Model worker

While I remember, I want to jot down a couple of points about the two macroeconomic models I have found to be of the most practical use in looking at policy and performance in emerging economies: the full Keynesian domestic economy model, which brings in flexible prices and depends on particular view of how firms are likely to respond to changes set off by a change in demand; and the Keynesian open economy model in the short run, which is for economies in which international trade is significant component. It assesses the likely impact and effectiveness of monetary and fiscal policies—the two main levers of policy control—when the exchange rate of a country’s currency is kept artificially fixed against the currencies of the outside world and when it is allowed to float. These models are best "applied" separately, even to the same economy, in order to simplify the analysis of the expected lines of causation.

ISLMAS(K)AD. In contrast to the situation when we are looking at the knock-on effects of demand changes on the goods and financial markets of the domestic economy only, the introduction of the possibility of changes in the price level produces two new effects for policymakers to consider. In the first, [and in addition to the feedback loops set off between the goods and money markets through changes in interest rates and national income,] a price change caused by a rise in demand in the goods market, reflecting perhaps a fiscal expansion, erodes the real money supply, altering the equilibrium conditions in the money market—that is, its shifts the LM curve down, wiping out some or all of the gain in output from the original change in demand. The second is the effect of a change in the price level on the labour market, understood as working in a particular way. The key features of this model, which give rise to its distinctive results, are the assumptions of flexible prices in combination with "sticky wages"—that is, when nominal wages take time to adjust to changes in the price level, either up or down. Assuming that there is spare capacity in the economy, a boost in government spending or a cut is taxes will push up demand for goods and services, but it will also push up price growth. If the nominal wage fails to adjust upwards to compensate for inflation, the real wage falls, inducing a rise in labour demand (ie firms find it profitable to employ more staff) and a fall off in labour supply (people want on average to work less). This divergence of labour demand and supply temporarily boosts the level of employment and so, as conditioned by a definite level of technological development, economic output and income. At the same time, it reduces the level of involuntary unemployment. In modern economies, at least until the great economic crisis of 2007-09, this was the direction of price movements that interested economists, as it matched, for a time, the broad empirical trends of the economies in which they found themselves. However, I think I'm right in saying that Keynes emphasised the "downward stickiness" of wages, as, writing in the 1930s on the events of the Great Depression, what interested him was, understandably, the impact of deflation, which he identified as a trigger of the intractable and socially damaging problem of high and enduring unemployment. This was because institutional and legal factors prevented money wages from adjusting to a fall in prices by falling themselves, as predicted in classical economic theory. In turn, this tended to boost the real wage and so induce a fall in labour demand from firms and a rise in labour supply, at once reducing both employment and output, and amplifying "involuntary" unemployment.

Because the model sets out systematically the relationships between a large number of variables, it is a helpful framework for looking at a wide range of phenomena relevant to assessing the health and stability of economies, from demand-pull inflation and hyperinflation, overheating, soft and hard landings, to the co-ordination of policy with economic recoveries and slumps.

ISLMBOP. In an open economy, which incorporates the impact of inward and outward/net currency flows on the financial and goods markets, fiscal policy is powerful when the country’s currency is set at a specific rate, whereas monetary policy is relatively ineffective. If the authorities allow their currency to find its own level, however, without interfering by buying or selling on the currency market, then the reverse is true: the impact on monetary policy in enhanced and that of fiscal policy weakened. The reason for this is that

Looking both ways

Question: How does a closed economy adjust to shocks from the outside or to economic policy changes in the short run? Why is using the ISLM a more sophisticated and useful approach than looking at the real and financial sectors separately?

ISLM: internal macroeconomic adjustment in the short run

An alarming slowdown in economic growth gnaws away at business confidence, so that increasing numbers of firms lose faith in their ability to hit next year's sales targets, leading them to hold off on investments that would otherwise have gone ahead, depressing economic growth still further. Or instability in the financial markets sees more investors cashing in financial holdings so as to avoid the chance of a fall in their value. It is the macroeconomic implications of scenarios like these that the forbiddingly named ISLM framework helps us to analyse systematically. By selecting the most relevant economic indicators and sketching the expected relationships between them, this framework helps us to trace through the rest of the economy the knock-on effects of destabilising economic developments, such as the ones above, and to work out the kinds of results that we might expect from policy responses to them. The most important variables include the rates of growth of government spending, household consumption, private investment expenditure, and the national output of goods and services. Important, too, are changes in tax rates, money holdings and interest rates. Over a longer period, changes in the price level would be included on this list. When looking at imbalances in the goods and the money markets taken separately or together, the crucial difference is that, in the second case, there are feedback loops between them, going in both directions. The key link by which imbalances in the real economy are transmitted to the financial sector is between the economic activity (or output) and money demand. Imbalances originating in the money market affect the production of goods and services by way of changes in short-term interest rates. And just as we conventionally show the main relationship as between output (Y) and the price level (P) in graphical form when looking at aggregate demand (“PY space”), so it is useful to illustrate the two-way links between the goods and money markets as a relationship between output and short-term interest rates (“IY space”), because these, as I have said, are the main channels through which changes in one market are transmitted to the other. Thus, the IS schedule (the letters stand for “investment” and “savings”) is simply a graphical summary of all possible combinations of interest rates and national output in which goods demand and supply just balance. It incorporates much the same information as in the PY or aggregate demand diagram—since aggregate demand is affected by changes in both the goods and the money markets—but is examined from a different angle so as to bring out the interlinks between the domestic economy’s component markets. As lower interest rates encourage borrowing by firms and households for investment and consumer purchases—and thus also higher levels of economic output—the IS curve is negatively sloped: as interest rates rise, investment, and so economic output, falls. Likewise, the LM schedule (standing for “liquidity preference”, or money demand, and “money”, or money supply) represents all the combinations of interest rates and output in which money supply and demand are in balance. In contrast with the IS line, the LM schedule is positively sloped: as output rises, it takes higher interest rates at every level to equate money demand with a (nominal) money supply that is centrally fixed. Movement along the curve can be read as showing that higher money demand is associated with increased rates of growth in national income—that is, to facilitate the rise in the number of transactions—but that higher rates of interest are required to maintain balance with the fixed money supply. The point of crossover of the two schedules thus represents the unique rates of interest and output growth needed to keep both markets in balance at the same time.

By goods alone: IS

One way to proceed is to contrast the results to be expected following the combined and separate adjustment to developments that upset balance in either market. In the real domestic economy, the kinds of changes that could affect the level of demand for goods and services include alterations in the pace of growth of private investment, household disposable income or government spending. It would also include changes in tax or savings rates, or in the responsiveness of private investment to changes in interest rates. (Reforms of public spending or of the rates of taxation—fiscal policy—are the main policy instruments used by the government to influence activity in the real sector.) Changes in the first set of factors would affect the position of the IS curve, shifting it up or down, boosting or sapping demand for goods and services—and thus the growth rate of national output—at all interest rates. Changes in the second set would tilt the IS curve so that it becomes flatter or steeper. A flatter IS curve implies that only small changes in interest rates are needed to induce a relatively large increase in investment demand. A steeper curve means that even large changes in the interest rate are able to induce only a small change in desired investment. (The slope of the IS curve might be said to reflect the level of development or friendliness of the business environment.) In the short run, changes in domestic spending mean that some combination of firms, households and the government together plan to buy more or fewer goods and services than are currently being supplied. Such a change tells domestic producers whether to make more or fewer products. In this relatively simple model of the domestic economy, firms are assumed to be able to respond unproblematically to imbalances in the goods market by adjusting production for the inputs they need: they supply just as much or as little as is desired.

Money alone: LM

In the financial sector, three factors are typically cited as capable of igniting disturbances. In each case, any imbalance in the money market triggers changes in interest rates, which ensure that a new equilibrium level, higher or lower than the initial one, is achieved. The first factor is a change in the pace of growth of economic activity. For example, a splurge in consumer spending—say, in the run up to Christmas, or ahead of a rise in value-added tax (VAT)—boosts aggregate demand and hence the rate of growth of national income, simultaneously pushing up the demand for money to carry out these additional buys. The LM curve shifts up and left. A second important destabilising factor would be any trend towards holding more private wealth as money. Such a rise in "liquidity preference"—say, in response to high volatility in bond markets, as in my opening paragraph—would likewise shift the LM curve leftwards and up, also by setting off by unbalancing rise in monetary demand. A third important factor that can produce money market imbalance is a change in the growth of the real money supply. In the short run, when prices are fixed, this is identical with the growth or contraction of the nominal money stock, which is controlled by the central authorities as a tool of (monetary) policy to influence other economic indicators, such as the short-term interest rate, or, over the longer term, the pace of growth of the general price level. Typically, it does this by buying or selling government securities (bonds and bills), which increases or decreases amount of cash in the financial sector, pushing interest rates down or up. The excess money supply linked to faster growth in the stock of money in the economy disturbs equilibrium in the money market, triggering a shift in the LM curve, this time rightwards and down, so that money market balance is restored: a reduction in the interest rate induces a switch from less attractive interest-bearing bonds to cash, so that money demand rises to the point where it just offsets the increase in the money supply, restoring money market balance.

Both together: ISLM

Probably the clearest example of the distinct result of the interaction of the goods and money markets can be seen by working through the knock-on effects of a change in demand. From such a change, the main conclusion is that impact of the multiplier, whether positive or negative, is dampened by the interaction with the financial sector, because of the two-way feedback loops between the goods and money markets.

Causes. A rise in demand could be the result either of putting more money into the circular flow of income or of withdrawing less from it. In a closed economy, this might result, for instance, from an increase in government spending, or a tax cut (which would leave households with a larger slice of their income to divide between spending and saving, in this way, assuming that the ratio between them stays the same, boosting consumption demand). Such measures featured heavily in the many "fiscal stimulus packages" that have been implemented by governments around the world since 2008 in an attempt to counter the impact of a sharp drop in foreign demand set off by the global economic crisis. A boost to domestic demand might also stem from an improvement in business or consumer confidence, lifting investment and consumption demand, perhaps because the outlook for economic growth has substantially brightened, or because the latest figures show employment growing more briskly than expected.

Mechanism. An increase in spending and/or confidence boosts aggregate demand, though the rise in output is larger than the original impetus because, along the way, the original sum becomes someone’s income and they, in turn, spend a proportion of it, creating additional goods demand. In the short run, however, with prices relatively rigid, the rise in demand induces only an increase in economic output and the IS curve shifts right: output is higher at all interest rates. But that's not the end of it because the expansion of economic activity shows up in the money market as an increase in demand for money, which is needed to cope with the increased number of transactions. With wealth split, for analytical purposes, between money and bonds, saying that there is an excess of demand for money is the same as saying that there is an excess supply of bonds. With bond offerings exceeding planned new bond purchases, bond prices fall and the yield on bonds moves in the opposite direction—ie the interest rate rises. (Another way or seeing it is that interest rates rise because, in the case of bond-financed government spending, government borrowing bids up the cost of borrowing by creating additional demand for the supply of loanable funds.) This restores balance in the money market by choking off the increase in money demand to equate it to the nominal money supply, which is fixed by the central monetary authorities. At the same time, some business projects are rendered unattractive by the rise in interest rates. This discourages some private investment demand ("crowding out"), reducing aggregate spending and shifting the IS curve somewhat back left. Thus the conclusion is that the full impact of the multiplier on national output is dampened by the feedback loop in the financial sector. This also works the other way, so that the same mechanism will ameliorate the impact on the real economy of a drop in demand. The result contrasts not only with the outcome expected in the goods market taken in isolation, where the impact on the multiplier unfolds fully, but also, looking ahead, with the expected outcome of macroeconomic adjustment over the longer term, once the effect of the inclusion of the domestic labour market is taken into account where fully flexible wages and prices ensure that a boost to government spending produces no increase in output or employment at all (at least, with the classical or monetarist versions of the supply curve). Instead, all of the adjustment takes place in the form of faster price growth and the complete crowding out of private investment. From the point of view of disturbances originating in the financial sector, such as a loosening of monetary policy to try to “jump start” the economy to offset an economic slowdown, or a change in the pattern of distributing assets between money and other forms of wealth, in the first case would see the LM curve shift right, reducing interest rates and pushing up investment demand, which in turn pushes the curve back in the direction it came from.

Practical application

Under what circumstances might such a model be of practical use? A practical use of such a model would be when the international context is either a small or negligible factor for the economy in question, or the international trading environment is stable. This would include countries with economies characterised by a relatively low level of trade of integration with international financial markets. In countries in which the capital or debt markets are underdeveloped, the feedback loop between goods and financial markets is inhibited and the financial sector is an ineffective medium for transmitting official interest rate policy.

Tell me, what is real?

Chapter nine of the WinEcon program, the first of the macroeconomic sections, turns immediately to some of the basic issues and indicators—interest rates, GDP growth, inflation and the balance of payments—with which macroeconomics deals, as well as some of the tools used to manipulate, describe and analyse them. This is used as a way of introducing some important definitions and distinctions concretely.

Kinds of variables
The first such distinction is between variables that show a pattern of increase or decrease over time (trended variables) and those that show no consistent long-term pattern (non-trended variables). The former include GDP and its components, inflation and the money supply; the latter include ratios such as unemployment rates, interest rates and exchange rates. A second basic distinction is between nominal variables, which measure changes in value, and real variables, which measure changes in volume or physical quantities. Ratios constitute a third category of variable.

Calculating real interest rates
This distinction between nominal and real is investigated in relation to interest rates, which indicate the scale of return on lending, or the cost of borrowing. A nominal interest rate is a ratio of asset yield to asset value (the asset could be a loan, for example), whereas the real interest rate—which takes into account movements in the price of goods and services—is a measure of the extra quantity of goods and services that can be bought from the loan plus the return. An approximate measure for calculating real interest rates is therefore the nominal interest rate minus the rate of inflation; the formula for a more accurate calculation is as follows:

Real interest rate (RR) = (1 + nominal interest rate/1 + inflation rate) -1

Therefore, if the annual nominal interest rate is 10% and the annual inflation rate is 6%, the crude measure gives a real interest rate of:

RR= 10 - 6 = 4%

Using the more accurate measure, the calculation is as follows:

RR = (1 + 0.1/ 1 + 0.06) -1 RR = 0.0377358—ie 3.77%

That is, rather than getting 10% more goods and services for the 10% return on your loan, with an inflation rate of 6%, you only get 3.77% more goods and services.

High inflation rates can turn real interest rates negative, with potentially profound economic consequences—helping to explain fluctuation in investment across time, for example. The pattern of interest rate developments in a selection of developed Western countries over three decades shows, broadly, that real interest rates were:

• low but positive in the 1960s;
• negligible to negative in the 1970s; but
• relatively highly positive in the 1980

Detrending GDP
Next, the program looks at three ways for analysing the patterns of economic growth, introducing the idea of detrending—a method by which any cyclical changes in trended variables can be separated out from the trend itself (this is useful when looking at short-term fluctuations in aggregate data).

Deviation of GDP from the linear trend. One method for detrending is to fit to observations of the level of GDP a line that minimises the sum of the squared deviations. The pattern of deviations from this line, when graphed, brings out the periods in which growth is above or below trend. (The formula for calculating the percentage deviation from trend level GDP is as follows: [real GDP - trend GDP/ trend GDP] x 100.) Looking in this way at the components of GDP by expenditure for the UK for 1955-2004, we can see that:

• household consumption grew at a rate below trend between 1975 and the late 1980s, but above trend since the late 1990s;
• government consumption was below trend for most of the 1990s, but above trend since the coming to power of the Labour Party in 1997;
• the growth of exports has been above trend throughout the 1990s; and
• the pattern of investment growth has been more erratic.

Deviation of natural log of GDP from the log-linear trend. If a variable grows at a constant rate, however, a second method can be used to get an accurate picture of patterns of change separate from the broad trend, which is to log the trend to produce an analysable linear graph, and then calculate the deviation of the logged GDP data from it. (We calculate the percentage deviation from a log-linear trend as follows: [natural log of GDP - log of trend] x 100.)

Period GDP growth rates. A third, more widely used, approach for separating out patterns of change in trended variables from the trend itself is to use growth rates of GDP in each period, with periods of high positive growth indicating a boom, and periods of contraction (typically, three quarters in succession) indicating a recession.

Constructing a price index
Inflation is the rate of change of the average price level (whereas hyperinflation is defined as persistently high rates of inflation, typically stemming from the inability of the authorities to tax and borrow amid generalised societal breakdown, often as a result of war, civil war or revolution). To get a realistic picture of inflationary patterns, it is important that the weighting of the goods and services in the price index reflects their relative importance in current patterns of spending, since these change over time. The first method, a base-weighted index, asks the question: How much do you have to spend, measured in the prices prevailing in each subsequent period, to buy the same quantity of goods as in the original, base period? A second method, a current-weighted index, asks: What would spending be if prices had stayed the same? The important GDP deflator is a ratio of the sum of the current values of all goods and services that make up GDP to the sum of the value of the same output in constant (base-period) prices, and it is used to work out real rates of economic growth.

The impact of devaluation on the balance of payments
The balance-of-payments records an economy’s transactions with the outside world, and may be used, among other things, to produce a picture of the geographical distribution of a country’s most important markets and suppliers. The balance-of-payments accounting framework may also be used to analyse the likely impact of using a devaluation of a fixed-exchange rate to address persistent external deficits—which should make exports cheaper and imports more expensive, stimulating and discouraging them, respectively, in order to close the external gap. Looking at the empirical results of just such a devaluation in the UK in the late 60s, we see that the external position temporarily worsened before it improved (the so-called J-curve), because both foreign and domestic demand takes time to adjust. In the short run, export quantities and prices in local-currency terms are unaltered; import quantities too are fixed, but local-currency prices for foreign goods and services rise straight away, so that the external imbalance is initially exacerbated. In the long run, however, export quantities increase and those of imports fall, as expected, reducing the external deficit.

Co-movements
A final section touches on the interesting and important topic of the interaction between macroeconomic variables, both within the domestic economy and between national economies. Plotting a scatter point diagram of GDP growth against a number of other domestic economic variables, the degree of correlation between them is indicated by the closeness of the co-ordinates to the best-fit line through the scatter points.

• A best-fit line with a positive slope indicates a pro-cyclical relationship—that is, one in which both variables move in the same direction. Those variables with the strongest pro-cyclical relationship with economic growth empirically include consumption, investment and imports.
• A negative slope indicates a countercyclical relationship, which means that a rise or fall in GDP growth is associated with a fall or rise, respectively, in the other variable. Empirically, changes in the rate of unemployment and inflation exhibit just such a relationship.
• When the best-fit line is horizontal, the relationship is described as acyclical, and no systematic relationship is discerned.

Correlations are scored between +1 and -1; the closer the correlation is to +1, the closer the scatter points to the positively sloping best-fit line, with a score of +1 indicating a perfectly positive correlation, in which all of the scatter points coincide with the best-fit line.

However, the linked movements of one macroeconomic variable and another are not always simultaneous. Sometimes a change in a variable occurs before a change in economic growth, and leads it; sometimes the change happens after a change in GDP, lagging it. Making an allowance for possible leads and lags in this way helps to untangle evidence regarding the difficult question of cause and effect.

GDP growth and interest rates. The relationship between economic growth and the Treasury-bill rate shows a strongish countercyclical lead movement, suggesting that an increase in the interest rate is associated with reduced output growth in the later period. The contemporaneous relationship is weakly pro-cyclical, but this strengthens when the variables are lagged, yielding some evidence that increased output growth pushes up interest rates, although with a delay.

GDP growth and changes in the unemployment rate. There is strongish countercyclical relationship when the variables are contemporaneous, which strengthens when the variables are lagged—that is, the rate of unemployment falls with rising economic growth, and this effect becomes more powerful over time.

GDP growth and inflation. An empirical investigation between output and inflation in the UK in 1951-93 reveals the interaction of the two to be slightly more complex than expected—specifically, there is a positive short-run connection between output growth and lagged inflation, but with periodic shifts, so that increases in output growth in the sub-period 1975-82 are associated with much larger increases in lagged inflation than for either 1951-74 or 1983-92.

Money supply and inflation. The strongest positive correlation between the rate of growth of the money supply is seen when plotted against data for the rate of inflation lagged for two years.

GDP growth and growth in other economies. Here, the question is: To what extent are booms and recessions transmitted? This depends on the degree of openness of a national economy to world trade and who its main trading partners are, which is often linked to geographical proximity. Thus, the GDP growth of the UK is most strongly positively correlated to economic growth developments in the US, Japan and France; for the US, GDP growth is most strongly linked to economic growth in Canada; for France, Italy; for Japan, Germany.

Measure for measure

"for with the same measure that ye mete withal, it shall be measured to you again"

Economic growth is defined as the rate of increase of output over a set period of time. In the EU at least, following the widespread adoption of the European System of Accounts (ESA 95)—which the UK did in 1998, for example—the standard measure of economic development is gross domestic product (GDP) at constant market prices.

GDP measures the value of final goods and services produced in the domestic economy in a given period of time, usually one year; it includes indirect taxes, net of any product subsidies (this explains the “market prices” bit).

By stripping out from the money value of current production—or nominal GDP—any changes in the average price level in the economy between one year and the next, we are able to derive real or volume data. One method for doing this is to value the output of a later year using the prices prevalent in the earlier or base year. By comparing the change in the level of real GDP between periods, we are able to calculate real rate of change of GDP per year (this explains the “constant” bit). Other measures of output, less common nowadays, include gross national product (GNP), which takes into account the net flow of resources into or out of the economy, and national income (net national product, NNP), which includes depreciation.

Typical conceptual criticisms of GDP as a measure of economic growth are that it fails to take into account what is not bought or sold—valuable non-market services such as housework, for example. It also fails to encompass the benefits or costs associated with the growth process: the positive or negative economic utility value of leisure or pollution, for instance. Consequently, measures such as net economic welfare (NEW) have been proposed to overcome some of these problems, but have not tended to catch on—so far, at least. Additionally, any attempt to measure growth is compromised by the fact that the permanent innovation (which is intimately linked with economic growth) makes comparisons of the value of products across time difficult or, if a new product allows an activity that could not previously be undertaken, impossible.