Understanding Macroeconomics: A User-Friendly Guide

Macroeconomics is one of those disciplines where the ideas are simple, but the lingo is complicated.

Paul Krugman, in his New York Times blog, is usually great at communicating the ideas of Macroeconomics in a human-friendly way.

But sometimes the language gets ahead of Krugman—sadly, most obviously when the ideas he’s expressing are important and deep. This post is a perfect example. The ideas are incredibly important for understanding what governments are doing or not doing to manage the financial situation, but without some specialist knowledge, it’s pretty hard to understand.

Here, I’ve written a summary of the stuff you’ll need to know to understand Krugman’s excellent writing, and get a sense of the deep and subtle ideas he’s discussing.

It’s not particularly short: there’ll be plenty of “too long didn’t read”s I suspect, but for those who are keen to understand what on earth is going on with macroeconomics—inflation, interest rates and all that—I think it’ll be worth the while.

Here it is:
disclaimer: this is just my own understanding of the situation. Don’t use this summary to actually run an economy, because there’s a chance that parts of it are wrong or oversimplified. If you’re an actual central banker, best get a proper qualification on the subject before fiddling with any knobs or levers.

Rob Levy’s User-Friendly Guide to Macroeconomics

or, how to understand Paul Krugman and his economist pals

 

A bank traditionally earns a profit by taking the money which savers have deposited with it, called deposits, and lending it back out to people who are looking for a loan. These borrowers might be after a mortgage, or after funds to invest in a business venture.

The banks encourage people to deposit their money by offering them interest. In order for the whole thing to make a profit, they charge more interest to the borrowers than they pay to the savers.
A bank has a legal obligation to keep a certain amount of its deposits in ‘cash’, and is free to lend out as much of the rest as they fancy. We’ll call the amount of cash they have to keep a “cash cushion”, because its designed to stop them running out of money if lots of the depositors suddenly want their savings back at the same time.

The relationship between a central bank and normal banks is exactly the same as between banks and customers: banks stash excess deposits with the central bank and earn an interest rate. Banks even borrow money from the central bank, for which they’re charged an interest rate. It’s this last interest rate which determines how much of a bank’s deposits it want to lend out and how much it wants to cling onto. We’ll see why in a second.

The setting of this interest rate is called ‘monetary policy’ and it’s ‘loose’ monetary policy when the interest rate is low.

When monetary policy is loose, banks are keen to dish loads of their deposits out as mortgages and business loans, because they can borrow for cheap from the central bank to keep their cash cushion at the right level. But if the interest rate is high, the bank will be more tempted to keep hold of its deposits because it doesn’t want to have to borrow to maintain its cash cushion.
When a bank is doing lots of lending, lots of business investment takes place and lots of houses are bought. These things are (usually) good for the economy so the central bank wants to encourage lending.

But there are limits: if the banks are so keen to lend that they’ll offer mortgages and business loans at ridiculously low prices, then people will start buying homes faster than they can be built, or expanding their businesses faster than they can expand their customer base. In this case, inflation sets in: prices rise because businesses have to pass on the cost of all this wasted investment to consumers. It’s this kind of mania for house-buying and business investment that economists refer to as the economy “overheating”.

So, the central bank, via the interest rate it charges to banks, can control how much lending the banks do. It therefore has to set a balance between too much lending (overheating) and not enough (recession); both are bad for the economy. What it really wants to do is set the interest rate to just the right level, such that there is just enough investment in businesses to continue to match demand as it ‘naturally’ grows or shrinks. This is the so-called ‘natural’ interest rate.

Natural growth in demand comes from innovation (a new smartphone model), population growth, the exploitation of natural resources, and improved manufacturing processes which means companies can makes the same products more cheaply. It’s this natural rate of growth that the central banks are trying to second-guess.

But there are limits to what the central bank can do. If banks have some reason to feel negative about the future, they won’t want to lend money however cheaply they can borrow it from the central bank. In this case, the central banks interest rate could get down to zero (at which point the banks can borrow money ‘for free’) and the banks still won’t take the bait. Once interest rates are at zero, that’s it. The central bank is out of options! This is what Krugman refers to as the ‘zero lower bound’. This whole set of circumstances is called a ‘liquidity trap’ because banks get addicting to hoarding their money (and money, when it’s cash as opposed to loans you’re owed, is called ‘liquid’: an extra layer of jargon to worry about.)

Once the central bank reaches this zero point, where they’re lending money to banks for free and still the banks won’t lend, its role as a controller of the economy is stuffed. All it can do is wait for things to improve on their own. This is clearly not what the central banks ideally want.

With this knowledge in your armoury, go and read “Secular Stagnation, Coalmines, Bubbles and Larry Summers”. It’s both well-written and important to understand. If you can get to the bit right at the end about offering a positive interest rate on all savings even when the market doesn’t really want to, you’ll be rewarded with a real “ah-ha!” moment.

Good luck!

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Author: Rob Levy

Economist at NEF. Former teaching Fellow in Economics at UCL and Bristol University. Recently submitted my PhD. We'll see what happens...

1 thought on “Understanding Macroeconomics: A User-Friendly Guide”

  1. Helllo, i have been in banking for abiut 12 years. I have experince from cash operations to mortgage lending branch manager to investment banking. I am repeating macroeconomics to raise my gpa and hoping to finly get my degree after all these years. However, i cant seem to understand krugman lingo. He uses actual industry terms but reinterpret it in such way that i confuses me. …..?

    Like

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