Macro Economics...Macro/Micro Economics Learners & Trainers 1st Floor Water House , Ijora Lagos....

SEGMENT II

Macro Economics

Learners & Trainers Macro/Micro Economics

Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860

MACRO ECONOMICS

MACRO is from the Greek word ‘MAKRO’ meaning ‘large’. MACRO Economics is

therefore ‘Large Economics’ that focuses on aggregate (overall) variables. It deals with

the economy as a whole and as a system.

Some major economic issues in our country today relate to the depreciating value of the

currency, the increase in minimum wage, high interest rate, high unemployment rate, the

national debt issue, privatization, etc.

Some Macroeconomic Considerations

Aggregate Demand for goods and services

Aggregate Output

Aggregate Employment

Aggregate Price Level (Interest rate, Exchange rate sand other prices)

Aggregate Money Supply, etc.

MACRO-ECONOMICS OBJECTIVES

Some of the major objectives of the macro economics is to review economic issues that

impact the life of each of us

Economic Growth

Price Stability

Full Employment

Balance of payment Equilibrium



MACRO ECONOMIC POLICES

Fiscal Policy

Monetary Policy

Income Policy

Fiscal Policy

Fiscal policy is concerned with the use of government’s variation in taxation and

government expenditure to achieve macro-economic objectives.

Instruments: -

Taxation i.e. increase or decrease in tax rates

Government Expenditure i.e. Increase or decrease in government spending.

Example: -

a. Reduction of tax rate can address the problem of low aggregate demand and

employment.

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b. Lower taxes would raise disposable income that in turn would increase

purchasing power and aggregate demand through the multiplier process.

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c. Increase in government spending will achieve similar effect.

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What will be the impact of increased government spending on inflation?

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Monetary Policy

Monetary Policy is the way the government uses the changes in money supply and cost

of credit to achieve macro-economic objectives.

Instruments: -

Some of the instruments that the government, through the Central Bank, uses

to drive its macroeconomic objectives include the following.

Cash and Liquidity Ratio

Open Market Operations

Special Deposits

Stabilization Securities

Discount (Bank) Rate

Moral Suasion



Example:

The Central Bank uses the Open Market Operations to control Interest rate and to

influence liquidity in the system. As banks buy treasury bills and other instruments from

the Central Bank, liquidity is mopped-up and the banks’ capacity to create credit declines.

Ultimately, via the multiplier process, there is less money in the hands of the banking

public and hence aggregate demand drops.

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Income Policy

Income Policy describes government’s attempt to achieve price stability and other

objectives by setting ‘caps’ and ‘floors’ i.e. limits on income or prices.

Sometime government policies are designed to suppress the effect of inflation through

wage and price controls and/or exhortation, such that outward shifts in aggregate

demand caused by fiscal and monetary stimuli will show up in larger GNP rather than in

higher price levels.

Instruments:

Minimum wage legislation

Price controls e.g., maximum rent collectible by landlords

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NATIONAL INCOME ANALYSIS

Definition:

National Income (NI) represents the monetary value of goods and services produced

during a particular year by the different sectors i.e. economics units within the economy.

This relationship is expressed in the following NI equation.

Y = C + I + G + (X - M)

Where,

Y = National Income

C = Consumption by Household (Individuals)

I = Investment by business firms

G = Expenditure of public sector (government)

X - M = External trade sector X = exports

M = imports



Methods of measuring National Income

Output Method

Measure NI in terms of Gross Domestic Product (GDP) i.e. goods and services produced

by all sectors (public sector and private sector vis-à-vis manufacturing, oil producing,

banking and finance sub sectors, etc)

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Expenditure Method

Measures NI in terms of Gross National Expenditure (GNE) i.e. total expenditure by all

economics units vis-à-vis household, business firm, Government and External Trade

Sector.

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Income Method

Measures NI in terms of Gross National Income (GNY) i.e. income accruing to all sectors

of production

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THE CIRCULAR FLOW OF INCOME

The flow of income in the economy is circular- ‘what goes round comes round’.

Households get their income from the firm as wages and salaries for their productive

services. The productive service of the household is one of the inputs into the generation

of the output of the firm. The firm gets income for the goods and products that it sells to

the households. The household needs the firm for its salaries while the firm depends on

the spending of the household.

The circular flow of income demonstrates the interdependence between the firm and the

household. The fortune of the household is closely tied to the success of the firm.

GDP = GNE = GNY

With accurate computation, total goods and services produced equals the total

expenditure on the products; which also equals the distribution of the sales proceeds as

factor payment; they are only different stages of the same circle.

Pmt to Capital, Wages,

Salaries

Productive Service

Money Goods and Services

FIRMS Households



THE MULTIPLIER CONCEPT

The multiplier refers to the rate of increase or decrease in the National Income level as a

result of changes in any aggregate variable such as Business Investment, Government

spending, etc. it explains the basic dynamics of the impact of government economic

policy on the total economy.

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MONETARY POLICY

Goals Of Monetary Policy

Government seeks to regulate the rate of inflation, economic growth and employment,

through the control of the money supply and the cost and availability of credit, in order to

regulate demand, output, inflation, interest rate etc. A very important objective is the

stability of the financial and investment environments especially the banking sector. Other

major goals of monetary policies are to increase output and reduce inflation in the

economy.

Monetary Policy is, however, only part of a government’s economic strategy and it is

vital that monetary policy is pulling in the same direction as other objectives.

For instance, a firm control of the money supply to restrain the level of monetary demand

would be useless if at the same time government did not control its own expenditure or

was to make big reduction in taxation.

Note that there could be conflict between the various objectives of the government’s

economic strategy. A possibility of conflict arises between maintaining a favourable

balance of payment. Devaluation of the currency has not stimulated the inflow of foreign

capital but has caused capacity underutilization and massive lay off of labour.

The federal government seeks to control the money supply through the central bank



Quantity Of Money

The relationship between the volume of money and the price level is a useful measure of

inflation.

The quantity theory of money is that increase in the money market stock leads to

higher expenditure, which in turn, through inflationary pressure (i.e. excessive demand in

relation to supply), can lead to rising prices.

The equation of exchange is often used in a very simplistic way to illustrate how this

may happen, i.e.

M V = P T

Where M = Money Supply,

V = Velocity of circulation,

P = Prices,

T = Transactions

The velocity of circulation is the number of times that the money supply changes

hands in a given period (usually a year) and MV is therefore the effective money supply.

The effective money supply must equal the total value of transactions during that given

period, but if it can be safely assumed that the velocity of circulation and total output have

remained unchanged, then the equation tells us that any increase in M will have brought

about an increase in P.

Unfortunately, it is not possible to measure the velocity of circulation, nor is it likely that T

will remain unchanged over any really reliable way in that T includes not only goods (the

output of which can be really measured) but also all other transactions such as financial

services.



What is Money?

Money is anything that permits indirect exchange of goods and services. (Barter is direct

exchange rice for yam).

Functions of Money

Store of value - a temporary store

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Unit of Account

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Medium of Exchange – a generally accepted means of payment

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Standard for deferred payment –a means to discharge debt

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Classification Of Money

Money is classified in terms of liquidity. Currency is the most liquid because it can

perform the function of cash on the spot

A liquid asset is one that can be quickly and readily used in transactions with minimal risk

to its value in the process of exchange of value.

M1 or Narrow Money

This includes currency in the hands of non-bank public, demand deposits.

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M2

This is a broader classification of money. It includes all categories of funds in M1 as well

as small savings deposits and small-time deposits. M2 emphasizes the function of money

more as a store of value

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M3

This classification includes M2 as well as large time deposits and similar assets held

primarily by businesses and wealthy individuals.

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The Creation of Credit

The tools used by the central bank, as the agent of government, to control the money

supply are centred round the control of the growth of bank deposits; Banks can create

credit, i.e. create new deposits.

When a bank receives a new deposit (note well that this must come from outside the

banking system), it can increase its advances by a proportion of that deposit. It needs to

keep a reasonable liquidity ratio. The regulatory authorities prescribe liquidity ratios to

control economic variables.

Illustration

If bank A receives a deposit of $1 million from a customer Abdullah who sold goods to a

government department for that amount; Bank A is required to keep 30% of it in cash and

other liquid assets and lend the remaining 70%.

Bintu borrows the $700M Bank A, He pays Mustapha who lodges the cheque drawn on

Bank A with Bank B.

Bank B is now in a position to lend part of the $700M

Let us assume that Bank B also keeps 30% in liquid form, it lends £490M to Yejide who

buys goods from Stobbers, a customer of bank C. Stobers pays this amount in his

account in Bank C

This process can go on and on with each in bank in turn lending 70% of each fresh

deposit. We will end up with an increase in bank deposit of $3,333,333 i.e. 3 ⅓ times the

original amount paid in.

Monetary Targets and Monetary Instruments

Annually, the government announces its target for the growth of the money supply during

the following financial year and sets about achieving that target. In order to do so, the

government must set a target for its own expenditure during that period (usually this

means the size of the deficit, i.e. the extent to which expenditure is to exceed income

from taxation and other sources), and also employ a number of monetary control tools

through the agency of the CBN. The possible tools are as follows,



Interest Rates.

By making money dearer through an increase in interest rates, a government might, in

theory, discourage borrowing and vice versa: If it makes money cheaper through a fall in

interest rates.

If borrowing is discouraged then banks will be less able to create credit and the money

supply is stopped from increasing. Considerable doubt has been expressed by

economists as to whether industrialists are discouraged from borrowing (and carrying out

capital investment) in this way, but it does seem likely that really high interest rates will

have this effect.

The central bank regulates the interest rate in the market. It now operates a policy of

guided deregulation. It continues to influence rate through its operation in the open

market (OMO).

Open Market Operations.

The Central Bank purchases or sells government securities (Commercial bills and

Treasury bills and, to some extent, government stocks) in the open market essentially to

the private sector. Trading is done in the money market and stock dealers. When the

Central Bank sells such assets, the Bank is able to mop surplus funds out of the market.

This reduces the ability of the banks to create credits and also tends to force up interest

rates because the supply of loan able funds is reduced.

The Central Bank could also drive down rates through its influence in the open market

operation by loosening its grip on funds are made available to the private sector, OMO

has two effects on the quantity as well as on the price.

Despite what has so far been said, do note that open market operations are used to a

considerable extent simply to even out the flow of funds. By evening out the flow, the

consequences of an uneven flow of funds on both the money supply and on interest rates

can be obviated.



Special Deposits. The Central Bank has the power to call upon recognized banks and

licensed deposit –takers to lodge a percentage of their eligible liabilities with the Central

Bank on a special deposit account to be frozen until the government decides that they

shall be released. The Central Bank determines the rate on these deposits. Central Bank

in the past slapped banks with stabilization securities on which it paid nothing. Such

compulsory deposits have an immediate and drastic effect upon the banks` ability to lend

money and they may even be obliged to reduce their advances in order to find the

necessary liquid funds to hand over to the Central Bank

Reserve Assets Ratio.

By compelling the banks to keep a certain proportion of their eligible liabilities in liquid

assets {cash, call money and bills}, the banks would find that only a restricted proportion

of any fresh cash coming into the banking system could be lent to customers. If the

reserve ratio was high, the effect upon the growth of the money supply could be severe,

Directives to the Banks.

The Central Bank gives guidelines annually concerning the level and nature of advances.

This tool has a direct effect upon credit-creation,

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THEORY OF INTEREST RATE

Definition and Background;

Interest rate is the reward to owners of capital or the cost to the employer of capital.

Here, we are narrowing down to money aspect of capital and therefore interest rate as

the price of money.

Put differently, interest rate is the opportunity cost of being liquid (holding money) i.e. the

yield foregone. Therefore, if this cost increases, people are more unwilling to hold money,

they would rather put it in other assets, while they tend to hold more money when interest

rate is falling.

Why People Hold Money

Transactionary Motive;

People hold money for purpose of meeting current transactions (purchases of

goods and services). The more current transactions undertaken, the larger the

demand for money e.g. During Christmas and other festive periods, people tend to

hold large idle money because of greater spending requirements.

Precautionary Motive;

People often hold money in readiness for contingencies or possible events in the

future that might require spending e.g. accident, unemployment, car maintenance

Speculative Purpose

According to Lord Keynes, people hold money for speculative purpose (motive)

i.e. to guard against capital loss or to make capital gains.

The fundamental factor underlining whether to hold wealth in money (cash) or in any

other asset is the opportunity cost (the yield) or the interest rate.



Implications of interest Rate

Most businesses are directly affected by interest rate on only the liability side of the

business balance sheet, banks are directly affected on both the assets and liabilities

sides.

Interest is paid on deposits lodged by savers (savers are rewarded for parting with

liquidity). Banks also charge interest on loans granted to borrowers (borrowers pay for the

bank’s loss of liquidity and associated risks).

Interest rate is a compensation for temporary loss of comfort and convenience of liquidity

and also contains a premium for risk (possibility) of permanent loss.

Therefore, interest rate is an instrument of persuasion or inducement for someone who

already possesses cash to exchange it for some other assets, such that the higher the

interest rate the greater the inducement or incentive to part with cash temporarily.

1. The longer an investment (or loan) the greater the credit risk and hence risk

premium is required.

2. The longer the maturity the greater the liquidity risk i.e. the greater the sacrifice of

liquidity, which also requires premium.

3. The longer the maturity the higher the chances of market rate changes (interest

rate risk) which requires premium.

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INTERNATIONAL ECONOMICS

International Trade

Why international trade

No nation is self- sufficient in all aspects

Different nations have different and peculiar endowments vis –a vis, mineral resources,

labour skills, climate.

Each country as an economic entity seeks to maximize its profits.

International trade, therefore, ensures availability where there is shortage and also

prevent waste where there is surplus and excess production capacity. It is also beneficial

in terms of opportunity cost of production i.e. comparative advantage (produce when

opportunity cost is lower)

A producer has comparative advantage if the opportunity cost of expanding production is

lower than for all other producers.

Imports are the goods and services one country buys from another

Export are the goods and services one country sells to another.

Hurdles in international Transactions

Differences in language

Weights and measures indices

Government regulations

Differences of currencies etc

These differences among the nations especially the currency make settlement a problem

among trading partners

The financial system through banks has minimized most of these problems substantially.



CONCEPT OF INTERNATIONAL TRADE

Terms of Trade

Terms of trade measures the purchasing power of one unit of export i.e. the quantity of

domestic goods or export that must be given up to get a unit of imported goods.

Put differently, it is also the opportunity cost of importing rather than domestic production.

It expresses the vulnerability of countries to the changing prices of their exports on the

international market

If a company can intervene to increase its term of trade, then the country should be able

to better its lot. However, the world market approximates a perfect competition therefore it

is difficult if not impossible for any one country to manipulate its export or import price

Laws of Comparative Cost

Comparative costs are about a country concentrating its productive resources and efforts

in the production of goods and services where it has the greatest comparative advantage.

It Is in fact possible for a country to benefit more by importing a good that it could produce

at less cost at home that abroad.

Purchasing Power Parity Theory:

According to this theory, the purchasing power of a currently, eventually, is the same in

whatever country it is spent.

Suppose it costs $100 to buy an item in Nigeria but the same item costs only $50 in USA

due to lower internal prices (inflation), it is more attractive to buy from the USA to take

advantage of the gain – Arbitrage

Ceteris Paribus, Nigerian importers would be buying from USA rather than at home until

the increased demand raises the price in USA to the same level in Nigeria - parity of the

Dollar ($) both in Nigeria and USA.

This theory also underscores the fact that inflation erodes purchasing power of the local

currency in terms of the other currencies.



Balance of Trade

The Balance of Trade looks at the different between what a country exports and what it

import.

☺ A favourable balance of trade arises when exports exceeds imports. This is also

referred to as a Trade Surplus

☺ An unfavourable balance of trade occurs when imports exceeds exports. This is also

referred to as the Trade deficit

Balance of Payments

Balance of payment is a record of the transactions between a country (its residents,

enterprise and the government) and the rest of the world over a period of time. It includes

all visible and invisibles exports and imports, both current and capital in nature.

Balance of Payment Surplus

Excess of exports (inflow of foreign exchange) over imports (outflows of foreign exchange)

is referred to as balance of payment surplus

Balance of Payment Deficit is the reverse, where imports (outflows of foreign exchange)

are greater than exports (inflow of foreign exchange).

Both scenarios (deficit or surplus) describe disequilibria in the external sector of a country.

However, the real problem is deficit, which has damaging consequences for the local

currency and the entire economy of the nation concerned.

Balance of payment deficit may not be a problem if it is only temporary, but it would surely

is a crisis it persists.

The balance of payment always balances for the following reasons:-

All sources of funds must equal all uses e.g. all spending of FX in excess must be

financed through borrowing, all of which must be accounted for.



The net Balance of Payment situation (deficit or surplus) is a mirror image of FX

position with the Central Bank. A surplus, invariably, is accounted for in the central

bank, by physical FX, foreign reserves balance, Gold reserve, IMF reserves etc,

while a deficit would reflect a depletion of these international assets.

Current and Capital Account

The current account records visible exports and imports, which are for immediate or short-

term consumption or maintenance purpose. There is current account deficit, if current

imports exceed exports. The converse is surplus. A country may have a current account

deficit but a balance of payment surplus and converse is also true.

The capital account records transactions which are for investments purpose or are basically

payment or long-term in nature e.g. machinery imported for purpose of plant installation,

direct foreign investments etc.

Visible and Invisible

Visible items are tangible assets e.g. gold, cocoa, oil etc.

They could either be current like cocoa.

Or capitals like plant.

Invisibles on the other hand, include services, expenditure on tourism, and investment

outside the country.

Invisibles could be current in nature such as tourism or

capital investment in nature such as long-term investment.

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Official Financing

This segment in balance of payment explains the transactions done by the Central Bank of

the nation either to fund the deficit or to apply the surplus.

In case of deficit, various financing sources available include, borrowing from IMF, exercise

of special drawing rights with IMF, loans from other multilateral and bilateral sources and

depletion of reserves (foreign reserves, gold reserves, or IMF reserves).

In case of surplus, the Central Bank could use the excess to increase the reserves of FX,

Gold or it could invest in international markets or pay-off outstanding debt.

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BACKGROUND TO FOREIGN EXCHANGE

Definition-

Foreign exchange is all claims to foreign currency payable abroad whether consisting of

funds held in foreign currency, with banks abroad, or bills or cheques payable abroad. A

foreign exchange transaction is a contract to exchange transaction is a contract to

exchange a bank balance in one currency for a bank in another currency at and agreed

rate on agreed date.

Foreign exchange is an integral part of our daily lives. Without foreign exchange

international trade would not be possible. For instance, a French wine producer will incur

his expenses in French, when he sells the wine, he wants to receive French francs to meet

those expenses. But he sells to an English merchant, the English man pays in his own

currency, pound sterling. In between a transaction has to occur that converts one currency,

into another. That transaction is undertaken in the foreign exchange market.

However, foreign exchange does not involve only trade. Trade these days is a small part

of the foreign exchange market. Movements of international capital, seeking the most

profitable home for the shortest term today dominate the foreign exchange markets.

Money changing has been a part of the business of money since the first coins were mind

and is even mentioned (somewhat unfavourably) in the Bible. The first forward foreign

exchange transactions can be traced back to the moneychangers in Lombardy in the

1500s.

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The Gold Standard,

Foreign exchange as we know it today has its roots in the Gold Standard, which was

introduced in 1880. The main features of eh Gold Standard were a system of fixed

exchange rates in relation to gold and the absence of any exchange controls. Under the

Gold Standard, a country with a balance of payment deficit had to surrender its gold, thus

reducing the volume of currency in the country, leading to deflation. The opposite occurred

to a country with a Balance of Payment surplus. The Gold Standard survived until the

outbreak of World War One.

After the war, attempts to re-introduce the Gold standard failed because the major

currencies were either under-or over-valued, and also had different inflation rates.

The economic crisis of the 1930s and the outbreak of the Second World War forced all

countries to introduce exchange controls and lead to a suspension of efforts to stabilize

currencies.

Breton Woods

In July 1944, a meeting at Breton Woods, New Hampshire, adopted a proposal, which

came to be known as the Breton Woods System. The international Monetary Fund was

established to monitor the new system, whose aims were to eliminate exchange control,

implement convertibility of all currencies, and establish exchange rates.

The 1905s were a period of stable exchange rates and world-wide economic growth which

ended in 1960 when the US trade deficit of two previous year led to a loss of confidence in

the US Dollar and heavy buying of Gold. The 1960s saw widely differing rates of growth

and a series of devaluations and revaluations

In 1971 there was another loss of confidence in the US Dollar, and it ceased to be

convertible into gold. Thereafter the major European currencies were allowed to float.

The 1971 Smithsonian Agreement set new fixed parities for exchange rates, but

speculation and movements of capital forced central banks to resort once more to floating,

and by the end of 1973 the Breton Woods System was over.



European Monetary System (EMS)

Since 1973, several European governments joined together to form the “snake”. Which

was the precursor for the European Monetary System (EMS), as a way of stabilizing their

currencies. Under the EMS, which was established in 1976, the currencies are permitted

to move within broad limits against each other and a central point.

The late 1989s have seen large fluctuations in exchange rates capital flows have been

liberalized. Although changes in exchange rates are usually gradual changes that used to

take place over a matter of weeks can now take place in minutes. This has led to various

co-operative attempts by central banks to control sudden fluctuations in currency values.

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Parties Active in Foreign Exchange markets

Central Banks

Mainly active in managing the country’s reserves, and smoothing out fluctuations in the

value of their local currency.

Commercial, Investment Banks

These not only speculate, hedge and invest on their own and their clients behalf, but

also provide the medium of exchange for international trade and the liquidity that the

market needs.

Foreign Exchange Brokers

Act mainly as middlemen between other participants, matching buying and selling

orders, and disseminating information about market conditions. Brokers earn

commissions (“brokerage’) on each rather than seeking profit from trading.

Investment Funds

Move funds from one currency and investment vehicle to another.

Corporations

move funds between units in different countries to hedge exchange risks and

increasingly, for speculative purposes,

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ECONOMICS OF FOREIGN EXCHANGE

Foreign exchange rates are influenced by long-term factors )both economic and political)

and short-term factors (technical analysis and expectation versus actual events)

Long Term Factors Economics

Balance of payments

The balance of payments is made up of

Current Account and the

Capital Account.

The Current account includes

imports and exports of goods (trade account),

services and investment income.

All other things equal, if a country’s currency account is in surplus (i.e. it is exporting

more than it is important) then the demand for its currency will be greater that the supply

and the currency strengthens.

If the current account is in deficit the country is importing more than it is exporting, and

supply of its currency will be greater than the demand the currency will weaken.

The Capital Account measures the inflows and outflows of capital during a year.

Movements across the capital account are reversible unlike the flows on the current

account.

In recent years, due to deregulation and improved communication, international funds

transfer has become a fast efficient process. Capital movements can now change direction

abruptly and on a large-scale basis and this factor of large sudden capital movements has

contributed to the increasing unpredictability of exchange rates.



The difference between current and capital account is the change in reserves.

If for example, a capital account surplus exceeds a current account deficit, a country’s

reserves will increase.

The other factors that influence exchange rate movements can be analyzed with respect

to the effect they have on current account or capital account movements.

Inflation

In comparing two currencies, the currency with the lower inflation rate, all other things being

equal, should be the stronger currency. This is basis on the purchasing power parity theory.

Assume country A and country B both produce cars and the price is 10A and 10B per

respectively. Assume that the exchange rate is at parity i.e. 1A =1B.

now assume that in country A inflation is zero over 1 year and in country B that inflation is

10% over 1 year. At the end of the year 1, a car will cost 10A in A and 11B in B. The logical

action of ‘B’ people will be to buy their cars from country A. They will therefore sell currency

B and buy currency A which will strengthen B until there was no effective difference in the

cost of cars between country A and B (i.e 1A=1B).

In other words, those countries with low relative inflation rates can sell goods at a more

competitive price internationally. This will generally be reflected in rising export volume and

therefore an improving current account.

Economic Growth

The rate of economic growth can affect the current account in different ways. A country’s

economic growth can be export-led as has been the case in Japan. However, in some

cases, if an economy is growing at a fast rate relative to its major competitions, the need

for imported goods grows. This is because domestic demand cannot be fully met by

domestic production, whilst export demand will be increasing less quickly than imports due

to weaker growth abroad.

This will lead to deterioration in the trade balance. The reverse would be the case if

economic growth were slow relative to other major economies.



Fiscal Policy

Fiscal policy essentially the way a government chooses to manage its revenue (namely

tax) and expenses (spending on health, education, defence etc). The difference between

the two is the government deficit.

An expansionary fiscal policy would be employed by a government to increase economic

growth; this would be achieved either by lowering taxes or by increasing government

expenditure. The method chosen depends on the political inclinations of the party: the more

the right-wing parties- tending to favour tax cuts whist the parties of the left would tend

favour increased government spending.

A contradictory fiscal policy (increasing taxes or decreasing government spending) would

be employed to reduce economic growth.

Monetary Policy

Monetary policy is the way in which central banks choose to control either interest rates or

money supply. Latterly the major economies have been concentrating on the control of the

money supply.

Based on the monetarist theory that reducing the supply of money in an economy will

reduce the inflation rate. The main methods used by central banks are open operations,

where government bonds are bought or sold to change the supply of money, and

administer interest rate changes.

By issuing bonds, money supply is reduced, as the purchasers of the paper have to

withdraw money from the banking system to pay for the bonds, By buying back bonds or

other bills, liquidity is increased as the central bank adds funds to the banking system. The

central bank will indicate its views on the level of interest rates by the rates at which it

relieves shortages.



Interest Rates

The relationship between interest and exchange rates is a somewhat circular one.

Interest rates can affect exchange rates as explained below:

1 The level of real interest rates (nominal interest rates less inflation) is one of the

major factors that international investors consider in determining where to invest. High

interest rates will tend to attract capital causing a currency to strengthen.

2 The level of real interest rates also affects the domestic economy. High interest rates

tend to slow economic growth thus having a beneficial effect on the current account

However, exchange rates will also influence interest rates:

A country with a depreciating currency will have potential inflationary pressures.

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ECONOMIC CYCLE

We shall now look at the four stages in the cycle.

Time

The Four Stages Recovery

Expansion

Boom

Recession



1. RECOVERY

During the previous stage of the cycle i.e. recession – companies made many

adjustments to help them cope; generally they liquidate inventory and reduce the

workforce and other overheads.

During the recovery stage

Increase in the product demand leads to

- Higher level of production

- Longer working hours, and ultimately increases in the labour force.

Profit increase

Business becomes more liquid

Internal sources of funds exceed financing needs

Companies are able to invest in money market instruments

Companies may resort to the capital market to refinance some the short-term

debts that would have built up during the period of recession.

The demand for business loans either remains flat or declines during the

recovery period.

II) EXPANSION The economy continues to expand but at a slower rate than during the early recovery

stage.

Demand continues to rise

Inventory level rises

Increase in plants and machineries for future growth

Increase in capacity utilization

Increase in productivity and earnings

Rise in internal cash flow and RE

Increase in salaries and wages



Inflation begins to rise

Demand for bank loan increases

Banks are more liquid as a result of the money market savings during the

earlier recovery phase

Competition for loans increases

Interest rate increases

The increasing interest rate structure forces companies away from bonds to bank

borrowing.

III) BOOM

This is also sometimes referred to as the late expansion phase. Optimism mounts and

expectation propels the economy. Speculative practices also develop.

Demands continue to rise

Pressure on productive capacity increases

Inventory stockpiling prevalent

Inflation accelerates rapidly

Monetary polices to moderate growth – credit squeeze

Demand for bank loans exceeds the supply at the prevailing interest rate

The yield curve may become inverted i.e. short term interest rate exceed long term interest rate

The bigger companies may turn to the commercial paper market.

This is one phase where organisations must exercise due caution: It is easy to get carried

away by the optimism and the spate of activity in the economy.

Even though short-term rates are higher, organisation believing that the rates will soon

peak and then drop, will hedge his position by borrowing short term.



IV) RECESSION

Business activities contract as the expansion finally gives way to recession.

Backlog and demands fail

Production is cut back

Efficiency of production declines

Sales decline,

and inventory piles up.

As the recession deepens

Further cut in production

Lay off employees

Delay investment in fixed asset

Decline in earnings – losses galore

Attempts at cutting cost and improving efficiency.

Gradually work down inventory to match lower sales level

Inflation begins to moderate

During the later stage of recession

The demand for short - term loans decrease as operating cost and capital expenditure

are cut back. More emphasis is also placed on receivable collections. The level of

internally generated funds increases, therefore demand for bank borrowing flattens out.

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Macro Economics...Macro/Micro Economics Learners & Trainers 1st Floor Water House , Ijora Lagos....

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