1. Macroeconomic Basics - the Circular Flow of Income (CFoI), with Government and Fiscal Policy
2. Money, Capital and Stock (Financial) Markets
3. Macroeconomics of Money with the CFoI( IS/LM)
4. Macroeconomics of International Trade (Forex Markets)
   
5. MacroEconomic Management

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1.    Macroeconomic Basics - the Circular Flow of Income (CFoI) - also applies to regional economies.

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• Consumption (C) is spending on goods and services for final use (consumption) during this period.
• Investment  (I) - an injection into the CFoI - is the purchase of actual physical capital (equipment etc.), or the improvement of peoples skills and expertise - final spending on things which are intended to increase income levels in future periods rather than this one. [Please Note:  Firms are responsible for most of this investment, not governments, though some government spending is investment for future periods rather than spending on current (this year's) goods and services]
• Saving (S) is just and only income which is NOT spent on final goods and services. (= Yd - C) - a withdrawal from the CFoI. [Please Note:  Investment spending is matched with Savings through the financial and money markets (see below), which are separate from this Circular Flow of INCOME picture of the economy]
• Government Spending (G) is ONLY spending on final goods and services (wages and salaries, paper, power, building maintenance and improvement etc.) used up in this period or intended for use in future periods (includes any government investment) - an injection into the CFoI
• The other (major) part of total government expenditure is Transfer Payments:  social security, unemployment benefit, public (national) pension payments etc.  which simply add directly to the recipients incomes, and which are not paid in return for actual services.
• Taxes (T)are the government reciepts - actually also raised on the spending loop (VAT, excise duties), as well as on income streams (income and corporation taxes)  - T is best thought of as total taxes minus transfer payments - a withdrawal from the CFoI
• Exports (X) of goods and services provide income for firms, and also measure this part of total output of the economy - an injection into the CFoI
• Imports (IM) of goods and services leak income out of the national (domestic) flow of income - a withdrawal from the CFoI
• Total Expenditure equals Output (C + I + G + X - IM) equals Income (called Gross Domestic Product) (Y) which equals Disposable Income (Yd) plus Taxes.

• Increasing Injections (G, I, X) and/or reductions in Withdrawals (T, S, IM) will increase the CFoI (increasing income and output (expenditures) and vice versa.
• Multiplier process - increasing an injection (for instance) increases income, which then leads to further increases in spending and resulting income:  an initial increase in spending(say by government) generates an equivalent increase in income, which then in turn generates a second round increase in spending (though of a smaller amount, since some of the increase in income will be saved), and so on . This MULTIPLIER process comes to a halt when the increased initial injection has generated sufficient increases in the withdrawls (leakages) for the system to return to balance.
• until income levels have risen sufficiently that new levels of withdrawals equal the new level of injections (increasing incomes tend to lead to increased savings, taxes and imports).  Y (GDP) will not be in equilibrium until resulting Withdrawals balance Injections.  Equilibrium is established when Injections are equal to Withdrawls (G+I+X) = (T+S+IM)

• Government Fiscal Policy (the balance between G and T) can influence equilibrium Income levels
• Increase G (or reduce T) to counteract  a recession
• Reduce G (or increase T) to counteract an unsustainable boom (income growth exceeding full capacity of the economy, which leads to inflation - see below)

• Total Capacity of the economy to generate output and income depends on the quantities of land, labour, management and capital plant and equipment available
• When all of these factors of production are fully employed, the economy is operating at full capacity (i.e on its PPF from the previous session).  Otherwise, there is unemployment - the economy could produce more income and output, if people were not unemployed when they are actually looking for work.
  
• Capacity can be increased by:
• investment in capital plant and equipment - more capital for production and output;
• increase in the labour force participating in the economy - more employment -> more output & income;
• improvement in technology - more output & income from the same amounts of labour and capital through technological improvement - better quality and more productive capital;
• improved productivity of labour - better skilled and better organised labour increasing the amounts that can be produced and the income that can be earned;
• structural change- re-organisation of resources among different firms with lower costs, improving management.
• Fiscal Policy (G and T) can affect these capacity increasing processes - so should be used with care and caution.

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2.    Money, Capital and Stock (Financial) Markets.

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Money and CFoI (and Inflation)

• National Income (GDP) = P x Y  (a grand sum of millions of price times quantity trades) - where Y is real income - in terms of purchasing power over all goods and services, and P is the general price level (an index of all prices in the economy)
• Money (M) is the medium through which these trades take place (notes, coins, and current accounts with banks)
• Money is a STOCK which is exchanged between different people and businesses as trades happen
• The FLOW of money round the CFoI is given by M x V, where V is the Velocity of Circulation - the number of times any one £ changes hands in the course of 1 year.
• MV = PY (the Quantity equation of exchange) always holds - it is the only way of defining and measuring V.
• If V is constant, then PY (nominal or current GDP, national income) can only increase if M increases.
• If Y is fixed by the Capacity Constraint - at Yf (full employment national income), then any increase in MV will lead to an increase in P -> inflation.

The Market for Money

Money is used both as a medium of exchange for transactions (active bank balances) and also as a store of wealth (idle bank balances).

• Demand for money (current account bank balances) depends on:
• Income (especially for transactions or active balances)
• Price (the interest rate) especially for idle balances - the higher the interest rate, the greater the opportunity cost of holding wealth as money rather than as financial or physical assets.
• Money Supply is controlled by the Monetary Authority - Central Bank, the Bank of England (BoE) in the UK
  
• Monetary Policy is decided by the Monetary Policy Committe of the BoE, with the objectve of controlling inflation
• either through controlling the Supply of Money directly (which proves to be rather difficult)
• or by setting the base lending (interest) rate of the Bank of England to the commercial banking system - the current system of Monetary policy. (Setting the interest rate at a new level above r* will automatically result in a contraction of the supply of money to match the reduced demand - since the BoE, through its function as lender of last resort, implicitly sets the supply of money to match its ruling interest rate)

Capital Markets:  Balance between Savings and Investment (in new plant and equipment etc.)

Financial and Asset (Stock) Markets - who owns what bits of existing capital.

These are Stock Markets: where a more or less fixed stock of existing shares are swapped between people who want more (buyers) and people who want to hold fewer shares (the sellers). The total stock of shares is pretty well fixed (aside from occasional new issues).  Their price (market value) is completey determined by the demand against a fixed (vertical) supply - see here for more discussion of the implications.

Back to Contents.

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3.    Macroeconomics of Money with the CFoI( IS/LM)

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The IS curve refers to the equilibrium levels of National Income in the markets for goods and services (CFoI).  Here, higher rates of interest are associated with lower levels of spending (higher savings, lower investment, lower levels of consumption) - so the IS curve slopes downwards. Note the direction of causation:  setting the interest rate determines savings (withdrawals) and investment (injections), which then determines the equilibrium level of national income.
The LM curve refers to the equilibrium in the Money Markets - given a fixed money supply. Here, higher levels of national income lead to greater demand for money (for transactions), and hence higher rates of interest (given a fixed money supply)- so the LM curve slopes upwards. Note the direction of causation (opposite from IS curve) - incomes drive the demand for money, which then sets the interest rate if the supply of money is fixed (or sets the supply of money if the interest rate is fixed)
Fiscal Policy affects the IS curve - expansionary (increase G, reduce T) shifts IS right, and vice versa.
Monetary Policy affects the LM curve - expansionary (increasing Ms, reducing interest rates) shifts LM right, and vice versa.
The relative effectiveness of Monetary and Fiscal Policies in influencing Y (and thus employment) depends, therefore, on the slopes of the IS and LM curves.
The steeper the LM curve, the greater the "crowding out" effect of government spending - G increases increase interest rates which reduce (crowd out) private spending.
Inflation effects - If equilibrium Y* is greater than the full capacity of the economy - there will be pressure on prices - leading to inflation.  Inflation reduces the value of the fixed Money Supply, shifting LM left, raising interest rates and reducing Y* back towards its full capacity level.
BoE MPC raising interest rates to limit inflation is the practical counterpart of this effect - by rasing interest rates, the MPC effectively holds the Money Supply constant in the face of increasing demand, and actively shifts the LM curve to the left if the economy threatens to become  inflationary.

Back to Contents.

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4.    Macroeconomics of International Trade

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• Demand for sterling (= supply of forex) depends on exports of goods and services, and on inward flows of investment funds from abroad (capital inflows)
• Supply of sterling (= demand for forex) depends on imports of goods and services, and on outward flows of investment funds from the UK to foreign countries (capital outflows)
• Balance of Payments (BoP) records all these transactions:
• Current Account  (Exports vs. Imports)
• balance of visible trade
• balance of invisible trade (services, tourism travel etc.)
• Capital Account (flows of investment (financial) funds into and out of the country
• Official Financing - change in the Central Bank (BoE in the UK) forex reserves.

• Increasing Income shifts Sf right (increasing demand for imports) -> e.r. depreciation or BoP deficit
• Increasing Interest rates shift Sf left (discouraging capital outflows), and Df right (encouraging capital inflows -> e.r. appreciation or BoP surplus

• Increases Y
• Reduces r
• depreciates e.r -> more expensive imports, more competitive exports -> further expansionary effect.
• more likely to generate inflation

• Any currency which is viewed by the market as being vulnerable is subject to considerable short term capital outflows, whichmakes the currency even more vulnerable and liable to devaluation of fixed rate or depreciation of a floating rate. Speculative bubbles (either bull or bear) are frequent in the Forex market, especially but not only for the lesser currencies (can even affect the major currencies - euro, $, yen, £)
• rapid growth from Foreign Direct Investment (FDI) tends to lead to currency appreciation as a result of the capital inflows (sometimes called theDutch disease, after the experience of the Netherlands when North Sea Oil was first discovered and exploited). This e.r appreciation puts major pressure on the domestic economy - making imports more competitive and exports more difficult to sell, tending to contract the domestic economy. The domestic economy needs to be both robust and flexible (sensible banks and stock markets) to cope with this pressure.
  

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5.    MacroEconomic Management: 

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• Boom -> rising incomes fueling expectations of further growth (often associated also with inflation)
  
• Limited by:
• capacity constraints  -> inflation, depreciation of e.r., increased uncertainty and pessimism about future prospects plus prospect of active policy deflation (increasing taxes, increased interest rates)
• Monetary constraints:  -> rising interest rates and appreciating e.r. -> slower growth
• Recession -> stable or falling incomes (slower growth), rising inventories of unsold goods, increasing layoffs and rising unemployment; also known as deflation.
  
• Limited by:
• falling prices encouraging consumption and falling wages or availability of unemployed labour encouraging entrepreneurs to expand,
• by offsetting macroeconomic policies
• falling interest rates discouraging saving (hence increasing consumption) and encouraging investment
• increased government spending (social security payments etc.) and lower taxes encouraging income growth

• information on the current state of the economy is always out of date, ->  response to past conditions, rather than current conditions;
• time lags between monetary or fiscal levers and their effects on the economy  substantial and variable.   Monetary Policy an advantage - changed more frequently and easily than Fiscal Policy;
• the structure of the economy - crudely summarised as the slopes of the IS and LM curves - is always uncertain;
• expectations conditon responses - expectations that booms will be exagerated and be followed by substantial recessions will lead to different responses from expectations that booms will be slow and longer and less prone to sudden reversals:  so the cyclical behaviour of economies becomes self-perpetuating.

• Automatic [Fiscal] Stabilisers:  taxes which increase and goverment spending items which decrease as incomes grow - and vice versa, so that booms and busts are self-limiting (e,g, progressive taxation - rising with incomes, or spending-related taxes, withdrawing more as spending increases (VAT, excise duties), and also government spending on unemployment benefit and social security (providing all incomes are rising and not just some)).
• Responsible Monetary Policy:  aimed at purposive adjustment of interest rates to prevent both inflation and recession - to achieve a low and stable inflation rate.

Deflationary (recession) situation: