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Macroeconomic Adjustment and Structural Reform. An Overview. Thorvaldur Gylfason. Outline. Micro economics of supply and demand Examples from agriculture and computers Macro economics of aggregate supply and demand

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Macroeconomic adjustment and structural reform l.jpg

Macroeconomic Adjustment and Structural Reform

An Overview

Thorvaldur Gylfason


Outline l.jpg

Outline

  • Microeconomics of supply and demand

    • Examples from agriculture and computers

  • Macroeconomics of aggregate supply and demand

  • Policy application: Macroeconomic adjustment through aggregate demand management

    • Monetary and fiscal policy; exchange rates

  • Structural reforms on the supply side


Introduction l.jpg

Introduction

  • Microeconomics: Alfred Marshall 1890

    • Allocation of scarce resources among alternative uses

    • Determination of prices by demand and supply in markets

    • Different market structures

      • Competition, oligopoly, monopoly

  • Economics: Adam Smith 1776


Macroeconomics l.jpg

Macroeconomics

  • John Maynard Keynes 1936

    • One of the chief architects of the IMF

  • Structure and functioning of national and international economy

  • Determination of national income, economic growth, unemployment, inflation, exchange rates, external debt, etc.

  • Grew out of the Great Depression 1929-39

    • Microeconomics not well suited to deal with macroeconomic problems


Microeconomics in action l.jpg

Microeconomics in action

Price

Supply

P*

Equilibrium

Demand

Quantity

Q*


Excess demand l.jpg

Excess demand

Price

Supply

Equilibrium

Demand

Excess demand

Quantity


Excess supply l.jpg

Excess supply

Price

Supply

Excess supply

Equilibrium

Demand

Quantity


Economic models l.jpg

Economic models

Exogenous

variables

Model

Endogenous

variables

Change in technology or weather

Demand for and supply of food

Price and quantity of food


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Application to agriculture

Price

Supply (elastic)

Equilibrium

Demand (inelastic)

Quantity


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Application to agriculture

Price

Supply (elastic)

Income of farmers

Demand (inelastic)

Quantity


Application to agriculture11 l.jpg

Application to agriculture

Price

Supply before

Technological progress

A

Supply after

B

Demand (inelastic)

Quantity


Application to agriculture12 l.jpg

Application to agriculture

Price

Supply before

Technological progress

A

Supply after

B

Income of farmers after

technical change

Demand (inelastic)

Quantity


The farm problem l.jpg

The farm problem

  • No coincidence that agriculture has economic problems all over the the world

  • Technological progress lowers production costs and prices without inducing a significant increase in food consumption

    • because food demand is constrained by people’s biological need for a fixed number of calories per day

  • Therefore, farm incomes fall!


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Computers: Another story

Price

Supply

Demand (elastic)

Quantity


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Computers: Another story

Price

Supply before

A

Technological progress

B

Supply after

Demand (elastic)

Quantity


Computers another story16 l.jpg

Computers: Another story

Price

Supply before

A

Producers and consumers both gain from technological progress

Loss

Supply after

B

Demand (elastic)

Gain

Quantity


Macroeconomics in action aggregate supply l.jpg

Macroeconomics in action: Aggregate supply

Price level

Aggregate supply

An increase in prices induces

producers to produce more, so that

aggregate supply increases

GNP


Aggregate demand l.jpg

Aggregate demand

Price level

An increase in prices induces

consumers to buy less, so that

aggregate demand decreases

Aggregate demand

GNP


Macroeconomic equilibrium l.jpg

Macroeconomic equilibrium

Price level

Aggregate supply

Equilibrium

P*

Aggregate demand

GNP

Y*


Excess demand20 l.jpg

Excess demand

Price level

Aggregate supply

Excess demand

drives prices up, as in Eastern Europe in the 1990s

Equilibrium

Excess demand

Aggregate demand

GNP


Excess supply21 l.jpg

Excess supply

Price level

Aggregate supply

Excess supply

Excess supply

drives prices down, as in America in the 1930s

Equilibrium

Aggregate demand

GNP


Experiment export boom l.jpg

Experiment: Export boom

Price level

AS

AD

GNP


Export boom l.jpg

Export boom

Price level

AS

B

A

Exports increase

AD’

AD

GNP


Export boom24 l.jpg

Export boom

Price level

AS

B

Excess demand

drives prices up

A

C

AD’

AD

GNP


Export boom25 l.jpg

Export boom

Price level

AS

B

As the price level rises,

so does GNP along the

upward-sloping AS curve

A

AD’

AD

GNP


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Comments on experiment

  • An export boom stimulates aggregate demand because Y = C + I + G + X - Z

  • Therefore, all other comparable boosts to aggregate demand will have same effect:

    • Consumption C (e.g., through lower taxes)

    • Investment I (e.g., via lower interest rates)

    • Government spending G

  • GNP will rise when AD increases

    • as long as AS curve slopes up


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An interpretation

Exogenous

variables

Model

Endogenous

variables

Export boom or

investment boom

Aggregate demand

and supply

Price level and GNP


Economic policy l.jpg

Economic policy

  • Economic policy instruments

    • Exogenous variables

      • Fiscal policy: Government spending, taxes

      • Monetary policy: Money, credit, interest rates

      • Exchange rate policy: Exchange rate (if fixed)

  • Economic objectives or targets

    • Endogenous variables

      • GNP level or growth

      • Price level or inflation

      • Employment, unemployment

      • BOP, exchange rate (if flexible), external debt


Aims of economic policy l.jpg

Aims of economic policy

  • Apply policy instruments to attain given economic objectives

  • E.g., by conducting monetary and fiscal policy in order to strengthen the BOP

    • Key to financial programming

  • Not only crisis management in short run

  • Also, important to conduct policy so as to foster rapid, sustainable economic growth

    • Key to economic and social prosperity


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Macroeconomic adjustment and structural reform

  • Begin with aggregate demand

    • Show how it depends on G, t, M, e

  • Then add aggregate supply

    • Show how it depends on structural reforms

  • Then add balance of payments

  • Then make policy experiments

    • Assess the effects of policy measures on macroeconomic outcomes


Aggregate demand31 l.jpg

Aggregate demand

  • Y = C + I + G + X – Z

  • C = c(Y-T) = (1-s)(1-t)Y

    • Where s = saving rate and t = tax rate

  • I = k(M/P)

    • Through r (real interest rate)

  • G = exogenous

  • X = aY* – bR

  • Z = mY + cR

    • Where R = eP/P* (real exchange rate)

Decrease in R means depreciation

a and m reflect income elasticities

b and c reflect price elasticities


Aggregate demand32 l.jpg

Aggregate demand

  • Y = (1-s)(1-t)Y + k(M/P) + G +

    (aY* – b(eP/P*)) – (mY + c(eP/P*))

    • Which means:

  • Y = F(P; M, G, t, e; Y*, P*)

    – + + – – + +

  • Aggregate demand schedule slopes down

    • Via real balances and the real exchange rate

  • ... and shifts in response to changes in exogenous variables, including policy


Aggregate supply l.jpg

Aggregate supply

  • Y = F(N)

  • N = N(W/P)

    • Labor demand varies inversely with real wages

  • Y = F(W/P) – or, equivalently,

  • Y = F(P; W)

    + –

  • Aggregate supply schedule slopes up

    • Through real wages

  • ... and shifts in response to changes in exogenous variables, including wages


Aggregate supply34 l.jpg

Aggregate supply

An increase in the real wage reduces employment and output.

Y

W/P

Production function

B

A

A

B

Labor demand

N

N


Slide35 l.jpg

Macroeconomic equilibrium

Price level

AS

W up

M up; G up; t down; e down

AD

GNP


Slide36 l.jpg

Monetary or fiscal expansion

Price level

An increase in M or G or a decrease in t increases both Y and P for given W.

AS

B

A

AD’

M up; G up; t down

AD

GNP


Slide37 l.jpg

An increase in wages

Price level

AS’

An increase in W increases P, but reduces Y.

AS

W up

B

An increase in the price of imported oil has the same effect.

A

AD

GNP


Slide38 l.jpg

Devaluation

Price level

When e decreases, W often also rises, so that P increases, but Y may either rise or fall.

Even if W stays put, AS will shift to the left as devaluation raises the price of oil and other imported inputs.

AS’

B

AS

W up

AD’

A

e down

AD

GNP


Effects of demand management and supply shocks overview l.jpg

Effects of demand management and supply shocks: Overview


Balance of payments l.jpg

Balance of payments

  • B = X – Z + F

  • X = aY* – bR

  • Z = mY + cR

  • R = eP/P*

  • F = exogenous

  • B = F(Y, P; e, F; Y*, P*)

    – – – + + +

  • To reduce deficit in the balance of payments

    • Must apply monetary or fiscal restraint to decrease Y or P or decrease e (devaluation) or increase F (capital inflow).


Slide41 l.jpg

Balance of payments adjustment

Price level

Suppose, at A, there is a deficit

in the balance of payments (B  0)

Can offset decrease

in aggregate demand by increasing e or F

AS

Then, to reduce deficit, must

reduce M or G or raise t to

reduce demand (shift AD left)

e down, F up

End result is still point A, but

now with balance of payments

equilibrium (B = 0). Level of

GNP is unchanged, but its

composition has changed.

A

AD

M or G down, t up

GNP


Slide42 l.jpg

Macroeconomic adjustment and structural reform

Price level

Start, at A, with a deficit in the

balance of payments (B  0)

Stimulate supply side by liberalization, stabilization, privatization, etc.

AS

Then, to reduce deficit, try to stimulate supply (shift AS right) in addition to reducing demand

AS’

End result is point E

with balance of payments

equilibrium (B = 0). Level of

GNP is unchanged, but its

composition has changed.

Price level is lower.

A

AD’

E

AD

M or G down, t up

GNP


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Conclusion

These slides will be posted on my website: www.hi.is/~gylfason

  • The essence of financial programming is to find the right combination of monetary, fiscal, and structural policy measures that improve the balance of payments ...

    • ... without damaging other important macroeconomic variables, including output and employment.

  • Theory and experience indicate that such measures are generally good for growth.

The End


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