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MACROECONOMICS

Macroeconomics is the study of the economy viewed as a single interactive system. It is concerned, not with individual transactions, but with aggregates, indicators, including GDP, price indices, and unemployment rates. At the theoretical level it seeks to explain the complex relationships between factors such as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. At the application level, it tests competing theories against the evidence provided by economic statistics and estimates the numerical relationships required to construct forecasting models in order to develop policies that could promote full employment, economic stability and economic growth while preventing economic recession and economic depression.

Macroeconomic Theory

The business cycle or trade cycle is a permanent feature of market economies: gross domestic product (GDP) fluctuates as booms and recessions succeed each other. During a boom, an economy expands to the point where it is working at full capacity, so that production, employment, prices, profits, investment and interest rates all tend to rise. During a recession, the demand for goods and services declines and the economy begins to work at below its potential. Investment, output, employment, profits, commodity and share prices, and interest rates generally fall. A serious, long-lasting recession is called a depression or a slump. They highest pint on the business cycle is called a peak, which is followed by a downturn or downswing or a period of contraction. The lowest point on the business cycle is called a trough, which is followed by a recovery or an upturn or upswing or a period of expansion. Economists sometimes describe contraction as 'negative growth'.

Management of the Economy

Tackling unemployment

The classical economists believed that nothing could be done to reduce unemployment except by reducing labour market rigidities. Keynesians believe that any tendency for demand to fall below the level necessary for full employment can be corrected by increased public expenditure or reduced taxation. That would be partly effected without specific government action by the operation of the economy’s automatic stabilisers. Monetarists recommend using a combination of automatic stabilisers and supply-side measures. However, a fiscal stimulus can quickly boost spending power, whereas monetary policy acts with long and uncertain lags. Discretionary fiscal policy has often been used to regulate developed economies but, because of legislative delays it has sometimes had a destabilising effect because the stimulus arrived when activity was recovering. A study by economists at the International Monetary Fund has shown that a fiscal stimulus package equivalent to 1 percent of country's GDP is associated on average with GDP increases of about 0.1 to 0.2 percent. In advanced economies, the longer-term effects are also positive and even possibly higher. But the longer-term effects are typically negative in emerging economies.

Controlling inflation

In the 1970s Keynesian economists considered inflation to be mainly the consequence of existing wage bargaining systems, and recommended incomes policies as a means of control. Incomes policies were tried in the USA and in Britain, but never had more than a brief transitory effect on inflation. On the contrary, their ineffectiveness sometimes generated adverse inflationary expectations that caused people to behave in ways that gave impetus to the growth of inflation. As already noted, attempts to control inflation by setting money supply targets were also unsuccessful. Current practice, described below, uses published inflation rate targets and attempts to meet them using the Central Banks' power to control interest rates.

Current monetary policy

Under normal circumstances, monetary policy is nowadays targeted directly upon the inflation rate and aims to maintain it within predetermined limits. It operates by use of the central banks power to control interest rates. Briefly, an increase in interest rates discourages borrowing and encourages savings. Because borrowers spend more than savers, it discourages consumer spending, and higher mortgage payments reinforce its effect by leaving householders with less to spend. Since it takes about a year for interest rate changes to affect output and two years to affect inflation, policy action depends upon judgements of forthcoming inflation. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market. Regulatory action depends mainly upon empirical data concerning the relation between the inflation rate and the output gap such as is embodied in the Taylor Rule. Under exceptional circumstances such as a severe recession, a credit crunch or an impending deflation, monetary policy may be used to create an increase in the money supply by substantial reductions in interest rates, and - if that action reduces its effectiveness - by the creation of money by a technique known as quantitative easing.

ECONOMIC POLICY

Policy aims
Applied macroeconomics is concerned with the policy aim of achieving stability of
economic activity and of the price level, and with the policy aim of achieving growth of the country's economic well-being. According to the current (neoclassical economics) consensus, both aims are well served by the effective working of competition in markets for goods and services. That is because competitive markets have the flexibility to respond to external shocks to the economy and because they promote economic efficiency and facilitate growth by directing economic resources into activities that improve economic welfare. Consequently, many of the policy actions considered are concerned either with the removal of obstacles to market competition, or with the promotion of economic efficiency in activities that cannot normally be traded (such as defence and public health). The policy instruments by which those aims can be pursued fall into the three categories of public expenditure, taxation and regulation.

Public expenditure
Public expenditure by local and central government is made up of transfer payments (such as social security payments), the provision of goods and services, and subsidies to private sector providers of goods and services. Of particular economic significance are public goods such as the infrastructure, which the market cannot supply because they cannot be bought and sold by individuals. Equally significant are goods that have public benefits which would otherwise be under-provided by the market. An example in the latter category is industrial research which, without government subsidies, would be underprovided because some of its benefits are often copied and thus lost to its providers. Another example is training by employers, which would be under-provided because of the prospect that some employees will leave, taking with them the skills that they have learned. According to endogenous growth theory those factors may be expected to have a determining effect on economic growth rates. Then there are activities such as education and medical care that are directed at the welfare of their clients but which have spin-off effects upon the community in terms of the benefits of living among healthy, well- educated people. Those externalities are held to justify some degree of subsidy, particularly as they may be expected to contribute to growth prospects. In principle, the criterion for each item of public investment is the satisfaction of a cost/benefit analysis criterion, with the amount of investment determined by the requirement that its marginal benefit should be equal to its marginal cost; and public investment that fails that test may be expected to reduce economic efficiency, as may failure to make investments that pass it. In practice, however, the necessary information may be uncertain or unavailable. In practice, also, the total amount of government expenditure may be limited by a budgetary constraint. If public expenditure exceeds the revenue from taxation, the resulting budget deficit has to be financed by borrowing. As noted in the above paragraph on current stabilisation policies, the tendency for deficits to increase during a recession in demand provides a contribution to the maintenance of stability. The resulting cyclical deficit may be expected to be balanced by a budgetary surplus during the cycle's recovery phase, leaving the total of the national debt unchanged. However, it is generally feared that a non-cyclical or structural deficit will have adverse long-term consequences, "crowding- out" private sector investment, increasing taxation, and possibly raising the inflation rate. Although the evidence for those fears is somewhat uncertain, there is a widespread consensus that structural budget deficits should be limited and preferably avoided.

Taxation

There is evidence to suggest that taxation can reduce economic output and growth in a number of different ways. Redistributive taxes can reduce private savings and investment because the rich save more than the poor. Income tax and social security contributions can reduce employment and output because the difference that they create between what employers pay and what employees receive, reduces work incentives. Other taxes can distort supply and demand relationships in other markets to the detriment of economic efficiency.

Regulation
In most countries, regulatory policy has significant positive and negative effects upon economic efficiency, output and growth. On the positive side is the basic framework of laws, regulations and codes of practice without which economic activity on the modern scale would not be possible. Without an effective system of law-enforcement and an accepted way of settling disputes, for example, much activity would be diverted from production and exchange into defence against violence. Also on the positive side – or potentially so – are measures to promote competition, either by removing barriers, as in the case of antitrust or competition policy, or by providing consumers with information that they would otherwise lack, as in the case of product standards. In the case of natural monopolies, and otherwise in absence of effective competition, regulations can be used to limit the extent of anti-competitive behaviour. Growth may also be facilitated by systems of patent law that provide incentives to innovation that might otherwise be lacking. Offsetting the benefits in every case are the costs to companies and individuals of complying with the regulations. On the negative side as far as macroeconomic considerations are concerned, are the many regulations that yield no economic benefit, and those whose costs exceed their benefits. Among them are regulations that prohibit innovation on the grounds of the mere possibility of harm – as advocated in the more extreme interpretations of the precautionary principle – and safety regulations that are based upon mistaken estimates of the expected (probability-weighted) negative value of the events against which they guard.