macroeconomic adjustment and structural reform an overview thorvaldur gylfason
TRANSCRIPT
Macroeconomic Adjustment Macroeconomic Adjustment and Structural Reformand Structural Reform
An OverviewAn Overview
Thorvaldur Gylfason
OutlineOutline
MicroMicroeconomics of supply and demandExamples from agriculture and computers
MacroMacroeconomics of aggregate supply and demand
Policy application: Macroeconomic Macroeconomic adjustmentadjustment through aggregate demand managementMonetary and fiscal policy; exchange rates
Structural reformsStructural reforms on the supply side
IntroductionIntroduction
MicroMicroeconomics: Alfred Marshall 1890Allocation of scarce resources
among alternative usesDetermination of prices by
demand and supply in marketsDifferent market structures
Competition, oligopoly, monopoly
Economics: Adam Smith 1776
MacroeconomicsMacroeconomics
John Maynard Keynes 1936One 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 1929-39Microeconomics not well suited to deal with
macroeconomic problemsmacroeconomic problems
Economic modelsEconomic models
Exogenousvariables
Endogenousvariables
Model
Change in technology or weather
Demand for and supply of food
Price and quantity of food
Application to agricultureApplication to agriculture
Price
Quantity
Supply (elastic)
Demand (inelastic)
Equilibrium
Application to agricultureApplication to agriculture
Price
Quantity
Supply (elastic)
Demand (inelastic)
Income of farmers
Application to agricultureApplication to agriculture
Price
Quantity
Supply before
Demand (inelastic)
Supply after
Technological progressTechnological progressA
B
Application to agricultureApplication to agriculture
Price
Quantity
Supply before
Demand (inelastic)
Supply after
A
B
Technological progressTechnological progress
Income of farmers after technical change
The farm problemThe 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 consumptionbecause food demand is constrained by
people’s biological need for a fixed number of calories per day
Therefore, farm incomes fall!
Computers: Another storyComputers: Another story
Price
Quantity
Supply before
Demand (elastic)
Supply after
A
B
Technological progress
Computers: Another storyComputers: Another story
Price
Quantity
Supply before
Demand (elastic)
Supply after
A
BLoss
Gain
Producers and consumers both gain from technological progress
Macroeconomics in action: Macroeconomics in action: Aggregate supplyAggregate supply
Price level
GNP
Aggregate supply
An increase in prices inducesproducers to produce more, so thataggregate supply increases
Aggregate demandAggregate demand
Price level
GNP
Aggregate demand
An increase in prices inducesconsumers to buy less, so thataggregate demand decreases
Macroeconomic equilibriumMacroeconomic equilibrium
Price level
GNP
Aggregate supply
Aggregate demand
P*
Y*
Equilibrium
Excess demandExcess demand
Price level
GNP
Aggregate supply
Aggregate demand
Equilibrium
Excess demanddrives prices up, as in Eastern Europe in the 1990s
Excess demand
Excess supplyExcess supply
Price level
GNP
Aggregate supply
Aggregate demand
Equilibrium
Excess supplydrives prices down, as in America in the 1930s
Excess supply
Export boomExport boom
Price level
GNP
AS
ADAD’
A
BAs the price level rises, so does GNP along the upward-sloping AS curve
Comments on experimentComments on experiment
An export boom stimulates aggregate demand because Y = C + I + G + XX - Z
Therefore, all other comparable boosts to aggregate demand will have same effect:Consumption CC (e.g., through lower taxes)Investment II (e.g., via lower interest rates)Government spending GG
GNP will rise when AD increases as long as AS curve slopes up
An interpretationAn interpretation
Exogenousvariables
Endogenousvariables
Model
Export boom orinvestment boom
Aggregate demand and supply
Price level and GNP
Economic policyEconomic policy
Economic policy instrumentsExogenous variables
Fiscal policyFiscal policy: Government spending, taxesMonetary policyMonetary policy: Money, credit, interest ratesExchange rate policyExchange rate policy: Exchange rate (if fixed)
Economic objectives or targetsEndogenous variables
GNP level or growthPrice level or inflationEmployment, unemploymentBOP, exchange rate (if flexible), external debt
Aims of economic policyAims of economic policy
Apply policy instruments to attain given economic objectives
E.g., by conducting monetary and fiscal policy in order to strengthen the BOPKey to financial programmingfinancial programming
Not only crisis management in short runAlso, important to conduct policy so as
to foster rapid, sustainable economic growthKey to economic and social prosperity
Macroeconomic adjustment Macroeconomic adjustment and structural reformand structural reform
Begin with aggregate demandaggregate demandShow how it depends on G, t, M, e
Then add aggregate supplyaggregate supplyShow how it depends on structural
reformsThen add balance of paymentsThen make policy experiments
Assess the effects of policy measures on macroeconomic outcomes
Aggregate demandAggregate demand
Y = C + I + G + X – ZC = c(Y-T) = (1-s)(1-t)Y
Where s = saving rate and t = tax rateI = k(M/P)
Through r (real interest rate) G = exogenousX = aY* – bRZ = mY + cR
Where R = eP/P* (real exchange rate)
aa and mm reflect income elasticities
bb and cc reflect price elasticities
Decrease in R means depreciationDecrease in R means depreciation
Aggregate demandAggregate demand
Y = (1-s)(1-t)Y + kk(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 Aggregate demand schedule slopes downdownVia real balances and the real exchange ratereal exchange rate
... and shifts in response to changes in exogenous variables, including policy
Aggregate supplyAggregate supplyY = 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 upAggregate supply schedule slopes upThrough real wagesreal wages
... and shifts in response to changes in exogenous variables, including wages
Aggregate supplyAggregate supply
Y
N
W/P
N
Labor demand
Production function
An increase in the real wage reduces employment and output.A
BA
B
Macroeconomic equilibriumMacroeconomic equilibrium
Price level
GNP
AS
AD
M up; G up; t down; e down
W up
Monetary or fiscal expansionMonetary or fiscal expansion
Price level
GNP
AS
AD
M up; G up; t down
A
B
An increase in M or G or a decrease in t increases both Y and P for given W.
AD’
An increase in wagesAn increase in wages
Price level
GNP
AS
AD
W up
AS’
A
B
An increase in W increases P, but reduces Y.
An increase in the price of imported oil has the same effect.
DevaluationDevaluation
Price level
GNP
AS
AD
e down
W up
AD’
AS’
A
B
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.
Effects of demand management Effects of demand management and supply shocks: Overviewand supply shocks: Overview
G t M e W
Y + - + -(?)
-
P + - + - +
Balance of paymentsBalance of payments
B = X – Z + FX = aY* – bRZ = mY + cRR = eP/P*F = exogenousB = F(Y, P; e, F; Y*, P*)
– – – + + +To reduce deficit in the balance of
paymentsMust apply monetarymonetary or fiscal restraintfiscal restraint to
decrease Y or P or decrease e (devaluation) or increase F (capital inflow).
Price level
GNP
AS
AD
Balance of payments Balance of payments adjustmentadjustment
A
Suppose, at A, there is a deficitin the balance of payments (B 0)
Then, to reduce deficit, must reduce M or G or raise t toreduce demand (shift AD left)
M or G down, t up
e down, F up End result is still point A, but now with balance of paymentsequilibrium (B = 0). Level of GNP is unchanged, but its composition has changed.
Can offset decreasein aggregate demand by increasing e or F
Price level
GNP
AS
AD
Macroeconomic adjustment Macroeconomic adjustment and structural reformand structural reform
A
Start, at A, with a deficit in the balance of payments (B 0)
Then, to reduce deficit, try to stimulate supply (shift AS right) in addition to reducing demand
M or G down, t up
End result is point Ewith balance of paymentsequilibrium (B = 0). Level of GNP is unchanged, but its composition has changed. Price level is lower.
Stimulate supply side by liberalization, stabilization, privatization, etc.
E
AS’
AD’
ConclusionConclusion
The EndThe EndThe essence of financial financial
programmingprogramming is to find the right combination of monetarymonetary, fiscalfiscal, and structuralstructural 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 good for growthgrowth..
These slides will be posted on my website: www.hi.is/~gylfason