Friday, October 17, 2014

Macroeconomic Logic-What Textbook Doesn't Tell You (Important for CIE/ CAL AS Economics) (Part 1)

This section is even far more important than my previous posting. A lot of the exam questions, especially macroeconomic essays cannot be well-answered if candidates have poor understanding of how Chapter 5, 6 and 7 are inter-connected. It is a crucial exam skill but for the current CAL/ CIE Economics syllabus, I personally find that the Chapters/ sub-topics aren’t organised in such a way that give candidates the best understanding of macroeconomics and how all those issues are related. In that perspective, Edexcel is way better where macroeconomic variables are introduced one at a time and students are taught to connect them all. While CIE does teach most of the macroeconomic variables, it seems that they are all over the place. GDP/ economic growth is in fact the most fundamental macroeconomic concept, but the weirdest part is that they chose to include it in A2. Most of the time when we talk about lowering unemployment, fall in inflation and widening of current account deficit, we cannot isolate economic growth from our discussions

At the most fundamental level, there are four main macroeconomic variables and they are economic growth, inflation, unemployment and current account deficit
1. Economic growth. Technically, a country/ nation is said to experience an economic growth if there is an increase in the real GDP or potential GDP. Both types of growth can be easily illustrated using the AD/ AS analysis. The former is achieved when the AD curve shifts rightward and the latter is attained when the AS curve increases. They are both growth but not quite the same. In layman’s term, real GDP refers to how much output (quantity) produced in the present whereas potential GDP refers to how much output a nation as a whole can actually produce if there is an improvement in both quantity and quality of factors of production. Since no one, not even economists can actually gauge the true underlying ability of an economy, therefore the term ‘potential’ is being used. As for out discussion here, we will mainly relate growth to an increase in real GDP. If you feel more comfortable, just think of it this way; so long as there an increase in output/ goods and services produced, then economic growth is said to have taken place in a country. More output implies more foods and beverages served, more new furniture produced, higher number of clothes, shoes, air conditioners, cars, mobile phones, papers, tiles, bricks, glasses, concretes, financial products, haircuts and others all made within the border of a country

2. Unemployment: It is when a person who is within the working age, willing and able to work but unfortunately fails to land on a job at the going wage rate. Bear in mind that not everyone who is within the working age group can be classified as jobless. To be counted as one, that person must fulfill all the conditions stated earlier. For an instance, if a person gave job searching and is 30 years old, then he/ she cannot be counted as one since there is no willingness involved. Equally if someone who voluntarily quits his/ her day job to enter full time studying, then that cannot be counted as well

3. Inflation: It is when there is a sustained increase in the average price level. Bear in mind this, just because the price of one or two main items have gone up, it cannot be a basis for us to claim that inflation has taken place. For inflation to exist, there must be an ongoing/ continuous rise in general prices and also overall price increase must be greater than overall price decrease. It is also true that the inflation may not be representative to everyone since our basket of consumption may differ substantially

Current account deficit. It is when the overall outflows of money are greater than the inflows for trade in goods, trade in services, net investment income and net transfers. Usually, the case of current account deficit is due to the poor overall performance for both trade in goods and trade in services. For most of the economies, these two components under the current account are the largest determinant

Now, upon understanding of the basics, we shall step into the next section which is understanding how these four components eventually affect one another. Please do not attempt to rot-learn/ rote-memorise. Use as much logic as possible. That is what I call as ‘sustainable learning’:

1. Economic growth vs. inflation: When there is growth, it is normally followed by a period of rising income. Well how? As mentioned earlier, more output will be produced and to produce that much output, factors of production have to be paid. With more income, consumption into the economy will increase and this can be represented by a rightward shift of AD curve. Demand-pull inflation takes place

2. Economic growth vs. current account deficit. Again, when income rises, people will have more money to spend into the economy. However, it is worth noting that not everything that they spent on is manufactured locally. Some of them are imported goods and services e.g. purchase of imported cars and travelling abroad. This means more money flowing out of the country and hence the case of current account deficit

3. Economic growth and unemployment. When income rises, people will have money to spend into the economy. They will go shopping, travelling domestically, watching movies, fine dining and others. This means businesses will have to employ more people to cater/ accommodate for the rise in customer sales and so unemployment will fall

4. Unemployment vs. inflation. There is an interesting relationship between these two. They are naturally, inversely related. As unemployment rises, inflation will fall and if unemployment falls, inflation will rise. Why is that so? When more people are unemployed, the spending power into the economy will fall. This means a fall in AD curve and so less demand-pull inflation. Likewise, when unemployment rises, it will put a downward pressure on wages. This means a fall in cost-push inflation as well. On contrast, when unemployment is low, there will be greater spending into the economy allowing demand-pull inflation to take hold. Equally, if unemployment is low, skilled manpower can be scarce and in other to retain or attract the best talents to work for them, wages have to be increased. This is the basis for cost-push inflation

5. Unemployment vs. current account deficit. When many people are jobless, that implies weaker overall spending into the economy which may lead to lower consumption of imported goods and services. As less money is outflowing from the country, then size of current account deficit will shrink

6. Inflation vs. current account deficit. When the country experiences relatively higher inflation than its commercial partners, then its goods and services produced are likely to become less price competitive. This implies lesser exports as trading partners would probably substitute towards other countries that are more price competitive. Therefore, current account deficit worsens

Part 2 will come very soon

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