macro economics...macro/micro economics learners & trainers 1st floor water house , ijora lagos....
Post on 20-Aug-2021
5 Views
Preview:
TRANSCRIPT
SEGMENT II
Macro Economics
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 2
MACRO ECONOMICS
MACRO is from the Greek word ‘MAKRO’ meaning ‘large’. MACRO Economics is
therefore ‘Large Economics’ that focuses on aggregate (overall) variables. It deals with
the economy as a whole and as a system.
Some major economic issues in our country today relate to the depreciating value of the
currency, the increase in minimum wage, high interest rate, high unemployment rate, the
national debt issue, privatization, etc.
Some Macroeconomic Considerations
Aggregate Demand for goods and services
Aggregate Output
Aggregate Employment
Aggregate Price Level (Interest rate, Exchange rate sand other prices)
Aggregate Money Supply, etc.
MACRO-ECONOMICS OBJECTIVES
Some of the major objectives of the macro economics is to review economic issues that
impact the life of each of us
Economic Growth
Price Stability
Full Employment
Balance of payment Equilibrium
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 3
MACRO ECONOMIC POLICES
Fiscal Policy
Monetary Policy
Income Policy
Fiscal Policy
Fiscal policy is concerned with the use of government’s variation in taxation and
government expenditure to achieve macro-economic objectives.
Instruments: -
Taxation i.e. increase or decrease in tax rates
Government Expenditure i.e. Increase or decrease in government spending.
Example: -
a. Reduction of tax rate can address the problem of low aggregate demand and
employment.
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
b. Lower taxes would raise disposable income that in turn would increase
purchasing power and aggregate demand through the multiplier process.
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 4
c. Increase in government spending will achieve similar effect.
______________________________________________________________
______________________________________________________________
______________________________________________________________
______________________________________________________________
What will be the impact of increased government spending on inflation?
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Monetary Policy
Monetary Policy is the way the government uses the changes in money supply and cost
of credit to achieve macro-economic objectives.
Instruments: -
Some of the instruments that the government, through the Central Bank, uses
to drive its macroeconomic objectives include the following.
Cash and Liquidity Ratio
Open Market Operations
Special Deposits
Stabilization Securities
Discount (Bank) Rate
Moral Suasion
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 5
Example:
The Central Bank uses the Open Market Operations to control Interest rate and to
influence liquidity in the system. As banks buy treasury bills and other instruments from
the Central Bank, liquidity is mopped-up and the banks’ capacity to create credit declines.
Ultimately, via the multiplier process, there is less money in the hands of the banking
public and hence aggregate demand drops.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 6
Income Policy
Income Policy describes government’s attempt to achieve price stability and other
objectives by setting ‘caps’ and ‘floors’ i.e. limits on income or prices.
Sometime government policies are designed to suppress the effect of inflation through
wage and price controls and/or exhortation, such that outward shifts in aggregate
demand caused by fiscal and monetary stimuli will show up in larger GNP rather than in
higher price levels.
Instruments:
Minimum wage legislation
Price controls e.g., maximum rent collectible by landlords
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 7
NATIONAL INCOME ANALYSIS
Definition:
National Income (NI) represents the monetary value of goods and services produced
during a particular year by the different sectors i.e. economics units within the economy.
This relationship is expressed in the following NI equation.
Y = C + I + G + (X - M)
Where,
Y = National Income
C = Consumption by Household (Individuals)
I = Investment by business firms
G = Expenditure of public sector (government)
X - M = External trade sector X = exports
M = imports
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 8
Methods of measuring National Income
Output Method
Measure NI in terms of Gross Domestic Product (GDP) i.e. goods and services produced
by all sectors (public sector and private sector vis-à-vis manufacturing, oil producing,
banking and finance sub sectors, etc)
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Expenditure Method
Measures NI in terms of Gross National Expenditure (GNE) i.e. total expenditure by all
economics units vis-à-vis household, business firm, Government and External Trade
Sector.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Income Method
Measures NI in terms of Gross National Income (GNY) i.e. income accruing to all sectors
of production
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 9
THE CIRCULAR FLOW OF INCOME
The flow of income in the economy is circular- ‘what goes round comes round’.
Households get their income from the firm as wages and salaries for their productive
services. The productive service of the household is one of the inputs into the generation
of the output of the firm. The firm gets income for the goods and products that it sells to
the households. The household needs the firm for its salaries while the firm depends on
the spending of the household.
The circular flow of income demonstrates the interdependence between the firm and the
household. The fortune of the household is closely tied to the success of the firm.
GDP = GNE = GNY
With accurate computation, total goods and services produced equals the total
expenditure on the products; which also equals the distribution of the sales proceeds as
factor payment; they are only different stages of the same circle.
Pmt to Capital, Wages,
Salaries
Productive Service
Money Goods and Services
FIRMS Households
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 10
THE MULTIPLIER CONCEPT
The multiplier refers to the rate of increase or decrease in the National Income level as a
result of changes in any aggregate variable such as Business Investment, Government
spending, etc. it explains the basic dynamics of the impact of government economic
policy on the total economy.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 11
MONETARY POLICY
Goals Of Monetary Policy
Government seeks to regulate the rate of inflation, economic growth and employment,
through the control of the money supply and the cost and availability of credit, in order to
regulate demand, output, inflation, interest rate etc. A very important objective is the
stability of the financial and investment environments especially the banking sector. Other
major goals of monetary policies are to increase output and reduce inflation in the
economy.
Monetary Policy is, however, only part of a government’s economic strategy and it is
vital that monetary policy is pulling in the same direction as other objectives.
For instance, a firm control of the money supply to restrain the level of monetary demand
would be useless if at the same time government did not control its own expenditure or
was to make big reduction in taxation.
Note that there could be conflict between the various objectives of the government’s
economic strategy. A possibility of conflict arises between maintaining a favourable
balance of payment. Devaluation of the currency has not stimulated the inflow of foreign
capital but has caused capacity underutilization and massive lay off of labour.
The federal government seeks to control the money supply through the central bank
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 12
Quantity Of Money
The relationship between the volume of money and the price level is a useful measure of
inflation.
The quantity theory of money is that increase in the money market stock leads to
higher expenditure, which in turn, through inflationary pressure (i.e. excessive demand in
relation to supply), can lead to rising prices.
The equation of exchange is often used in a very simplistic way to illustrate how this
may happen, i.e.
M V = P T
Where M = Money Supply,
V = Velocity of circulation,
P = Prices,
T = Transactions
The velocity of circulation is the number of times that the money supply changes
hands in a given period (usually a year) and MV is therefore the effective money supply.
The effective money supply must equal the total value of transactions during that given
period, but if it can be safely assumed that the velocity of circulation and total output have
remained unchanged, then the equation tells us that any increase in M will have brought
about an increase in P.
Unfortunately, it is not possible to measure the velocity of circulation, nor is it likely that T
will remain unchanged over any really reliable way in that T includes not only goods (the
output of which can be really measured) but also all other transactions such as financial
services.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 13
What is Money?
Money is anything that permits indirect exchange of goods and services. (Barter is direct
exchange rice for yam).
Functions of Money
Store of value - a temporary store
-----------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------
Unit of Account
-----------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------------
Medium of Exchange – a generally accepted means of payment
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Standard for deferred payment –a means to discharge debt
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
__________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 14
Classification Of Money
Money is classified in terms of liquidity. Currency is the most liquid because it can
perform the function of cash on the spot
A liquid asset is one that can be quickly and readily used in transactions with minimal risk
to its value in the process of exchange of value.
M1 or Narrow Money
This includes currency in the hands of non-bank public, demand deposits.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
M2
This is a broader classification of money. It includes all categories of funds in M1 as well
as small savings deposits and small-time deposits. M2 emphasizes the function of money
more as a store of value
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
M3
This classification includes M2 as well as large time deposits and similar assets held
primarily by businesses and wealthy individuals.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 15
The Creation of Credit
The tools used by the central bank, as the agent of government, to control the money
supply are centred round the control of the growth of bank deposits; Banks can create
credit, i.e. create new deposits.
When a bank receives a new deposit (note well that this must come from outside the
banking system), it can increase its advances by a proportion of that deposit. It needs to
keep a reasonable liquidity ratio. The regulatory authorities prescribe liquidity ratios to
control economic variables.
Illustration
If bank A receives a deposit of $1 million from a customer Abdullah who sold goods to a
government department for that amount; Bank A is required to keep 30% of it in cash and
other liquid assets and lend the remaining 70%.
Bintu borrows the $700M Bank A, He pays Mustapha who lodges the cheque drawn on
Bank A with Bank B.
Bank B is now in a position to lend part of the $700M
Let us assume that Bank B also keeps 30% in liquid form, it lends £490M to Yejide who
buys goods from Stobbers, a customer of bank C. Stobers pays this amount in his
account in Bank C
This process can go on and on with each in bank in turn lending 70% of each fresh
deposit. We will end up with an increase in bank deposit of $3,333,333 i.e. 3 ⅓ times the
original amount paid in.
Monetary Targets and Monetary Instruments
Annually, the government announces its target for the growth of the money supply during
the following financial year and sets about achieving that target. In order to do so, the
government must set a target for its own expenditure during that period (usually this
means the size of the deficit, i.e. the extent to which expenditure is to exceed income
from taxation and other sources), and also employ a number of monetary control tools
through the agency of the CBN. The possible tools are as follows,
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 16
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 17
Interest Rates.
By making money dearer through an increase in interest rates, a government might, in
theory, discourage borrowing and vice versa: If it makes money cheaper through a fall in
interest rates.
If borrowing is discouraged then banks will be less able to create credit and the money
supply is stopped from increasing. Considerable doubt has been expressed by
economists as to whether industrialists are discouraged from borrowing (and carrying out
capital investment) in this way, but it does seem likely that really high interest rates will
have this effect.
The central bank regulates the interest rate in the market. It now operates a policy of
guided deregulation. It continues to influence rate through its operation in the open
market (OMO).
Open Market Operations.
The Central Bank purchases or sells government securities (Commercial bills and
Treasury bills and, to some extent, government stocks) in the open market essentially to
the private sector. Trading is done in the money market and stock dealers. When the
Central Bank sells such assets, the Bank is able to mop surplus funds out of the market.
This reduces the ability of the banks to create credits and also tends to force up interest
rates because the supply of loan able funds is reduced.
The Central Bank could also drive down rates through its influence in the open market
operation by loosening its grip on funds are made available to the private sector, OMO
has two effects on the quantity as well as on the price.
Despite what has so far been said, do note that open market operations are used to a
considerable extent simply to even out the flow of funds. By evening out the flow, the
consequences of an uneven flow of funds on both the money supply and on interest rates
can be obviated.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 18
Special Deposits. The Central Bank has the power to call upon recognized banks and
licensed deposit –takers to lodge a percentage of their eligible liabilities with the Central
Bank on a special deposit account to be frozen until the government decides that they
shall be released. The Central Bank determines the rate on these deposits. Central Bank
in the past slapped banks with stabilization securities on which it paid nothing. Such
compulsory deposits have an immediate and drastic effect upon the banks` ability to lend
money and they may even be obliged to reduce their advances in order to find the
necessary liquid funds to hand over to the Central Bank
Reserve Assets Ratio.
By compelling the banks to keep a certain proportion of their eligible liabilities in liquid
assets {cash, call money and bills}, the banks would find that only a restricted proportion
of any fresh cash coming into the banking system could be lent to customers. If the
reserve ratio was high, the effect upon the growth of the money supply could be severe,
Directives to the Banks.
The Central Bank gives guidelines annually concerning the level and nature of advances.
This tool has a direct effect upon credit-creation,
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 19
THEORY OF INTEREST RATE
Definition and Background;
Interest rate is the reward to owners of capital or the cost to the employer of capital.
Here, we are narrowing down to money aspect of capital and therefore interest rate as
the price of money.
Put differently, interest rate is the opportunity cost of being liquid (holding money) i.e. the
yield foregone. Therefore, if this cost increases, people are more unwilling to hold money,
they would rather put it in other assets, while they tend to hold more money when interest
rate is falling.
Why People Hold Money
Transactionary Motive;
People hold money for purpose of meeting current transactions (purchases of
goods and services). The more current transactions undertaken, the larger the
demand for money e.g. During Christmas and other festive periods, people tend to
hold large idle money because of greater spending requirements.
Precautionary Motive;
People often hold money in readiness for contingencies or possible events in the
future that might require spending e.g. accident, unemployment, car maintenance
Speculative Purpose
According to Lord Keynes, people hold money for speculative purpose (motive)
i.e. to guard against capital loss or to make capital gains.
The fundamental factor underlining whether to hold wealth in money (cash) or in any
other asset is the opportunity cost (the yield) or the interest rate.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 20
Implications of interest Rate
Most businesses are directly affected by interest rate on only the liability side of the
business balance sheet, banks are directly affected on both the assets and liabilities
sides.
Interest is paid on deposits lodged by savers (savers are rewarded for parting with
liquidity). Banks also charge interest on loans granted to borrowers (borrowers pay for the
bank’s loss of liquidity and associated risks).
Interest rate is a compensation for temporary loss of comfort and convenience of liquidity
and also contains a premium for risk (possibility) of permanent loss.
Therefore, interest rate is an instrument of persuasion or inducement for someone who
already possesses cash to exchange it for some other assets, such that the higher the
interest rate the greater the inducement or incentive to part with cash temporarily.
1. The longer an investment (or loan) the greater the credit risk and hence risk
premium is required.
2. The longer the maturity the greater the liquidity risk i.e. the greater the sacrifice of
liquidity, which also requires premium.
3. The longer the maturity the higher the chances of market rate changes (interest
rate risk) which requires premium.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 21
INTERNATIONAL ECONOMICS
International Trade
Why international trade
No nation is self- sufficient in all aspects
Different nations have different and peculiar endowments vis –a vis, mineral resources,
labour skills, climate.
Each country as an economic entity seeks to maximize its profits.
International trade, therefore, ensures availability where there is shortage and also
prevent waste where there is surplus and excess production capacity. It is also beneficial
in terms of opportunity cost of production i.e. comparative advantage (produce when
opportunity cost is lower)
A producer has comparative advantage if the opportunity cost of expanding production is
lower than for all other producers.
Imports are the goods and services one country buys from another
Export are the goods and services one country sells to another.
Hurdles in international Transactions
Differences in language
Weights and measures indices
Government regulations
Differences of currencies etc
These differences among the nations especially the currency make settlement a problem
among trading partners
The financial system through banks has minimized most of these problems substantially.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 22
CONCEPT OF INTERNATIONAL TRADE
Terms of Trade
Terms of trade measures the purchasing power of one unit of export i.e. the quantity of
domestic goods or export that must be given up to get a unit of imported goods.
Put differently, it is also the opportunity cost of importing rather than domestic production.
It expresses the vulnerability of countries to the changing prices of their exports on the
international market
If a company can intervene to increase its term of trade, then the country should be able
to better its lot. However, the world market approximates a perfect competition therefore it
is difficult if not impossible for any one country to manipulate its export or import price
Laws of Comparative Cost
Comparative costs are about a country concentrating its productive resources and efforts
in the production of goods and services where it has the greatest comparative advantage.
It Is in fact possible for a country to benefit more by importing a good that it could produce
at less cost at home that abroad.
Purchasing Power Parity Theory:
According to this theory, the purchasing power of a currently, eventually, is the same in
whatever country it is spent.
Suppose it costs $100 to buy an item in Nigeria but the same item costs only $50 in USA
due to lower internal prices (inflation), it is more attractive to buy from the USA to take
advantage of the gain – Arbitrage
Ceteris Paribus, Nigerian importers would be buying from USA rather than at home until
the increased demand raises the price in USA to the same level in Nigeria - parity of the
Dollar ($) both in Nigeria and USA.
This theory also underscores the fact that inflation erodes purchasing power of the local
currency in terms of the other currencies.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 23
Balance of Trade
The Balance of Trade looks at the different between what a country exports and what it
import.
☺ A favourable balance of trade arises when exports exceeds imports. This is also
referred to as a Trade Surplus
☺ An unfavourable balance of trade occurs when imports exceeds exports. This is also
referred to as the Trade deficit
Balance of Payments
Balance of payment is a record of the transactions between a country (its residents,
enterprise and the government) and the rest of the world over a period of time. It includes
all visible and invisibles exports and imports, both current and capital in nature.
Balance of Payment Surplus
Excess of exports (inflow of foreign exchange) over imports (outflows of foreign exchange)
is referred to as balance of payment surplus
Balance of Payment Deficit is the reverse, where imports (outflows of foreign exchange)
are greater than exports (inflow of foreign exchange).
Both scenarios (deficit or surplus) describe disequilibria in the external sector of a country.
However, the real problem is deficit, which has damaging consequences for the local
currency and the entire economy of the nation concerned.
Balance of payment deficit may not be a problem if it is only temporary, but it would surely
is a crisis it persists.
The balance of payment always balances for the following reasons:-
All sources of funds must equal all uses e.g. all spending of FX in excess must be
financed through borrowing, all of which must be accounted for.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 24
The net Balance of Payment situation (deficit or surplus) is a mirror image of FX
position with the Central Bank. A surplus, invariably, is accounted for in the central
bank, by physical FX, foreign reserves balance, Gold reserve, IMF reserves etc,
while a deficit would reflect a depletion of these international assets.
Current and Capital Account
The current account records visible exports and imports, which are for immediate or short-
term consumption or maintenance purpose. There is current account deficit, if current
imports exceed exports. The converse is surplus. A country may have a current account
deficit but a balance of payment surplus and converse is also true.
The capital account records transactions which are for investments purpose or are basically
payment or long-term in nature e.g. machinery imported for purpose of plant installation,
direct foreign investments etc.
Visible and Invisible
Visible items are tangible assets e.g. gold, cocoa, oil etc.
They could either be current like cocoa.
Or capitals like plant.
Invisibles on the other hand, include services, expenditure on tourism, and investment
outside the country.
Invisibles could be current in nature such as tourism or
capital investment in nature such as long-term investment.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 25
Official Financing
This segment in balance of payment explains the transactions done by the Central Bank of
the nation either to fund the deficit or to apply the surplus.
In case of deficit, various financing sources available include, borrowing from IMF, exercise
of special drawing rights with IMF, loans from other multilateral and bilateral sources and
depletion of reserves (foreign reserves, gold reserves, or IMF reserves).
In case of surplus, the Central Bank could use the excess to increase the reserves of FX,
Gold or it could invest in international markets or pay-off outstanding debt.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 26
BACKGROUND TO FOREIGN EXCHANGE
Definition-
Foreign exchange is all claims to foreign currency payable abroad whether consisting of
funds held in foreign currency, with banks abroad, or bills or cheques payable abroad. A
foreign exchange transaction is a contract to exchange transaction is a contract to
exchange a bank balance in one currency for a bank in another currency at and agreed
rate on agreed date.
Foreign exchange is an integral part of our daily lives. Without foreign exchange
international trade would not be possible. For instance, a French wine producer will incur
his expenses in French, when he sells the wine, he wants to receive French francs to meet
those expenses. But he sells to an English merchant, the English man pays in his own
currency, pound sterling. In between a transaction has to occur that converts one currency,
into another. That transaction is undertaken in the foreign exchange market.
However, foreign exchange does not involve only trade. Trade these days is a small part
of the foreign exchange market. Movements of international capital, seeking the most
profitable home for the shortest term today dominate the foreign exchange markets.
Money changing has been a part of the business of money since the first coins were mind
and is even mentioned (somewhat unfavourably) in the Bible. The first forward foreign
exchange transactions can be traced back to the moneychangers in Lombardy in the
1500s.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 27
The Gold Standard,
Foreign exchange as we know it today has its roots in the Gold Standard, which was
introduced in 1880. The main features of eh Gold Standard were a system of fixed
exchange rates in relation to gold and the absence of any exchange controls. Under the
Gold Standard, a country with a balance of payment deficit had to surrender its gold, thus
reducing the volume of currency in the country, leading to deflation. The opposite occurred
to a country with a Balance of Payment surplus. The Gold Standard survived until the
outbreak of World War One.
After the war, attempts to re-introduce the Gold standard failed because the major
currencies were either under-or over-valued, and also had different inflation rates.
The economic crisis of the 1930s and the outbreak of the Second World War forced all
countries to introduce exchange controls and lead to a suspension of efforts to stabilize
currencies.
Breton Woods
In July 1944, a meeting at Breton Woods, New Hampshire, adopted a proposal, which
came to be known as the Breton Woods System. The international Monetary Fund was
established to monitor the new system, whose aims were to eliminate exchange control,
implement convertibility of all currencies, and establish exchange rates.
The 1905s were a period of stable exchange rates and world-wide economic growth which
ended in 1960 when the US trade deficit of two previous year led to a loss of confidence in
the US Dollar and heavy buying of Gold. The 1960s saw widely differing rates of growth
and a series of devaluations and revaluations
In 1971 there was another loss of confidence in the US Dollar, and it ceased to be
convertible into gold. Thereafter the major European currencies were allowed to float.
The 1971 Smithsonian Agreement set new fixed parities for exchange rates, but
speculation and movements of capital forced central banks to resort once more to floating,
and by the end of 1973 the Breton Woods System was over.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 28
European Monetary System (EMS)
Since 1973, several European governments joined together to form the “snake”. Which
was the precursor for the European Monetary System (EMS), as a way of stabilizing their
currencies. Under the EMS, which was established in 1976, the currencies are permitted
to move within broad limits against each other and a central point.
The late 1989s have seen large fluctuations in exchange rates capital flows have been
liberalized. Although changes in exchange rates are usually gradual changes that used to
take place over a matter of weeks can now take place in minutes. This has led to various
co-operative attempts by central banks to control sudden fluctuations in currency values.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 29
Parties Active in Foreign Exchange markets
Central Banks
Mainly active in managing the country’s reserves, and smoothing out fluctuations in the
value of their local currency.
Commercial, Investment Banks
These not only speculate, hedge and invest on their own and their clients behalf, but
also provide the medium of exchange for international trade and the liquidity that the
market needs.
Foreign Exchange Brokers
Act mainly as middlemen between other participants, matching buying and selling
orders, and disseminating information about market conditions. Brokers earn
commissions (“brokerage’) on each rather than seeking profit from trading.
Investment Funds
Move funds from one currency and investment vehicle to another.
Corporations
move funds between units in different countries to hedge exchange risks and
increasingly, for speculative purposes,
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 30
ECONOMICS OF FOREIGN EXCHANGE
Foreign exchange rates are influenced by long-term factors )both economic and political)
and short-term factors (technical analysis and expectation versus actual events)
Long Term Factors Economics
Balance of payments
The balance of payments is made up of
Current Account and the
Capital Account.
The Current account includes
imports and exports of goods (trade account),
services and investment income.
All other things equal, if a country’s currency account is in surplus (i.e. it is exporting
more than it is important) then the demand for its currency will be greater that the supply
and the currency strengthens.
If the current account is in deficit the country is importing more than it is exporting, and
supply of its currency will be greater than the demand the currency will weaken.
The Capital Account measures the inflows and outflows of capital during a year.
Movements across the capital account are reversible unlike the flows on the current
account.
In recent years, due to deregulation and improved communication, international funds
transfer has become a fast efficient process. Capital movements can now change direction
abruptly and on a large-scale basis and this factor of large sudden capital movements has
contributed to the increasing unpredictability of exchange rates.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 31
The difference between current and capital account is the change in reserves.
If for example, a capital account surplus exceeds a current account deficit, a country’s
reserves will increase.
The other factors that influence exchange rate movements can be analyzed with respect
to the effect they have on current account or capital account movements.
Inflation
In comparing two currencies, the currency with the lower inflation rate, all other things being
equal, should be the stronger currency. This is basis on the purchasing power parity theory.
Assume country A and country B both produce cars and the price is 10A and 10B per
respectively. Assume that the exchange rate is at parity i.e. 1A =1B.
now assume that in country A inflation is zero over 1 year and in country B that inflation is
10% over 1 year. At the end of the year 1, a car will cost 10A in A and 11B in B. The logical
action of ‘B’ people will be to buy their cars from country A. They will therefore sell currency
B and buy currency A which will strengthen B until there was no effective difference in the
cost of cars between country A and B (i.e 1A=1B).
In other words, those countries with low relative inflation rates can sell goods at a more
competitive price internationally. This will generally be reflected in rising export volume and
therefore an improving current account.
Economic Growth
The rate of economic growth can affect the current account in different ways. A country’s
economic growth can be export-led as has been the case in Japan. However, in some
cases, if an economy is growing at a fast rate relative to its major competitions, the need
for imported goods grows. This is because domestic demand cannot be fully met by
domestic production, whilst export demand will be increasing less quickly than imports due
to weaker growth abroad.
This will lead to deterioration in the trade balance. The reverse would be the case if
economic growth were slow relative to other major economies.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 32
Fiscal Policy
Fiscal policy essentially the way a government chooses to manage its revenue (namely
tax) and expenses (spending on health, education, defence etc). The difference between
the two is the government deficit.
An expansionary fiscal policy would be employed by a government to increase economic
growth; this would be achieved either by lowering taxes or by increasing government
expenditure. The method chosen depends on the political inclinations of the party: the more
the right-wing parties- tending to favour tax cuts whist the parties of the left would tend
favour increased government spending.
A contradictory fiscal policy (increasing taxes or decreasing government spending) would
be employed to reduce economic growth.
Monetary Policy
Monetary policy is the way in which central banks choose to control either interest rates or
money supply. Latterly the major economies have been concentrating on the control of the
money supply.
Based on the monetarist theory that reducing the supply of money in an economy will
reduce the inflation rate. The main methods used by central banks are open operations,
where government bonds are bought or sold to change the supply of money, and
administer interest rate changes.
By issuing bonds, money supply is reduced, as the purchasers of the paper have to
withdraw money from the banking system to pay for the bonds, By buying back bonds or
other bills, liquidity is increased as the central bank adds funds to the banking system. The
central bank will indicate its views on the level of interest rates by the rates at which it
relieves shortages.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 33
Interest Rates
The relationship between interest and exchange rates is a somewhat circular one.
Interest rates can affect exchange rates as explained below:
1 The level of real interest rates (nominal interest rates less inflation) is one of the
major factors that international investors consider in determining where to invest. High
interest rates will tend to attract capital causing a currency to strengthen.
2 The level of real interest rates also affects the domestic economy. High interest rates
tend to slow economic growth thus having a beneficial effect on the current account
However, exchange rates will also influence interest rates:
A country with a depreciating currency will have potential inflationary pressures.
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 34
ECONOMIC CYCLE
We shall now look at the four stages in the cycle.
Time
The Four Stages Recovery
Expansion
Boom
Recession
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 35
1. RECOVERY
During the previous stage of the cycle i.e. recession – companies made many
adjustments to help them cope; generally they liquidate inventory and reduce the
workforce and other overheads.
During the recovery stage
Increase in the product demand leads to
- Higher level of production
- Longer working hours, and ultimately increases in the labour force.
Profit increase
Business becomes more liquid
Internal sources of funds exceed financing needs
Companies are able to invest in money market instruments
Companies may resort to the capital market to refinance some the short-term
debts that would have built up during the period of recession.
The demand for business loans either remains flat or declines during the
recovery period.
II) EXPANSION The economy continues to expand but at a slower rate than during the early recovery
stage.
Demand continues to rise
Inventory level rises
Increase in plants and machineries for future growth
Increase in capacity utilization
Increase in productivity and earnings
Rise in internal cash flow and RE
Increase in salaries and wages
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 36
Inflation begins to rise
Demand for bank loan increases
Banks are more liquid as a result of the money market savings during the
earlier recovery phase
Competition for loans increases
Interest rate increases
The increasing interest rate structure forces companies away from bonds to bank
borrowing.
III) BOOM
This is also sometimes referred to as the late expansion phase. Optimism mounts and
expectation propels the economy. Speculative practices also develop.
Demands continue to rise
Pressure on productive capacity increases
Inventory stockpiling prevalent
Inflation accelerates rapidly
Monetary polices to moderate growth – credit squeeze
Demand for bank loans exceeds the supply at the prevailing interest rate
The yield curve may become inverted i.e. short term interest rate exceed long term interest rate
The bigger companies may turn to the commercial paper market.
This is one phase where organisations must exercise due caution: It is easy to get carried
away by the optimism and the spate of activity in the economy.
Even though short-term rates are higher, organisation believing that the rates will soon
peak and then drop, will hedge his position by borrowing short term.
Learners & Trainers Macro/Micro Economics
Learners & Trainers 1st Floor Water House , Ijora Lagos. (+234) 8187479171 8035390860
Page 37
IV) RECESSION
Business activities contract as the expansion finally gives way to recession.
Backlog and demands fail
Production is cut back
Efficiency of production declines
Sales decline,
and inventory piles up.
As the recession deepens
Further cut in production
Lay off employees
Delay investment in fixed asset
Decline in earnings – losses galore
Attempts at cutting cost and improving efficiency.
Gradually work down inventory to match lower sales level
Inflation begins to moderate
During the later stage of recession
The demand for short - term loans decrease as operating cost and capital expenditure
are cut back. More emphasis is also placed on receivable collections. The level of
internally generated funds increases, therefore demand for bank borrowing flattens out.
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
top related