Transcription Doc

Macroeconomic Policies and Tools

Note: This transcription document is a text version of the upGrad videos present in this session. It
is not meant to be read independently, but can be used to complement your video watching
experience.

Video 1

Speaker: Chris Oates

Welcome. In this session we're going to talk about ways in which governments try to manage
economic activity to increase growth and prevent recessions.

The first thing that we're going to talk about and one that you may have heard on the news, quite
a bit is a monetary policy. The primary actor in monetary policy are central banks. So the Federal
Reserve in the United States, the Reserve Bank of India, the European Central Bank. These are
the primary actors when it comes to monetary policy. So if you ever hear that the Federal Reserve
met or the ECB issued a statement, it is very likely to be related to monetary policy in some way.

The purpose of monetary policy is to influence the investment and savings and spending decisions
of consumers and businesses in their economy. Now, if you remember from the consumption
function segment, we talked about how the marginal propensity to spend and the marginal
propensity to save are related and then from our talk about interest rates and investments that
interest rates are related to money supply and they are also related to economic activity. These
are really the vectors through which central banks and monetary policy influences economic
activity.

The first way that monetary policy can work is through shaping the money supply, and there are
some technical ways to how this works. Oftentimes, at least in the United States, the Federal
Reserve will buy a government bond and will create dollars to do so, but the effect is that what
central banks can do is increase the amount of money that exists in the economy. And, if you ever
remember, reading about quantitative easing. That was an unconventional way to do so to try to
increase the money supply.

Now, one of the reasons that that might be desirable is a lower interest rate and, most
importantly, a higher GDP, a higher economic output. So, by increasing the money supply, you
should decrease the interest rate and increase economic activity.
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So you might be asking yourself: if lower interest rates lead to higher economic output, why
wouldn't every central bank simply decide to set their interest rates constantly at zero? The lowest
interest rates possible should lead to the highest economic activity. Well, the reason is that if we
recall from the aggregate demand-aggregate supply model that increased economic activity
should lead to higher prices. So the better the economy is the more likely you are to see.
Inflation.

And this is really the dilemma for any central bank dealing with monetary policy. If interest rates
are low, inflation is likely to accelerate. If interest rates are high, economic activity is likely to
stagnate.

So what they're trying to do is they're trying to find the point for whatever the economic
conditions are right now that gives price stability, i.e. low inflation, but also help economic growth.

Now, there's a couple of other things to remember: Dove usually means looser monetary policy or
lower interest rates. Hawkish usually means tighter monetary policy or higher interest rates.
Monetary policy has its own set of jargon that you have to remember.

One other thing to note about monetary policy is that this is why stagflation is such a worrisome
term for an economy. Now you may have come across the term stagflation. It is a combination of
stagnation, meaning flat economic growth and inflation. And that's because, as we saw from the
models that high inflation should go along with good economic growth and when those two things
don't go together, when poor economic growth goes along with high Inflation, it really makes
things harder for central banks.

Do they target inflation, bringing down that inflation, but making the economy even worse or do
they target the economy, maybe boosting growth at the cost of making inflation even higher? It's
been mentioned whether India is in this situation, but it's something to know, because it means
that monetary policy is at a bit of a crossroads and there will be debates about what should be
done, and it also means that monetary policy might not be as effective in helping the economy in
that situation.

Video 2

Speaker: Chris Oates

When the 2009 recession hit the US, the US government tried to revive the economy through
various measures, like cutting taxes and increasing government spending. In other words, it
undertook expansionary fiscal policy. Fiscal policy refers to the spending taxation and borrowing
that the government uses to tide over the economy through fluctuations in the business cycles.
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To simplify, if monetary policy is about what the central bank does to steer the economy, the
fiscal policy about what governments do, the main motivation behind using fiscal policy to shape
the economy is based on the components of the GDP.

As you recall, GDP equals to C plus I plus G plus X minus M, where G which stands for
government spending is a major part of any economy. So, any change in the government
spending will likely have a major impact on the GDP.

According to some estimates, Indian government's contribution to GDP is likely to be around 14%
in 2021. If a government increase its spending, that will lead to an increase in the GDP.
Conversely, if it decreases spending, then GDP will shrink.

This works through changes in aggregate demand. If the government gives everyone a tax cut
during a session, when the demand is low, then households will have more money to spend and
demand will go up. Likewise, if a government spends lots of money on building infrastructure, it
gives money to the businesses building the infrastructure. This means that more money is flowing
through the economy. And therefore, the demand increases.

Recall this from the circular flow of income covered earlier. In times of recession, governments
often look for fiscal policy that has high multipliers. As discussed in the previous session, the
multiplier effect means that an investment can provide a further boost to the economy by being
circulated further.

Now, the question that arises is why doesn't the government spend an infinite amount of money
to keep growing the GDP? There are two reasons for this. First, when governments use fiscal
policy as a tool to boost the economy, it has to use deficit spending. That is, it has to borrow
money. This debt will eventually need to be paid back with interest in the future, and any
government would want to avoid that burden.

The second concern is the crowding out effect. When a government spends too much money in
the economy by way of borrowing, it increases the aggregate demand for money, which means
the demand for money increases. This leads to higher interest rates as we know from monetary
policy, this will contract economic activity.

It is important to note that the fiscal policy is highly political in nature and can be difficult to
enact, especially in a country like India, due to the involvement of several stakeholders and
interests. Because fiscal policy is passed through legislation, usually it also means that it can be
slower to react to events than monetary policy.

During the global financial crisis of 2008 and 2009, though the US federal reserve was able to
quickly lower interest rates to use monetary policy to address the crisis, the fiscal policy measures
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to deal with the broader recession did not pass until about five months after the collapse of
Lehman brothers.

Now, you must recall that I mentioned expansionary fiscal policy at the start of the video. So,
fiscal policy can be of two types, expansionary and contractionary.

Expansionary fiscal policy is used during times of recession or slow economic activity in order to
stimulate the economy and increase the aggregate demand. On the other hand, governments use
contractionary fiscal policy for saving in times of economic boom by decreasing spending or
increasing taxes or both.

Video 3

Speaker: Chris Oates

You may have heard about a strong dollar or a weak rupee. What does this mean? In this
segment, you will learn about a key macroeconomic issue for global businesses, which is
exchange rates.

Now for any country, the term foreign exchange refers to all currencies other than its domestic
currency. And the foreign exchange rate refers to how much of another currency can one
currency buy. For example, if one US dollar is equal to 74 Indian rupees, then that is the relative
price of one US dollar in Indian rupees. This is also called the nominal exchange rate.

This is different from real exchange rate, which refers to the relative price of goods of two
countries. It is the rate at which one country can trade it's good for the goods from another
country. Now let's understand why the currency values fluctuate, as in how they get stronger or
weaker.

Recall the concepts of basic supply and demand in microeconomics. If the demand for something
goes up and the supply is constrained, then the price will go up. If the supply increases but
demand remains the same, the price will fall.

Well, currency also operates on the same basic principle. So, imagine that you want to buy
something from US. You need to pay for it in dollars, and therefore you need to convert your
rupees into dollars. However, if there is only a fixed amount of dollars in the world, then you have
to compete with those who also want to use dollars.

This increased demand for the dollar would mean that it's price or the exchange rate will increase.
You will have to pay more rupees for each dollar. As exchange rate show how much each

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currency can buy of another currency, they are listed as currency peers. For example, the USD-
INR exchange rate or the dollar-Euro exchange rate.

Exchange rates can rise and fall for a number of reasons. But in general, economic growth will
make a currency appreciate or go up relative to others. As economic difficulties or a recession will
make it depreciate or go down.

Let's look at this through the example of Brexit. As global markets perceive this event negatively,
the day after the EU referendum for the UKs exit from the European Union was passed, the pound
dropped sharply against both Euro and the dollar. So, in a way exchange rate is also an indicator
of a country's economic health.

Another theory that you need to know in order to better understand exchange rate is purchasing
power parity, or PPP. This theory states that no matter where in the world you are, the same
bundle of products should cost you the same. The purchasing power of two currencies must be in
parity. That is, they must be equivalent.

If a tennis racket costs 20 Euro in Germany, it should cost the equivalent of 20 euros in the other
country. But does this parity exist? No, exchange rates keep fluctuating and do not stay the same.
Therefore, the theory of purchasing power parity says that the nominal exchange rate between
two countries must reflect the different price levels between them.

Now, why do exchange rates matter? Well, when a currency appreciates, it can buy more than it
used to. For example, assuming $1 is worth about 75 rupees, if you spend a hundred dollars to
buy Indian products, you get 7,500 rupees worth of products. And if the dollar appreciates 10% to
82.5 rupees to the dollar, then you can spend hundred dollars, but get 8,250 rupees worth of
stuff. Because of the fluctuating exchange rate, you have bought more while spending the same
amount.

Now, if the US is importing from India and if this figure is in millions, you can imagine the impact
that such a movement in exchange rate can have for the involved parties. So, when a currency is
tendons, it can buy more goods and services in other currency. A strong domestic currency
therefore helps imports, but it makes exports more expensive. Conversely, a weak domestic
currency helps exporters and makes imports more expensive.

Another important concept in exchange rate is currency pegging. This refers to fix exchange rates
as opposed to floating exchange rates, which change based on market conditions and various
factors. Under currency pegging, a country undertakes policies to ensure that its currencies either
does not move or only moves by a small amount against the other currency.

For example, the UAE has pegged its currency at 3.673 dirhams to one US dollar. Currency
pegging gives greater certainty to both exporters and importers in terms of exchange rate in the
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longer term. In countries with volatile economic or political conditions, currency pegging assures
investors that their investments are secure from fluctuations in domestic currency in times of
crisis.

Video 4

Speaker: Chris Oates

Let's assume that you're a business and you want to know more about the economy of a country
that you're considering operating in. Where do you find that information? Well, obviously, every
country is different. Every country has different sources of data and quality of data.

Generally speaking, more developed economies or larger economies will have better information
about it. If you want to know more about the United States economy, there are countless
magazines, newspapers, TV channels that will tell you about it.

But if you want to go beyond just commentary and actually find the raw data that goes into what
makes up the picture of the economy, what you probably want to find are some of the most
important economic indicators and track those carefully.

One of the best places to go, if you want to find these is the World Bank. The World Bank data
has a lot of great economic indicators about many countries of the world going back decades. So
it's usually at least when I am working on a project. The first place that I will go to check out
some information. This especially is great because it's free. So if you don't want to have an
expensive subscription access or you're not sure if you do, the World Bank is a great place to look
for it.

Another great place to look for economic data is from the government of each country. Most
countries have statistical organizations either as a single entity within their government or
scattered throughout different agencies.

So in the United States, for example, the Bureau of Labour Statistics will put out unemployment
numbers, the Bureau of Economic Analysis will put out GDP figures. The Energy Information
Agency releases information about energy, and these are our departments that are dedicated to
gathering information about the economy and releasing it for free and doing it on a regular basis.

And so that's a great place to find information. And when you find information, there's two criteria
that you want to keep in mind and that is the frequency and reliability of the information.
Generally speaking, more high frequent information like weekly jobless claims might be a bit
noisier. So, that's not to say that they're bad data, it's just that they might be noisy data. They are
estimates and they jump around quite a bit.
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Whereas quarterly data or annual data is unlikely to be revised dramatically going forward. So that
can be a downside, if you need timely information. So during the COVID'19 pandemic, the
economy was changing so rapidly that a lot of investors started paying a lot of attention to weekly
data. But if things aren't changing that rapidly and you want to only look for a certain amount of
time every month at economic data, you probably want to look then at monthly or quarterly or
annual data, just because it's a bit more signal and a bit less noise.

So when you're looking at an economy, find the most reliable information find the most timely
information and try to balance those two criteria, if you have to.

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