DEVELOPMENT ECONOMICS
MICRO & MACRO ECONOMIC PRINCIPLES
Economists think about the overall wellbeing of a nation’s economy by looking at several key concepts and have developed several policy tools to help the overall economy grow.
Scroll down or use the menu to the right to learn more about microeconomics and macroeconomic principles.
Inflation, Labor Markets & Exchange Rates
How does the economy function as a whole?
While microeconomics focuses on the actions of individual agents within the economy, macroeconomics inform how the economy functions as a whole.
What is macroeconomics?
Macroeconomics is the study of a national economy as a whole and its major aggregates – Consumption, Investment, National Savings, etc.
Macroeconomics can help answer some of these important questions:
- What determines how many goods and services a nation produces?
- What determines how many jobs are available in an economy?
- What determines a nation’s standard of living?
- What causes the economy to speed up or slow down?
Successful macroeconomic policy tries to maintain price stability, full employment, and external economic balance through the following tools:
Inflation
Labor Market
Exchange Rates
Governments focus on limiting inflation to ensure the stability of prices and wages
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Inflation refers to an increase in the general price level, measured in percentage terms. We can measure this multiple ways:
- CPI (Consumer Price Index) – A price index measured as a weighted average value of a “basket” of goods and services typically bought by a household in a given year.
- PPI (Producer Price Index) – A price index measured as a weighted average value of a basket of inputs (such as wages, energy prices, raw materials, etc.) that reflects the cost of production facing manufacturers.
Growth Impact
Price stability helps create an environment conducive to investment, entrepreneurship, and innovation. Purchasing power for households is better maintained with low, stable inflation, enabling a better standard of living and the ability to smooth consumption.
For firms, price stability enables better planning and a focus on business improvements.
Measuring Inflation
Measurement of inflation data is an extremely important task that involves large teams of economists and researchers who constantly track the prices of goods and services across a country. Over time, measurements of inflation provide important feedback for policymakers.
Data Source
Inflation has dropped globally over the past decades, but varies greatly by country. Look up your country’s annual inflation for consumer prices here.
The labor market refers to the people in an economy who are working (full-time or part-time, formally or informally) or actively looking for paid work.
Governments pay close attention to these metrics:
- Size of the labor force
- Unemployment rate
- Labor force participation rate
- Employment-to-population ratio
At the same time, governments want an active labor market to drive economic growth
Growth Impact
Greater labor force participation across the board ultimately means that a country’s economy can potentially produce more goods and services.
It is also important to understand what proportion of people are employed and whether there is excess labor since this will affect wages and other prices.
We will look at how labor fits into theories of growth in the development economics theory module.
The Informal Sector: Labor in Developing Economies
In many developing countries, a significant share of the labor force is in the informal sector. Individuals working in the informal economy may be more vulnerable to shocks and have fewer opportunities to increase earnings.
Deep Dive: The Long Shadow of Informality
Read “The Long Shadow of Informality” to learn more about challenges posed by the informal economy and economic growth. Full link here.
Externally, governments try to stabilize the value of their currency to buy and sell goods abroad
Growth Impact
A stable exchange rate allows a country’s economy to be able to buy and sell goods and services abroad. Producers can buy important inputs from foreign suppliers and anticipate the cost of operating. Consumers abroad can buy a country’s exports and producers at home can be reimbursed adequately to cover costs.
We will look at how international trade can promote or inhibit growth in the International Trade Principles module.
The nominal exchange rate (ER) is the price of one currency in terms of another. Governments traditionally pursue one of two policies relating to exchange rates:
Fixed exchange rate – Government commits to buying and selling currencies at the fixed rate to keep the rate stable.
Floating exchange rate – Government lets the market determine the exchange rate at any given moment.
Macroeconomic Policy
How does the government achieve macroeconomic stability?
Governments use both monetary and fiscal policy to maintain macroeconomic balance
Government Objectives
- Short-Run Goals – Maintain price stability (low inflation), high employment, and rising economic output.
- Long-Run Goals – Promote rising living standards, economic growth, and development that is inclusive and equitable.
Governments use two main tools to achieve macroeconomic stability:
Fiscal Policy
- Government Spending
- Tax Policy
Monetary Policy
- Interest Rates
- Reserve Requirements
- Money Supply
Countries use monetary policy to stabilize the overall economic environment
Monetary Policy Tools
Interest Rates
To help reduce inflation, interest rates can be increased by decreasing the money supply through sales of government securities (e.g., a bond). If the goal is to boost spending and investment, the Central Bank can lower the interest rate by increasing the money supply and increasing the amount of cash in circulation.
Reserve Requirements
A Central Bank can raise or lower the required amount of cash reserves that banks must hold to decrease or increase the money supply.
Credit Conditions
A Central Bank can loosen or tighten the lending requirements for banks to either make it easier or more difficult for individuals and firms to borrow.
Effective monetary policy responds to two concepts related to a national currency
Inflation
- Low to moderate inflation can be a sign of a healthy economy;
- However, high inflation erodes the value of savings and may lead to higher borrowing costs for individuals, firms, and the government.
- Hyperinflation can occur if money supply growth far exceeds growth in the real economy.
Deflation
- Deflation is a fall in the general price level, causing the value of money in circulation to rise. People delay spending to wait for lower prices, which puts pressure on businesses.
- This leads to production cut-backs and lay-offs, which further curtails consumer spending.
Monetary policy that establishes strong international credit is good for growth
National Credit
It is important for countries to have access to international credit markets. International credit allows countries to borrow from abroad for additional spending. Monetary policy that does not ensure stable currency values will make it hard to borrow or repay international loans.
Data Source
You can look at the credit ratings of different sovereign debt here. Some countries’ debt may not have ratings.
Monetary policy that fails to check inflation can quickly destabilize the economy
Hyperinflation: Economic Collapse in Venezuela
While not unique to Venezuela, uncontrolled inflation can quickly destabilize an economy. Since 2017, Venezuela’s economy collapsed with prices of goods quickly outpacing salaries. Businesses could no longer pay outside suppliers of essential goods.
Deep Dive: Venezuelan Economic Crisis
Read more from the Council on Foreign Relations about the economic crisis in Venezuela here.
At the height of the Venezuelan economic crisis in 2018, annual inflation was estimated at more than 65,000%
Fiscal policy uses government spending on programs to stimulate economic development
Fiscal Policy
Government Spending
To spur economic growth, a government may decide to spend some of its resources on important programming. For example:
- Infrastructure Investment & Public Works
- Healthcare & Hospitals
- Student Scholarships & Schools
- Agricultural Training
- Microfinance and rural savings programs
We will look at what types of government policies may be used to fuel economic development in the development economics theory module.
Revenue Generation
Governments can fund fiscal policy initiatives through the following mechanisms:
Taxes
Governments traditionally fund spending through taxes on consumption, trade, corporate profits, and wages.
Borrowing
Governments can obtain funds by issuing government bonds, which are purchased by investors in both domestic and international financial markets. For more information, take a look at the principles of international trade module.
Development Banks: Financing Development
Many developing countries receive loans from international development banks to fund government programs that will enable achievement of an important development goal. The most well-known development bank is the World Bank, which was established in 1944.
Deep Dive: Development Banks
Read more about the roles of development banks and how they support economic development here.
This module on micro and macro economics gave you an idea of some of the underlying factors that inform economic decisions made my individuals, firms, and governments.
The other three modules in this toolkit will take a deeper look at the factors that spur economic growth.
Learn more about Development Economics
