Thoughts on Macroeconomics

Some thoughts:

  1. How wealthy or economically strong a country is depends on the real output (goods and services) of the country. The real output is independent of the currency.
  2. Another way to think about how wealthy is a country is in terms of how much is consumed by the country in terms of real goods and services. For example, the U.S. can be consuming alot through current account deficits and borrowing and the country is using those to fuel current consumption. The citizens are indeed enjoying the goods and services. This could be paid for by other countries if the U.S. is able to inflate their way out of debt.
  3. Why is it that goods and services in developing countries such as Indonesia are cheaper compared to other countries, in other words, why is it that its currency is weaker (in terms of purchasing power for real goods and services) compared to other countries’ currencies? Clearly the law of one price does not hold. This may be due to trade barriers or natural barriers (e.g. for local services). What would happen a country with a weaker currency suddenly decides to issue a new currency which is pegged at 1 to 1 with say the USD or Euro?
    1. Instead of being paid X$1 per hour in the past where X$100 = US$1, each worker is now paid Y$1 per hour where Y$1 = US$1. Apples in the country, instead of costing X$1 or US$0.01. it now costs Y$1 or US$1.
    2. For a country with domestic self-sufficiency with no imports or exports, this can work, afterall it is merely a change in the currency label.
    3. If a country has exports, those exporters will suffer as what they are selling has now become much more expensive in the global market. They will end up selling less, receive less of Y$s, and have less spending power in their own country. Even for companies that invested and produces overseas, their repatriation profits will be hurt. However, the upside of this is that the majority of  the citizens will benefit as they now earn in Y$s which is now an internationally strong currency. For example, a fruit seller can now travel in style in a country with a much weaker currency, much as how people from America and Europe travel in Asia.
    4. For imports, now the citizens have greater purchasing power, and is able to import more goods from other countries.
    5. What is the flip side of exporting less and importing more? The country with the trade deficit will need to finance it somehow in order to obtain the goods from another country. It can do so in two ways: it can either borrow money (i.e. issue IOUs in either its own currency or the other country’s currency), or it can print more of its own currency. Can a country increase its money supply without devaluing its currency? Yes if there is a corresponding increase in the real output of the country. [actually it is more complicated than this: a company say Toyota when they “export” cars to the U.S., they would put in investments into the U.S. upfront, and sales are in US$, cost of production is in US$, profits are kept in US$ unless repatriated. This is as opposed to toy exports from China where there is a currency transaction for each shipment, as the cost of production is in RMB. So not all “exports” are the same.]
    6. When a country gives away its currency, it is also giving claims to other countries on the real output of the country, which can be consumed now or in the future.
    7. Note that any activity where foreigners exchange their currency for the local currency in order to consume local goods and services, is a form of export. For example, tourism is an export even though the consumption is within the country.
  4. Money
    1. How does increase/decrease in money supply affect interest rates, exchange rates, and price levels? The relationships are not clear cut. The textbook relationship assumes that the increase/decrease in money supply is the only factor that changes, and the demand for money remains the same. Hence when money supply increases, interest rate falls, exchange rate depreciates, and price level rises (inflation). And the relationships are flipped when money supply decreases.
    2. When money supply increases, interest rate should go up in the medium-term. The Fed increases money supply by purchasing Treasury bills from the market. They create money simply by increasing the value of the seller’s account at the Fed (i.e. increases the Fed’s liability). Where does that created money go to? It essentially is giving the seller (of the bills) new cash (i.e. increases the seller’s reserves). The seller can then proceed to use the money (e.g. issue more loans), circulating the new money into the system, starting the money multiplier effect. Eventually, the money ends up in the hands of individuals and retained in companies. Interest rate should go up because when everybody is more “wealthy” in the money-sense, the market can demand a higher interest rate of repayment which can be met if there has already been a pattern (and people expect the pattern to continue) of money creation. This would be the case when the real output increase is lower than the increase in money supply, leading to an increase in aggregate price level. At the extreme, you can think of the scenario of hyperinflation where interest rates can be 100% a day.
    3. In the short-term, interest rates go down because the Fed as the buyer of Treasury bills is willing to pay higher prices (i.e. accept lower interest rates) to implement their policy decision. When the banks are able to borrow at a lower interest rate, they will earn increased profits in the immediate term,  but competition would gradually cause them to lower the interest rates at which they lend money to others, hence leading to lower interest rates in the short-term for the market as well.
    4. In a hypothetical scenario where there is no Fed, but there is a sudden increase in the money supply, interest rates would only go down when the lenders hold a concentration of the created money (which would likely take time), and the additional money has no additional outlet (e.g. other investments, buying imports, increase in real output of the country that needs the increased money to oil).
    5. What about the case where money supply decreases? The Fed can reduce the money supply by selling Treasury bills to banks, which reduces the amount of reserves held at the Fed. By accepting a lower sale price (hence giving the buyer a higher interest rate of return), the Fed can effectively increase the interest rate of borrowing (for future sellers) as well. One is by taking out the buyers that only require a lower rate of interest for returns (think in terms of bid-ask), and another is by decreasing the amount of reserves available for lending hence if the demand for reserves remain the same the fed funds rate will increase). By increasing the fed funds rate, this woul cascade down to the market rate of interest as banks will increase their lending rate to maintain margins. Hence in the short-term, when the money supply decreases, interest rates rise.
    6. What about in the medium-term? Theoretically, when money supply decreases, and the amount of output decreases by a lesser amount or does not decrease at all, the aggregate price level of goods and services should drop (e.g. deflation). Because of that, if the expectation is for deflation to continue (which can be due to either policy actions or pure psychology as what happened in the 1929-1933 depression), then interest rates should go down in the medium-term. This typically triggers a whole set of problems which policy makers would rather avoid by always increasing the money supply and controlling inflation instead.
    7. For exchange rates, this is an interesting situation. It is somewhat similar to stocks but yet dissimilar. In stocks, you have informed investors making long-term bets with big money, and short-term fluctuations driven by speculation, so in the short-term it is unpredictable but in the long-term stock values follow the economic fortunes of a company. For exchange rates, the major difference is that it is rare to have long-term investors in the currency market (e.g. horizons of 5 years or more) that help to “right” the market. Hence the fluctuations in exchange rates is driven more by central bank policies, trade and economic growth considerations. Hence it is really important to look at what each country is likely to do in the currency market. If say we disregard that for a moment, and assume that it is a truly free market. When money supply increases, it does not translate to a depreciating currency unless there is a need to buy the output of other countries, hence the need to sell the local currency and cause the depreciation. Without such a need, the increased money supply can be retained within the country without immediately affecting the exchange rates. What about in the medium-term?
    8. For the aggregate price level, if the real output of the country remains the same while money supply increases, without taking into account imports/exports, the aggregate price level clearly rises. It should stay the same if the real output of the country increases at the same rate (again without considering imports/exports).
  5. On-going


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