Fundamentals of Macroeconomics:
- The aggregate spending in an economy determines the level of production and employment. Aggregate spending includes government spending, household and business spending as well as spending that results by foreign spending on domestic goods (exports).
- Increase in aggregate spending does not always result in inflation. Only if the economy is under full employment that further increase in spending, causes inflation
- Fiscal policy (government spending, taxing policy, export policy) affects aggregate spending in an economy and can help move level of production and employment. Inflation would only occur if this is spending increase is beyond full employment.
- Monetary Policy is the action taken by Central Bank to change the reserves that commercial banks have parked by it. Increase in reserves should increase new loans, reduce interest rate and spur household and business spending. This moves level of production and employment. Again inflation would only occur if this spending is beyond full employment
- Central bank can change reserves by changing reserve ratio, increasing/decreasing discount rate or through open market operations. In open market operations, the Central Bank buys government bonds from the commercial banks (secondary market). Commercial banks had bought these bonds which are are issued by the Govt. treasury to finance govt. spending. By buying bonds, Central Bank increases the reserve of that commercial bank's account with it, spurring investment and introducing new money. If central bank does not buy govt. bonds, it can result in crowding out effect as commercial banks and individuals buy govt bonds, the commercial's bank's reservers with central bank's falls, and may not give new loans increasing interest rate. To prevent interest rate from rising and reducing investment, Central Bank purchases these bonds from the bank giving it new money and keeping interest rate same. This is called monetising the debt.
- Exchange rate is determined by intersection of demand and supply curve (flexible or free floating exchange regime).
When a country exports a lot, foreigners demand for rupees increases (to pay for the imports). this appreciates the rupee as demand curve shifts to the right. Foreigners supply foreign currency and demand rupees. This increases foreign exchange reserves. This can auto-stabilize as appreciating rupee makes exports expensive and bring back equilibrium. To prevent this, a country can artificially support its currency. It can do this by increasing the supply of rupees which shifts supply curve to the right. This may have the effect of stoking inflation as quantity of money increases and increased supply may also increase spending by businesses and households due to lower interest rates.
When a country imports, it buys foreign currency and sells its domestic currency. This increases the demand for the foreign currency and unless the foreign country increases supply of its own currency, the country importing will see the value of its currency drop (as explained in previous paragraph).
When the country is facing recession, fiscal policy and monetary policy is used. Fiscal policy will boost aggregate spending in the economy. Since country is in recession, this will not stoke inflation but move country towards full employment. However to finance this increased spending, the government will sell bonds to banks and public. As banks and public buy these bonds, interest rates demanded will increase as banks's reserves with central bank falls. This may have a negative effect as increasing interest rate hurts spending. Central bank will intervene and monetise the debt by increasing money supply to prevent rise in interest rate. The increase in money supply shifts the supply curve to the right. This depreciates the local currency. This can be counter balanced if exports increase (and hence demand for local currency increases). However if the country is in sanctions and not able to export (like Iran or Russia), the demand for local currency might actually further fall. The increased money supply from Central Bank may result in inflation in the country (negated somewhat by decreased demand for its local currency). However if the country is dependent on imports, the falling local currency means it needs more local currency to buy imports. This will force the government to print more money, further increasing inflation and finally taking the country towards hyper-inflation. One way the country can be saved is if it has foreign exchange reserves as it can pay for necessary imports using its foreign exchange reserves without resorting to printing more local currency.
Alternatively when a country is a hot-bed for investment, demand for its local currency will be high. With increased demand, the demand curve shifts to the right and the local currency appreciates. This also increases foreign exchange reserves. The appreciating of local currency may hurt exports. If the government tries to prevent this by increasing money supply (hence shifting supply curve to the right)- This has the effect of increasing money supply in economy and stoking inflation. Alternatively if the country is no longer hot-bed for investment, foreign investment pulls away. This decreases demand for local currency (shifts demand curve to the left). This devalues the currency and the country will be forced to increase money supply to pay for its imports (stoking inflation) or use up its foreign exchange reserves to pay for imports.
Important to understand: By itself, appreciating or depreciating a local currency has no relation to inflation. Inflation is an indirect effect when government tries to increase or decrease money supply to maintain a stable exchange rate. In a flexible exchange rate system, no govt. intervention would mean to affect to inflation (but has other problems of volatility in exchange rates).
Current Account - the net exchange of foreign exchange which includes Exports-Imports + Interest Payments + transfers.
Capital Account - the net exchange of foreign exchange which includes investments in and out of the country and well as purchase of govt bonds by foreigners.
In US, when it imports more than it exports, there is net current account deficit. Since it imports more than it exports, there is net deficit in dollars. To fund for these "missing" dollars, US govt. would be forced to raise money through bond selling. Foreigners purchase these bonds giving it a net positive capital account transfer. This balances the current account deficit to zero and hence called balance of payments. If a country cannot fund for its current account deficit through raising money by bonds (as happens in Russia, Iran who are not allowed to export but are forced to import needs imports and have falling currency), the only option left for that country is to pay for those imports by selling its foreign exchange reserves or gold. These countries could try to increase the value of their domestic currency by reducing aggregate spending (fiscal austerity), this moves the supply curve to the left (and appreciates the currency) allowing it to pay for its imports but is problematic as it hampers future growth.
If a country has its currency as reserve currency (like US), it is good because there will always be demand for dollars irrespective if its money supply increases (like it happened in this recession). Even with increased money supply, there was no devaluation of dollar as demand for dollar as reserve currency increased.
