Macroeconomics: Impact on Inflation, Trade Cycles, and Public Debt

Posted on Dec 13, 2024 in Economy

Inflation: Causes and Consequences

Inflation is a gradual increase in the prices of goods and services over time, which reduces the purchasing power of money. This means that the same amount of money can buy fewer goods and services. Inflation can have many consequences, including:

  • Consumers: Inflation can cause consumers to tighten their belts and become more pessimistic about the economy.
  • Businesses: Inflation can cause companies to lose purchasing power and see their margins decline.
  • Investors: Investors should ensure that their returns on investments are at least as high as the inflation rate.
  • Fixed Incomes: Inflation can cut the real value of pensions and other savings for retired people.
  • Lenders: Inflation can be harmful to lenders if real interest rates on loans are negative.
  • Savers: Inflation can be harmful to savers if real returns on commercial bank deposits are negative.
  • Low-Paid Workers: Inflation can be harmful to workers in low-paid jobs with little bargaining power.
  • Exporting Firms: Inflation can cause exporting firms to lose sales and profits if they become less competitive.
  • Debtors and Creditors: Debtors gain during inflation, while creditors lose.
  • Wages and Salaries: Inflation can harm wages and salary earners because their salaries do not rise in the same proportion as the cost of living.

A small but positive inflation rate can be economically useful. However, high inflation can feed on itself and impair the economy’s long-term performance.

Trade Cycle Definition

Business or trade cycles are the terms used to describe the cyclical expansion and contraction of economic activity. “Period of Expansion, Upswing, or Prosperity” refers to the era of high income, high output, and high employment. The era of contraction, recession, downswing, or depression is a time of low income, poor production, and low employment.

The stages of a trade cycle, also known as the business cycle, are:

  1. Expansion or boom
  2. Recession
  3. Depression or trough or contraction
  4. Recovery

A trade cycle is a series of ups and downs in economic activity. It’s influenced by many factors, including employment, output, income, prices, and profits. Here’s some more information about the stages of a trade cycle:

  1. Trough: The economy hits a low point, with supply and demand at their lowest. This is a difficult time for the economy, but it can be an opportunity for individuals and businesses to reorganize their finances.
  2. Peak: The economy reaches a saturation point, where economic indicators are at their highest. Prices are also at their peak.
  3. Length: Trade cycles can last anywhere from two to twelve years. Primary trade cycles are usually longer, lasting four to eight years or more, while minor trade cycles last three to four years.
  4. Global Nature: Trade cycles are international in nature, and booms and depressions in one country can affect other countries through international trade.

Public Debt: Types and Implications

Public debt is the total amount of money that a government borrows to cover its expenses and development budget. It is also known as national debt or federal debt. Public debt can be acquired from within a country or from abroad. It is usually in the form of bonds, government securities, or paper. In some cases, the debt is acquired directly from a supranational body like the IMF.

Public debt is different from private debt, which is the debt of individuals, business firms, and nongovernmental organizations. Public debt is an indicator of how much public spending is financed by borrowing instead of taxation.

The concept of public debt is modern, with some experts tracing the first examples back to the mid-12th century. It developed into a similar concept to what we recognize today in the 1800s.

Types of Public Debt

There are four types of public debt, and they are as follows:

  1. Internal and External Debt: The government’s borrowing within the country is known as internal debt. The government can borrow this debt from sources like banks, individuals, business firms, and other internal sources. On the other hand, the government’s borrowing from abroad or internationally is known as external debt. These types of debts contribute to the development programs. A few of the sources are bilateral borrowings, multilateral borrowings, loans from the Asian Development Bank, World Bank, etc.
  2. Productive and Unproductive Debt: If the loan is financed for projects that will bring revenue to the government, it is known as productive debt. They are self-liquidating in nature—for example, irrigation, power projects, infrastructure, etc. When the loans are a net burden on the community, they are known as unproductive debts. In this case, the government charged additional taxation for service and repayment.
  3. Compulsory and Voluntary Debt: Loans that are raised due to the government’s borrowing from the public by using coercive methods are known as compulsory debt—for example, the taxes paid by the public. The members of the public and institutions like commercial banks can subscribe to the securities issued by the government loans, which is known as voluntary debt. For example, the public borrowings.
  4. Redeemable and Irredeemable Debt: The debt that the government repays after a fixed period is known as redeemable debt. To sell securities to the public, the government borrows money from them. The interest on this debt is paid irregularly. The debt that has no promised date of repayment by the government is known as irredeemable debt. Therefore, the interest paid may be regular. But such borrowings are not reported by the government.

Credit Creation by Commercial Banks

Introduction

Commercial banks play an essential role in the economy through the process of credit creation. This function of commercial banks is crucial for maintaining a steady flow of money in the economy. The central bank of a country manages the supply of money in the economy by circulating currency. However, it cannot execute this task alone and relies on commercial banks and their reserves. Commercial banks thus contribute to the economy by creating credit.

Process of Credit Creation by Commercial Banks

  1. Deposits: The process begins when customers deposit money into their accounts at commercial banks. These deposits form the base on which the banks can create credit.
  2. Reserve Requirements: Commercial banks are required to hold a certain percentage of their deposits as reserves. The reserve requirement is set by the central bank and varies from country to country. The portion of deposits that banks are required to keep in reserve is not available for lending.
  3. Excess Reserves: The portion of deposits that banks hold above the required reserves is known as excess reserves. Banks have the ability to lend these excess reserves to borrowers.
  4. Lending: Banks extend loans to individuals, businesses, or other entities using the excess reserves. This is where the process of credit creation takes place. The bank creates a new deposit in the borrower’s account, essentially creating money through the act of lending.
  5. Multiplier Effect: The initial deposit and subsequent loans create a multiplier effect on the money supply.

Limitations of Credit Creation

  1. Risk of Default: The primary limitation is the risk of default by borrowers. If borrowers fail to repay their loans, it can lead to non-performing assets (NPAs) and financial losses for the banks.
  2. Economic Instability: Excessive credit creation can contribute to economic instability, as it may lead to asset bubbles, inflation, and speculative behavior in financial markets.
  3. Cyclical Nature: The process of credit creation is cyclical, and during economic downturns, banks may become more risk-averse, reducing their lending activities. This cyclical nature can amplify economic cycles.
  4. Liquidity Concerns: If a large number of depositors demand their funds simultaneously, it can create liquidity issues for banks. Banks may not have sufficient reserves to meet the withdrawal demands, potentially leading to a financial crisis.
  5. Interest Rate Risk: Fluctuations in interest rates can impact the profitability of banks. If interest rates rise significantly, banks may face higher costs of borrowing, affecting their net interest margins.

Advantages of Credit Creation

  1. Economic Growth: Credit creation by commercial banks facilitates economic growth by providing funds for investments in businesses, infrastructure, and innovation.
  2. Financial Inclusion: Banks play a crucial role in extending credit to individuals and businesses, promoting financial inclusion and allowing a wider range of people to access financial services.
  3. Monetary Policy Transmission: The ability of commercial banks to create credit is essential for the transmission of monetary policy. Central banks can influence economic conditions by adjusting interest rates and influencing the level of credit creation.
  4. Job Creation: Credit creation supports job creation by enabling businesses to expand, invest in new projects, and hire more employees.
  5. Wealth Creation: Access to credit allows individuals to invest in assets such as homes or start businesses, contributing to wealth creation and economic prosperity.

What is Macroeconomics?

Macroeconomics studies an economy at the aggregate level, focusing on factors like GDP, unemployment, inflation, and overall growth. It explores how government policies, monetary systems, and global interactions impact a nation’s economic performance. By analyzing these trends and their interplay, macroeconomics aims to understand and predict economic fluctuations, guide policy decisions, and ensure stable, sustainable growth.

Macroeconomists also study the role of the government in the economy, including how it contributes to growth and fights inflation. Macroeconomics often extends to the international sphere, as domestic markets are linked through trade, investment, and capital flows.

Nature of Macroeconomics

Macroeconomics studies an economy’s overall performance and behavior, focusing on factors like economic growth, unemployment, inflation, and government policies.

Nature of Macroeconomics: Explanation and Examples

  1. Holistic View: It focuses on the entire economy as a system, e.g., analyzing the national unemployment rate.
  2. Aggregates: Macroeconomics studies total economic quantities, e.g., calculating Gross Domestic Product (GDP).
  3. Big Picture: It emphasizes broad economic trends, e.g., analyzing the business cycle phases.
  4. Policy Emphasis: It informs government decisions and actions, e.g., evaluating the impact of fiscal stimulus.
  5. Unemployment and Inflation: Macroeconomics examines the causes and effects of both, e.g., studying how inflation affects purchasing.