Simplify Your Life

This is the very first thing I wanted to simplify… ever. Economics, especially macro economics is one of the key factors that drives our world and our daily lives (how many times did you hear the word inflation this month?), yet i can guarantee that most people have no clue why and how these factors impact us.

So, if you are keen to understand how simply macro economics works, read on.

Let’s start with what is Macro economics – simply put, it’s the study of the economy of a whole country i.e. a big picture view. Micro economics on the other hand takes a narrower view of how demand, supply and prices of 1 items changes.

Key terms in simple terms

1. GDP (Gross Domestic Product)

Total value of goods and services produced by a country in a year. The wealth of a country is measured by its GDP. Average wealth of the people of the country is measured by GDP per capita (i.e. GDP per person).

Ways to measure GDP:

• In simplest term, sum total of price x quantity of each goods and services
• Another way to measure is GDP per capita (productivity) x # of people

Why do governments aims to increase GDP YoY (Year on Year) instead of letting it drop or keep it constant?

• Govt wants to reduce unemployment rate of the country’s citizens. This automatically leads to higher GDP
• Coz it’s relative wealth. If all countries don’t do the same, the country that doesn’t focus on increasing GDP will keep becoming relatively poor. Unless the country is completely self sufficient, it needs to buy goods and services from other countries and if you get relatively poorer, you can only get lesser goods and services YoY.

2. Inflation

Price of goods and services going up year on year. Measured using increase in CPI (Consumer Price Index) which is price for a fixed basket of goods and services. Inflation only really impacts people if the wage/income is not growing at the same or higher rate as inflation.

A steady GDP growth may result in steady inflation eg. 2% GDP growth will cause 1-2% inflation. As GDP is price x quantity, to keep GDP growth at steady rate both, price and quantity needs to go up at a steady rate.

3. Recession

If GDP falls 2 consecutive quarters, the economy is said to be in recession.  

4. Interest rate (IR)

Cost of borrowing/ taking a loan. The less risky the loan/borrower is, the lesser the cost and hence lesser the IR. In US, IR of loans taken by Treasury (called Government Bonds) is the lowest as government is the least risky borrower (too big to fail?)

5. Unemployment rate

% of the people who are eligible to work and want to work (called labour force), who are not working at the moment.

As you can see, it‘s not based on the population but only considers those who are “eligible and want to” work. Hence, another factor to consider is Labour force participation rate which is Labour force expressed as a % of the population. The labour force participation rate for a country doesn’t change drastically over the year but may change over the long term eg. More women want to work.

Key organisations that oversee macro-economics

Federal reserve or Fed

• Key objective is to maintain a low & steady inflation rate (eg. ~2%) and low unemployment rate (eg. <5%)
• Sets the interest rate on the reserves that commercial banks have to keep with Fed and hence sets the IR that’s experienced by the public.
• Also prints money – I will add more details on this soon.

Treasury dept of the government

• Collect taxes and spends money on govt programs and national infrastructures 
• Same objectives as Fed + increase GDP (promote economic growth). Spending money on govt programs will help boost countries GDP

How to drive the various factors of macro economics

Now that we have a good understanding of the various factors/ terms in macro economics, how do we influence them and how do they impact each other?

Price of goods/services vs demand & supply – The fundamental principle in economics

• Prices go up when demand increases or supply decreases
• Prices go down when demand decreases or supply increases
• Free markets tries to get to an equilibrium when demand = supply to set the steady state price

How to increase GDP

• Easiest way (short term) is to increase # of people employed (increase employment rate or labour force participation rate). If productivity is assumed constant, more people will mean more GDP.
• More difficult way (long term) is to increase productivity per employed person either through technology & automation or shift focus to industries with higher price (eg. Move from manufacturing to Pharma) 

Why inflation goes up beyond steady rate

• Most common reason – Drastic drop in supply of raw materials or labour eg. during Pandemic shut down of factories
• High demand more than expected. Unusual high demand is temporary as either the supply will catch up or unusual demand will die down.
  1. High demand can be due to a need for specific items – eg. indoor goods during Pandemic 
  2. Can be due to pumping too much money into economy – eg. when Govt gives every citizen money during pandemic or drastically decreases interest rate (through Fed)

Why its not ideal to have inflation above a steady predictable rate

• Like I mentioned above, inflation only really impacts people if the wages/income is not growing at least at the same rate as inflation
• If inflation is not primarily caused by wage increase (which most often its not because there is not usually shortage of people), the wage increases won’t keep up with initial inflation and people will feel poorer i.e get lesser goods for the same amount of spending -> leads to demand for more wages -> leads to further increase of cost of goods and services -> leads to businesses passing the cost to customer by increasing prices. Hence above normal inflation can be a vicious circle unless intervened.

How to control inflation 

• If cause is due to Supply shortage, harder to control but can still be controlled via below.
• If cause is due to excess Demand, easier to control by Fed through increasing internet rate on the reserves that commercial banks have with them-> makes the commercials banks increase their interest rates to their customers -> Depositing money in bank makes more sense while borrowing money both for personal reasons and for companies make less sense & for mortgages with variable rates, the immediate expenses of the customers go up -> less money for “investment” for companies and for “expenses” for customers -> Investments by companies go down and demand for things by customers go down -> Demand goes down -> Prices shouldn’t go up and hence inflation should go back to steady state.
• Inflation is sometimes caused by expectation of inflation. If some people think that other people and companies are going to increase prices, they increase their own prices in anticipation. Hence it’s important for govt to manage inflation expectation.
• There is a delay b/w increasing interest rate and CPI going down (up to 2 yrs) if done in a gradual way. Plus with the need to manage expectations of inflation, the new found wisdom is to increase interest rate at a drastic rate to send clear signal to market the intent of the govt.

Dangers of trying to control inflation

• Demand can fall too fast and hence prices go down so fast that GDP goes down leading to Recession.
• Lesser demand means lesser need for labour and hence unemployment and hence further reduction in demand. This is the opposite vicious circle that can start.