Macroeconomic Management by the State – How Does It Work in Principles of Economics?

 

Macroeconomic management is about how the economy is led towards desirable directions and targets without confronting major volatilities. Markets constantly play a major role in this through their automatic gears connected to prices. However, the subject of macroeconomic management is mainly referred to how the state intervenes in the economy in order to achieve certain public interest targets as the state bureaucracy lines believe desirable for the general public from time to time. How the states do this world over are diverse. 

The two opposite extremes of interventions are the free-market system proposed by Adam Smith in the 18^th century and the fair income distribution between capitalists and labor proposed by Karl Marx in the 19^th century. Countries are seen following diverse points between the two extremes.

Examples for State Interventions

The types of state interventions proposed by various activists are diverse. A few examples are cited below.

• The types of state interventions proposed by various activists are diverse. A few examples are cited below.

• The state must cut its spending and budget deficit in order to reduce the public debt and inflationary pressures.

• The Central Bank should raise interest rates to reduce the growth of money supply in order to prevent inflationary pressures in the future.

• The Central Bank should keep interest rates low to promote economic growth and employment.

• Imports should be controlled while promoting exports to achieve a surplus on foreign trade.

• Import tariffs should be raised to protect local producers.

• Currency depreciation should be reduced in order to control the costs of production and living.

• The government should engage in a borrowing program from the IMF to solve the foreign currency problem.

• The government should facilitate the inflow of foreign direct investment to attract non-debt foreign exchange to strengthen the foreign reserve and protect the currency.

• The government should tax the wealthy and channel the proceeds to fund welfare schemes.

• The government should impose maximum prices on basic food items to reduce the cost of living.

• The government should impose minimum prices on domestic agricultural produce to protect the farmers.

One can compile an endless list of such proposals. However, many do not know whether or how such proposals can achieve the intended public objectives. Conversely, there are many instances that such proposals implemented in the past have not achieved the objectives. 

To understand the impact or effectiveness of such policy interventions, we must understand the operating mechanism of the economy.

Operating Mechanism of Economies – Supply Side and Demand Side

• The economy produces goods and services (GDP) which generate income (Y) based on its resource base or production capacity. This is the supply side of the economy. The income is spent for consumption and investment (spending). This is the demand side of the economy. Therefore, the GDP is necessarily equal to spending in real terms (equilibrium) in the economy. The savings is only an intermediary act to channel a part of income for investment. Savings in cash/currency kept idle is negligible in modern monetary economies and, therefore, savings is equal to investment over a period of time.

• Main sectors of the economy are the private sector and the government. Both sectors participate in production (GDP) and spending.

• In open economies, domestic spending is more than the GDP due to imports (M) and less than the GDP due to exports (X). Therefore, to calculate the GDP from the domestic spending, imports must be deducted, and exports must be added.

• The private sector has to pay taxes (T) and, therefore, its spending, i.e., consumption (C) and investment (I), is equal to its income less taxes.

• The government also spends (G)on consumption and investments financed by taxes and borrowing.

• Now, the macroeconomic chemistry is: GDP=Y=C+I+G-T+X-M. This is known as income identity which shows that the domestic income (value of the GDP) is equal to domestic spending. Savings is the amount of income not spent on consumption. Therefore, savings (S) available to the private sector is nearly equal to Y-C. Changes in income, tax and consumption will change the S.

• Accordingly, the income identity can be rearranged as: S= I+G-T+X-M. This gives a simple result as (G-T)=(S-I)+(M-X).

• This means that the government budget deficit is equal to the sum of the private sector net savings (S-I) and country’s current account deficit (net imports of goods and services including factors, M-X) in the BOP.

• This shows that although the economy’s GDP is equal to its spending (equilibrium of the economy), its sectors, i.e., private, government and foreign, can run on deficits or surpluses (sectoral disequilibria).

• The intuition behind this is as follows. If the state is to run a budget deficit, resources should be provided by the private sector through net savings and by the rest of the world (trade partners) through BOP current account deficits (or net imports) to finance the budget deficit. For example, if the budget deficit is 8% of GDP and BOP current account deficit is 2% of GDP, the private sector net savings should be roughly 6% of GDP.

• Further, if the private sector also wants to invest more than its savings (private sector deficit) while the state runs a budget deficit, both deficits should be financed by the net imports or BOP current account deficit. This is the importance of the global economy. A country can import resources, produce incomes and spend exceeding the level of domestic resources.

• The deficit in the BOP current account means the inflow of foreign funds or capital by way of foreign loans, business investments and foreign reserves. Therefore, the current account surplus is possible only if the sum of the state and private sector balances is a surplus, i.e., private sector savings is greater than its investments and the budget deficit.

• Therefore, the operating fundamental of the economy consists of budget balance, private sector savings-investment gap and the BOP current account balance which add to zero at the equilibrium of the economy.

The above operating mechanism (see the diagram below) can be expanded to explain how various behaviors of the public and government affect or determine sectoral balances, demand side and supply side of the economy. This is known as macroeconomic modeling.

Money, Central Bank and Economy

In the above operating mechanism, all transactions on goods, services and resources take place through the exchange of money. However, the amount of money (money stock or supply) circulating in the economy is not a part of the production or GDP. However, income earned on money services such as banking and financial businesses involved in the circulating of money is a part of GDP. Money comes in credit to the hands of the government and private sector from the outside of the GDP. Accordingly, money is only an intermediary or a broker between transactions, i.e., receiving income in money and spending money out of income on production activities between the demand side and supply side. As a result, all economic transactions are priced or valued in monetary units whereas the composite of all such prices is the general price level in the economy.

The amount of money available for transactions can be increased through the printing of new money and new credit that go to the hands of the government and the public. As a result, new money causes an increase in spending or demand for goods and services (value of the demand side) which can exceed the available supply or GDP (value of the supply side). As the new supply or GDP comes with a time lag to meet the higher demand, the prices of the existing supply of goods and services will rise for the time being. As a result, money while facilitating the transactions will cause disparities between the supply and demand through the demand side if the size of the money stock does not match the supply side of the economy.

Accordingly, monetarists believe that money does not have real effects (effects on output and employment levels) in the long run and causes only changes in the general price level. However, money serving as credit/capital or input to fuel consumption and investment have real effects when the economy has unutilized resources or capacity (or current output is less than the potential output).  

Further, foreign trade or BOP causes transactions in foreign moneys in the economy. Accordingly, foreign moneys are traded for domestic money at prices that are known as exchange rates. Similar to domestic money, foreign moneys also are supplied by external sources.

Only the Central Bank/monetary authority is mandated to control the money stock to match the supply side of the economy. For this purpose, it controls transactions in both domestic money and foreign currencies/moneys. This Central Bank’s control over money is known as the monetary policy. Therefore, the Central Bank and money influence the economy’s operating mechanism by sitting outside the mechanism through two channels. Those are the amounts of moneys made available to the economy and the prices of money. 

The amount of money comes from printing and bank lending. Money prices are the interest rates on domestic money and exchange rates of foreign moneys. Changes in these vehicles first cause changes in the demand/spending side of the economy which will then cause the supply side to produce for the new demand. However, although central banks through monetary policies attempt to control both money stock and money prices to suit the level of economic activities, no central bank has a mathematical formula or divine knowledge to determine their levels correctly consistent with the level of the economy.

Therefore, the Central Bank operates on money printing and monetary policy outside the GDP mechanism and makes a risk-free profit. This profit goes to the government budget as dividend income. Therefore, this profit is virtually the tax paid by the economy on money printing or monetary policy.

Government

The government is the single biggest component in the spending/demand side of the economy through government spending and taxes. As the government has public powers to tax from the private sector and spend beyond tax income, these government operations on the demand side of the economy are known as fiscal policy. All public services including law and order, national security, regulations, infrastructure and social services are covered in the fiscal policy and spending. 

The value of these services is taken as a part of the GDP too which is not expected to be significant as compared to the GDP generated by the Private Sector. However, state enterprises in which the government involves in direct production activities are accounted in the private sector and their overall outcome is reflected in the fiscal policy through taxes, dividends, grants, lending, etc., connected with state enterprises.

 Markets in the Economy

The economy is a sum of many markets operating in various sizes in all corners of the economy. Labour, property, goods, services, capital, credit/debt and foreign exchange are the broad categories of markets. All these markets have prices for the products that are traded by buyers and sellers. The supply side and demand side of the economy are driven by the interactions of these markets.  Therefore, any mismatch between the GDP and spending or between the supply side and demand side and thereby sectoral balances, i.e., budget deficit, private savings-investment gap and BOP current account balance, are determined by the overall impact of markets.

It is believed that markets will move to change prices automatically to clear mismatches if they are free to behave. This is known as the market mechanism presented by Adam Smith’s ideology. As such, any change in the price of any market reflects changes in the underlying market conditions due to various factors. Therefore, the price is only monetary value that can change to any level depending on the behaviours of markets in response to various factors. This is easily understood by global price volatilities of goods, services and moneys consequent to uncertainties created by the Corona pandemic.

Government Interventions in the Economy

All interventions are caused under the fiscal policy and monetary policy. Although some tend to show the Central Bank as an independent policymaker, it is also a government institution with the non-profit mandate given by the government to serve the public in line with the goals set by the government.

Policy proposals listed at the beginning of this article are few examples for government interventions in the economy. Policy interventions target various points in the operating mechanism highlighted above so that selected economic activities can be manipulated for intended objectives. Therefore, any intervention will affect several markets, the demand side, sectoral balances and the supply side of the economy short term and long term. Interventions first affect the demand side and eventually cause changes in sectoral balances and supply side leading to a mismatch between the demand (spending) and supply (GDP). 

This impact analysis depends on the knowledge of market behaviors. For this purpose, actual market data are required. Therefore, any hypothetical interventions implemented on the belief of certain economic theories or individual hypotheses without the support of relevant market data will bound to fail sooner or later causing disruptions to the operating mechanism of the economy and public life.

Some Examples of Interventions and Their Impact on the Economy

Given below are only few examples for interventions along with highlights of quick response from markets and economic outcomes.

• Control of foods prices

As controlled prices are generally lower than prevailing market prices, the demand will rise exceeding the supply at lower controlled prices. If the government is unable to supply for the higher demand or excess demand, prices will increase causing the food inflation. Any bureaucracy involving food rationing and trade controls, if introduced as a secondary solution, would lead to shortages of food and black-market (well-known outcome).  Since the purchasing power of wages declines due to higher food prices, wages will increase causing a secondary rise in inflation as higher wage costs are passed on to prices.

• Not permitting the exchange rate to depreciate (keeping an overvalued exchange rate) in countries with BOP current account deficits for a long time

This policy is mainly to prevent the increased cost of imports in domestic currency. Therefore, the overvalued exchange rate is a subsidy to imports and, therefore, current account deficit will further rise. As the non-debt foreign capital inflow to many developing countries is very low, the government has to raise foreign borrowing to source foreign exchange to build up the foreign reserve for financing current account deficit and keeping the exchange rate overvalued. This causes a further rise in the BOP current account deficit and government foreign debt. 

Therefore, when foreign debt rollovers/raising new debt are difficult, debt default is imminent due to the depletion of the foreign reserve and the economy tends to shrink with prices rising (stagflation) mainly due to shortages of imports. This is the present plight of some countries, consequent to the Corona pandemic instabilities. Restriction on imports as a solution to the acute foreign exchange shortage at this stage will cause further disruptions to the economy to the extent of its import dependency.

Exchange rate control is also a price control by selling the foreign exchange to meet the excess demand. Since the government cannot print foreign exchange, it has to borrow foreign exchange to replenish the foreign reserve as the country runs a BOP current account deficit. Therefore, this price control is maintained at continued foreign borrowing causing a spiral of BOP deficit and foreign borrowing.

• Fiscal stimulus packages to households and businesses affected by the Pandemic

Budget deficit will increase as the tax base has been reduced by the Pandemic. This indicates the budget deficit has to be funded by the reduction in private investments (increase in net private savings) and increase in BOP current account deficit. At this stage, if policymakers control imports and foreign debt to reduce the BOP current account deficit, private investments have to decline further to offset it. This happens through the increase in interest rates in the government debt market to attract private savings by discouraging investments riskier than government debt. As a result, the country’s growth and employment will decline and inflation will rise until the budget deficit brings multiplier expansion on the economy to offset the effects of the downfall of private investments.

• Tightening the monetary policy at this time to tame inflationary pressures in the future

As a result, interest rates will rise and the growth of bank credit will decline. As the government spending will not respond to increase in interest rates, the budget deficit will rise due to the increased cost of borrowing. Therefore, private sector net savings and BOP current account deficit have to rise. The increase in interest rates and deceleration in private credit will reduce private sector spending which will shrink the production, income and employment. If the private sector does not respond to the monetary policy and continues to demand credit, the central bank being the bank regulator will impose direct bank credit/lending restrictions affecting the banking business too. Further, high interest rates being a key part of the cost of production in modern monetary economies will be passed on to prices by the private sector causing higher inflation.

As central banks implement the monetary policy mainly through the control of interest rates, this is also a price control. The difference between this price control and other price controls is that the central banks can print money any amount of money to keep the price/interest rates at fixed/controlled levels. However, they can do this only for some time because money so printed will cause various side effects to the economy. Therefore, they have to reverse the control sooner or later.

• Fiscal stimulus or increase in budget deficit funded by money printing or relaxed monetary policy (modern monetary theory)

This is the policy being globally followed to help recover from the Corona pandemic. As money is an external vehicle, the increase in budget deficit can be maintained/financed through money printing without any corresponding increase in net savings and BOP current account deficit. Therefore, this will cause imbalances in the economy, i.e., demand greater than supply, causing inflationary pressures until the production capacity and GDP recover to pre-pandemic level over time. Until such time, imports have to increase over time causing the BOP current account deficit to rise. If imports are controlled, prices of domestic goods and services will rise. 

Import controls and increase in domestic prices will reduce the exports and raise the BOP current account deficit. Rising inflationary pressures would cause the momentary policy tightening sooner or later which will reduce private sector investments and encourage savings at higher interest rates. This will cause net savings to rise. Therefore, net savings and BOP current account deficit will rise to match the increased budget deficit over time causing instabilities in the economy.

The Lesson to learn

Markets have evolved through a long history of human development to modern monetary economies operating with high frequency of information. Therefore, government interventions will be significant noises to markets. Markets are in constant discovery of prices through market forces and will adjust to all noises and shocks quickly or with a time lag. Such adjustments will take place through changes in the demand side or supply side or both.

For example, Corona pandemic has caused a historic shock to the supply side or disruptions of global supply chains. State policy interventions (i.e., fiscal stimulus, ultra-loose monetary policy and pandemic control measures) taken in response have been causing significant shocks to the demand side first (rise in the post-pandemic demand) which will help recover the supply side over time. 

Therefore, these policy interventions must be reversed gradually when instabilities in markets start fading. Otherwise, the cost of heavily controlled market mechanism by way of side effects to the demand side and supply side and sectoral balances of the economy and resulting long-term instabilities such as bubbles, market manipulations, bureaucratic irregularities, rising income/wealth inequalities and decline in productivity.

Line bureaucracies normally tend to implement interventions to the letter and sprint, subject to resources available to them, without constant assessment on the level of their objectives and their side effects. Their general tendency is to keep those interventions/regulations for a long time whether they are relevant or not for new conditions as they love them. Therefore, the lack of finetuning of interventions to suit new conditions causes significant distortions to markets, their forces and the operating mechanism of the economy which will finally be reflected in prices and real income level that are the core of living standards. This is the first-round impact of state intervention on the general public.

Finally, riffle effects of all interventions in aggregate will eventually end up in the budget deficit and public debt. This is the second-round impact on the public. Therefore, the size and the trend in the budget deficit and accompanying sectoral imbalances (net private savings and BOP current account deficit) are the best indicators of the extent of the state interventions in the economy.

In contrast, relevant bureaucracy lines state that interventions are to balance the markets and the economy due to external shocks as they do not understand drastic shocks and imbalances they create through interventions without allowing the markets to sort out initial imbalances through the normal market mechanism.

(This article provides some thoughts of the author based on his hands-on experience in public service and economic analyses.)

P. Samarasiri

Former Deputy Governor, Central Bank of Sri Lanaka