Macroeconomic Stabilization and Structural Reform An Overview Thorvaldur

Macroeconomic Stabilization and Structural Reform An Overview Thorvaldur Gylfason

Outline ü Microeconomics of supply and demand Micro q. Examples from agriculture and computers ü Macroeconomics of aggregate supply and Macro demand ü Policy application: Macroeconomic adjustment through aggregate demand management q. Monetary and fiscal policy; exchange rates ü Structural reforms on the supply side

Introduction üEconomics: Adam Smith 1776 ü Microeconomics: Alfred Marshall 1890 Micro q. Allocation of scarce resources among alternative uses q. Determination of prices by demand supply in markets q. Different market structures üCompetition, oligopoly, monopoly

Macroeconomics 1. John Maynard Keynes 1936 1. One of the chief architects of the IMF 2. Structure and functioning of national and international economy 3. Determination of national income, economic growth, unemployment, inflation, exchange rates, external debt, etc. 4. Grew out of the Great Depression 192939 1. Microeconomics not well suited to deal with macroeconomic problems

Microeconomics in action Price Supply P* Equilibrium Demand Q* Quantity

Excess demand Price Supply Equilibrium Excess demand Producers have power Demand Quantity

Excess supply Price Excess supply Supply Equilibrium Consumer is king Demand Quantity

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 Price Supply (elastic) Equilibrium Demand (inelastic) Quantity

Application to agriculture Price Supply (elastic) Income of farmers Demand (inelastic) Quantity

Application to agriculture Price Supply before A Technological progress Supply after B Demand (inelastic) Quantity

Application to agriculture Price Supply before A Technological progress Supply after B Income of farmers after technical change Demand (inelastic) Quantity

The farm problem ü No coincidence that agriculture has economic problems all over the world ü Technological progress lowers production costs and prices without inducing a significant increase in food consumption qbecause food demand is constrained by people’s biological need for a fixed number of calories per day ü Therefore, farm incomes fall!

Computers: Another story Price Supply Demand (elastic) Quantity

Computers: Another story Price Supply before A Technological progress B Supply after Demand (elastic) Quantity

Computers: Another story Price Supply before Producers and consumers both gain from technological progress Supply after B A Loss Demand (elastic) Gain Quantity

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 Price level An increase in prices induces consumers to buy less, so that aggregate demand decreases Aggregate demand GNP

Macroeconomic equilibrium Price level Aggregate supply Equilibrium P* Aggregate demand Y* GNP

Excess demand Price level Aggregate supply Equilibrium Excess demand drives prices up, as in Eastern Europe in the 1990 s Aggregate demand GNP

Excess supply Price level Excess supply Aggregate supply Equilibrium Excess supply drives prices down, as in America in the 1930 s Aggregate demand GNP

Experiment: Export boom Price level AS AD GNP

Export boom Price level B AS A Exports increase AD’ AD GNP

Export boom Price level B A AS Excess demand drives prices up C AD’ AD GNP

Export boom Price level B AS As the price level rises, so does GNP along the upward-sloping AS curve A AD’ AD GNP

Comments on experiment ü An export boom stimulates aggregate demand because Y = C + I + G + X - Z ü Therefore, all other comparable boosts to aggregate demand will have same effect: q. Consumption C (e. g. , through lower taxes) q. Investment I (e. g. , via lower interest rates) q. Government spending G ü GNP will rise when AD increases qas long as AS curve slopes up

An interpretation Exogenous variables Export boom or investment boom Model Aggregate demand supply Endogenous variables Price level and GNP

Economic policy ü Economic policy instruments q. Exogenous variables üFiscal policy: Government spending, taxes policy üMonetary policy: Money, credit, interest rates policy üExchange rate policy: Exchange rate (if fixed) policy ü Economic objectives or targets q. Endogenous variables üGNP level or growth üPrice level or inflation üEmployment, unemployment üBOP, exchange rate (if flexible), external debt

Aims of economic policy ü Apply policy instruments to attain given economic objectives ü E. g. , by conducting monetary and fiscal policy in order to strengthen the BOP q. Key to financial programming ü Not only crisis management in short run ü Also, important to conduct policy so as to foster rapid, sustainable economic growth q. Key to economic and social prosperity

Macroeconomic adjustment and structural reform ü Begin with aggregate demand q. Show it depends on G, t, M, e ü Then add aggregate supply q. Show it depends on structural reforms ü Then add balance of payments ü Then make policy experiments q. Assess the effects of policy measures on macroeconomic outcomes

Aggregate demand üY = C + I + G + X – Z ü C = c(Y-T) = (1 -s)(1 -t)Y q. Where s = saving rate and t = tax rate e represents foreign currency content of q. Through r (real interest rate) domestic currency ü I = k(M/P) ü G is exogenous ü X = a. Y* – b. Q ü Z = m. Y + c. Q ies reflect income elasticit a and m cities nd c reflect price elasti ba q. Where Q = e. P/P* (real exchange rate)

Monetary expansion shifts AD schedule right Aggregate demand Domestic credit 1. Y = (1 -s)(1 -t)Y + k(M/P) + G + [a. Y* – b(e. P/P*)] – [m. Y + c(e. P/P*)] q. Which means: ü Y = F(P; M, G, t, e; Y*, P*) - + + - - + + ü Aggregate demand schedule slopes down q. Via real balances and the real exchange rate ü. . . and shifts in response to changes in exogenous variables, including policy AD schedule slopes down Devaluation shifts AD schedule right

Aggregate supply ü Y = F(N) – aggregate production function ü N = N(W/P) q. Labor demand varies inversely with real wages ü Y = F(W/P) – or, equivalently, ü Y = F(P; W) + - ü Aggregate supply schedule slopes up q. Through real wages ü. . . and shifts in response to changes in exogenous variables, including wages

Aggregate supply Output Real wage Production function B B A An increase in the real wage reduces employment and output. A Labor demand Employment g rice level, by increasin the p herefore, a decrease in T utput. ces employment and o du the real wage, also re

Macroeconomic equilibrium Price level AS W up M up; G up; t down; e down AD GNP

Monetary or fiscal expansion Price level AS B A An increase in M or G or a decrease in t increases both Y and P. AD’ M up; G up; t down AD GNP

An increase in wages Price level AS’ AS W up B An increase in W increases P, but reduces Y. An increase in the price of imported oil has the same effect. A AD GNP

Devaluation Price level B W up A When e falls, W often AS’ also rises, so that P AS increases, but Y may either rise or fall. Even if W stays put, AS will shift to the left as devaluation raises AD’ the price of oil and other imported inputs. e down AD GNP

Effects of demand management and supply shocks: An overview G t M e W - + Y + - + (? ) P + -

Balance of payments üB = X – Z + F ü X = a. Y* – b. Q ü Z = m. Y + c. Q ü Q = e. P/P* ü F is exogenous ü B = F(Y, P; e, F; Y*, P*) - - - + + + ü So, to reduce deficit in the balance of payments q. Must apply monetary or fiscal restraint in order to decrease Y or P or decrease e (devaluation) or increase F (capital inflow).

Balance of payments adjustment I Price level Need to offset increase in demand by reducing M or G or raising t to prevent inflation from weakening B again A M or G down, t up Suppose, at A, there is a deficit in the balance of payments (B 0) AS Then, to reduce deficit, consider lowering e (devaluation) to strengthen current account: this increases demand (shifts AD right) e down AD 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. GNP

Balance of payments adjustment II Price level Can offset decrease in aggregate demand by lowering e A M or G down, t up Suppose, at A, there is a deficit in the balance of payments (B 0) AS e down AD 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. GNP

Balance of payments adjustment III Price level AS A M or G down, t up e down 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. AD GNP

Macroeconomic adjustment and structural reform Price level Stimulate supply side by liberalization, stabilization, privatization, education, etc. AD’ A Start, at A, with a deficit in the balance of payments (B 0) AS AS’ To reduce deficit, consider stimulating supply (shifting AS right) as well as reducing demand Case in point: Marketing boards E M or G down, t up AD 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. GNP

Conclusion These slides will be posted on my website: www. hi. is/~gylfason ü The essence of financial programming is to find the right combination of monetary, monetary fiscal, and structural policy measures that fiscal improve the balance of payments. . . nd E he T q. . . without damaging other important macroeconomic variables, including output and employment. ü Theory and experience indicate that such measures are generally good for growth.