Boring and confusing…
It may be difficult for many people to keep listening to a speech on a “macroeconomic issue” for one hour without falling asleep. It is such a boring area of economics to talk about inflation, money stock, budget deficit, interest rates and exchange rates. However, it is at the heart of economic management and policy making of a country. For the same reason, investors, professionals and businessmen are always interested to know how the macroeconomic fundamentals work. The subject is very close to the heart and life of an average person from any background so that something from macroeconomics is important to everybody.
It is not only such a boring area of economics, but also a confusing area of economics. If you said “right” for something yesterday, probably tomorrow you may have to say it is “wrong” for the same thing! If you said “yes” it won’t be surprising if you had to say “no”, another day. That is the macroeconomic reality.
Today, I thought of elaborating on a couple of realities. I hope it would be “interesting” to you, if you had the idea that it was boring. It may also help clearing the confusion, if you had considered it was confusing.
Before we begin our discussion, it would be noteworthy that macroeconomics is fairly a new subject area of economics for economic management and policy making, while it did not exist in the world prior to the time of the Great Depression in the 1930s. It was true that the governments or even the kings in ancient times, collected taxes and spent that money for administration, military activities, public works, and personal use; but there was no fiscal policy! In the same way, money was printed, and the banking system existed; but there was no monetary policy! In fact, it was only after the Second World War ended in 1945 that these policies aimed at macroeconomic management became evident in the world.
Two engines
There are two “engines” of an economic machinery of a country: One is called “demand” and the other, “output”. These two engines help an economic system to run smoothly in the first place. They also help the economy to grow and achieve progress provided that we strive to accelerate the engines; but this is an area that goes well beyond macroeconomic policy making.
There are various kinds of shocks in the world which can interfere with these two engines – demand and output, and they cause disruptions. This is exactly why macroeconomic management and policy making is important for a country. The shocks can be economic ones or non- economic ones, and smaller ones or big ones depending on the magnitude of disruptions that they cause.
Global financial crisis that the world experienced in 2008/ 09 was one of the big economic shocks. For whichever the reason ( as I have discussed previously), the people and companies lost their wealth and suddenly became poor. As a result, demand collapsed! Consumers cut down their spending and companies cut down their spending.
When there is lower demand for output, it may lead to two outcomes: falling prices and diminishing production. Producers and suppliers must cut down their output of “goods and services” they produce and supply. They can even cut down wages, but it is not easier everywhere to the same extent. Producers, anyway, cut down jobs and work. This means income falls and unemployment rises, in spite of lower inflation.
Rescue operations
Here come the government and the Central Bank with rescue operations in order to offset the demand shock, either independently or collaboratively. As both consumer demand and business demand get weaker, the government can try accelerating the demand engine again by increasing its own spending on public consumption and public investment.
There is, however, a problem: Governments need more money to spend more. As demand has slowed down, the indirect tax revenue has fallen too. As incomes fall and unemployment is up, the direct tax revenue has fallen too. The options available to the government are either borrow money ( from domestic banks or from foreign sources) or to get the Central Bank to print money for the government ( that is borrowing from the Central Bank).
The problem is not over, however, because these options are not without limits. There are limits to all sorts of borrowings including money printing; is there anyone on earth, who doesn’t have borrowing limits? The reason is that they all cause public debt to rise and get accumulated. For the same reasoning, it is pretty understood that to the governments which are already caught up in a high debt problem, the limits of further borrowing are not far away.
Pumping more money
The Central Bank is also in a position to pump more money to the economy on its own through the banking system ( apart from financing government spending). When the Central Bank adopts this option, the idea is that there will be increased liquidity in the banks to generate more credits at lower interest rates.
Private credit expansion to both consumers and businesses is expected to accelerate demand engine again. Consumers can borrow and spend to buy so that there will be increased consumer demand. Similarly, the businesses can also have access to cheaper credit and increase their business spending. Thus, there is a possibility that demand will revive in order to sustain output and employment.
Though it looks pretty simple, there are complications too. The first thing we need to understand is that there is a link between money and inflation. It is because of this link that the existence of the Central Bank makes sense; otherwise, the Central Bank can be reduced to a money- printing press. However, a “demand shock” normally weakens the money-inflation link so that the central banks are in a better position to exercise the money-pumping option.
The second issue related to money pumping is the link between money and interest rates. Countries which have higher interest rates may enjoy more room for money pumping which pushes the interest rates down, but not without limits. The third complication is that both higher money growth and lower interest rates will accelerate foreign exchange outflow causing exchange rate depreciation. Therefore, the countries with a weaker external finance position cannot go too far with the option of money pumping too.
There is, however, a problem: Governments need more money to spend more. As demand has slowed down, the indirect tax revenue has fallen too. As incomes fall and unemployment is up, the direct tax revenue has fallen too. The options available to the government are either borrow money (from domestic banks or from foreign sources) or to get the Central Bank to print money for the government (that is borrowing from the Central Bank).
Shrinking space
What is evident from the above discussion is whatever the options available for economic management, the space for any of these options is gradually shrinking. Because there are limits, which are also pretty short in some countries, the more they adopt such options the closer will be the limits. But the irony is that without a significant magnitude of the options adopted, it is difficult to anticipate a significant outcome in mitigating the negative impact of a demand shock on the economy.
The world after two consecutive wars and the Great Depression in between them, had enough room for increased government spending, accelerated money and credit expansion after 1945; and the Western world made use of this opportunity for reconstruction and development. By the end of the 1960s, they got closer to the limits; growth started to slow down, and inflation accelerated!
By the way, out of the two engines, we discussed only about one of them called demand. The other engine “output” can also get interrupted with “supply shocks”. If such supply shocks are big enough such as the 1973 oil shock or the current COVID- 19 pandemic, output collapses. When the output of goods and services falls, there will be a loss of incomes and jobs. The rest of the story is not different from what we have explained so far, although in both cases the options are not limited to macroeconomic policies.