Introduction
It is of crucial importance to understand the sources
of macroeconomic instability. When an economy is functioning well this leads to
political, social stability. An economy that is unstable, that is characterised
by low growth/ recession, unemployment, price instability, either due to
hyperinflation/ deflation, is an economy that engenders both political and
social instability. The recent economic woes faced by Greece, Zimbabwe, and
Venezuela and the accompanying political and social turmoil found in these
countries are illustrative of the need to understand and thus prevent or
rectify macroeconomic instability.
The reasons for macroeconomic instability are myriad.
Factor endowments, extreme or destructive weather conditions, unresolved
structural defects are all possible reasons for instability.
Monetary policy (which essentially determines the
amount of money created, credit provided in a fiat money economy, via the
interest rate) is another great potential source of macroeconomic instability.
When applied correctly monetary policy is a powerful tool, one that can restore
stability to an economy, which can engender growth, employment and price
stability. However, when misused monetary policy has the potential to further
exacerbate any potential instability in an economy.
Neutrality of money
Before proceeding, it would be appropriate to discuss
the neutrality of money. This is the core concept at hand. Money is considered
neutral if any change in the quantity of money found in an economy only leads
to changes in nominal variables, e.g. prices, wages and does not affect any
real variables, e.g. employment and real GDP.
This concept has lead to substantial debate amongst
economists, and different economic schools of thought hold differing views. The
classical economists held that money was neutral, whilst Keynes rejected the
neutrality of money in both the long and short run. The monetarists held, and
this view is supported by many economists, that money is not neutral in the
short run but only in the long run. (Snowdon: 2005)
It is because of this the short-run non-neutrality of
money that the incorrect application of monetary policy has the capacity to
create or further exacerbate macroeconomic instability. And in contrast, the
appropriate application of monetary policy is a great stabiliser in an economy.
Macro and micro equilibrium
Macroeconomic studies and analysis deals with the
general state of the economy. That is, the general price level, which is
determined via an appropriately representative basket of prevalent goods as
well as aggregate income. A state of macroeconomic equilibrium is attained when
there is sufficient aggregate demand that allows firms to sell their aggregate
output, utilising their full capacity (UNISA,2015b) (this is in contrast to macroeconomic
instability which is determined by the state of a number of factors including;
unemployment, growth, price stability, inequality (World Bank)). The aggregate
goods market equilibrium condition and aggregate monetary budget equation are
utilised in this regard.
For any exchange of goods to take place in the current
economic setup, money is needed to facilitate exchange.
The macroeconomic equilibrium condition (∑ Ps,ySyt=
∑ PD,yDyt) shows this. This
condition indicates that the supply price multiplied by the quantity of all
recently produced goods is equal to the demand price multiplied by the quantity
of all recently demanded goods, aggregated, at a certain moment in time. This
implies that every supplier of a good is naturally then a demander of money,
whilst every demander of a good is then a supplier of money. The logical
outcomes derived from the above, is that for market coordination to occur the
physical quantities which are demanded (say 3 bananas) must be supplied, but
also that demanders of goods must possess the requisite amount of money to pay
for the goods demanded (say R6 for 3 bananas). Thus monetary disturbances are
transmitted to the goods market, from the demand side by changing the quantity
of money held by demanders, hence changing planned demand.
Goods market equilibrium (∑ Ps,nSyt=
∑ PD,nDyt) consists of both macro and micro equilibrium.
Microeconomic equilibrium occurs when supply is equal to demand in a specific
market, or for a specific good. Sb =Db (b=bicycles). The
micro sector experiences disturbances in equilibrium due to real factors (changes
in tastes, weather patterns and technology) whilst disturbances in the macro
sector occur due to monetary disturbances.
The circulatory income spending stream
The circulatory income stream is an important tool in
macro-monetary analysis as it demonstrates the dynamic processes which occur in
an economy vis-a- vis the demanding and supplying of money.
Robertson’s (UNISA 2015b, quoting Robertson : 1940)
budget equation (∑ Ps,ySyt-p + ∑ Mst-p = ∑ PD,yDyt
+ ∑ MDt+1) demonstrates
the circular, dynamic nature of monetary exchange. Considering the current
moment as “t” then every current demander of money, was a supplier
in the previous period, “t-p’’.
Money creation also occurred in the same, prior period.
What this means is that the income and money creation
which occurred in the past (for the economy as a whole) must be sufficient to
enable current, planned spending as well as planned increases in passive money
holding for the immediate future, t+1.
This equation provides 2 important concepts; money
creation is an injection into a circular income-spending stream and hoarding is
a leakage from it.
Leakages and injections
Aggregate spending in an economy is determined by the
aggregate income earned in that economy in the preceding period(s), the net
effect of injections-leakages, is also a determinant of aggregate spending.
If the net effect of injections-leakages were zero
than the economy would be in a stationary state (where goods roll over in the
economy, and the same sum total of money merely oscillates between market
participants). In this case the value of aggregate spending would be equal to
the value of the prior aggregate income.
However, when injections are greater than leakages then aggregate
spending will be greater than aggregate income, and if leakages are greater,
then aggregate spending will be less, thus in this manner leakages and
injections are the transmission mechanisms whereby spending, hence the real
economy, is affected by money and quantitive changes thereof.
Passive money holding (hoarding) is a form of a
leakage. This is money which is earned but then not re-spent.
Money creation which occurs as a result of commercial
banks lending money to the non-bank public as well as the government. This is
an injection. Also when banks purchase assets e.g. bonds from nonbanks, money
is created and this is therefore an injection.
Leakages also occur as a result of money destruction.
This occurs when nonbanks repay their debts to the banks. Also when nonbanks
invest in bank non-monetary deposits, loans or equity.
Any increase in the volume of secondary financial
assets traded by nonbanks will constitute a leakage.
A trade surplus on the Balance of Payments (BoP) constitutes
an injection, while a deficit constitutes a leakage.
The Keynesian view and related difficulties
The ISLM theory, which is often the starting point for
students studying macroeconomic analysis, is a representation of the ideas of
Keynes.
The Keynesian version differs in that aggregate income
results due to actual spending. Under the circulatory stream aggregate income
leads to aggregate spending. The
Keynesian (IS) approach does not allow for leakages and injections. This
creates a troubling problem, how are changes in income explained? The IS
approach is to then explain changes in income as a result of changes in
autonomous spending: autonomous consumption, investment and government
expenditure. Another problem then becomes apparent, how are these changes in
autonomous spending financed? The IS analysis is unable to answer this
question. And financing is assumed to just occur, without any method being
explained.
By not allowing for leakages and injections, a further
difficulty is created, i.e. the treatment of savings and investments. Defining
savings as unconsumed income (UNISA, 2015b), savings would then constitute a
form of monetary finance. This only holds if savings are deposited into bank
accounts. If unconsumed income (savings) is “stashed under the mattress”, then
in no way does it become a form of monetary finance, and is in fact a passive
money holding and thus a leakage. Keynes did not make this differentiation and
treated all savings as passive money holding. A possible reason for this is
that in Keynes’s time bank deposits typically earned very little interest. This
is possibly why under his liquidity preference framework, people either choose
to hold cash balances or invest in bonds. Thus, Keynes’s approach can be
understood in the context of his time, when there would be little difference
between “stashing under the mattress ” and depositing unconsumed income with a
bank.
Keynes’s treatment of investment as an injection is
also not always true. If investments are financed entirely from aggregate
income then they are not injections at all. However, if investments are
financed by borrowing from banks then due to the resultant money creation
investments will be an injection, not directly, but rather due to money
creation. Keynes generally held that investments are financed by money
creation. (UNISA, 2015B).
Leakages and injections during different historical
periods
Under an economic system where commodity money is used
there are two possible forms of injections:
·
More of the commodity being found, e.g. a new gold
mine is discovered
·
A surplus on a countries BoP
For a country trading in gold, a third form of an
injection would be when gold which is not in the form of coinage is smelted and
minted into gold coins.
Leakages would occur as result of a deficit on the BoP
and if gold coins are removed from circulation, melted down and used in some
other regard.
With the introduction of fractional reserve banking,
money is created when banks borrow money, buy bills from nonbanks. Money is
destroyed when nonbanks pay back their loans or purchase bills from banks.
Under a fiat banking system the primary injections are
money creation by commercial banks, financial asset purchases by banks from
nonbanks and a surplus on the BoP.
The primary leakages are the repayment of bank loans,
financial asset sales to nonbanks and a deficit on the BoP.
Effects of improper monetary policy
When monetary policy is not applied appropriately this
can result in hyperinflation. This occurs when there are several periods of
rapid and increasing inflation. (inflationdata.com). This causes massive price
instability, erodes savings, transfers wealth from wage earners to business
owners. Hyperinflation occurs due to unrestrained money creation.
When the money stock in an economy does not increase
adequately, there is a risk of deflation. This means that a reduction in the
price level occurs, which implies that the real value of the money stock has
increased. At first blush this would seem like a positive component. However,
deflation has a secondary, insidious component and that is it causes the in the
real value of bank indebtedness. This is a great problem, and
counterintuitively the more people try to pay their debts off, the more money
destruction occurs, which causes the value of the money stock to again increase
and the real value of bank indebtedness to increase once again. A truly vicious
cycle.
Macroeconomic disequilibrium and macroeconomic
instability
Macroeconomic disequilibrium occurs when firms are not
able to sell their aggregate output utilising their full capacity. This then
leads firms to curtail production, which implies job losses. A result of
unemployment is that aggregate spending decreases which means that even less of
firms output would be purchased, creating and perpetuating a cycle of
diminished production and unemployment.
Increasing unemployment creates a burden on the government
by increasing the demand for welfare transfer payments and subsidies. These
transfer payments are funded through taxation and government borrowing.
Increased taxation makes firms less competitive, realtively, whilst increased
borrowing increases the possibility of a deficit on the BoP.
Unemployment also leads to political and social
instability. In this manner if macroeconomic disequilibria are not corrected
they have the potential to create macroeconomic instability.
Current examples of macroeconomic instability
From 2000 to 2009 Zimbabwe experienced massive
macroeconomic instability. Recessions, hyperinflation, mass unemployment were
all experienced by Zimbabwe. This was due to the central bank increasing the
money stock recklessly. The central bank did this due to it lacking the
independence which would allow it to resist governmental pressure. As this
independence was lacking the central bank was forced to “monetize the debt’’ of
the government, which meant purchasing massive amounts of government bonds,
hence creating massive amounts of money. As a result of this macroeconomic
instability, political instability has also occurred with violence, rigged
elections and a massive refugee crisis which has swamped neighbouring South
Africa all occurring.
Another interesting case is that of Greece. Greece
owes large debts. Were Greece a country that enjoys central bank autonomy she
would simply “print her way out of trouble”. What this entails is a cutting of
the interest rate which leads to greater money entering circulation which
results in a depreciation of the currency allowing exports to increase and the
economy to expand. Quantitive easing where liquidity is supplied by the central
bank to financial institutions other than commercial banks is another method
whereby central banks create liquidity (money) in an economy.
However Greece cannot do this as under the provisions
of the Treaty of Maastricht it has ceded control of its monetary policy to the
European Central Bank (ECB) . This has left Greece with austerity measures as
the only solution. These measures are exceptionally unpopular and have resulted
in great hardships being visited on the Greek people.
Thus macroeconomic instability has occurred, here too.
With recessions, mass unemployment and austerity measures being the order of
the day.
References
http://inflationdata.com/articles/hyperinflation/
accessed 21 June 2015
Snowdon, B. and Vane, H. (2005). Modern
macroeconomics. Cheltenham, UK: E. Elgar.
UNISA 2015b. Tutorial Letter 103. ECS 4864. Pretoria
UNISA
www1.worldbank.org/prem/lessons1990s/chaps/04-Ch04_kl.pdf
Accessed 21 June 2015
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