = I + (X – M)

The national savings rate is equal to national savings divided by national income. Alternatively, we can also use GDP as the divisor.

National savings rate = National savings / GDP

Private savings formula

Private savings include household savings plus business savings. It equals the remaining aggregate income after deducting taxes and consumption.

Where: Y = Aggregate income; I = Private investment; G = Government spending; T = Tax revenue; X = Export; M = Import

• Household savings is the portion of disposable income unspent by households on goods and services.
• Business savings are retained earnings (undistributed profits as dividends) plus capital consumption.

Public savings formula

Public savings represents the budget surplus, the positive difference between government revenues and expenditures. The government has leftover money, which is available to the economy. Also called government savings.

Public savings = Tax revenue – Expenditure

• Public dissavings occurs when the government runs a budget deficit. That reduces national savings, and therefore, loanable funds, which can lead to a crowding-out effect.

Aggregate demand

Aggregate demand (AD) represents the total expenditure on domestic output at various price levels. It assumes:

• Planned expenditure equals actual output/income – giving rise to the IS curve.
• The money market is in equilibrium – giving rise to the LM curve.

Economists then draw it into a curve, the aggregate demand curve. Its negative slope is due to the real wealth effect, the interest rate effect, and the exchange rate effect. To get it, economists explain with the IS-LM model.

• The real wealth effect explains the impact of changes in the aggregate price level on household consumption. An increase in the price level lowers households’ real wealth, prompting them to reduce consumption.
• The interest rate effect explains why when the price level changes, business investment also changes. For example, a higher price level causes an increase in real interest rates, increases the cost of funds, and reduces investment by businesses.
• The exchange rate effect explains how the price level affects net exports. For example, increasing the price level makes domestic goods more expensive and less competitive, lowering exports. As a result, net exports fell, ceteris paribus.

Determinants of aggregate demand

When the price level changes, it causes aggregate demand to move along the aggregate demand curve. Meanwhile, any change in the determinants other than the price level causes the curve to shift. Such shifts can be caused by changes in:

• Fiscal policy
• Monetary policy
• Household wealth
• Consumer and business confidence
• Capacity utilization
• Exchange rate
• Global economic growth

Changes in the above factors can lead to aggregate demand shocks.

• A positive shock causes an increase in aggregate demand, for example, an increase in consumer confidence.
• A negative shock causes a decrease in aggregate demand, for example, an increase in interest rates.

Multiplier

The multiplier shows you how a $1 increase in autonomous spending increases aggregate output and aggregate spending many times over. It can come from:

• Expenditure multiplier, derived from changes in one component of aggregate demand.
• Tax multiplier, derived from tax changes.

How big the multiplier depends on the marginal propensity to consume (MPC).

• MPC equals the change in consumption spending divided by the change in disposable income. It shows how much is spent on consumption for each additional $1 in disposable income.

MPC = Δ Consumption / Δ Disposable income = 1- MPS

• The marginal propensity to save (MPS) denotes the portion saved for each additional $1 in disposable income. It equals the change in savings divided by the change in disposable income.

MPC = Δ Savings / Δ Disposable income

• Economists assume disposable income is allocated for two purposes: consumed and saved. Hence, MPC + MPS = 1.

Aggregate supply

Aggregate supply (AS) represents the total output the domestic producers are willing and able to supply at various price levels. Economists specifically divide the period of aggregate supply into two:

• Short run
• Long run

There is also a very short run. It is a period when firms can only change the level of output to a certain extent without changing prices. The curve is a horizontal line.

Short-run aggregate supply

Short-run aggregate supply (SRAS) is aggregate output when nominal wages and input prices are rigid.

• The SRAS curve is upward sloping, indicating a positive relationship between the price level and aggregate output.
• A higher price level increases profitability because costs are relatively unchanged (wage and input price stickiness).
• That encourages businesses to increase output to reap more profits.

Changes in the price level cause SRAS to move along the curve. Meanwhile, changes in other determinants shift the SRAS curve to the right or to the left, including:

• Raw materials and other inputs price
• Nominal wages
• Future price expectations
• Business tax
• Business subsidies
• Exchange rate
• Changes to the determinants of LRAS

Changes in these factors cause aggregate supply shocks in the economy.

• Positive shocks raise short-run aggregate supply 
• Negative shocks lower short-run aggregate supply

Long-run aggregate supply

Long-run aggregate supply (LRAS) is aggregate output when wages and input prices are fully flexible. It represents potential output, and the economy uses its resources in full (full employment).

• The price level change does not have an impact on the economy’s output.
• Input prices and wages are fully flexible and adapt to changes in the price level.
• An increase in the price level does not increase profitability because production costs increase proportionally.
• Consequently, a higher price level has no effect on the quantity supplied.

The LRAS curve shifts due to changes in the determinants of potential output, including:

• Labor supply (their quantity and quality)
• Natural resource supply
• Capital supply
• Technology

Macroeconomic equilibrium

Economists divide the macroeconomic equilibrium into two:

• Short-run equilibrium
• Long-run equilibrium

Short-run equilibrium is when the short-run aggregate supply curve intersects with aggregate demand. It represents the economy’s actual output in the short run (real GDP).

Long-run equilibrium occurs when the short-run equilibrium intersects exactly on the long-run aggregate supply curve. At this point:

• Actual output = Potential output (real GDP = potential GDP)
• Unemployment rate = Natural unemployment rate
• The economy operates at full employment or full capacity.

However, the short-run equilibrium often deviates from the potential output. Its fluctuations around potential output form the business cycle. We call the difference between potential output and actual output the output gap.

• A negative gap is when the actual output is less than the potential output. The short-run macroeconomic equilibrium is to the left of the long-run aggregate supply curve. The unemployment rate rises, and inflation tends to be pushed down. Also known as the deflationary gap or recessionary gap.
• A positive gap is when actual output exceeds potential output. Inflation tends to rise (upward pressure on the price level), and the unemployment rate falls. Also known as the inflationary gap or expansionary gap.

Business cycle

The business cycle denotes the fluctuation in the economic activity due to changes in aggregate supply and aggregate demand. Cycles affect economic growth, employment, and price levels in the economy. The phases of the cycle consist of expansion, peak, contraction, and trough.

Expansion is when aggregate economic activity increases, indicated by an increase in real GDP. It is the period after the trough and before the peak.

• Economic recovery is the initial period of expansion when the economy comes out of a trough. Real GDP is starting to increase but slowly. Also known as early expansion.
• Boom is the final part of the economic expansion phase before it reaches its peak. The economy is growing high and testing its limits. During this period, the economy overheated due to high inflationary pressures. Also called the late expansion.

Peak shows the highest point of the cycle. It was the end of expansion before leading to contraction and recession. Economic activity reached its limit.

Contraction is when aggregate economic activity declines. Real GDP declined.

• Recession is when a contraction lasts for two consecutive quarters. It is called the Great Recession as during 2008-2009 in the United States if it is severe enough.
• Depression is a severe and long-lasting recession. Even worse was the Great Depression, like in the 1930s, where the economy slumped and lasted longer than the great recession.

Trough refers to the lowest point of the business cycle. The recession ended, and the economy headed for recovery and expansion.

Long run cycle

Real business cycle is caused by long-term supply shocks rather than short-run fluctuations in aggregate supply and demand. It assumes wages and prices are completely flexible. Fluctuations occur due to changes in factor productivity, such as changes in technology, affecting the quality of capital and labor.

• Kondratieff cycle – lasts from 50 to 60 years.

Economic indicators

Economic indicators are useful statistics to provide information about the state of the economy. They can come from government agencies and private organizations. There are many variables; however, in general, they fall into three groups:

1. Leading economic indicators. They have turning points before the business cycle, or the economy changes direction. Therefore, they have predictive value for the future state of the economy.
2. Coincident economic indicators. They move to coincide with the business cycle. As the cycles go up, they will also go up. When the cycle goes down, it goes down too. Their turning point is right at the turning point of the business cycle. They are used to identify the current state of the economy.
3. Lagging economic indicators. Their changes occur after the business cycle changes direction. They are usually to confirm past economic conditions.

Economic growth

Economic growth points to an increase in the economy’s output over time. The growth rate is measured by the percentage change in real GDP. When real GDP rises, the economy grows. Conversely, when real GDP falls, the economy contracts.

From the long-term perspective, economic growth is also defined as an increase in the economy’s potential output. That is analogous to a shift out of the production possibilities curve. When potential output increases, the economy can produce more goods and services.

One of the economic models to explain the source of long-term growth is the Solow growth model. And, in a nutshell, potential output increases due to the following two factors:

• Increasing the quantity of inputs (such as labor and capital)
• Increased productivity through improved technology. In the Solow model, it is represented by the total factor productivity, the residual of the model.

Technology is the key to growth because labor and capital have a diminishing marginal return. That allows the economy to produce a larger output with the same amount of labor and capital.

• The capital-to-labor ratio is the proportion of capital per worker in an economy. It has diminishing marginal returns.
• If the ratio is already high, any investment to increase the ratio (capital deepening) generates lower returns (productivity) than when the ratio is low. It then gives rise to a “convergence.”
• Convergence shows you the per capita income of developing countries is ultimately equal to the per capita income of developed countries. Developing countries will enjoy higher growth due to a lower capital-to-labor ratio.
• But, in fact, why is it still difficult for developing countries to catch up with developed countries? The reason is the technology factor.

Unemployment

Employment refers to the condition of having a paid job. For aggregate figures, it shows how many people are currently employed to receive salaries in the economy.

Meanwhile, unemployment is when individuals are not working but are actively looking for work. The keyword is actively looking for work. Those who are not actively working are not counted as unemployed.

Unemployment is part of the labor force, namely the productive age population working or actively looking for work.

• The productive age population is those aged around 15-64 years. Another definition might use the 16-64 year range. Also known as the working-age population.
• The labor force refers to the working-age population currently employed plus the unemployed who are actively looking for work. It excludes those who aren’t actively looking for work, such as housewives and students, even though they are in their productive age (around 15-64 years).

Voluntary unemployment and Hidden unemployment

Voluntary unemployment is when a person voluntarily leaves the labor force. For example, unemployed workers reject available vacancies even though they can work and the vacancies match their qualifications. Or they choose not to pursue a full-time job.

• Involuntary unemployment is when someone is unemployed even though they are willing to work for the prevailing wages.

Hidden unemployment is unemployment but is not counted in official unemployment statistics. It consists of discouraged and underemployed workers.

• Underemployment is when individuals are willing to work full-time but can only find part-time work. Or, they are unable to utilize their productive potential due to working in positions below their skills.
• Discouraged workers stop looking for work out of desperation, for example, because they are rejected too often by potential employers or poor job prospects, such as during a recession.

Types of unemployment and their causes

Economists usually focus on discussing three types of unemployment: structural, frictional, and cyclical unemployment.

• Structural unemployment – due to structural changes in the economy. The skills of the unemployed are no longer needed by the market.
• Frictional unemployment – due to the time lag in finding a new job. It takes time to find a job and go through the selection process. As long as individuals follow the process, the statistics bureau counts them as unemployed.
• Cyclical unemployment – due to the rise and fall of economic activity during the business cycle. For example, during a recession, weak aggregate demand in the economy leaves some resources unemployed, including labor. It left some people unemployed. Also known as demand deficient unemployment.

One more thing, there is seasonal unemployment. It is caused by seasonal factors, common to several jobs in agriculture, construction, and tourism.

Indicators to measure employment conditions

Activity ratio, or the labor force participation rate, is equal to the total labor force divided by the total working-age population, expressed as a percentage. 

The unemployment rate equals the number of unemployed divided by the labor force multiplied by 100%.

• The natural rate of unemployment (NARU) is the unemployment rate when the economy is at full employment. It represents the lowest unemployment rate, consisting only of structural and frictional unemployment. It’s never zero percent.
• Sometimes NARU is equated with the non-accelerating inflation rate of unemployment (NAIRU), the lowest limit of the unemployment rate before eventually causing inflation to rise. If the unemployment rate falls below NAIRU, inflationary pressures increase.

Labor productivity shows how many goods and services a worker produces. It may be measured per worker or per hour worked. For example, it is calculated by dividing GDP by the number of aggregate hours worked for an aggregated figure.

Inflation

Inflation points to a persistent rise in the price level in the economy during a given period.

• Price level, or aggregate price level, refers to the average price of goods and services in the economy, measured by the GDP deflator. 
• Headline inflation is inflation for all goods and services in the economy.
• Core inflation is inflation for all goods and services other than volatile components such as food and energy.

Inflation rate shows the percentage increase in the price level over a given period, calculated from the percentage change in the price index. Thus, it measures the speed of price movement.

• Deflation is when the price level falls (negative inflation), for example, from 1% to -2%.
• Disinflation is when the inflation rate slows down but is still positive, for example, from 5% to 2%.
• Stagflation is when a high inflation rate accompanies stagnant economic growth, usually resulting from shocks in aggregate supply.
• Reflation is when the inflation rate starts to creep up thanks to expansionary economic policies.

How bad is inflation?

• Creeping inflation is when inflation rises at a relatively moderate rate of about 3% a year. Also called mild inflation or moderate inflation.
• Walking inflation is when inflation increases by about 3-10% a year.
• Galloping inflation is when the inflation rate rises high, more than 10%, but is lower than hyperinflation.
• Hyperinflation is when the inflation rate skyrockets significantly, even reaching more than 50% per month.

Causes of inflation

Inflation arises due to an increase in demand and an increase in costs.

• Cost-push inflation results from increased production costs, such as skyrocketing oil prices, without increasing productivity. Profitability is depressed. As costs rise, businesses then look for ways to increase output prices to protect profit margins.
• Demand-pull inflation is due to an increase in aggregate demand, for example, due to an aggressive reduction in interest rates.

Measuring the inflation rate

We measure the rate of inflation from the percentage change in the price index. The index makes it easier for us because we cannot count all goods and services manually. However, the index also has some drawbacks.

Price index is a single number to represent the average price of a basket of goods and services. There are several indexes we can use:

• Consumer Price Index (CPI) represents the price of a basket of goods and services purchased by households, usually those living in urban areas.
• Producer price index (PPI) represents the price of a basket of goods and services purchased by producers. That’s a good indicator of future CPI changes because ultimately, the cost increase is passed on to the consumer.
• Wholesale price index covers the prices of goods for wholesale trade, whether purchased by consumers or businesses. Sometimes, it is equated with PPI because it only covers goods purchased by the business.
• GDP deflator represents the price of all goods and services in the economy, both purchased by consumers and producers.
• Personal Consumption Expenditures Price Index (PCE price index) represents the prices of goods and services for personal consumption. It is important to reflect changes in consumer behavior.

Next, some formulas for building the index are:

• Paasche index uses the composition of the current basket of goods and services. However, it tends to understate the price increase, as it already reflects some changes in consumption patterns.
• Laspeyres index uses a constant consumption basket composition. The concept is similar to calculating real GDP but in reverse. It holds constant quantities of goods over time but uses the current prices each year. That gives rise to biases: substitution bias, new product bias, and quality bias.
• Fisher index uses the geometric mean of the Laspeyres index and the Paasche index.

Costs of inflation 

Expected inflation refers to the inflation rate anticipated by economic actors to occur or be realized in the future.

• Unexpected inflation is when the actual inflation rate does not match what was previously expected, causing errors in making economic decisions and allocating resources.

Economic actors consider the current rate of inflation and its value in the future. They rely on this information to make important economic decisions such as spending, saving and investing. And actual inflation may or may not be in line with their expectations.

• Menu costs are the costs of changing and updating price lists and price tags. If the inflation rate is unstable, businesses will constantly have to bear the cost of printing new menus if they adjust their selling prices.
• Shoe-leather costs denote the time and effort spent on trips to the bank. When inflation is high, many people prefer to hold less money and make additional trips to the bank more often.

High and unstable inflation has several negative impacts, including:

• Erode the purchasing power of money, so money becomes less valuable.
• Cause more inflation, such as going through the wage-price spiral.
• Raising nominal interest rates due to higher risk premium 
• Make loans more expensive due to higher interest rates.
• Reduce business investment because funding costs are more expensive.
• Inequitable transfer of wealth between borrowers and lenders.

Real variable vs. nominal variable

Nominal variable – the monetary value of a variable such as wages, income, or interest. For example, nominal wages mean how much money workers earn – also known as money wages.

Real variable – nominal variable adjusted for the inflation rate. For example, real wages mean how much goods are earned from wages received from employers.

Fiscal policy

Fiscal policy is a policy to influence the economy through changes in the government budget. The two tools are taxes and government spending. Changes in spending have a direct impact on aggregate demand, while taxes affect indirectly.

Types of fiscal policy

Expansionary fiscal policy aims to stimulate aggregate demand in the economy. That is by increasing government spending, lowering taxes, or a combination thereof. Also known as easy fiscal policy or loose fiscal policy.

• For example, a tax reduction leaves households and businesses with more money to spend on goods and capital investment.

Contractionary fiscal policy aims to moderate aggregate demand. It does so by increasing taxes or reducing government spending.

• For example, when the government lowers its spending, it has a direct impact on aggregate demand.

Government budget

The government budget is the estimated expenditure and government revenue for a particular period. Also known as the fiscal budget.

There are three possible budgets:

• Budget surplus – revenue exceeds expenditure
• Balanced budget – revenue equals expenditure
• Budget deficit – revenue is less than expenditure

Each has implications for the economy. For example, when running a deficit, the government must borrow to cover the deficit. If the debt is too high, the government may pursue austerity policies by increasing taxes, reducing spending, or combining the two. However, those alternatives are painful for the economy in the short term.

Government revenue

Government revenue is the money received by the government to finance its expenditures. Most of the revenue comes from taxes, either direct or indirect taxes.

• Direct taxes are collected directly to the taxpayer. Income taxes, capital gains taxes, and corporate taxes are examples.
• Indirect taxes are levied on goods and services before they reach the customer.

Government expenditure

Government expenditure is money spent by the government. It includes spending by national, regional, and local governments, both routine spending and public investment. It is grouped into three categories:

• Transfer payments are spending without involving the exchange of goods or services. Examples are unemployment benefits and income support for poor families.
• Current government spending is expenditure for day-to-day operations to provide services such as shopping for office equipment.
• Government capital expenditure refers to infrastructure spending, which contributes to the capital stock of the economy.

National Debt

National debt is the amount owed to creditors by the government. Governments borrow to cover budget deficits, usually by issuing government bonds. Also called sovereign debt or government debt.

• The current outstanding government debt represents the accumulated fiscal deficit over time minus the fiscal surplus.

Debt has an impact on the economy. When debt is high, fiscal sustainability is in question. Payments of principal and interest on debt burden the government budget. The default risk increases. That could trigger a debt crisis, as has happened in the European Union since late 2009.

To reduce the high debt, the government may implement austerity policies by increasing taxes or cutting spending.

One indicator to measure the sustainability of government debt is debt to GDP. You can also look at sovereign ratings issued by international rating agencies – such as Standard and Poor’s, Moody’s, and Fitch – to assess the default risk.

Automatic stabilizer vs. discretionary spending

The automatic stabilizer is a countercyclical policy tool to stabilize the economy. It reduces short-term business cycle fluctuations without direct action by the government. Two examples are unemployment benefits and progressive income taxes.

• Both rise and fall in the opposite direction of the business cycle. For example, during a recession, unemployment benefits automatically increase because the unemployment rate is higher. Instead, it falls during an economic expansion as the unemployment rate declines.

In contrast, government discretionary spending requires direct action. For example, the government may allocate more spending to certain expenditure items and reduce others. It also usually requires parliamentary or congressional approval.

Fiscal policy stance

Fiscal policy stance is about how the government intentionally adjusts its spending and taxes to influence the economy and achieve macroeconomic goals. Thus, it involves the government’s discretionary policy concerning its budget policy orientation.

This concept is about questions like this “when increasing (reducing) the budget deficit, is it really the government’s intention to stimulate (moderate) aggregate demand, or is it due to an increasing component of automatic stabilizers?”

Economists then introduce two budget deficits to assess the government’s policy stance.

• Structural budget deficit – continues to exist even when the economy is at its potential output. It does not vary directly with the business cycle.
• Cyclical budget deficit – its changes vary directly with the business cycle.

Fiscal multiplier

A fiscal multiplier refers to the increase in aggregate income due to a $1 change in the government budget. It is equal to the change in national income divided by the change in government spending.

Say the government increases the budget for infrastructure. It stimulates related businesses to increase production and absorb more labor, creating more income in the economy. Rising incomes stimulate businesses and households to increase consumption and investment, pushing up aggregate demand.

Fiscal multipliers can be:

• Expenditure multiplier – due to changes in government spending.
• Tax multiplier – due to changes in taxes.

Next, there is another balanced budget multiplier. It is a multiplier effect when a change in government revenue equals a change in government spending. For example, the government increases tax revenue by $100. But, it also increases the spending by $100. Thus, the balance of the government budget has not changed from the previous period.

Why is the fiscal multiplier important?

The government budget is autonomous. Therefore, it tends not to vary directly with the business cycle compared to business investment or household consumption.

For example, during a recession, it is difficult to increase investment and consumption because the prospects for business profits and household incomes deteriorate. So, under such conditions, the government can take discretionary policies to stimulate the economy by increasing spending.

Fiscal policy limitations

Crowding out is the negative effect of a budget deficit on private investment. An increase in the deficit raises interest rates and makes investment costs more expensive. As a result, private investment fell, perhaps more substantially than increased government spending, leading to weaker economic growth. That is the opposite of crowding-in, where higher government spending leads to increased private sector investment.

Ricardian equivalence shows that tax cuts or debt increases have no effect on national spending and saving. It assumes the private sector is forward-looking. They fully anticipate future possibilities and use them in making current decisions. That includes the possibility of tax increases in the future due to the current high government debt.

Policy lag refers to the time it takes for a fiscal policy to effectively affect the economy. Governments need time to identify shocks, design policies, and implement them. Because there is a lag, policy prescriptions may become ineffective as the economy has changed course, no longer as assumed. Policy lag falls into three categories:

• Recognition lag – the time it takes to recognize a shock in the economy, for example, because the data is not real-time.
• Action lag – policy lag due to delays between policy decision-making and implementation.
• Impact lag – the time lag for economic policies to effectively influence and move the economy in the desired direction.

Sovereign crisis. Higher debt increases the default risk. The government’s ability to repay its obligations is in doubt, leading to a debt crisis. Debtors or bailout providers can force the government to implement austerity measures by increasing taxes or reducing spending. Thus, high debt ultimately leads to fiscal unsustainability.

Monetary policy

Monetary policy is an economic policy to influence the amount of money circulating in the economy. It is under the central bank. It affects the economy through aggregate demand. Monetarists believe that the monetary side (money supply) plays a significant role in influencing economic fluctuations.

The three main monetary policy tools are:

• Policy interest rates. It can take several names, such as the Fed Funds Rate or the discount rate.
• Open market operations. The central bank sells or buys government securities. If done massively, it is called quantitative easing.
• Reserve requirement ratio. It is the portion of the deposit the bank must hold as a reserve, not to be loaned out.

Types of monetary policy

Expansionary monetary policy is to increase the money supply, which in turn pushes up aggregate demand. That is by cutting policy interest rates, lowering the reserve requirement ratio, and buying government securities. Also known as loose monetary policy or easy monetary policy.

Contractionary monetary policy aims to reduce the money supply. That is by raising policy interest rates, raising the reserve requirement ratio, and selling government securities.

Roles of the central bank

The central bank is the monetary authority responsible for the money supply in the economy. Apart from being the sole supplier of currency and running monetary policy, they also have several responsibilities such as:

• Acts as lender of last resort – lend money when no other entity is ready to do so.
• Supervise the banking system – regulate activities and oversee the health of banks, including setting reserve requirements. This role may be replaced by other authorities in some countries, for example, financial services authorities.
• Supervise, regulate, and set payment system standards.
• Manage foreign exchange reserves.

Monetary policy transmission

The monetary transmission mechanism is about which path changes in monetary policy affect the economy. Transmission can be through interest rates, exchange rates, asset prices, and expectations of economic actors. For example, say the central bank lowers interest rates. It resulted in:

• Commercial banks lower their base rate – individuals and businesses borrow more for consumption and investment.
• The domestic currency depreciates as foreign capital goes out to pursue higher returns abroad – exports rise, and imports fall.
• The asset price rises because the present value of the expected future cash flows increases.
• Economic agents’ expectations are positive because they associate higher interest rates with stronger future economic growth.

Exchange rate targeting vs. inflation targeting

Exchange rate targeting points to a monetary policy strategy in which the authorities choose currency exchange rates as the policy target rather than the inflation rate. To support the target, the central bank buys and sells domestic currency in the foreign exchange market.

Inflation targeting is when the central bank directs its monetary policy to keep the inflation rate close to a predetermined target level. The central bank publicly announces the inflation target corridor and adjusts monetary policy to achieve this target.

Fisher effect

The Fisher effect relates the nominal interest rate, the real interest rate, and the inflation rate. Real interest rates are stable over time, so nominal interest rates change depending on future inflation rates. Fisher stated that the nominal interest rate is the same as the real interest rate plus the expected inflation rate.

Nominal interest rate = Real interest rate + Expected inflation rate

Limitations of monetary policy

Money neutrality: “increasing the money supply in the long run only affects nominal variables such as prices and money wages and does not affect real variables such as aggregate output and employment.

Liquidity trap is when the demand for money is infinitely elastic (horizontal demand curve). As a result, conventional monetary policy is less effective for influencing aggregate demand and economic activity.

• Interest rates have been very low, near zero percent, and difficult to fall further.
• Such conditions require non-conventional monetary policies such as quantitative easing (QE), open market operations but on a more significant scale.

Bond market vigilantes are bond market participants who protest against monetary policy. For example, when a central bank lowers the policy rate, they may perceive the policy to be inflationary, prompting them to reduce demand or sell long-term bonds. This action pushed bond prices down, and yields increased. As a result, borrowing costs rose, tightening monetary conditions.

Money

Money refers to anything accepted as a medium of exchange and a unit of account. Money has a vital role in the modern economy and replaces the barter economy. We have abandoned the gold standard system. Now, we use fiat money, like the paper money you hold.

Although it has no intrinsic value, fiat money is a legal tender because the government declares it. Moreover, its printing resulted in seigniorage, a profit made by the government because the nominal fiat money was higher than the value of producing and distributing it.

It was different from commodity money like gold coins. They have intrinsic value because we can use them for other purposes.

Money function

Medium of exchange – Money is used to pay for goods and services. It makes trading transactions easier because anyone recognizes it.

Store of value – Money is an asset you can use in the future because it retains purchasing power over time. With money, you can transfer current wealth into the future. This function works well during low inflation rates.

Unit of account – Money is used as a standard unit against which the prices of goods and services can be expressed, and their values ​​can be compared.

Money creation process

Money creation is about how the money supply increases as it circulates in the economy. It works through a loan-deposit mechanism, which ultimately results in a monetary multiplier (money multiplier).

• The reserve requirement ratio is the portion of total deposits held by banks as reserves instead of being loaned out.

Reserve requirement ratio = Required reserves / Total deposits

• The money multiplier shows how much the money supply increases for every $1 change in the monetary base. And, in a simple formula, the money multiplier is equal to one divided by the reserve requirement ratio. If the ratio is 10%, every $10 will increase the money supply to $100.

Money multiplier = 1 / (Reserve requirement ratio)

Measuring the money supply

There are several categories for measuring how much money is circulating in the economy. However, economists typically focus on growth in the following two categories:

• Narrow money includes paper money and coins circulating in an economy, plus other highly liquid deposits.
• Broad money includes narrow money plus demand deposits and near-cash liquid assets, which can be easily converted into cash or used to make purchases.

Both are then translated into various categories: the monetary base (M0), M1, M2, and M3, where each country is usually different.

Quantity theory of money

The quantity theory of money reveals the relationship between money and the price level. It states that the money supply (M) times its velocity (V) equals real output or real GDP (Y) times the price level (P).

M x V = P x Y

M x V represents the amount of money used to buy all goods and services in the economy. Meanwhile, P x Y is equal to the value of these goods and services.

The velocity of money tells you how many times a year the same dollar circulates and is used to buy all the final goods and services in the economy. It is equal to the nominal gross domestic product (GDP) divided by the money supply.

Money market equilibrium

The demand for money reflects the amount of wealth people choose to hold in money (rather than bonds or equities). It is inversely proportional to the nominal interest rate. For example, when interest rates rise, the demand for money falls because people prefer to save it in banks for higher returns and vice versa. Therefore, the money demand curve has a negative slope.

There are three motives for holding money:

• Transaction motive – People need money to finance transactions.
• Precautionary motive – People save money to use in unforeseen circumstances.
• Speculative motive – People hold cash to anticipate the opportunities and risks of holding other financial instruments (such as bonds). It is inversely proportional to the return and positively proportional to the perceived risk in the instrument.

The money supply is unaffected by the nominal interest rate; rather, it is determined by the Central Bank. Therefore, the curve is a vertical line.

Money market equilibrium occurs when the money supply and demand curves intersect. It determines the short-run equilibrium nominal interest rate in the economy.

Supply-side policy

Supply-side policies affect the production side of an economy. It aims to shift the long-run aggregate supply curve to the right by influencing the quantity and quality of the factors of production. It can be:

• Market-based policy
• Interventionist policy

Market-based supply-side policies emphasize free market mechanisms, which are important for a more efficient allocation of resources. The policy can be by:

• Encouraging more competition such as through antitrust regulation, deregulation, privatization, and trade liberalization
• Labor market reforms to make it more flexible by reducing the power of unions, removing the minimum wage, and reducing unemployment benefits.

Interventionist supply-side policies emphasize:

• Investment in human capital, such as investment in education and training to improve the quality of human capital.
• Invest in new technologies by encouraging research and development
• Invest in infrastructure to reduce the cost of doing business
• Industrial policies such as through tax cuts and subsidized loans for strategic sectors

International trade

Most countries today are open economies. It is almost impossible to find a country with a closed economy (autarky).

International trade involves both export and import.

• Imports – buying goods and services from abroad.
• Export – selling goods and services abroad
• Net exports or trade balance = Exports – Imports

The trade balance can be:

• Trade surplus – exports exceed imports
• Balanced trade – exports equal imports
• Trade deficit – exports less than imports

Meanwhile, the ratio between the prices of products exported and imported is referred to as the term of trade. It measures the purchasing power change of exports relative to imports.

Trade theory

Two theories explain international trade: absolute advantage and comparative advantage.

• Absolute advantage – producing goods at a lower cost of production than other countries.
• Comparative advantage – producing goods and services at a lower opportunity cost than others.

Furthermore, where does a country’s comparative advantage come from? Again, you can study the Ricardian model and the Heckscher‐Ohlin model.

• Heckscher-Ohlin model – comparative advantage comes from factor endowments. Each country specializes in producing goods according to these factors.
• Ricardian model – comparative advantage comes from technology, which affects differences in labor productivity between countries.

Trade protection

Under free trade, goods and services can enter and leave between countries without any barriers. But often, there are limiting conditions for export and import activities. If it comes from government policies, we call it trade protection. Trade barriers can be tariff or non-tariff such as quotas, voluntary export restraints, export subsidies, and administrative barriers (e.g., environmental standards and product safety).

Tariff is a tax levied on the products exported or imported. Export tariffs are usually to protect the domestic market from a shortage. Meanwhile, import tariffs aim to increase the prices of imported products, making them less competitive in the domestic market.

Quota limits the quantity of products exported or imported, generally for a certain period. 

• An import license is a permit from an authority to import goods from abroad. It determines the number of goods that can be imported.
• Quota rent is the profit quota license holders can earn by raising their goods price higher than the price without a quota.

Voluntary export restraints (VERs) are agreements between countries in which the exporting country voluntarily agrees to limit its exports to partner countries. It may be at the request of the government of the importing country. Or, it is due to pressure from importing countries because they are more powerful economically and can carry out more aggressive trade retaliation.

Export subsidies refer to monetary assistance to export-oriented businesses. It aims to make domestic products more competitive in foreign markets. Subsidies can be tax breaks, soft loans, or subsidies on the price of raw materials.

International capital flows

Relations between countries involved not only trade in goods and services but also the capital. It can be through direct investment or indirect investment.

• Foreign direct investment is an inflow of investment from abroad to obtain controlling ownership in domestic companies. Alternatively, the investment involves purchasing an existing asset or building a new production facility. Direct investment is more long-term oriented than portfolio investment, and the investor has control over the assets.
• Foreign portfolio investment is investment inflows from abroad to domestic financial instruments such as stocks, corporate bonds, and government bonds. The investor has no control over the assets. It is usually short-term oriented and for speculative purposes.

Some portfolio investments are considered to disrupt economic stability. Take, for example, hot money flows. It is easy going in and out of a country in response to risk and return. And the flow is also massive, affecting exchange rate volatility, which has a major impact on macroeconomic stability.

Therefore, in some countries, governments take up capital barriers. They control money going into and out of the economy.

• Capital controls are actions taken by governments or central banks to limit the free movement of capital between countries. These may be tariffs, transaction volume restrictions, minimum length of stay requirements, or foreign ownership restrictions.

Balance of payments

The balance of payments tracks a country’s transactions with the rest of the world over a period of time, usually quarterly or annually. It reports inflows and outflows arising from international trade, income, transfers, and asset transactions. It consists of three parts:

• Current account 
• Capital account
• Financial account

Usually, the latter two are combined into one, namely capital and financial account. Current account plus capital and financial accounts must be equal to zero. The deficit in one of them must be balanced by the other.

Current account

The current account records:

• Merchandise and service trade
• Factor income – includes income from holding foreign assets such as interest and dividends.
• Unilateral transfers – one-way transfers of assets such as worker remittances and direct foreign aid.

Of the three components, merchandise and service trade usually contributes the most significantly.

The current account deficit is when the current account balance is negative. It usually happens when there is a trade deficit.

• The deficit must be offset by the capital and financial account surplus. The domestic economy needs money to pay for imports. And that means foreign capital flows in both portfolio investment and direct investment.

A current account surplus is when the net current account balance is positive. It usually occurs when exports exceed imports.

• The surplus is used to finance the partner country’s current account deficit (through loans and investments in real and financial assets in that country).

Capital account

The capital account records:

• Capital transfers include net flows for items such as non-life insurance claims, investment grants, and debt forgiveness.
• Purchase and sale of nonproduced, nonfinancial assets such as contracts, leases and licenses, and goodwill

Financial account

Financial account records portfolio investments, direct investments into and out of a country, plus changes in reserve assets. It consists of:

• Domestic assets held overseas include gold, foreign currency, foreign securities, government reserve positions in the IMF and foreign direct investment, and claims reported by resident banks.
• Domestic foreign-owned assets include asset ownership of government and private securities, direct investment, and domestic liabilities to foreigners reported by the banking sector.

Exchange rate

An exchange rate refers to the relative price of one currency against another. We can also say it is the purchasing power of one currency against another.

Nominal exchange rate is the exchange rate without being adjusted to the purchasing power of goods and services. That is how much foreign currency you earn for each nominal amount of domestic currency you exchange.

• Bilateral exchange rate means the exchange rate between two countries.
• The nominal effective exchange rate represents a weighted average of the bilateral nominal exchange rates, used to measure a country’s currency purchasing power against the currencies of its trading partners.

Real exchange rate is the relative purchasing power of two currencies after adjusting for the inflation rate in each country. We calculate it by multiplying the nominal exchange rate by the ratio of the foreign price index to the domestic price index. If you use the inflation rate to calculate it, you can use the following real exchange rate formula:

Real exchange rate = Nominal exchange rate x [(1 + Foreign inflation rate) / (1+ Domestic inflation rate)]

• Suppose you calculate the weighted average of the real exchange rates of a country with its trading partners. In that case, you get the real effective exchange rate.

Purchasing power parity (PPP) emphasizes the differences in purchasing power between countries. It is based on the law of one price, where the price of goods must be the same wherever they are, assuming no transaction costs or trade barriers. Thus, the nominal exchange rate between the two currencies should reflect the price difference.

Cross rates or cross-exchange rates are exchange rates between two currencies where the respective exchange rates are expressed against a third currency. For example, to find out the exchange rate of the US dollar against the Japanese Yen, USD/JPY, you can calculate it by multiplying the US dollar exchange rate against the Euro, USD/EUR, and the Euro against the JPY, EUR/JPY.

USD/JPY = (USD/EUR) x (EUR/JPY)

• Triangular arbitrage refers to the practice of taking short-term profits by exploiting inconsistencies in cross-exchange rates. USD/JPY may not equal USD/EUR times EUR/JPY, giving rise to arbitrage opportunities.

Currency appreciation and depreciation

Appreciation is when the exchange rate of the domestic currency against a foreign currency strengthens. For example, suppose you hold US dollars and want to convert them into Euros. If the US dollar appreciates, you get more Euros than before for the same amount.

• Revaluation is a deliberate appreciation by the government under a fixed exchange rate system, in which the government sets the exchange rate stronger than before. It could be aimed at supporting cheaper imports of high-tech capital goods from abroad.

Depreciation is when the purchasing power of the domestic currency against foreign currencies weakens. As a result, you earn less foreign currency than before for every domestic currency you exchange.

• Devaluation is a deliberate depreciation by the government under a fixed exchange rate system. It is the opposite of revaluation. It usually aims to increase exports by making domestic goods cheaper in international markets. On the other hand, it also reduces imports as foreign products become more expensive for domestic buyers.

Foreign exchange market

Foreign exchange market (forex market) is a market where currencies of various countries are traded. Demand and supply determine the exchange rate of a country. Transactions in the forex market can involve:.

• Spot exchange rate (spot rate) is the exchange rate for immediate delivery, rather than some time in the future.
• Forward exchange rate (forward rate) refers to the exchange rates currently quoted for currency exchange on a specific date in the future. Forward contracts are one way to hedge against exchange rate risk.
• Currency futures are similar to the forward exchange rates but are standardized and traded on an exchange. Meanwhile, forward contracts are traded in the over-the-counter market and are not standardized.
• Foreign exchange swap (FX swap) involves simultaneous spot and forward transactions.
• Foreign exchange options (FX options) give the buyer the right, but not the obligation, to make an exchange rate transaction (buy or sell) on a predetermined date in the future at an agreed exchange rate today.

Exchange rate regime

The exchange rate regime is a system or way of regulating a country’s currency and its policies. In general, it is divided into:

• Fixed exchange rate – the value of one currency against another is kept unchanged. It is not influenced by supply and demand in the forex market but rather is determined by the government. The government actively intervenes in the market. Because it is fixed, the exchange rate may be undervalued or overvalued compared to its equilibrium in the market.
• Floating exchange rate – the exchange rate fluctuates according to supply and demand in the market. There is no government intervention. Also called a flexible exchange rate or clean floating.
• Managed floating exchange rate – the exchange rate is allowed to move freely near equilibrium, and the government periodically intervenes to stabilize it in the short term. Also known as dirty floating.

In practice, there are several variations of the exchange rate system, including:

• Dollarization – adopting a more stable foreign currency as the official currency. Because the US dollar is often used, we call it dollarization.
• Monetary union – adopting a single currency by member countries of an economic union such as the Euro in the Eurozone.
• Currency board system (CBS) – a fixed exchange rate at which the central bank will print money only if it is backed by foreign exchange reserves. Thus, the money supply in a country is closely related to its foreign exchange reserves.
• Fixed parity – the domestic currency exchange rate is pegged, and the central bank is ready to buy or sell foreign currency reserves to keep the exchange rate within narrow limits.
• Target zone – similar to fixed parity, but the exchange rate is maintained within slightly wider limits.
• Crawling pegs – exchange rates are adjusted in line with inflation rate trends (active crawling) or previously announced exchange rates for the coming weeks to influence inflation expectations (passive crawling).

Economic integration

Economic integration is when the economies between countries are “tied” to each other. It usually involves the reduction of trade barriers and the mobility of factors of production. The practice involves a lot of contractual arrangements. Agreements can be:

• Bilateral trade agreements involve two countries.
• Multilateral trade agreements involve more than two countries, usually involving the World Trade Organization (WTO).

Regional integration is how the countries’ economies in certain geographic areas become interconnected and unified. It may be:

• Preferential trade agreements – reduce trade barriers for certain products between participating countries.
• Free trade area – goods and services flow freely between them without trade barriers. But, each member has a different policy regarding trading with non-members.
• Customs union – a free trade area plus a uniform policy on trade with non-members.
• Common market – customs union plus the free movement of factors of production (capital and labor) among member countries.
• Economic union – a common market plus member states coordinate economic policies by establishing joint economic institutions like the European Central Bank (ECB) in the European Union.
• Monetary union – an economic union plus adopting a single currency such as the Eurozone, the part of the European Union whose members adopt the Euro as the official currency.

Pros and cons of economic integration

• Trade creation – member countries benefit from regional integration by importing cheaper products from other member countries.
• Trade diversion – inefficiency resulting from higher-cost imports from member countries replacing lower-cost imports from non-member countries.
• Trade deflection – non-member countries take advantage of tariff variations between member countries in the free trade area. They export to members where import tariffs are low and then ship them to other member countries without being subject to import tariffs.