1. The Link between Microeconomics and Macroeconomics - General Equilibrium in all markets
2. Macroeconomic Basics - the Circular Flow of Income (CFoI), with Government and Fiscal Policy
3. Macroeconomics of Money Money Markets, Financial Markets and Capital Markets - and Monetary Policy
4. Macroeconomics of Money with the CFoI( IS/LM): Monetary and Fiscal Policy to achieve Macroeconomic equilibrium (low Unemployment and low Inflation)
5. Macroeconomics of International Trade - The Forex market
6. MacroEconomic Management:
• The Basics - using the IS/LM model
• Which of Fiscal or Monetary Policy is more effective?
• Inclusion of the Forex market.

1.    The Link between Microeconomics and Macroeconomics - General Equilibrium in all markets and Value Added

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The general picture of interacting markets - the circular flow of income:

• Households own the factors of production (land - including raw materials, labour, management and physical capital).
• Note - capital here means physical capital - plant, equipment, buildings and machinery etc. (c.f. financial and money markets below)
• Households rent these factors to firms, in return for income:  land rents; capital interest and dividend payments, and equity appreciation (capital gains); wages and salaries.
• Factor ownership provides income which fuels consumption and demand in the goods and services markets
• Firms rent the factors of production from households according to their demands for these factors, which is derived from the demands for the final goods and services
• Factor markets operate so as to encourage the owners of land, labour, manaement and capital to rent out the services of the factors to the highest bidder
• Firms add value to their own purchases of inputs and raw materials. They earn gross margins (total revenues minus cash input costs [fuel, power, packaging etc.] which is the value added to these inputs.  The Gross margin, or added value, or gross product (each term means essentially the same thing for our purposes) is the income available to the fixed factors - land, labour, management and capital.
• In equilibrium, these returns will be normal profits - each firm earning sufficient to cover the opportunity costs of the factors of production which they employ.

[Note:  profits in the everyday sense are, typically, just the returns to capital - the earnings of the firms which are left after all other legitimate costs (including labour and management costs) have been deducted.  For self-employed family businesses, taxable profits will include the returns to the owners own labour and management, as well as returns to the owners land and capital, less allowable expenses in servicing mortgages, loans and debts.]

The UK food chain illustrates the outcome of this circular flow of income.
Agricultural and Food Chain, UK, 2000
Farms produce £15.3 bn. of output, of which £8.7bn. is spent on purchased inputs, leaving £6.6bn. as the gross product (gross margin) or returns to the factors of production (land, labour, management and capital).

• The farm sector generates incomes to all those with a direct interest in farming - the labour, owners of the capital (including the banks and their shareholders), the owners of the land, and the managers and farmers themselves.
• Likewise, the input supply industries also process their own inputs, using their own factors of production, producing their outputs (purchased by the farm sector) and generating their own incomes to land (including natural resources), labour, management and capital.
• Farm Output, in turn, is further processed by the Processing, Distribution and Retailing (PDR) sectors to generate both incomes to their own factors, and also the final output purchased by the final consumers.
• Thus, the final consumption figure (£123 bn.) represents the cumulative total of all values added throughout the food chain, and hence represents the total cumulative income earned by all those engaged, both directly and indirectly, in the food chain.
• Note that imports generate incomes in other countries rather than the UK, while exports generate incomes in the UK.

• Each of these flows (measured in £ bn.) represents a large collection of individual trades (prices times quantities): P x Q
• Flows change through time because both prices and quantities change: P1 x Q1 different from P2 x Q2
• Comparison between different years (periods) compares both price and quantity changes
• Prices represent that rates at which quantities of one good or service are exchanged for other goods and services - including the services of factors of production (land, labour, management and capital), whose prices are rents, wages and salaries, and rates of return to capital.
• With prices set at some given, fixed level:  quantities then represent real income and real output of goods and services - the actual quantities of factor services which can be traded for the purchase of actual quantities of goods and services - the purchasing power of each good or service in terms of all other goods and services.
• To measure these real quantities,  prices (wages, rents etc. as well as prices of goods and services) have to be fixed at some given level. - Pf. - constant prices
• Comparison of Pf x Q1 with Pf x Q2 then shows the changes in quantities between Q1 and Q2.
• Also, comparison between Pf x Q1 and P1 x Q1 shows the difference in prices between the fixed, constant, prices and those ruling in period 1.
• Notice - simply fixing the price of ONE good (say for fertiliser), allows the actual physical quantities of fertiliser used by farms between years to be measured, but does NOT allow the measurement of the purchasing power of this fertiliser - to measure the purchasing power, we need to fix all prices at some constant level.

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2.    Macroeconomic Basics - the Circular Flow of Income (CFoI)

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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 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 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 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.

Distinguish between

• trend growth (improvement in technology and productivity (outputs per unit inputs)) typically about 2.5 - 3.5% per year
• cyclical growth (or decline) round the trend growth - booms (strongly positive growth rates) and recessions (slower growth rates) or depressions (negative growth rates).

• 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
• 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

• 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.  Otherwise, there is unemployment - the economy could produce more income and output.
• 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.

• 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.

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3.    Macroeconomics of Money

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• 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 - the Bank of England (BoE).
• 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)

Financial Markets  ->  the rate of interest

1. Rate of Interest = price of money:- the cost of getting more of it from banks etc., or the opportunity cost of saving (= storing income as wealth, by owning assets, from savings accounts (loans to other people and businesses) up to land, buildings, and old master paintings)
2. Assets differ in terms of:
• their Liquidity (how easily and cheaply they can be transformed into a certain amount of money (for transactions).
• their Rate of Return - how much they earn in annual interest payments (and how much they will appreciate in value (capital gain).  Higher liquidity typically means lower rates of return.
3. The Rate of Return earned by any asset is fundamentally related to the ratio of the current capital value of the asset (its price for outright purchase now) to its annual return (i).  In general, Present Value of an asset = discounted sum of all future returns (annual payments or Future Values), where the discount rate is the rate of interest.
• The Internal Rate of Return (i) is that rate of interest which makes the present value = the current market price for the asset
• The higher the price (capital value), the lower the rate of return, and vice versa (ceteris paribus)
• The higher the rate of interest, the lower the Present value of assets (their prices)
4. Rates of Return differ because:
• differences between borrowing and lending rates  =  payment for services (which could be charged for separately).
• differences in the risks associated with each different asset. The more risky, the higher the rate of return necessary to persuade people to accept the risk.  Differences in risk also account for differences between banks borrowing and lending rates.
• the value of money itself is not guaranteed - inflation happens.  Uncertainty about future inflation rates, and the extent to which any particular assets annual returns will keep pace with inflation or not (the sensitivity of returns to inflation), also affect the rate of return on assets.
5. In general: the rate of return on any asset  i = r + u + p, where i is the asset's rate of return in current or nominal terms: r is the real interest rate (opportunity cost of money); u is the risk premium for this asset; p is the expected rate of inflation.  [Note:  physical assets also depreciate (wear out and become obsolete), so their value diminishes over time - so their rate of return has to include an allowance for depreciation (d).]

Capital Markets:

Back to Contents.

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4.    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.
 

Back to Contents.

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5.    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 BoE 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

This theory relies simply on the pursuit of profitable trading opportunities - there are at least some people or firms who will take advantage of the opportunities to buy cheap and sell dear and make a profit. If they can, they will, and will go on doing so until the prices (and exchange rates) adjust to remove the profitable opportunities. This pursuit of trading profit is also known as arbitrage - from the same root as arbitrate - to arbitrate between prices on the basis of profit opportunities. It is this arbitrage which ensures, in this simple 'model' or view of the world, the adjustment of prices and exchange rates to make prices the same in all countries - it is only then that arbitrage opportunities are eliminated.
The Economist magazine regularly publishes (at least once a year) its Big Mac index of exchange rates based on this principle - what would the exchange rate have to be to make the price of a Big Mac the same? The answer is a close approximation to the PPP rate between the two countries.
Back to Contents.

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6.    MacroEconomic Management: 

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6.1.    The Basics

• Boom -> rising incomes fueling expectations of further growth.
• 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,
• 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 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:

6.2    Which is more effective?  Fiscal or Monetary Policy?

Slopes of the IS and LM Curves:

The IS curve depends on the sensitivity (responsiveness) of aggregate demand to changes in the rate of interest. It will be flatter the more responsive aggregate demand (the expenditure loop of the CFoI) is to changes in the interest rate. On the other hand, if aggregate demand (consumption plus investment) mostly depend on the current state of the economy and feelings or expectations about future incomes and spending (growth), then interest rates may be relatively unimportant in determining aggregate demand, and the IS curve will be steep.

The LM curve depends on the sensitivity (responsiveness) of money demand to income - the more responsive the demand for money is to income changes, the steeper is the LM curve. It is also the case that the more responsive the demand for money is to interest rates, (the more elastic the demand for money w.r.t interest rates) the flatter is the LM curve.

Scenario 1 - the classic Depression

• If investors are "shy" of investing in expanded capacity because they are unsure about the growth prospects for the economy rather than deterred by the level of interest rates, the IS curve will tend to be steep (Keynes referred to the "animal spirits" of business leaders being more important to investment decisions than the rate of interest).
• If, at the same time, the economy is stuck in a depressed state with consumers tending to save more in the face of uncertainty about the future, hence not increasing the demand for money much as incomes grow, then the LM curve will tend to be flat.
• If, in addition, the financial markets are following traditional patterns of "portfolio management", seeking security and reliability from financial and physical assets rather than "quick" profit or capital gain, then the demand for (speculative or idle) balances will be insensitive to interest rate changes and the LM curve will be flat

Scenario 2 - the more modern economy

• If interest rates are important to investment decisions, then the IS curve will tend to be flatter.
• If incomes are expected to grow and personal savings are largely pre-determined through current income levels (through mortgages, insurance premiums and pension contributions), then increases in incomes may well be associated with substantial increases in demand for money - as discretionary incomes increase. So the LM curve will be steeper since increased demands for money against a fixed supply will increase the interest rate.
• As financial markets become more sophisticated and communications make transactions faster and cheaper, and as the volumes of cash financial institutions have to deal with increase, so financial portfolio management by large companies may become more interest sensitive, making the LM curve steeper.

Effect of inflation: Notice, if there is inflation in the economy, then this will reduce the value of money in terms of its purchasing power, which will mean that more money is required to finance any given level of transactions or level of real national income. This means that the supply of money in real terms is reduced, shifting the LM curve to the left, increasing interest rates and reducing the level of national income.

Inflation will thus tend to reduce income and increase unemployment - so long as monetary policy is kept reasonably tight. Overheating (expanding) the economy will, in these conditions, generate stagflation (both inflation and increased unemployment) - the typical economic condition in the UK during the 1970s.

6.3    Inclusion of Forex Market:

As the economy expands, and national income grows, there is a tendency for imports to expand faster than exports, and for the Balance of Trade to move into deficit. This would lead to a depreciation of the exchange rate. To maintain the exchange rate, the monetary authorities could (should?) increase interest rates to encourage capital inflows and discourage capital outflows on the capital account of the Balance of Payments, thus offsetting the current account deficit.
Thus we may also include an exchange rate equilibrium condition on the IS/LM diagram, which shows this necessary relationship to keep exchange rates constant. This is drawn in the following diagram as the B/C curve - showing an equilibrium exchange rate at some fixed rate achieved through the balance of the Balance of Trade and the Capital account of the Balance of Payments.

Thus, any point to the left of the BC curve indicates a Balance of Payments surplus at that level of Y and r, and an appreciating currency under a floating exchange rate regime. Any point to the right of the BC curve indicates a balance of payments deficit and a depreciating currency. As the currency depreciates, so BC shifts rightwards. As the exchange rate appreciates, so BC shifts left.

This diagram also includes the 'target' of full employment or full capacity National Income (Y*). The implication is that this economy as pictured is not yet at equilibrium at full employment - nor is there yet a consistent equilibrium at any level of national income at which all three major markets (goods, money and forex) will be at equilibrium. It needs managing!  One obvious management tool is to allow the exchange rate to depreciate - shifting the B/C curve to the right.

The market mechanism (under floating exchange rates) can be expected to shift the BC curve to the right, as the currency depreciates towards the money/goods equilibrium (intersection of the IS and LM curves). As it does so, there may be some inflation triggered by the depreciation, which would shift the LM curve to the left, raising interest rates. But this new equilibrium would not be at full employment - it would lie to the left of Y*. The economy would now have to rely on one of two major responses:

• an automatic (market-driven) shift of the IS curve to the right, triggered by the exchange rate depreciation (making exports more competitive and imports less competitive with domestic goods) and  entrepreneurs in the economy taking advantage o spare or idle capacity in the economy and investing in new plant, and also cutting prices to sell unsold stocks (reducing the price level and allowing the LM curve to shift back to the right.
• a proactive monetary and fiscal policy combination - shifting either or both of the IS and LM curves to the right - to hit full employment.