Practical macro

Some quick, simple, but useful points on macro to remember

1. Different versions and combinations of models are suitable for looking at different circumstances or problems. Lots of ways of dividing the cake. One way:

• For looking at impact of short-term domestic policy or shocks from demand side: simple IS-LM.
• For looking at impact of short-term policy or shocks in an open economy from demand side: IS-LM-BoP.
• For looking at domestic economy with demand and supply sides integrated: IS-LM-AS-AD.

2. What are the main indicators relevant for working with these models?

• GDP (by expenditure, C, G, I; by origin; confidence indicators), employment, wages
• Inflation: consumer (food, non-food, services, core) and producers
• External: trade, current account, capital flows, debt
• Exchange rate: nominal, real, real effective
• Monetary policy: interest rates and tools
• Fiscal policy: government spending and tax

3. Aggregate demand (AD) curve incorporates results from adjustments in the goods and money markets, but by looking at how this affects the relation between prices and output/jobs (PY space), rather than the relation between interest rates and output/jobs focussed on in IS-LM (IY space).

AD curve can shift because of by developments in the goods market [IS; changes in C+G+I+(X-Z)] or in the money market [LM; policy change on Ms or affect income/interest rates on Md]

Rising prices are anti-growth because i) it erodes purchasing power of consumers' nominal income and ii) it makes borrowing more expensive for firms (and households), as effective cut in the real money supply puts up interest rates. Both reduce output/jobs.

4. The importance of consumer and business confidence/ sentiment as "autonomous" components (that is, not assumed to be directly influences by changes in income and interest rates) that shift C and I up or down, depending on outlook for economic performance and policy; specifically, how the might affect income/ tax payments and job prospects for consumers; for business, how news on growth, employment, budget, inflation, debt, tax changes, exchange rates, current account but affect their operating outlook and so income/sales.
 

5. The importance of an undesired build-up of inventories or a swift drawdown on stocks and an indicator of business confidence—but to be interpreted in the broader macro context.
 

6. "Twin deficits" can be linked via bond-financed budget deficits, but only for textbook/advanced/ safe-haven countries in this way:

• Government demand for loans to cover the shortfall in public finances pushes up interest rates for "loanable" funds.
• But higher than average interest rates means high than average returns on investment internationally, so that more foreigners start to buy local currency to reap higher returns.
• On the one hand, this leads to appreciation of the local currency, so that the trade balance "tends towards deficit".
• On the other hand, the accumulation of local currency/assets by foreigners often returns to "safe-havens", as loans or capital inflows, which reduces interest rates for "loanable" funds.

 

In theory, therefore, bond-financed deficits are relatively cost-free for these kinds of countries (eg the US and Germany). Examples: China to the US; Germany to the rest of western Europe. In standard notation:

(G-T) = (S-I) + (Z-X)

Which means:

Budget balance, or the demand for loans = domestic loan supply available + foreign loan supply available