Last update: Friday, Monday, April 29, 2013

Lecture 8
Objectives of lecture
 To indicate the major focus of MACROECONOMICS
 To indicate the relevance and importance of the study of macroeconomic
phenomena.

Contents of lecture
Growth
 GROWTH is defined as an increase in aggregate output.
 Generally reference is made to the annual rate of increase in output.
 A distinction is drawn between long-term or the trend rate of growth, and
the short-term or cyclical rate of economic growth.
o Heterodox economists typically refer to trend vs cyclical growth and
Neoclassicals to long-run vs short-run rates of economic growth.
 Growth is typically measured by the annual rate of change in GDP at
constant prices. It is sometimes measured by the annual rate of change of
GNP at constant prices. The difference between GDP and GNP is that the
latter looks is a measure of all goods produced by enterprises owned by
nationals of a country whether geographically located in or outside of the
country, while GDP simply looks at what is produced in a given country,
whether by local or foreign enterprises. World GDP and world GNP are, by
definition, equal.
 GDP is measured using a combination of techniques. One is by direct survey
of goods produced, e.g., cars by the 10 largest manufacturers, or potatoes
but the 500 largest farms. The other technique is by estimation; taking the
value of what is produced in a sector and then estimating the rise in prices in
that sector and deducting it from the increase in value.
 Growth is seen as important by most economists in the sense of being a
precondition for higher living standards and economic power.
 Growth is seen as important for a government’s popularity only over the long-
term.
 For developing countries, with a population growth of about 1.5% per annum a
good trend growth rate would be above 5%. A rapidly growing developing
country could be expected to achieve an average rate of growth of around
7%+.

Inflation
 INFLATION is defined as an increase in the aggregate money price level.
 Generally reference is made to the annual rate of inflation.
 Distinctions are also drawn between short-term fluctuations and long-term
trends, but this distinction is not as common as with growth.
o Again, there are differences between Neoclassical and Heterodox
which stem from a denial of cycles by Neoclassicals.
 Distinctions are also made between consumer, producer and economy-wide
inflation. Consumer inflation is a measure of price increases in consumer
goods. Producer inflation is a measure of price inflation in goods that are
used as productive inputs by producers. And, economy-wide inflation
measures the rise in prices of all goods produced in a country. It excludes
import prices, whereas both consumer and producer inflation measures take
this into account.
 Inflation is seen as particularly important for governments’ popularity over
the short-term. It is well-known that as elections near government’s become
particularly worried about their performance on the inflation front.
 Inflation is seen as particularly important for businesses in general, and
certain sections in particular. Financial markets typically do not like inflation
because it erodes the value of financial assets (e.g., the value of loans) and
typically causes bond and other financial market prices to fall.
 Economists differ about what levels of inflation are ideal. Neoclassicals
tend to favour zero or very low levels of inflation, while Heterodox
economists are less worried about inflation, particularly if it accompanies
(and is mostly due to) a rapid growth process.

The balance of payments and exchange rate

 THE BALANCE OF PAYMENTS is a set of accounts which records inflows
and outflows of money resulting from the transactions between the
residents of a country and the outside world.
 The accounts may be presented in local currency and/or foreign currency
(typically US dollar) terms.
 Money flows between countries for a number of reasons including trade,
income payments, investments, etc.
 The balance of payments accounts typically comprise 3 major sub-accounts;
the CURRENT, CAPITAL and FINANCIAL accounts. Money flows between
countries are organised into these three sets of sub-accounts.
 Money flows into and out of a country flow through FOREIGN EXCHANGE
MARKETS where local currency is exchanged for foreign and visa versa.
When money comes into a country it comes in as foreign currency and is then
exchange for local currency. When it goes out of a country local currency
exchanges for foreign currency and then the foreign currency goes out of
the country.
o Distinctions are drawn between long and short-run as well as trend
and cyclical movements in the external balance of a country.
 The exchange ratio of one currency for another in the foreign exchange
market is known as THE EXCHANGE RATE of one currency in terms of
 another. If the exchange rate of a country’s currency is such that more
units of its own currency are exchanged for a foreign currency then
economists say that the local currency is depreciating in value or becoming
weaker. If less units of a country’s currency are being exchanged for the
foreign currency then economists say the local currency is appreciating in
value.
 If a country experiences a balance of payments deficit it means that more
money is flowing out of the country than flowing in. When this happens the
country is said to be losing its reserves of foreign exchange or currency. If
the country has a balance of payments surplus then more money is flowing
into the country than flowing out and the foreign exchange reserves held by
the country can be expected to be growing.
 Typically economists focus on current, and especially trade, account flows
of a country since the latter are said to reflect the competitiveness of the
economy. Most theories of the balance of payments are actually theories of
the trade balance. The bigger the trade balance as a proportion of GDP the
more positively a country is viewed by economists.
 When looking at foreign CURRENCY RESERVES economists use the yardstick
of reserves in relation to imports (typically the months of imports the
reserves could finance). The usual benchmark for a developing country’s
reserve holdings is 3 months of imports. It is argued that anything below
this figure is problematic.
 A deficit in the balance of payments is also known to put pressure on the
exchange rate, causing it to depreciate (possibly alongside losing reserves).
A surplus in the balance of payments is seen to cause the exchange rate to
appreciate (possibly alongside a growth of reserves). The logic of the
argument here is that a deterioration of the balance of payments represents
a fall in the demand for the local currency in relation to the foreign
currency, while a surplus represents the opposite.
 A strong balance of payments and a large holding of reserves is considered
important by many developing country government’s because it avoids
possible disruptions to normal economic activities (most of which require
imports) and the likelihood of external interference in their economic
affairs.
 A continuous or large depreciation of the currency is considered by most
economists as something to be avoided since typically it is accepted as giving
rise to domestic inflation (putting upward pressure on interest rates) and
possibly dampening economic growth.
 Note the key points to be made here are a) that the balance of payments is
not simply the trade balance, nor even the trade balance and money market
capital flows (which respond to interest rate differences), and b) that the
flows of money into and out of a country imply pressures on a country’s
exchange rate in a market determined environment.