Comprehensive Introduction to Macroeconomics and IS-LM Theory

Fundamental Concepts of Macroeconomics

• Macroeconomics is the study of the economy as a whole, focusing on aggregate variables such as inflation, unemployment, and economic growth.

• Microeconomics, by contrast, is the study of how households and firms make choices, interact in specific markets (e.g., markets for cars or personal computers), and how the government attempts to influence those specific choices.

• Macroeconomics focuses on factors that affect many markets at the same time.

Major Macroeconomic Issues

• Economic Growth: Refers to the ability of the economy to produce increasing quantities of goods and services. Growth is vital because a slow-growing economy fails to raise living standards.

• Business Cycles: Alternating periods of expansion (increasing production/employment) and recession (decreasing production/employment).

  • Historical Example: The Great Depression (1930) followed by a subsequent economic boom.

  • Malawi Context: The economy has experienced these alternating periods since 1964.

• Productivity: Defined as getting more output from a given amount of inputs (Labour and Capital).

  • Labour Productivity: Measured as Output per Worker or Output per hour worked.

  • Increases in productivity often stem from workers having more capital or from technological improvements (Technical Change) in the long run.

• Inflation: The percentage increase in the average level of prices (or the overall price level) from one year to the next.

• Unemployment: Refers to individuals who are not working but are actively looking for jobs.

  • In the short run, employment levels are significantly affected by the business cycle.

  • In the long run, the effects of the business cycle disappear, and other factors determine employment.

• Government Budget Deficits: Occur when government spending exceeds tax revenue collected.

  • A surplus occurs when taxes exceed spending.

  • Deficits are financed by borrowing. If the central bank (Reserve Bank of Malawi) finances this borrowing, it increases the money supply and is considered inflationary.

• Interest Rates: The cost of borrowing or the charge on borrowing.

  • High interest rates reduce demand by increasing the cost of borrowing.

  • Low interest rates induce demand by reducing the cost of borrowing.

• Exchange Rate: The value of local currency (Kwacha) expressed in terms of international currencies.

  • A rise in the cost of buying domestic currency makes domestic goods more expensive relative to foreign goods.

Targets and Instruments of Policy

• Targets: Specific goals the government aims to achieve, such as high living standards, high employment, low inflation, and management of recessions/booms.

• Instruments: Tools used to reach targets.

  • Fiscal Policy: Government spending and Taxes.

  • Monetary Policy: Interest rates, money supply, and exchange rate.

Measuring Total Production: Gross Domestic Product (GDP)

• Definition: GDP is the market value of all final goods and services produced in a country during a specific period, usually one year.

• Final vs. Intermediate Goods:

  • Final Good/Service: Purchased by its final user; not used in the production of another good (e.g., a car or computer purchased by a consumer).

  • Intermediate Good/Service: An input into another good or service (e.g., tires on a truck). The value of the tire is already incorporated into the value of the truck and is not counted separately to avoid double counting.

• Production Period: GDP only includes production within the indicated time period. It excludes the value of used goods being resold.

• GDP Computation in Malawi: Calculated by the Reserve Bank of Malawi (RBM) using Kwacha values rather than quantities.

Methods of Calculating GDP

• Expenditure Method: Summing up spending on all final goods and services.

  • Example Computation:

    • Product: Eye examination (100 units at K50) = K5,000

    • Product: Bread (80 units at K10) = K800

    • Product: Books (20 units at K100) = K2,000

    • Product: Paper (2,000 units at K0.10) = K200 (Note: If all paper is used for books, it is an intermediate good and is excluded).

    • Total GDP = $K5,000 + K800 + K2,000 = K7,800$.

• Value Added Method: Adding the market value a firm gives to a product (Sale price minus price paid for intermediate goods).

  • Example (Shirt Production):

    • Cotton farmer (Value added: K100).

    • Textile manufacturer (Mapeto DWS) (Sells at K300, Value added: $K300 - K100 = K200$).

    • Shirt company (Chilimba garments) (Sells at K1,500, Value added: $K1,500 - K300 = K1,200$).

    • PEP Store (Retail price K3,500, Value added: $K3,500 - K1,500 = K2,000$).

    • Total Value Added = $K100 + K200 + K1,200 + K2,000 = K3,500$.

The Circular Flow of Income

• GDP measures both total production and total income because every Kwacha spent is income to someone else.

• Firms use factors of production: Labour, Capital, Natural Resources, and Entrepreneurship.

• Households supply these factors in exchange for income:

  • Wages: Paid for labor.

  • Interest: Paid for use of capital.

  • Rent: Paid for natural resources.

  • Profit: Income remaining after paying wages, interest, and rent; it is the return to entrepreneurs for bearing risk.

• Transfer Payments: Social security, unemployment insurance, etc. These are NOT included in GDP because they do not involve the production of new goods/services.

Components of GDP (The Expenditure Method Equation)

• The fundamental equation is: $Y = C + I + G + NX$

  • $Y$: GDP or Output.

  • $C$: Consumption (divided into services, non-durable goods like food, and durable goods like furniture).

  • $I$: Investment (Business Fixed Investment, Residential Investment, and Changes in Business Inventories).

    • Inventories are goods produced but not yet sold (e.g., if Mapeto increases unsold cloth from K20m to K35m, inventory investment is K15m).

  • $G$: Government Purchases (spending on teachers’ salaries, highways, etc., excluding transfer payments).

  • $NX$: Net Exports (Exports minus Imports).

• Autarky: A state where a country does not trade internationally ($NX = 0$).

Shortcomings of GDP as a Measure

• Incomplete Measure of Production:

  • Household Production: Self-produced goods (e.g., a carpenter making his own bookcase or cleaning one's own house) are excluded.

  • Underground Economy (Informal Sector): Hidden transactions to avoid taxes/regulations or illegal activities (drugs/prostitution).

• Incomplete Measure of Well-being:

  • Not adjusted for negative externalities like pollution.

  • Not adjusted for social issues (crime, divorce rates).

  • Does not account for income distribution (the ‘size of the pie’ vs. how it is divided).

  • Excludes the value of leisure time.

Real GDP vs. Nominal GDP

• Nominal GDP: Measures output in current-year prices. It changes due to physical output changes and price changes.

• Real GDP: Measures output using constant base-year prices to isolate changes in physical volume.

• Example (Base year 2010):

  • 2010 N-GDP: K14.00

  • 2015 N-GDP: K21.00 (50% increase).

  • 2015 R-GDP (2015 quantities at 2010 prices): K17.20 (23% increase).

  • Real GDP at 23% is a more accurate measure of physical growth than Nominal GDP's 50% increase.

Additional Income Measures

• Gross National Product (GNP): Production by residents of a country, even if produced abroad.

• National Income: GDP minus depreciation (the value of worn-out machinery/buildings).

• Personal Income: Income received by households. Calculated as National Income minus retained corporate earnings plus transfer payments and interest on government bonds.

• Disposable Personal Income: Personal income minus personal taxes. This is the best measure of spendable income for households.

Price Indexes and Inflation

• GDP Deflator: A measure of the price level using Nominal and Real GDP.

  • Formula: $\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

  • Increases in the deflator track inflation over time.

• Consumer Price Index (CPI): Measures the cost of a fixed basket of goods/services for an urban consumer.

  • Differences from GDP Deflator:

    1. CPI uses a specific, fixed basket of goods; the Deflator represents everything produced.

    2. CPI includes import prices for consumer goods; the Deflator only includes domestic production.

  • Inflation Rate Calculation: $\frac{\text{CPI}_2 - \text{CPI}_1}{\text{CPI}_1} \times 100$

• Producer Price Index (PPI): Tracks prices firms receive at all production stages (includes intermediate goods like flour, steel). Used as an early warning signal for CPI changes.

• Adjusting for Inflation:

  • Formula: $\text{Value in Newer Kwacha} = \text{Value in Older Kwacha} \times \frac{\text{CPI}_{\text{New}}}{\text{CPI}_{\text{Old}}}$

  • Example: Salary of K20,000 in 1984. CPI-1984 = 104, CPI-2016 = 219.

  • Value in 2016 terms: $K20,000 \times \left(\frac{219}{104}\right) = K42,115.38$.

Aggregate Demand (AD)

• The AD curve shows the relationship between the price level and quantity of real GDP demanded by households, firms, and government.

• Downward Slope Reasons:

  1. Wealth Effect: Higher prices reduce the real value of household wealth, decreasing consumption.

  2. Interest Rate Effect: Higher prices lead firms/households to need more money, increasing borrowing and interest rates, which reduces investment.

  3. International Trade Effect: Higher domestic prices relative to foreign prices make exports more expensive and imports cheaper, reducing net exports.

• Shifts in AD:

  • Monetary Policy: Central bank changes money supply and interest rates.

  • Fiscal Policy: Changes in government spending/taxes.

  • Expectations: Optimism/pessimism regarding future income or profitability.

  • Foreign Variables: Changes in demand for exports or foreign production.

Aggregate Supply (AS)

• Long-Run Aggregate Supply (LRAS): Vertical line at Potential GDP (Full-employment GDP). It is determined by workers, capital stock, and technology. It shifts right annually as these factors grow.

• Short-Run Aggregate Supply (SRAS): Upward sloping because prices of inputs (wages) rise more slowly than final goods prices, increasing profitability at higher price levels.

• Reasons for Upward Slope/Sticky Prices:

  1. Contracts: Multi-year wage or input agreements keep costs fixed while output prices rise.

  2. Slow Adjustments: Unions might only negotiate once a year; firms may be slow to change prices (‘menu costs’).

• Shifts in SRAS:

  • Increase in labor force or capital stock (shifts right).

  • Technological change (shifts right).

  • Expected future price level increases (shifts left).

  • Supply Shocks (e.g., sudden oil price hikes) shift it left.

Macroeconomic Equilibrium and Adjustments

• Equilibrium: Where AD, SRAS, and LRAS intersect.

• Recession (Decline in AD):

  • AD shifts left. Real GDP falls below potential level.

  • Prices fall. In the long run, workers accept lower wages, shifting SRAS right back to potential GDP (the Automatic Mechanism).

• Expansion (Increase in AD):

  • AD shifts right. Real GDP rises above potential.

  • Prices rise. In the long run, workers demand higher wages, shifting SRAS left back to potential GDP.

• Supply Shock (Stagflation):

  • SRAS shifts left. This causes the ‘unpleasant combination’ of inflation and recession.

The Goods Market and the IS Curve

• The IS (Investment-Savings) curve shows combinations of interest rates ($i$) and output ($Y$) where the goods market is in equilibrium.

• Derivation:

  • Lower interest rates ($i$) lead to higher investment ($I$).

  • Higher investment increases aggregate demand ($ZZ$ curve shifts up).

  • Higher demand increases equilibrium output ($Y$).

  • Result: The IS curve is downward sloping.

• Points off the IS curve:

  • Excess Supply of Goods (ESG): Interest rate is higher than equilibrium; investment is too low.

  • Excess Demand for Goods (EDG): Interest rate is lower than equilibrium; investment is too high.

Money and Banking

• Definition of Money: Anything generally accepted in payment for goods/services or debt repayment.

• Functions:

  1. Medium of Exchange: Minimizes transaction costs and the ‘double coincidence of wants’. Characteristics must include being standardized, widely accepted, divisible, portable, and durable.

  2. Unit of Account: A consistent way to measure value.

  3. Store of Value: Saves purchasing power for the future.

• Evolution of Payment Systems:

  • Commodity Money: Precious metals (heavy/hard to transport).

  • Fiat Money: Paper currency decreed as legal tender by government.

  • Checks: Order to a bank to transfer funds; avoids carrying large sums but slow to clear.

  • Electronic Money (E-money): Substitutes for checks/physical cash.

• Measuring Money Supply:

  • M1: Currency, checking account deposits, traveler’s checks.

  • M2: M1 + savings deposits, small-denomination time deposits, money market mutual funds (highly liquid).

  • M3: M2 + large-denomination time deposits, repurchase agreements.

Types of Banks and their Roles

• Commercial Banks: Receive deposits, give short-term loans, facilitate trade.

• Exchange Banks: Specialize in foreign trade and discounting foreign bills.

• Industrial Banks: Provide long-term capital for machinery (Example: INDE Bank, which was sold to National Bank of Malawi).

• Agricultural/Co-operative Banks: Funds for farmers for land, fertilizers, seeds.

• Savings Banks: Aim to discourage hoarding and mobilize small savings.

• Central Bank (Roles):

  • Monopoly on issuing currency.

  • Banker to the government (manages public debt, receipts, and payments).

  • Banker’s Bank and Supervisor (custodian of cash reserves, lender of last resort, clearer of checks).

  • Controller of credit and money supply via monetary policy.

  • Exchange control (maintaining Kwacha value vs. USD).

The Money Market and the LM Curve

• Motives for Holding Money (Keynesian Theory):

  1. Transactions Motive: For everyday purchases.

  2. Precautionary Motive: As a cushion against unexpected needs.

  3. Speculative Motive: Money held as a store of wealth based on interest rate and bond price expectations.

• The Demand for Money ($M_d$): Downward sloping. Higher interest rates increase the opportunity cost of holding money, reducing demand.

• The Supply of Money ($M_s$): Vertical line, as it is controlled exclusively by the central bank.

• The LM Curve: Shows combinations of interest rates and income ($Y$) where the money market is in equilibrium.

  • It slopes upward because higher income increases demand for transactions money, requiring higher interest rates to maintain equilibrium.

Policy in the IS-LM Model

• Monetary Policy:

  • Expansionary: Raise money supply ($LM$ shifts right). Interest rates fall, output rises.

  • Contractionary: Lower money supply ($LM$ shifts left). Interest rates rise, output falls.

  • Tools:

    1. Open Market Operations (OMO): Buying/selling treasury bills.

    2. Reserve Requirements: Adjusting the portion of deposits banks must hold.

    3. Discount Rate: The rate the central bank charges commercial banks for loans.

• Fiscal Policy:

  • Expansionary: Increase government spending or decrease taxes ($IS$ shifts right). Output and interest rates rise.

  • Contractionary: Decrease spending or increase taxes ($IS$ shifts left). Output and interest rates fall.

  • Funding Methods: Taxation, Seigniorage (printing money), Borrowing (domestic/abroad), Sale of assets.

Evaluation and Criticism of Fiscal Policy

• Crowding Out: Increased government spending may lead to higher interest rates, reducing private sector investment.

• Time Lags: Delays in identifying needs and implementing spending plans.

• Disincentives: High taxes to curb inflation can discourage work and productivity.

• Information Gaps: Incorrect forecasts can lead to policies that cause inflation or recession.

• Multiplier Effect: Effectiveness depends on the size of the multiplier and the marginal propensity to spend.

The Simple Multiplier

• The multiplier ($K$) measures the magnitude by which an initial change in autonomous expenditure ($A$) affects total GDP ($Y$).

• Formula: $K = \frac{\Delta Y}{\Delta A}$

• In a simple model: $K = \frac{1}{1 - z}$, where $z$ is the marginal propensity to spend.

• Mechanism: An initial injection (e.g., 100m) becomes income for someone else, who then spends a portion based on $z$ (e.g., 0.8), creating further income of 80m, then 64m, etc.

• If $z = 0.8$, the multiplier is $1 / (1 - 0.8) = 5$. A 100m increase in autonomous spending results in a 500m increase in total income.