Development of Macroeconomics

Introduction to Macroeconomics

• Macroeconomics involves understanding the origin and the key macroeconomic variables.
• Macroeconomics also involves identifying relationships between variables and macroeconomic tools.

Macroeconomics Defined

• The study of macroeconomics began following the World Economic Recession.
• Adam Smith and David Ricardo were pioneers who proposed a basic macro-theory.
• Macroeconomics covers national income, economic growth, inflation, unemployment, finance and banking, trade, and macro-policy (monetary and fiscal).

Modern Macroeconomics: Keynesian Era

• John Maynard Keynes in 1936 proposed modern macroeconomics through "The General Theory of Employment, Interest and Money".
• "Keynesian Economics" emphasizes the government's role in regulating the economy for economic stability, especially during recessions.
• According to Keynesian Economics, the economy does not always automatically reach equilibrium.
• The government intervention is needed through fiscal and monetary policies such as addressing issues of unemployment and ensuring sufficient aggregate demand.

Post-World War II

• After World War II, macroeconomics grew rapidly.
• Keynesian economics became the basis of many government economic policies worldwide, especially after the war.
• Many countries use fiscal and monetary policies to control the economic cycle and maximize economic growth.
• In the 1970s, the weakness of Keynesian theory became apparent when stagflation (high inflation and unemployment) affected several developed countries.
• Monetarism, a new theory by Milton Friedman, focuses on controlling the money supply.
• Monetarism controls inflation and believes the market will return to equilibrium without significant government intervention.
• Macroeconomics continues to evolve, combining ideas from Keynesianism and Monetarism.
• Rational expectations and business cycle theory are essential for understanding economic change.
• Globalization and technological developments also impact the macroeconomy, as well as various issues, the role of global financial institutions, international trade relations, and financial crises impacting the global economy.

Macroeconomic Variables Defined

• Macroeconomic variables refer to the main factors that affect the economy as a whole.
• Examples of macroeconomic variables, economic growth rates, inflation, unemployment and employment, balance of payments, deficit spending, interest rates, exchange rates, per capita income, investment, and social welfare index.

Economic Growth

• Economic growth refers to an increase in the amount of goods and services produced by an economy in a certain period.
• GDP is the main measurement of economic growth.

Growth Rate Formula

• GDP measures the rate of economic growth.
• The growth rate formula: Growth Rate = ((GDP Year 2 – GDP Year 1) / ​​GDP Year 1) x 100%

Gross Domestic Product (GDP)

Nominal GDP

• Nominal GDP values goods and services at market prices, which includes inflationary effects potentially increasing the price of goods and services.
• Nominal GDP is used to form economic policies, monitor economic performance, and enable comparisons between countries.

Real GDP

• Assesses prices of goods and services using fixed prices from the base year, removing the inflationary effect.
• It measures the growth of economic output unaffected by price changes.

GDP Deflator

• GDP Deflator is calculated to see if the country is experiencing inflation or deflation.
• GDP deflator = (GDP nominal / GDP real) × 100

Important Concepts

• Business Cycle: Fluctuations in GDP that consist of complete rounds of ups and downs.
• Expansion: The economy grows and shows economic growth.
• Peak: The highest point in the business cycle where economic activities reach their maximum level.
• Recession: A state of contraction marked by a decline in economic activity.
• Trough: The lowest point in the business cycle, with economic activities at their lowest, high unemployment, and low consumer spending.
• Depression: A long-lasting and severe form of recession, with a very weak economy, sharply falling GDP, and very high unemployment.
• Recovery: The economy begins to emerge from the trough phase, with increasing GDP growth, consumer demand, declining unemployment and business investment recoveries.

Inflation, Deflation, Stagflasi & Desinflation

Inflation

• Refers to an increase in the price of goods and services.

Deflation

• A decrease in the general price level.

Stagflation

• High unemployment and high inflation conditions.

Disinflation

• A decrease in the inflation rate.

Inflation Indicator

• IHP (Consumer): the average change in the price of goods and services purchased by consumers.
• IPP (Producer): changes in the price that manufacturers receive for their goods and services before they reach the end consumer.
• IHPb (Construction): used to measure price changes in the development sector.

Formula IHP

• IHP = (Price of the current year / Price of the base year) × 100
• Rate of inflation = ((IHP current year - IHP base year) / IHP base year) × 100

Relationship Between Inflation Rates and Money Value

• Inflation causes the value of money to fall or decline.
• This comparison is shown between the base CPI and the current CPI.
• Money value (NW) = (IHPbase / IHP current) × 100%

Relationship Between Inflation and Interest Rates

• Inflation Rate: The average rate of increase in the price of goods and services in the economy.
• The purchasing power of money decreases when inflation rises.
• Interest Rate: The rate charged by the bank/financial institution on a loan, and are used by central banks as a monetary policy tool to control inflation.
• Both indicators are important to the economy and are very influential.
• Inflation causes interest rates to rise and increasing interest rates will reduce the demand for money, increasing borrowing costs.
• Conversely, interest rate increases can make savings increase.
• When inflation rises, central banks raise interest rates to control inflation, and when inflation is low and the economy is weak, interest rates may be reduced to encourage spending and investment.

Labour Force, Employment & Unemployment Rate

• Unemployment Rate = (Total Unemployment / Total Labour Force) × 100%
• Example: Total Employment = 5,500,000, Total Unemployment = 500,000, Unemployment rate = (500,000 / 6,000,000) × 100% = 8.33%
• A 4% unemployment rate is known as natural unemployment.

Relationship Between Unemployment and Inflation

• In the short term, unemployment and inflation are usually inversely related.
• There is an inverse relationship between the level of unemployment and the rate of change in wages.

Exchange Rate

• Exchange rate is the value of a country’s currency in comparison with the currencies of other countries.
• Trade relations involve the occurrence of foreign currency exchange.
• A stronger the exchange rate corresponds to a higher the value of the country's money.

Interest Rate

• Interest rates are an important variable to the macroeconomic course of a country that affects investment, employment, consumption, and inflation.
• Consumers borrow money from a bank (loan) which affects total employment.
• Rising interest rates control high inflation.
• Interest rates affect currency exchange rates
• Tool to balance between stable economic growth, controlled inflation, and overall financial stability.

Balance of Payments

• Balance of payment statements show transactions between countries.
• Balance of payments are indicators of economic influence on currencies, health, economic policies, and external balances.

Macroeconomic Policy

• Financial/Monetary Policy: Central banks control the money supply to target interest rates, to control aggregate demand and achieve full employment and price stability.
• Fiscal Policy: Government expenditure and taxation policy to control aggregate expenditure/demand, to achieve full employment and price stability, using tools such as taxes and expenses.
• Trade policy controlling international trade through foreign exchange rates to ensure a stable balance of payments.
• Foreign exchange policy for the central Bank will control the exchange rate of a country's currency with a foreign currency.

Macroeconomic Policy Steps

• Exchange rate control is to set fixed or floating exchange rates.
• Intervention in the foreign exchange market involves the buying and selling of national currencies to control the value of a currency.
• Determining capital flows involves controlling foreign currency inflows and outflows by introducing FDI and portfolio investments.
• Management of foreign reserves allows foreign currency reserves to accommodate international trade and ensure access to foreign funds in a crisis.

Explore the catalyst for macroeconomics, Keynesian economics role in recessions, and the challenges it faced in the 1970s. Understand Monetarism by Milton Friedman and fiscal and monetary policy examples. Learn about self-regulating capacity of the economy.