Download Macroeconomic Stabilization and Structural Reform

Macroeconomic Stabilization
and Structural Reform
An Overview
Thorvaldur Gylfason
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
Economics: Adam Smith 1776
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
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
Price
Supply
P*
Equilibrium
Demand
Q*
Quantity
Excess demand
Price
Supply
Equilibrium
Excess demand
Demand
Quantity
Excess supply
Price
Excess supply
Supply
Equilibrium
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
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
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
Excess demand
drives prices up,
as in Eastern
Europe in the
1990s
Aggregate demand
GNP
Excess supply
Price level
Excess supply
Aggregate supply
Equilibrium
Excess supply
drives prices
down, as in
America in the
1930s
Aggregate demand
GNP
Experiment: Export boom
Price level
AS
AD
GNP
Export boom
Price level
AS
B
A
Exports increase
AD’
AD
GNP
Export boom
Price level
AS
B
A
Excess demand
drives prices up
C
AD’
AD
GNP
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
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
An interpretation
Exogenous
variables
Export boom or
investment boom
Model
Aggregate demand
and supply
Endogenous
variables
Price level and
GNP
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
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
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 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)
Monetary expansion shifts AD schedule right
Aggregate demand
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
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 supply
Output
Real wage
Production
function
B
A
B
An increase in the
real wage reduces
employment and
output
A
Labor demand
Employment
Employment
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
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).
Balance of payments
adjustment I
Suppose, at A, there is a deficit
in the balance of payments (B  0)
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
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
Suppose, at A, there is a deficit
in the balance of payments (B  0)
Price level
Can offset decrease in
aggregate demand by
lowering e
A
M or G down, t up
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
Start, at A, with a deficit in the
balance of payments (B  0)
Price level
Stimulate supply side
by liberalization,
stabilization,
privatization,
education, etc.
AD’
AS
To reduce deficit, consider
stimulating supply (shifting AS
AS’ right) as well as reducing demand
A
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
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