MACROECONOMICS PROBLEMS

-CORE-Kalaiyarasi Danabalan

A’ Level (Economics)

CONTENT

• Inflation

• Balance of payments problems

• Fluctuations in foreign exchange rates

INFLATION

• Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.

• When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money.

CALCULATING INFLATION

• Rate of inflation is measured by calculating the percentage price increase in goods and services over a period of time.

• Inflation is measured through a Price Index. The economists monitor the price changes of a collection of goods & services over a period of time.

• There are different Price Indices that can be used, the most popular are:

Consumer Price Index (CPI) – measure the price of a selection of goods and services for a typical consumer.

Producer Price Index (PPI) – measures the prices for all goods and services at the wholesale level. It is like the consumer price index but it is measuring the prices the producers have to pay.

MAIN CAUSES OF INFLATION

• Quantity Theory of Money

• Cost-push Inflation

• Demand-pull inflation

DEMAND-PULL INFLATION

• It’s occur when there is services in an total demand for goods and services in an economy.

• Increase in demand ‘pulls’ prices upwards if the economy does not have spare capacity to meet these increased needs.

• When an increase in consumer spending (often government induced) at a time of low unemployment has pulled up the price level.

Demand pull inflation is caused due to the changes in the determinants of AD. Whenever, any of the components of AD (i.e. consumption, investment, government spending and net exports) will increase, this will result in an increase in aggregate demand.

COST-PUSH INFLATION

Increase in cost of production will result in cost push inflation. As the cost of production increases, the firms will reduce supply. The main reasons why costs might rise are

• increases in wages and salaries (the biggest cost of production economy wide);

• increases in the cost of raw materials

• increases in the price of imported goods (either as finished goods, semi-finished manufactures or raw materials) due to a fall in the value of the price rises in the country of origin

• increases in indirect taxes (or reductions in government subsidies).

QUANTITY THEORY OF MONEY

• Monetarists believed that sustained inflation would only occur if there was an increase in the money supply. The 'Quantity Theory of Money' can be used to explain the monetarists' point of view.

• If V is constant and y is at least predictable, then any significant change in M will cause a similar change in P. So large rises in the money supply (M) cause large rises in the price level (P).

Effects of Hyperinflation

• Money will be losing purchasing power.

• People will lose confidence in money & may even go back to barter for their day-to-day needs.

• People become dissatisfied with the government’s failure to control the high rise in prices and may look to parties offering radical solutions to the problem

• Shoe leather cost - cost of time and effort (more specifically the opportunity cost of time and energy) that people spend trying to counter-act the effects of inflation

Balance of Payment

• All the transaction that take place between residents of their country and all other countries in the rest of the world.

• This is recommended by the International Monetary Fund (IMF) and permits economists to make international comparisons.

• The balance of payments consists of the current account , capital account and the financial account.

Components of Balance of Payment

The current Account

It includes

• Trade in goods: visible account. It covers items that can be touched, weighted or counted as they are traded.

• Trade in services: Its cover exports and imports of services. Its invisible account consists of transport, tourism and insurance etc.

• Net Income flows: Income flows consist of wages, interest and profits flowing into and out of the country.

• Current transfers of money: Government contributions to and receipts from international organisations and international transfers of money by private individuals and firms

Capital Account

• It records flow of funds, into the country (credits) and out of the country (debits), associated with the acquisition or disposal of fixed assets.

Financial Account

• Its known as the capital account. It records the flow of money in and out of a country because of investment, other financial flows.

http://www.youtube.com/watch?v=amvwQvRFiQg

BALANCE OF PAYMENTS PROBLEMS• Balance of Payments is an accounting record of all monetary transactions

between a country and the rest of the world.

• BOP is a record which countries use to monitor all international monetary transactions at a specific period of time.

• All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country

• If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit.

• Usually, the Balance of Payments is calculated every quarter and every calendar year.

Equilibrium in the Balance of Payments

• Its refers to a situation where manageable deficits are cancelled out by modest surpluses over a period of time. Two situations of equilibrium are described below:

a.) where the imports of goods and services exceeds exports but where this is offset by an inflow of foreign direct investment.

b.) where the exports of goods and services exceed imports but where there is substantial investment abroad by companies and residents.

Disequilibrium in the Balance of Payments

• over a particular period, a country is recording persistent deficits or surpluses in its balance of payments. It has to be recognized that the exchange rate is either overvalued or undervalued on the foreign exchange market.

• Disequilibrium in the balance of payments can arise where:

a)The imports of goods and services exceed exports and the financial account is in deficit.

b)Exports of goods and services may just exceed imports but there is a persistent deficit on the financial account.

c) There is a large surplus on the current account, generating an overall balance of payment surplus.

Causes of Balance of Payments Disequilibrium • The economy has a high propensity to import goods.

Consequently, substantial deficit are recorded annually on the trading account.

• There may be lack of confidence in a particular economy, resulting in a few capital inflows. There may even be an exodus of capital from the economy.

• From a shorter-term standpoint, a period of expansion in the macroeconomy, leading to increased consumer spending power, could produce a situation where much of this is spent on imported rather than locally produced goods

FLUCTUATIONS IN FOREIGN EXCHANGE RATES

• Nominal exchange rates

The price of one currency in terms of another. Changes in the nominal exchange rate of one country’s currency with that of another will affect the transaction price of goods and services bought and sold between these two countries.

• Trade Weighed Exchange Rates

Changes in the nominal exchange rate of one country’s currency with that of another will alter the price of goods and services traded between these two countries.

CAUSES OF THE FLUCTUATION IN CURRENCY VALUE

• Changes in the imports and exports of the country

• Changes in Interest rate.

• Changes in Inflation rate:.

• Rise in domestic income relative to incomes abroad:

• Investment opportunities.

• Speculative sentiments.

• Global trading patterns.

• Changes in relative inflation rates.

Effects of Changing Exchange Rates on the Economy

Scenario 1- Currency depreciates

• A depreciation in exchange rate should lead to a rise in demand for exports and a fall in demand for imports – the balance of payments should ‘improve’,

• Exports will improve, this will lead to more output, more employment will be created thus economic growth will be achieved. However, exports is a component of AD, an increase in exports will lead to the shift of AD to the right and might also lead to inflation. The economy might also suffer from ‘imported inflation’ as imports are now expensive due to depreciation of your currency.

Scenario 2 – Currency appreciates

• An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in demand for imports – the balance of payments should get ‘worse’.

• When exports fall, real output will fall which leads to unemployment. Economic growth is compromised and the economy may suffer from ‘deflationary gap’.

• However, The volumes and the actual amount of income and expenditure will depend on the relative price elasticity of demand for imports and exports.

Video Clip

http://www.youtube.com/watch?v=EHf6n_JXMAE

http://www.youtube.com/watch?v=pzjEWHO7tfI

http://www.youtube.com/watch?v=--Z1W4i2lxY

http://www.youtube.com/watch?v=XitV1hn36Lc