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Macroeconomic Stabilization 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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Presentation Transcript
outline
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
Introduction
  • Microeconomics: Alfred Marshall 1890
  • Economics: Adam Smith 1776
  • Allocation of scarce resources among alternative uses
  • Determination of prices by demand and supply in markets
  • Different market structures
    • Competition, oligopoly, monopoly
macroeconomics
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
Microeconomics in action

Price

Supply

P*

Equilibrium

Demand

Quantity

Q*

excess demand
Excess demand

Price

Supply

Equilibrium

Producers have power

Demand

Excess demand

Quantity

excess supply
Excess supply

Price

Supply

Excess supply

Equilibrium

Consumer is king

Demand

Quantity

economic models
Economic models

Exogenous

variables

Model

Endogenous

variables

Change in technology or weather

Demand for and supply of food

Price and quantity of food

application to agriculture
Application to agriculture

Price

Supply (elastic)

Equilibrium

Demand (inelastic)

Quantity

application to agriculture10
Application to agriculture

Price

Supply (elastic)

Income of farmers

Demand (inelastic)

Quantity

application to agriculture11
Application to agriculture

Price

Supply before

Technological progress

A

Supply after

B

Demand (inelastic)

Quantity

application to agriculture12
Application to agriculture

Price

Supply before

Technological progress

A

Supply after

B

Income of farmers after

technical change

Demand (inelastic)

Quantity

the farm problem
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!
computers another story
Computers: Another story

Price

Supply

Demand (elastic)

Quantity

computers another story15
Computers: Another story

Price

Supply before

A

Technological progress

B

Supply after

Demand (elastic)

Quantity

computers another story16
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
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
Aggregate demand

Price level

An increase in prices induces

consumers to buy less, so that

aggregate demand decreases

Aggregate demand

GNP

macroeconomic equilibrium
Macroeconomic equilibrium

Price level

Aggregate supply

Equilibrium

P*

Aggregate demand

GNP

Y*

excess demand20
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
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
Experiment: Export boom

Price level

AS

AD

GNP

export boom
Export boom

Price level

AS

B

A

Exports increase

AD’

AD

GNP

export boom24
Export boom

Price level

AS

B

Excess demand

drives prices up

A

C

AD’

AD

GNP

export boom25
Export boom

Price level

AS

B

As the price level rises,

so does GNP along the

upward-sloping AS curve

A

AD’

AD

GNP

comments on experiment
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
slide27

An interpretation

Exogenous

variables

Model

Endogenous

variables

Export boom or

investment boom

Aggregate demand

and supply

Price level and GNP

economic policy
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
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
macroeconomic adjustment and structural reform
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
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 is exogenous
  • X = aY* – bQ
  • Z = mY + cQ
    • Where Q = eP/P* (real exchange rate)

e represents foreign currency content of domestic currency

a and m reflect income elasticities

b and c reflect price elasticities

aggregate demand32
Aggregate demand

Monetary expansion shifts AD schedule right

Domestic

credit

  • 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

AD schedule slopes down

Devaluation shifts AD schedule right

aggregate supply
Aggregate supply
  • Y = F(N) – aggregate production function
  • 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
Aggregate supply

An increase in the real wage reduces employment and output.

Output

Real wage

Production function

B

A

A

B

Labor demand

Employment

Employment

Therefore, a decrease in the price level, by increasing the real wage, also reduces employment and output.

slide35

Macroeconomic equilibrium

Price level

AS

W up

M up; G up; t down; e down

AD

GNP

slide36

Monetary or fiscal expansion

Price level

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

AS

B

A

AD’

M up; G up; t down

AD

GNP

slide37

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

Devaluation

Price level

When e falls, 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

balance of payments
Balance of payments
  • B = X – Z + F
  • X = aY* – bQ
  • Z = mY + cQ
  • Q = eP/P*
  • F is exogenous
  • B = F(Y, P; e, F; Y*, P*)

- - - + + +

  • So, to reduce deficit in the balance of payments
    • Must apply monetary or fiscal restraint in order to decrease Y or P or decrease e (devaluation) or increase F (capital inflow).
slide41

Balance of payments adjustment I

Price level

Suppose, at A, there is a deficit

in the balance of payments (B  0)

Need to offset increase in demand by reducing M or G or raising t to prevent inflation from weakening B again

AS

Then, to reduce deficit, consider lowering e (devaluation) to strengthen current account: this increases demand (shifts AD right)

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

e down

AD

M or G down, t up

GNP

slide42

Balance of payments adjustment II

Price level

Suppose, at A, there is a deficit

in the balance of payments (B  0)

Can offset decrease in aggregate demand by lowering e

AS

Then, to reduce deficit, consider

reducing M or G or raising t to

reduce demand (shift AD left)

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

e down

AD

M or G down, t up

GNP

slide43

Balance of payments adjustment III

Price level

  • Choice among alternative policy packages depends on initial position.
  • If reserves are low and output is low (unemployment is high), devaluation may be advisable.
  • If reserves are low and inflation is high, monetary and fiscal restraint may be in order.
  • As a rule, do both at once.

AS

A

e down

AD

M or G down, t up

GNP

slide44

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, education, etc.

AS

To reduce deficit, consider stimulating supply (shifting AS right) as well as 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.

Bonus: Price level is lower.

Case in point:

Marketing boards

A

AD’

E

AD

M or G down, t up

GNP

conclusion
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