Macroeconomic Stabilization and Structural Reform

1. Macroeconomic Stabilization and Structural Reform An Overview Thorvaldur Gylfason

2. 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

3. 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

4. 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

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

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

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

8. Economic models Exogenous variables Model Endogenous variables Change in technology or weather Demand for and supply of food Price and quantity of food

9. Application to agriculture Price Supply (elastic) Equilibrium Demand (inelastic) Quantity

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

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

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

13. 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!

14. Computers: Another story Price Supply Demand (elastic) Quantity

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

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

17. Macroeconomics in action: Aggregate supply Price level Aggregate supply An increase in prices induces producers to produce more, so that aggregate supply increases GNP

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

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

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

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

22. Experiment: Export boom Price level AS AD GNP

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

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

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

26. 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

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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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.

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

36. 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

37. 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

38. 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

39. Effects of demand management and supply shocks: An overview

40. 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).

41. 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

42. 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

43. 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

44. 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

45. 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