INTRODUCTION

Question 1

6 Main Applications of macro-economic theory

Answer 1

1. Understanding the macro-economic relations between employment, growth, inflation, and the business cycle is the first step in designing policies to ameliorate the worst effects of cyclical fluctuations in the global and national economies. The collection, organisation and analysis of macro-economic data will help governments in their understanding of:

    a. Where the society is in the economic cycle
    b. How and when to formulate appropriate policies to avert economic downturns and encourage economic growth, while avoiding high inflation 

Macro-economic models and forecasts are thus used by governments to assist in the development and evaluation of economic policy. It is a short step to then advocate the forecasting of these variables, with a view to controlling the future path of the economy by appropriate selection of monetary, fiscal and social tools, and policies. However, the track record of such macro-economic forecasting is mixed.

2. Related to point 1, macro-economic theory helps us design policies to encourage economic growth, boost productivity, and reduce poverty levels. This can be done by establishing minimum wage policies, for example. Closely related to this is macro-economics’ role in understanding the implications of changes to tax spending by governments.
3. There is a crucial international aspect to macro-economics, and it is important to understand the following:
   • Exchange rates and balance of payments relations between countries
   • The transmission of economic shocks and flows between countries

For example, both tariffs and exchange rate policies have profound international implications.

4. Businesses have a deep interest in macro-economics, particularly in trying to anticipate the impact of future government policies on the corporate sector, and forecasting future investment needs
5. Consumers will be interested in macro-economic developments as they try to:
   
   • Plan their personal finances, including forecasting the cost of borrowing
   • Anticipate employment market opportunities
6. Macro-economic relationships will be central to governments in:
   
   • Planning budgets
   • Raising taxes
   • Quantifying expenditures
   • Making policy decisions

Question 2

Causes of financial crises

Answer 2

• A stock market whose trailing price-earnings (PE) ratio is, say, twice that of the historical average (the USA in 2000)
• A ratio of average house price to average disposable income surpassing all previous historical values (a few countries in 2008).
• A sudden trigger (possibly bad macro-economic news heralding a recession) may lead to individuals or institutions selling assets, even with prices falling rapidly.
• Incentives to take on too much risk (e.g. bonus schemes)
• A tax regulatory environment which encourages excessive borrowing
• Herd-like behaviour by economic who are not making independent, ‘rational’, analyses of situations
• Non-financial exogenous shocks e.g. COVID-19

Question 3

What is financial amnesia?

Answer 3

A phenomenon in which financial market participants behave in a way that suggests they have forgotten the lessons of financial market history. Participants may be both individuals, as well as regulators.

Usually after a prolonged period of stable economic growth accompanied by fully functioning financial markets, certain asset prices become divorced from their fundamental drivers of value.

Question 4

Why is market discipline not maintained?

Answer 4

Among financial firms, a failure of corporate governance often occurs together with an over-reliance on themselves to impose market discipline. An inevitable market failure follows, with a systematic under-pricing of risk.

Drives of such behaviour may include:

- Incentive structures for senior management, which may encourage unsustainable activity which is detrimental to the wider financial system.

- Moral hazards, with the wider economy carrying the cost of excessive risk-taking by the financial sector;

- Key aspects of behavioural finance, including;
	○ Cognitive dissonance (or dismissal of inconvenient evidence)
	○ Herding and groupthink
	○ The illusion of control and overconfidence
	○ The disposition effect (the reluctance to take losses and change behaviour)

Alongside such behavioural biases, regulatory failure also occurs, possibly due to organisational or resource constraints.

Question 5

How to prevent financial amnesia and bubbles?

Answer 5

• Education on the history of financial markets
• Research into measures of ‘excess’ to flag up problems before they arise
• Improved corporate governance among financial firms
• Independent and well-informed regulators with focus on managing systemic risk while avoiding regulations that inhibit financial innovations and business activity
• Central bank independence and strict limitations on their activities to prevent excessive levels of debt from building up that leads to the booms that will end in financial crises and deleveraging
• Constraints on destabilising activities by governments such as running sustained budget deficits that can lead to sovereign debt crises