Q.
a) Describe the two (2) following methods to control inflation:
i. Monetary Policy. (5 marks)
ii. Fiscal Policy. (5 marks)
b) Explain the difference between macroeconomics and microeconomics. (10 marks)
(20 marks, 2019 Q1)
A.
a) Methods to control inflation
i) Monetary policy.
Investopedia has the below write-up on "Monetary Policy and Inflation":
In a purely economic sense, inflation refers to a general increase in price levels due to an increase in the quantity of money; the growth of the money stock increases faster than the level of productivity in the economy. The exact nature of price increases is the subject of much economic debate, but the word inflation narrowly refers to a monetary phenomenon in this context.
Using these specific parameters, the term deflation is used to describe productivity increasing faster than the money stock. This leads to a general decrease in prices and the cost of living, which many economists paradoxically interpret to be harmful. The arguments against deflation trace back to John Maynard Keynes' paradox of thrift. Due to this belief, most central banks pursue a slightly inflationary monetary policy to safeguard against deflation.
How Central Banks Influence the Money Supply
Contemporary governments and central banks rarely ever print and distribute physical money to influence the money supply, instead relying on other controls such as interest rates for interbank lending. There are several reasons for this, but the two largest are: 1) new financial instruments, electronic account balances and other changes in the way individuals hold money make basic monetary controls less predictable; and 2) history has produced more than a handful of money-printing disasters that have led to hyperinflation and mass recession.
When interest rates rise, for example, savers can earn more on their demand deposit accounts and are more likely to delay present consumption for future consumption. Conversely, it is more expensive to borrow money, which discourages lending. Since lending in a modern fractional reserve banking system actually creates "new" money, discouraging lending slows the rate of monetary growth and inflation. The opposite is true if interest rates are lowered; saving is less attractive, borrowing is cheaper, and spending is likely to increase, etc.
Increasing and Decreasing Demand
In short, central banks manipulate interest rates to either increase or decrease the present demand for goods and services, the levels of economic productivity, the impact of the banking money multiplier and inflation. However, many of the impacts of monetary policy are delayed and difficult to evaluate. Additionally, economic participants are becoming increasingly sensitive to monetary policy signals and their expectations about the future.
There are some ways in which the Federal Reserve controls the money stock; it participates in what is called "open market operations," by which federal banks purchase and sell government bonds. Buying bonds injects new dollars into the economy, while selling bonds drains dollars out of circulation. So-called quantitative easing (QE) measures are extensions of these operations. Additionally, the Federal Reserve can change the reserve requirements at other banks, limiting or expanding the impact of money multipliers. Economists continue to debate the usefulness of monetary policy, but it remains the most direct tool of central banks to combat or create inflation.
Ref:
Investopedia "Monetary policy and inflation", available at
https://www.investopedia.com/ask/answers/122214/how-does-monetary-policy-influence-inflation.asp
ii) Fiscal policy.
In short, government can reduce taxes so that there will be more money in the system and therefore, inflation can rise. From Investopedia,
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences a nation's money supply.
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when between 2% and 3%), increases employment, and maintains a healthy value of money. Fiscal policy plays a very important role in managing a country's economy.
The idea is to find a balance between tax rates and public spending. For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the risk of causing inflation to rise. This is because an increase in the amount of money in the economy, followed by an increase in consumer demand, can result in a decrease in the value of money—meaning that it would take more money to buy something that has not changed in value.
Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down, and businesses are not making substantial profits. A government may decide to fuel the economy's engine by decreasing taxation, which gives consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy by decreasing taxation and increasing government spending is also known as "pump priming." In the meantime, overall unemployment levels will fall.
With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money while pushing up prices (because of the increase in demand for consumer products). Hence, inflation exceeds the reasonable level.
For this reason, fine-tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals.
When inflation is too strong, the economy may need a slowdown. In such a situation, a government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy, in the long run, could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business cycles.
Ref:
What is Fiscal Policy? From Investopedia, available at,
https://www.investopedia.com/insights/what-is-fiscal-policy/
b) Differences between macroeconomics and microeconomics.
Earlier questions as below linked:
Investopedia has the below write-up on the differences between macroeconomics and microeconomics.
Microeconomics vs. Macroeconomics: An Overview
Economics is divided into two different categories: microeconomics and macroeconomics. Microeconomics is the study of individuals and business decisions, while macroeconomics looks at the decisions of countries and governments.
While these two branches of economics appear to be different, they are actually interdependent and complement one another. Many overlapping issues exist between the two fields.
KEY TAKEAWAYS
- Microeconomics studies individuals and business decisions, while macroeconomics analyzes the decisions made by countries and governments.
- Microeconomics focuses on supply and demand, and other forces that determine price levels, making it a bottom-up approach.
- Macroeconomics takes a top-down approach and looks at the economy as a whole, trying to determine its course and nature.
- Investors can use microeconomics in their investment decisions, while macroeconomics is an analytical tool mainly used to craft economic and fiscal policy.
Microeconomics
Microeconomics is the study of decisions made by people and businesses regarding the allocation of resources and prices of goods and services. It also takes into account taxes, regulations, and government legislation.
Microeconomics focuses on supply and demand and other forces that determine the price levels in the economy. It takes what is referred to as a bottom-up approach to analyzing the economy. In other words, microeconomics tries to understand human choices, decisions, and the allocation of resources.
Having said that, microeconomics does not try to answer or explain what forces should take place in a market. Rather, it tries to explain what happens when there are changes in certain conditions.
For example, microeconomics examines how a company could maximize its production and capacity so that it could lower prices and better compete in its industry. A lot of microeconomic information can be gleaned from the financial statements.
Microeconomics involves several key principles including (but not limited to):
- Demand, Supply, and Equilibrium: Prices are determined by the theory of supply and demand. Under this theory, suppliers offer the same price demanded by consumers in a perfectly competitive market. This creates economic equilibrium.
- Production Theory: This principle is the study of how goods and services are created or manufactured.
- Costs of Production: According to this theory, the price of goods or services is determined by the cost of the resources used during production.
- Labor Economics: This principle looks at workers and employers, and tries to understand the pattern of wages, employment, and income.
The rules in microeconomics flow from a set of compatible laws and theorems, rather than beginning with empirical study.
Macroeconomics
Macroeconomics, on the other hand, studies the behavior of a country and how its policies affect the economy as a whole. It analyzes entire industries and economies, rather than individuals or specific companies, which is why it's a top-down approach. It tries to answer questions like "What should the rate of inflation be?" or "What stimulates economic growth?"
Macroeconomics examines economy-wide phenomena such as gross domestic product (GDP) and how it is affected by changes in unemployment, national income, rate of growth, and price levels.
Macroeconomics analyzes how an increase or decrease in net exports affects a nation's capital account, or how GDP would be affected by the unemployment rate.
Macroeconomics focuses on aggregates and econometric correlations, which is why it is used by governments and their agencies to construct economic and fiscal policy. Investors of mutual funds or interest-rate-sensitive securities should keep an eye on monetary and fiscal policy. Outside of a few meaningful and measurable impacts, macroeconomics doesn't offer much for specific investments.
John Maynard Keynes is often credited as the founder of macroeconomics, as he initiated the use of monetary aggregates to study broad phenomena.1 Some economists dispute his theory, while many of those who use it disagree on how to interpret it.
Investors and Microeconomics vs. Macroeconomics
Individual investors may be better off focusing on microeconomics than macroeconomics. There may be some disagreement between fundamental (particularly value) and technical investors about the proper role of economic analysis, but it is more likely that microeconomics will affect an individual investment proposal.
Warren Buffett famously stated that macroeconomic forecasts don't influence his investing decisions. When asked about how he and business partner Charlie Munger choose investments, Buffett responded, "Charlie and I don’t pay attention to macro forecasts. We have worked together now for 50 years and can’t think of a time we made a decision on a company where we’ve talked about macro."2 Buffett also has referred to macroeconomic literature as "the funny papers."3
John Templeton, another famously successful value investor who died in 2008 at the age of 95, shared a similar sentiment. "I never ask if the market is going to go up or down because I don't know. It doesn't matter. I search nation after nation for stocks, asking: 'where is the one that is lowest priced in relation to what I believe it's worth?'" he once said.
Ref:
Microeconomics vs Macroeconomics: What's the difference? Available at
https://www.investopedia.com/ask/answers/difference-between-microeconomics-and-macroeconomics/