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Macroeconomics Primer

(Appendix to Step 3 of Business Planning)

Changes in interest rates, inflation rates, and exchange rates can impact farmers. Macroeconomics is the study of how the behavior of the economy as a whole and changes in monetary and fiscal policy at federal, state, and local levels can impact these variables. Macroeconomists are interested in total economic activity of a country and how output changes over time as a result of business fluctuations, changes in labor skills and demographic patterns, changes in fiscal and monetary policy, and international trading practices. Although individual farmers often have limited control over these factors, understanding how changes in these variables affect the well-being of farm businesses is important. The purpose of this primer is to delineate a few of these key relationships.

Interest Rates

An interest rate can be thought of as the price of money. As more people seek money for either investment or consumption purposes, the demand for money increases. Consequently, the price of money or the interest rate rises to ration the quantity of money available for each use. Investors and consumers with the most viable or credit worthy projects are able to obtain adequate credit. Investors with projects that are viable only if low interest rate financing can be obtained will not be able to secure adequate financing.

Demand for Money

The individual wants of consumers, businesses, and investors across the United States and around the world determines the aggregate demand for money. Although local conditions do eventually impact money demand, the primary determinants are aggregate economic factors. Agriculture is a small component of total credit demand, accounting for approximately 1%. Real estate investment is highest at 30.5%, followed by commercial and industrial uses (24.5%) and consumer uses (14.1%).

Money demand for real estate and commercial purposes is highly correlated with the performance of the economy. As economic activity increases, commercial businesses demand more money as they seek to expand. A major indicator of economic activity is the gross national product. Another is the index of leading economic indicators. Many analysts follow these statistics to determine if the economy as a whole and, consequently, the demand for money are likely to rise or fall in the future.

Two important indicators of consumer economic activity are the index of consumer confidence and index of consumer durable purchases. Both of these indicators are reliable forecasts of money demand on the part of consumers.

Since consumer optimism and commercial business activity depend on each other, demand for money in the economy is highly cyclical. As the economy expands, both consumers and commercial businesses seek additional capital. Conversely, when the economy slows, consumers and commercial businesses alike become more cautious and guarded with respect to money demand. Therefore, interest rates tend to decline in response to lackluster demand. These cyclical patterns of interest rate swings are predictable. Consequently, astute farm business operators can frequently alter the timing of major investments to take greater advantage of these market opportunities.

Supply of Money

In addition to the demand for money, the other important determinant of interest rates or the price of money is supply. The Federal Reserve System conducts and implements monetary policy in the United States through open market operations. The Federal Reserve sells or buys U.S. government securities to expand or contract the money supply. The Federal Reserve also has several other mechanisms for controlling the money supply. These are primarily regulations and policies that govern the operations and management of commercial banks, including reserve requirements, lending limits, and discount lending opportunities.

Federal Reserve operations supply liquidity to financial markets. Therefore, these actions have the greatest impact on short-term interest rates, i.e., rates on loans of less than one year. Private capitalists (i.e., individual investors, brokerage firms, commercial businesses) supply capital for longer-term investments. The Federal Reserve operations have a minimal impact on the supply and, thus, interest rates of this type of capital. Inflation expectations primarily govern the supply of long-term capital. If inflation prospects are low, investors are interested in supplying capital because they can be assured that the value of their principal will not erode over time. However, as inflation rises, capitalists are reluctant to supply money because the value of their funds will be less at the end of the investment period. Therefore, the supply of money declines and interest rates rise.

Inflation Rates

Inflation represents the nominal increases in prices that occur over time. Major indicators of inflation are the Consumer Price Index and the Implicit Price Deflator for the Gross National Product. The first index reflects price increases that affect individual consumers, whereas the second index attempts to capture price changes in the entire economy.

Increased demand for goods and services, excessive money supply, and external shocks to an economy cause inflation. When the economy is in an expansion phase, consumers are optimistic and increase their purchases of necessities and luxury items. As demand for these items increase, they become more scarce and their prices rise. This increase in the general price level is, by definition, inflation. As consumers witness increasing prices of basic commodities, they feel poorer and try to negotiate higher wages to maintain their standard of living. Employers, who pay these wages, must raise prices of the products they produce to compensate for higher costs. Thus, a higher round of commodity prices makes consumers feel less well off, and the price spiral continues upward until policy curbs it or consumer demand subsides. This type of inflation is often referred to as cost-push inflation.

A second cause of inflation is excessive money supply. If the Federal Reserve supplies more funds than people and businesses require, interest rates fall below equilibrium levels. When this happens, economic activity increases because marginal investments become profitable and households have additional income after interest expenses. This additional economic activity leads to increased demand for goods and services and, in turn, greater inflation. This form of inflation is the easiest to predict. Attention is usually focused on money supply statistics from the Federal Reserve to determine if the rate of expansion is in line with business activity and past monetary policy.

A final source of inflation is external shocks. The oil crisis of the 1970s, widespread drought of the latter 1980s, and periods of labor unrest have contributed to past inflationary periods. Political uncertainties around the world usually have an inflationary impact because of concerns over disrupted supply of products. Although external shocks can lead to rather significant and concentrated inflationary pressures, they are periodic and of rather short duration.

Agriculture and Inflation

The impact of inflation on agriculture is mixed. Inflation is usually costly to an economy or a sector, such as agriculture, because of the transaction costs associated with it. For example, inflation is a net drag to the economy because employees must spend additional time re-pricing merchandise. The additional time required for repricing is a transaction cost because the economy shows no net gain. Also, as inflation increases, people have more difficulty planning for the future, which leads them to become more passive in their investment actions. Finally, in an inflationary environment, investors place residual funds in "inflation hedges" such as gold and artwork rather than seek productive investments that would expand the economic base of an economy.

Inflation impacts other aspects of agriculture differently. One of the inflation hedges investors seek is land. Consequently, when inflation pressures rise, the value of farmland increases, and farmland owners experience capital gains. However, not all farmers benefit from increasing land values. Entering farmers face higher land costs with no associated increase in productivity.

Farmers also typically use considerable debt financing. When inflation rates rise, these debt holders benefit because they can repay their indebtedness with cheaper dollars in the future - to the extent that they have fixed rate loans. Finally, farmers benefit from increased commodity prices due to the indirect impact of exchange rates on exports.

Federal Government Spending and Inflation

Significant attention has been focused on the federal budget deficit and its potential impact on the economy. In sorting out this impact, business owners may want to divide the problem into two issues: 1) the impact of high current government borrowing and 2) the impact resolution of the problem will have on the economy is useful.

The short-term problem of the deficit is the impact it has on national credit markets. To finance the budget deficit, the federal government has to undertake significant borrowing, which absorbs existing funds that are in the market, increases total demand for money, and crowds some consumers and businesses out of an opportunity to borrow. The impact on the economy is uncertain because it depends on whether the pool of funds is fixed. Some economists argue the pool is fixed and that the additional demand can lead to higher interest rates. Others, however, note the elasticity of foreign investors and argue that they can offer large amount of funds so that the impact on interest rates is modest. During the 1980s, foreign investors did provide substantial capital to the United States. However, whether the United States will be able to continue to attract this inflow is uncertain as economic conditions in other countries begin to decline with recessions.

The long-term impact is also uncertain. The two options are to repay the debt from future incomes, which would be a net drag on the economy and limit investment, or to monetize the deficit through higher inflation (the deficit would become worth less as the value of the dollar declines). Given the differential impacts of inflation on some areas of agriculture, resolution of the deficit problem should be of interest to farmers.

Exchange Rates

In the past two decades, farmers have become increasingly aware of the impact foreign exchange rates have on their ability to export. When the value of the dollar is high, foreign buyers would need additional funds to purchase the same quantity of U.S. goods that they bought previously. Thus, farmers have difficulty competing overseas because foreign buyers can find cheaper sources of commodities in other countries.

Relative interest rate and inflation rate policies across countries have a significant impact on exchange rates. If U.S. interest rates rise more than foreign interest rates, foreign capitalists would prefer to purchase U.S. securities because they offer a higher relative return. To purchase U.S. securities, they must purchase dollars because the securities they desire can only be purchased with dollars. Consequently, the value of the dollar increases as foreign investors seek to complete the transaction. The increase in the dollar hinders U.S. exports, however. Thus, the change in monetary policy is a disadvantage for farmers who depend on export markets. Increasing interest rates, resulting from a tighter monetary policy, have a negative impact on the agricultural sector because of its heavy reliance on export markets. The opposite is also true -- falling interest rates lead to increased export activity.

Rising rates of inflation have the opposite impact -- they lead to greater exports. When the U.S. inflation rate rises more than other countries, foreigners are reluctant to invest in the U.S. for fear of capital erosion. Therefore, an excess supply of dollars exists; and the price of the dollar (exchange rate) declines, benefiting exports.

Expectations have a significant impact on exchange rates. The United States has the largest economy of any country in the world. Moreover, people across the globe have great confidence in the United States. As a result, they demand U.S. currency, especially during periods of uncertainty and international tension. The U.S. dollar is often referred to as the world's reserve currency. The default currency often is specified in international transactions. This role of the dollar is a disadvantage to farmers and other industries that depend on exports.


The numerous cross-linkages that exist complicate understanding the impact of macroeconomic policy on the agricultural sector. Interest, inflation, and exchange rates appear to depend on the each other. A farmer's understanding of these relationships is important because of the impact changes in these variables have on the agricultural sector.


Last Updated October 31, 2005


Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

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