The European economy has been the center of our attention in the past weeks causing unnecessary panic to those that are new in the stock market. The problem with new investors is that they use the following formula to formulate their opinion for deciding on what to do with their portfolio:
Opinion of Mr. X + Opinion of Mr. Y = Your Opinion
The formula that I stated above causes them to blame others on what happens with their portfolio. That should not be the case if you follow this formula:
Facts + Knowledge = Your Opinion
Facts are those that already occurred and knowledge is theoretical understanding of a subject. An example of fact is: Greece’s credit rating was downgraded to CCC while an example of knowledge is, in this case, the knowledge in Macroeconomics.
Others’ opinion should only be a guide. I personally solicit opinion from others to serve as my guide and verify if it’s possible but I do not use is as a basis of my opinion.
Examples of opinions are:
1. Greece will exit the EU. (negative opinion)
2. Greece will not exit the EU. (positive opinion)
3. We are affected in the EU crisis. (negative opinion)
4. We are not affected in the EU financial crisis. (positive opinion)
This week, I will post about the basics of a branch of Economics, Macroeconomics. This is to equip you with the knowledge to analyze the facts and formulate your own opinion.
Economics can be divided to two major branches:
1. Microeconomics – Concerned on the details of the economy like firms and individuals.
2. Macroeconomics – Concerned with the behaviour of the economy as a whole.
As I’ve already mentioned we will focus on Macroeconomics.
Macroeconomic performance is judged by three broad measures:
1. Inflation – Percentage rate increase of the level of prices during a given period.
2. Gross National Product (GNP) – Value of all goods and services produced in the economy in a given period.
3. Unemployment – Part of the labor force that cannot find a job.
Notice on the news that interest rates, tax rates, and government spending are tweaked? The one tweaking them are called policy makers these policy makers have at their command macroeconomic policies which has two broad classes:
1. Monetary policy – Controlled by the Bangko Sentral ng Pilipinas (BSP). In the case of the Euro zone, European Central Bank (ECB). In the US it’s the Federal Reserve System (the FED) that controls the monetary policy.
Instruments of monetary policy are:
1. Increase or decrease in stock of money
2. Changes in the interest rate
3. Banking regulations
2. Fiscal policy – Controlled by the congress and usually initiated by the executive branch.
Instruments of fiscal policy are:
1. Tax rate
2. Government spending
You might ask, what is the relationship between macroeconomic policies and the three broadmacroeconomic measures?
The answer is the famous aggregate supply and demand concept!
Aggregate demand is the relationship between spending on goods and services and the level of prices whileaggregate supply is the relationship between the output and the level of prices.
Let us have Juan and Jose’s situation as an example to illustrate the concept.
Juan is the buyer of fish that has cash (demand) and Jose is the seller of three fishes (supplier). In this example, it takes one bundle of cash to buy three fishes. (For simplicity, let us assume that Jose is the only seller of fish.)
Increase in demand:
One day, Juan has a competitor in the name of Juana who is also willing to buy three fishes. Jose saw the increase in demand and happily increased his supply to meet the demand.
Renzie: Jose’s action of increasing his output caused the prices of fish to remain stable. Jose’s action contributed to the growth of the economy or in the Gross National Product (GNP).
Decrease in output:
After a week Juan came to Jose’s store to buy fishes, regretfully, Jose told his customers that he cannot catch enough fish because most of the fishes are in deep waters. As a result he caught only 3 fishes that week (decrease in output). Jose saw that the demand is still the same so he increased the prices of his fishes.
Renzie: Decrease in output coupled with a stable demand causes increase in prices or what is called inflation.
Decrease in demand:
Jose’s output is still three fishes. However, Juan suddenly lost his job and therefore could not afford to buy fish. Jose saw the decline in demand so he lowered his price.
Renzie: Increased unemployment rate decreases demand because the unemployed citizen will have not enough money to buy the goods that they desire. Theoretically, increasing unemployment rate would decrease the inflation rate (which most of you think is good) but ignoring the increased unemployment rate would causesocial problems in an economy.
***End of the Story***
I already mentioned GNP growth, inflation rate, and unemployment rate.
Now, let’s put macroeconomic policies in the picture.
The story about Juan and Jose above is an illustration of laissez faire where economic activities are free from any interventions. Macroeconomic policies intervene in the natural flow of the economy with the intention to “stabilize” it.
In the story, look back at the situation “Decrease in output.” Jose was unable to catch more fish because most of the fishes are in deep waters.
BSP and Congress intervention:
1. BSP decreased the interest rates of the banks.
2. Congress lowered the tax rates for fishing businesses.
Interest rate affects the borrowing costs for the banks and therefore the loan interest rates granted to consumers.
Consumers borrow money from the bank and banks borrow money from the BSP. With the BSP lowering the interest rates, banks can also lower the interest rates of their loans granted to consumers like Jose.
With the low interest rates of the bank, Jose borrowed money to finance his purchase of a more improved fishing boat which can sail to deep waters. And with the lower tax rates, Jose can have enough income to pay the principal of his loans.
The increase in output will meet the increase in demand and thus “stabilize” the price. Also the increase operational capacity of Jose can lower unemployment rate since Jose will hire additional employee to man his new boat.
The effect of congress lowering taxes is self explanatory.
(For those that have knowledge in macroeconomics, I know that technically, BSP rediscounts the loan liabilities of a bank. For simplicity, I called it “BSP lends money to the Bank” since this is the basic purpose.)
Again, let’s look back at the story. Focus your attention in “Decrease in demand” situation. In that situation, Juan lost his job. Since unemployment causes social problems in an economy the government intervenes by creating more jobs.
BSP and Congress intervention:
1. Increased the government spending
2. Increasing money supply.
Increase in government spending decreases unemployment rate because:
The government issues government securities to the public like treasury bills. A recent event where the Bureau of Treasuries missies their target on treasury bills issuance is an example. For the BSP to increase the monetary supply, what they will do is to buy the issued government securities from the banks. The increase in cash inventory of the banks would cause them to lower their interest rates in loans. It has the same effect as lowering interest rates.