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

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

Simplify the whole economy as an interaction between Consumers (households), Producers (firms), and Government.  NOTE:  This is a circular flow of INCOME (and spending) - although measured and identified in money terms, it is the livings (income and spending) - the real purchasing power of the money - which is important here.  Always refer to the flow as an INCOME flow and not a flow of money.
NOTE:  Necessary Accounting equality (Total Expenditure = Income) over any one period (one year)  does not necessarily imply equilibrium.  If Expenditure is growing, then so too will income - and both will be larger in the next period.  If income is falling, then spending will also fall, and both will be smaller next period.

  Equilibrium Process of the CFoI. Note:  This picture is STATIC. In practice, economies tend to grow (as more capital is invested (built and commisioned) and as people get better atdoing what they do. Trend growth (improvement in technology and productivity (outputs per unit inputs)) typically about 2.5 - 3.5% per year for developed countries, and may well be substantially higher for well managed developing countries (8 - 10% or more for China, for instance)

The balances between injections and withdrawls here are better thought of as cyclical growth (or decline) round the trend growth - booms (strongly positive growth rates) and recessions (slower growth rates) or depressions (negative growth rates).

Fiscal Policy
as a stabiliser of economic cycles: Capacity Limits:
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2.    Money, Capital and Stock (Financial) Markets.

Money and CFoI (and 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).

The Money Market DiagramDemand for and Supply of Money:  The price of money is the interest rate, what it costs to get more of it, and the opportunity cost of holding money, rather than converting it into interest bearing assets (stocks and shares, savings accounts etc.)

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

The rate of interest also influences Savings and Investment - the balance in the capital market for loanable (investment) funds
Notice: If the interest rate (set in the money market) results in I > S, then there will be a tendency for the level of National Income (Y) to grow - increasing savings (shifting this ceteris paribus Savings supply curve shifts to the right as incomes increase) to match the additional investment.  However, increasing Y might also increase Imports and Taxes - so that the imbalance between savings and investment might persist - offset by imbalances between G and T, and between IM and X.

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.

The critical outcome of these markets is the market valuation of the stocks (shares) in both the commercial sector and the government (through the valuation of government stocks and bonds). In each case, these stocks, shares and bonds are simply certificates which promise to pay the owner either a fixed amount  (yield) annually [for a bond] or a share of the distributed profits (dividend) if any - usually once every six months.  The value of these bits of paper is, therefore, the discounted sum of the expected future stream of annual yields or future dividends, plus the expected future changes in the market value of these bits of paper (the 'capital' gains or losses.

The key relationship is that as interest rates increase, so the market value of these paper assets tends to decrease,  and vice versa, because the discount rate (the opportunity cost of money, as the interest rate) is higher (lower).

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

Management of the Macroeconomy depends on achieving an appropriate balance between the markets for goods and services (as represented by the CFoI) and the money markets (as above).
It therefore depends on achieving an appropriate balance between the two major levers of macroeconomic management: Fiscal Policy and Monetary Policy.
The Key variables in this balance are the level of national income (Y) and the rate of interest (r) - charted on the IS/LM diagram:

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.

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4.    Macroeconomics of International Trade

What, if anything, balances Imports with Exports in the CFoI?   The Foreign Exchange (Forex) market  -  where people and businesses trade one currency for another. The 1996 UK situation:
DemandCeteris paribus, exports and capital inflows will be greater the lower the exchange rate - demand curve slopes downwards.
Supply : ceteris paribus, will be greater the higher is the exchange rate - the supply curve slopes upwards.
Equilibrium exchange rate balances exports plus capital inflows with imports plus capital outflows.
Exchange rate managed by Central Bank (BoE) control of Forex reserves, and also through borrowing (repaying) loans from foreign banks.
Dforex and Sforex are also affected by Incomes (Y) and Interest rates Monetary Policy more powerful under floating exchange rates than fixed:  Expansionary monetary policy: Under fixed exchange rates, domestic expansion tends to increase imports faster than exports, opening up a trade deficit. If this deficit is not counter-balanced by a tight monetary policy (higher interest rates), then the BoP deficit tends to get worse - and can only be financed by running down forex reserves (or increased borrowing from abroad by the Central Bank).  The cure is then contraction of the domestic economy, tight fiscal and monetary policy, or devluation - which will tend to lead to inflation.

Purchasing Power Parity:  this theory is derived from the fact that, in the long run, we would expect the exchange rate to adjust to actual trade flows, rather than to capital flows, since the latter should ultimately reflect the international competitiveness of the economy.  If trade were all one way (all imports, for instance, and no exports) then the exchange rate would depreciate, since  more people would be trying to sell the currency than trying to buy it.  On the other hand, if trade were all exports and no imports, then the exchange rate would be expected to appreciate.  When in balance, imports will equal exports, and the exchange rate will be stable.  What this means is that exchange rates will tend to adjust (in the long run) so that the prices of tradable goods are the same in all countries in the trading world - so there is no incentive to buy in one place and sell in another. So long as there is no other intervention (taxes or subsidies etc.) in the domestic markets, then prices  will be the same valued at the so-called purchasing power parity rates. The Economist regularly approximates these rates by calculating the exchange rates which would have to hold if the price of a Big Mac hamburger were to be same the world over (assuming that Big Mac hamburgers are essentially tradable).  See here for the latest version of this calculation, and the explanation.

NOTE:  the capital account is typically much larger than the current (trade) account. Capital inflows and outflows dominate export and import flows, so the exchange rate is typically very sensitive to capital movements, especially short term capital flows (unless these are controlled).  This can cause serious short term problems:
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5.    MacroEconomic Management: 

Economies tend to cycle between booms and recessions: Counter-cyclical macro-management:  (trying to actively predict and counter-act these cyclical tendencies)  Problematic because: Active counter-cyclical management tended to exacerbate rather than ameliorate economic cycles  - boom/bust economies.  Prefered option now: Inflationary (boom) situation:

Deflationary (recession) situation:
Deflationary Picture

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