I have recently contacted one of my past students. Currently she is an investment advisor in a foreign country. Surprisingly, in our conversation, she mentioned: "The macroeconomic knowledge and thinking process you taught us are still beneficial for my current role in investment firms." I am surprised not because my teaching can help my students' career. But I have never expected that it is macroeconomics. Which aspects in macroeconomics taught by me can really help my students?
Upon reflection, it is also obvious that macroeconomics is much more relevant to understanding the current economic situation while investment advisors are normally concerned with the "current issues" as these are most important for the "current" performance of their investment portfolios (via buying and selling stocks or other financial assets).
But exactly how can macroeconomics help? Perhaps one recent example is about the interest rate movements. Financial investors are very much concerned with the interest rate movements as interest rate represents the cost of funding. When the cost of funds (interest rate) rises, fewer financial investors will buy financial assets (e.g. stocks) and can buy less. A smaller purchasing power implies that the prices of these assets will decline. Some asset-holders will suffer from a loss. Some asset-holders would like to sell before others sell so that they can avoid the loss of selling later than others. Macroeconomics exactly offers a framework for analyzing the interest rate movements.
In macroeconomics, the issue may appear to be simple enough: Central banks control the money supply, and therefore affect the interest rate, at a given level of money demand. If central banks increase money supply, interest rate will fall, and vice versa. But the question is: will central banks opt for a lower or higher interest rate (more or less money supply)?
Normally, we know central banks have two targets: low inflation and low unemployment rate (or high GDP). The dilemma is that often the two goals cannot be achieved at the same time. Hence, central banks have to struggle between the two goals, and analysts try hard to understand how the central banks will strike the balance. In fact, a recent problem confronting analysts is that how far the US central bank, the Fed, will increase the US interest rate, and when it will stop rising the rate.
Again, how does macroeconomics help us to think about the issue? Firstly, the current economic problem is that both recession and inflation happen at the same time while inflation is particularly high, once exceeding 8% in US. Macroeconomics has obviously provided us a useful framework to understand the phenomenon. By the AS-AD model, we know that AD (aggregate demand) is not the cause of such a problem (higher price as well as smaller output). It is AS (aggregate supply): when AS moves up, price will go up and output will go down.
Why did AS move up? Answers: The global production chains have been disturbed by the pandemic. The war between Russia and Ukraine obstructed supply of basic food. The economic sanctions imposed by the Western countries on Russia generated crisis in oil-related products. All these increases the cost of production. When production cost increases, AS moves up.
While inflation stepped in, central banks have a mission to control it. They have a pressure to, and have already taken actions to, increase interest rate. The action to increase interest rate is equivalent to a contractionary monetary policy (decreasing money supply or slowing down its growth), which will reduce the aggregate demand for goods. This releases the pressure for price to rise (easing inflation) but add extra pressure on output contraction.
So far so good? But what next? Will interest rate continue to rise for a longer period (then the financial market sentiments will be much dampened), or will the rate reach the peak soon (then investors should start to buy now)? This is again about the two goals that central banks aim at attaining - output growth and inflation. When inflation is high, the central banks adopt contractionary monetary policy, raising the interest rate. But when a contractionary monetary policy is implemented, this generates pressures on output contraction. So, this jeopardizes the second target of central banks - to maintain output growth or stability. If central banks don't want GDP to slow down or even decrease, it will restrain its action to push up interest rate, or to stop pushing it up. Analysts would like to know when this will happen, and the answer depends on the output performance.
Hence, these months analysts have a close look at the economic performance in, say US. The sign of output stagnation is, paradoxically, interpreted as good news because this may indicate that the central bank will stop raising interest rate sooner. In case they expect the interest rate rise will plateau soon (say, in early next year), they will start accumulating financial assets (e.g. stocks) at low prices today and wait for the asset-price appreciation (due to interest rate being peaked). If they expect interest rate will not peak soon, they will wait for longer, not buying today and so asset prices will keep falling for a while.
Do we need to learn macroeconomics to know all these? Perhaps we don't but obviously having learned it makes us have a clearer concept and that's useful for doing analysis.
Furthermore, macroeconomics do really let you figure out a point clearly: if the original source of the problem is due to AS, analysts' judgments about the timing of interest rate peak should take this into account.
From the very beginning, the recession was not caused by the central bank's contractionary monetary policy, which depressed demand. If there was no high inflation, the central bank would not take this depressing action. The economic performances for many countries, including US, did not look too bad early this year. Many of them actually started recovering from the turbulence from pandemic. Hence, it is clear that the source of the problem is due to AS, not AD. We may call the output recession caused by AS as the primary cause of output reduction.
If so, then what? When we say the central bank will be mindful of the recession and will not let interest rate to raise too much, this is about AD: stopping the contractionary monetary policy will ease interest rate upward pressure and will ease also the output downward pressure at the expense of a stronger price upward pressure. In other words, AD is only a factor to aggravate the recession originated from AS. We may call the output recession caused by AD as the secondary cause of output reduction.
When analysts concentrate on the central bank policy, and on when it will stop raising interest rate, their attention is paid to the secondary cause mentioned above. This concentrates on a problem that is generated by the central bank (output loss due to high interest rate) as if the central bank wants to cause a trouble to itself. But the central bank has never wanted to generate any problems to the economy from the outset. It simply responds to the economy and tries to makes things better.
This brings us back to the primary cause, which is really the origin of the problem and should not be ignored. If the factors contributing to the primary cause have not improved, the inflation pressure is still there and the central bank has to take care. Analysts should bear in mind that the central bank has to take the painful action (in terms of output loss) exactly because of the primary cause, which is not generated by the central bank policy but by some fundamental production disruptions as mentioned earlier. They should not simply focus on the secondary cause.
