How to understand macroeconomics of your country

[ar81]

So you want to understand how economy of a country works.
This is how economists plan economy of a country when they make macroeconomical financial programming.
The model they use has lots of numbers and formulas and uses a model of linear programming.
We are going to simplify it a bit, to make it simple, understandable, non esoteric model, without complex math.

CREATING THE CHART

Open Excel or your favorite spreadsheet software
Go to cell A1
Paste this list:

Price
Market
Government
Companies
Banks
Trade
Internal market
Excess of demand

(Notice that "Excess of demand" will end up in row 8)

Goto cell B1 and paste this

Price of goods
Goods

Goto cell C1 and paste this

Interest rate
Foreign credit

Goto cell D1 and paste this

Interest rate
National credit

Goto cell E1 and paste this

Exchange rate
Capital market

Goto cell F1 and paste this

Amount of currency
Currency

Draw borders for cells from B3 to F8
Make row 8 to contain total per colum for all columns, from row 3 to row 7 (for example, B8 should sum cells from B3 to B7)

Set all values in rows 1, 2 and 8 to have bold style.

Save the sheet.

USING THE CHART

Columns in this chart represent markets.
Rows represent sectors or participants of economy.
Who are the participants?

Government
Companies: All non financial companies
Banks: Financial entities
Trade: Exports and imports. You have deficit when imports exceed exports.
Internal market: Normal people who buy, citizens. Income is usually wage.

In the cells with borders, you will put deficits.

Deficit = Expenses - Income

Notice that if you sum all cells in each row, total must be zero.

EXAMPLE

For example, if government spends more than it collects as taxes, you have a deficit.
Let's say deficit is $100
So cell B3 contains 100.

Since total per row is zero, let's add -100 to cell C3, as government sold bonds to other countries.
As you can see, we will have excess of demand in markets of goods and also foreign credit.
Such excess of demand pushes changes in the price (see row 1), and in this case you will have inflation (price of goods change) and also changes in interest rates for external credit.

NOTES

Notice that deficit in one sector is compensated with money from at least one other market, altering the balance of the country as excess of demand exists.

If you want to learn, just ask.

When you have your spreadsheet ready, with no numeric data, we may start talking so you understand and be able to intuitively forecast how the economy will behave, and what needs to be done, without having too many numbers.

This may help you to understand how to make proposals.

[Strem2]

I understand how the government money will have to come out to zero, or, during the Clinton time there was an excess of money they were going to save for Social Security shortfalls when the population aged.

If a company makes a profit, then there will be no deficit, correct?

Now, we know that the banks use the government as an investor. So if a bank has a deficit, you would balance it with national credit?

And, if you have a trade deficit, what do you balance it with?

And, the internal market -- How can this be a deficit?

Finally, if the excess of demand total at G8 is 0, then would there be changes in inflation?

I guess I don't understand why, in your example, there is inflation. Is there always inflation if you have any excess of demand?

[ar81]

Originally Posted by Strem2

I understand how the government money will have to come out to zero, or, during the Clinton time there was an excess of money they were going to save for Social Security shortfalls when the population aged.

They need to match income with government spending. Either you raise income or reduce expenses. This is why nationalizing banks is so good. Banls do not produce any value added, and it raises government income with interests, and bank deficits are turned to zero, and if banks are having no deficit, the surplus would help to fight government deficit if nationalized.

Originally Posted by Strem2

If a company makes a profit, then there will be no deficit, correct?

Right. The original model which is used by many central banks, lack internal market, because there is an assumption that company profit leads to raise of employment, but just as you have seen, company profits have been achieved lately but sending jobs overseas, or by laying people off. Then a growth of economy does not become higher wages or higher employment, but exactly the opposite.

It basically makes company surplus to be generated by transferring deficit to internal market. With the incomplete model, transferring such deficit would balance national excess of demand. But as the assumption is wrong, internal market is needed, and the whole transfer of deficit leaves the national excess of demand untouched.

Originally Posted by Strem2

Now, we know that the banks use the government as an investor. So if a bank has a deficit, you would balance it with national credit?

If bank deficit is compensated with debt (government lending money), then for macroeconomic purposes you still have the deficit in the market of goods that creates excess of demand in the market of goods, and the use of the loan generates excess of demand in the market of credit.

Such excess of demand in market of goods will cause unstable prices of goods, and excess of demand in credit market will cause unstable interest rates.

So even if it looks like the use of government money cancels the deficit, it does not because it involves 2 different markets, so money is transferred between markets. So in the row of banks, the sum of the row is still zero as it should be, but excess of demand will not be zero in those 2 markets.

Originally Posted by Strem2

And, if you have a trade deficit, what do you balance it with?

Trade deficit comes when imports exceed exports. It causes a deficit in the market of goods, and to compensate the market of capitals will have an excess of demand and unstable exchange rates between currencies.

Exchange rates makes less attractive to import and more attractive to export, which in the case of US would mean to plunge the price of dollar to its real value. Dollar has been overpriced before Yuan for too long, causing a trade deficit.

Of course, Federal Reserve may choose not to apply the required adjustments, but it only would make the pain more painful, as a bubble is created, and when bubbles pop, many people suffer.

Originally Posted by Strem2

And, the internal market -- How can this be a deficit?

Internal market is composed by people. If you make $100 a month, but you need $1000 to survive or pay your bills, then there is deficit of $900. If you are unemployed, you make $0 a month and you need $1000.

How do people compensate their deficits? Use of credit card (excess of demand in credit market), buying less (transferring deficit to companies because you don't have the money, which will backfire as companies fire people and transfer deficit back to people).

So in a few words, poverty is a classic state of deficit. If poverty is enough to starve people, health problems become a source of deficit as it adds to the economical needs of people. So if you were healthy and you needed $1000, with health problems you may need $2000.

But as internal market has been omitted because of a wrong assumption, then what happens with excess of demand in the internal market remains invisible, unaccounted, and for political purposes it is convenient, because the suffering of people may be hidden from economic reports.

Omitting internal market is like managing an economy without humans, without consumers. It is senseless. Right?

Internal market was omitted because it would have been socialist to think about "wealth distribution" which basically implies to provide people with a source of income, and it was expected that the trickle down effect (which CEPAL has proven non functional long ago) would turn economical growth into employment and higher wages.

Originally Posted by Strem2

Finally, if the excess of demand total at G8 is 0, then would there be changes in inflation?

Inflation is a change of price. Prices in the market of goods rely on changes of liquidity. Deficits in the market of goods make prices unstable. If there is inflation or not, it depends on the impact on different sectors of economy. While inflation of food may be good for food producers, it may be bad for non essential products which may suffer deflation. The overall effect is the result of the sum of deficits and surplus you will have for the country. Also, oil inflation would cause inflation in US, creating deficit in different sectors of economy. Why does it happen? Because US depends too much on oil, so they can set whatever price and US will pay for it.

Excess of demand relates to unstability, not to inflation or deflation as a fixed formula. It depends on the effect, and also on political decisions to either adjust, or create bubbles. US dollar should have crumbled long ago, banks should have been nationalized long ago. This supposed end of recession is a temporary bubble that will pop. And as it pops they will create more bubbles to procrastinate the pain, while not solving the root cause of the problem, because the adjustment would be a bitter medicine, and politicians do not like to apply bitter medicines.

You tell me that excess of demand of G8 is 0. In what market? Do they consider internal market? I'd dare to think they do not.

If there is inflation, and excess of demand is 0. something is wrong. It could be a problem of estimation of data, intentional or unintentional (like the problem in Argentina where they manipulated the numbers, so nowadays their figures are unreliable). Manipulating figures is very convenient, politically speaking. It also could be caused by the lack of internal market in their model.

In some other situations, estimation of indicator depends on methodologies. For example if your methodology did not include services to calculate GDP, it will be lower. GPD is supposed to estimate growth, according to many people. Others think it describes value added. But it is just a measure of transactions without telling you about good or evil.

If you have more crime, security expenses add to the GDP. If companies destroy environment to produce they will add to the GDP, and when government comes to repair damage it also will add to GDP. If people get divorced and pay their lawyers, that adds to GDP. Is GDP a reflection of value added or growth?

Indicators are estimations, subject to methodologies and assumptions and other considerations.

Originally Posted by Strem2

I guess I don't understand why, in your example, there is inflation. Is there always inflation if you have any excess of demand?

Excess of demand causes prices to be unstable. But inflation itself depends on liquidity of economy and previous prices, not deficit or surplus.

For example, imagine this. In US and Japan you have 100 Americans and 100 Japanese making $10 a month. Americans spend $110 a month, and Japanese spend $90 a month.

American internal market would be at deficit, which is compensated by credit. Japanese would have no deficit. This is what appears in the macroeconomical model, I just showed you. It has nothing to do with liquidity.

Let's say those Americans and Japanese buy 100 tomatoes in their respective countries. It means that in US $110 are available to buy 100 tomatoes and in Japan $90 would buy 100 tomatoes, saving $10. Money that is not spent is mostly as if it did not exist, when you talk about liquidity, because even if the money is there, it is not being used to buy.

If previous reference price was $1 per tomato then US had inflation and Japan deflation, but if previous price was $0.9, US would have inflation, and Japan would not have had deflation or inflation.

Now you wonder why are prices so high in Japan. It is because exchange rates and accumulated effects from the past. Policies aimed at a strong yen. But they use to suffer because people do not like to spend, as they save a lot, which opposes to the deficitary behavior of people in US, where use of credit card is widespread, not as a tool for purchase, but as a source of credit.

Credit cards is a tool to make US economy unstable, since deficitary behavior can be easily tuned to credit. It increases inflation, and when the hyperinflation comes after this recession, it will pose a problem. Inflation reduces the buying power of your wage. So even if you did not use a credit card, you suffer the effects.

Credit cards add liquidity to economy, pushing inflation up. It also creates an incentive to deficitary purchasing behavior (deficit in market of goods) as it provides easy credit (which pushes excess of demand in the market of credit).

As you pay, liquidity is maintained, but internal market deficit may increase, as now people need more money to pay their bills.

[Lauxa]

Hm, you're going over my head a little here, but I made the spreadsheet, maybe some numbers would help clarify.

[Strem2]

Originally Posted by Lauxa

Hm, you're going over my head a little here, but I made the spreadsheet, maybe some numbers would help clarify.

I am going to give this a try, and hope that AR81 comes back to clarify if I am wrong.

The first column, "Price of goods" will always only be a deficit in the market row. So, if one market has a surplus, don't write in anything. Only write in the deficits.

If you have a number in the first column, it has to be balanced by a negative number in another column so that the numbers in column G, totals, are always zero.

Therefore, if you put a deficit in the trade market (row 6, column b), it has to be balanced by a change in foreign credit, national credit, the exchange rate, or the amount of currency.

In the US, all these columns are controlled by the central bank, the Federal Exchange Bank (which is a private enterprise and not government controlled). This was a tremendous power held by Greenspan for a long, long time. His balance was to reduce the exchange rate in the Capital Market (ar81, is that right?) but now that we are down so close to zero, this cannot be used anymore.

• Column C is what is borrowed from foreign governments. Column d is what is borrowed or taxed from citizens.
• Column E -- I'm less clear about. AR81, can you explain this please?
• Column F is the amount of currency. When the Fed (in the US) prints more, there is more available which lowers its value - inflation. When the Fed prints less, it increases its value - deflation. I believe, in AR81's example about the US worker spending more than he earns against the Japanese worker saving some, the Japanese would be in a position to strengthen their currency by printing less, because there would be money available for corporate borrowing since the workers are saving some of their earnings.

[Strem2]

Ok, Ar81, here is the big question. If wages fall, (row8) (due to people losing good jobs and taking anything they can get or remaining unemployed) or if people are spending more than they earn (row 8), then how is this balanced?

What column takes up the slack?

For a while people can use credit to supplement their lost income -- is that column D, National Credit?

They can also get back from the government, money that they put in, known as Unemployment Insurance. Is that also column D?

[ar81]

Originally Posted by Strem2

If you have a number in the first column, it has to be balanced by a negative number in another column so that the numbers in column G, totals, are always zero.

Row totals must always be zero.
You are right, a negative number should go in another column.

Column totals may not.
Non zero column totals means there is excess of demand.

Originally Posted by Strem2

Therefore, if you put a deficit in the trade market (row 6, column b), it has to be balanced by a change in foreign credit, national credit, the exchange rate, or the amount of currency.

Exchange rate.

Originally Posted by Strem2

In the US, all these columns are controlled by the central bank, the Federal Exchange Bank (which is a private enterprise and not government controlled). This was a tremendous power held by Greenspan for a long, long time. His balance was to reduce the exchange rate in the Capital Market (ar81, is that right?) but now that we are down so close to zero, this cannot be used anymore.

Market of capitals takes into account exchange rates between different currencies. Currencies are subject to supply and demand, and that determines relative prices, which we call exchange rates.

Exchange rates are not zero. You have a price of dollar vs Euro, dollar vs Yen.

Originally Posted by Strem2

• Column C is what is borrowed from foreign governments. Column d is what is borrowed or taxed from citizens.
• Column E -- I'm less clear about. AR81, can you explain this please?
• Column F is the amount of currency. When the Fed (in the US) prints more, there is more available which lowers its value - inflation. When the Fed prints less, it increases its value - deflation. I believe, in AR81's example about the US worker spending more than he earns against the Japanese worker saving some, the Japanese would be in a position to strengthen their currency by printing less, because there would be money available for corporate borrowing since the workers are saving some of their earnings.

Column C: Debts that must be paid to foreign entities like an international bank or another country.

Column E: Market where different currencies are traded. Basically you may have reduced value of your currency or higher value. It will determine how many dollars you get when you trade with other countries. For example, if dollar falls before Euro, for every transaction where someone sells in Euros he gets more dollars. But if someone has to buy in Euros and he uses dollars to sell products, he may face a problem of increased price of raw materials.

In the case of China, even if most of transactions are made in dollars, as China devaluates its currency, it affects prices of imports and exports to China. Overpriced dollar exploits US policiy of having a strong dollar, and encourages trade deficit as chinese products are cheaper, and american products would be very expensive for average chinese.

Column F: When government prints more money, the effect of inflation comes in the market of goods due to increased liquidity, unless that extra liquidity is saved and not spent. In either case, printing more money has an effect on excess of demand, and makes economy unstable.

Originally Posted by Strem2

Ok, Ar81, here is the big question. If wages fall, (row8) (due to people losing good jobs and taking anything they can get or remaining unemployed) or if people are spending more than they earn (row 8), then how is this balanced? What column takes up the slack?
For a while people can use credit to supplement their lost income -- is that column D, National Credit?
They can also get back from the government, money that they put in, known as Unemployment Insurance. Is that also column D?

Govt unemployment insurance will represent an income for unemployed that reduces deficit of unemployed, but adds deficit to government.

If unemployed have deficit, it depends on what people do to compensate. If they ask for loans with credit cards, it would go to national debt. Be aware that this spreadsheet is a simplified model of the economy, easy enough to understand but it may have its limitations.

[ar81]

Originally Posted by Strem2

The first column, "Price of goods" will always only be a deficit in the market row. So, if one market has a surplus, don't write in anything. Only write in the deficits.

This is where assumptions come up to make the model accurate or not.
In the original model that I have at home, you do not get rid of surplus.
Just like I found that the model has missing Internal Market, we also may try to question if surplus must be added or not.

I will try to dig the original model at home, because it contains formulas for every cell, using specific indicators.

When we change a model, the assumptions will be changed, and the meaning of the output also may change.

Models are representations of reality, and they may be incomplete or inaccurate, so the idea of this thread is to question and perfect the model, which has not been questioned or perfected by economic ideologists.

The problem of ideology is that it responds to beliefs. And the world does not always work on beliefs. If you think that rain dance will bring money, it may not be so true, if you are a politician or economist making decisions for a country.

I do not work on macroeconomical financial programming, but I have spend a considerable amount of time understanding the implications of the model, and questioning if it was accurate. It has worked to understand US crisis and the implications of it.

[Lauxa]

Could you find an online reference that explains this model? Does it have a name?

How would you use this model to predict the macro-economy of the US? I've been betting on massive inflation, but what does this model predict?

[Strem2]

Good idea. I like the idea of keeping track of surplus as well. Perhaps a surplus in one area is what allows deficit in another, even though the model doesn't show that....

For example, if companies have a surplus, couldn't that count to balance the amount of currency in the same way that worker savings (if present) help to balance amount of currency to avoid inflation -- even if the government is working at a deficit?

[ar81]

Originally Posted by Strem2

Good idea. I like the idea of keeping track of surplus as well. Perhaps a surplus in one area is what allows deficit in another, even though the model doesn't show that....

For example, if companies have a surplus, couldn't that count to balance the amount of currency in the same way that worker savings (if present) help to balance amount of currency to avoid inflation -- even if the government is working at a deficit?

The problem is that even if excess of demand in the market of goods is zero (no changes in prices), but sectors have deficit, the resulting effect on other markets would cause excess of demand (credit market for example) that will keep economy unstable and very changing.