MACROECONOMICS

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MACROECONOMICSMACROECONOMICS

Enrico C. Mina

IntroductionIntroduction

Every enterprise encounters the basic fact of scarcity of resources in the pursuit of its primary objectives. Productivity is vital.

The productive units of society are linked together in an economic system. Managing a business or a not-for-profit enterprise requires a clear understanding of how this complex system works.

Course ObjectivesCourse Objectives

At the end of this course, the participants would be able to:

Understand how a free enterprise system worksIdentify and apply basic concepts and principlesUnderstand the relevance, limitations, and implications of these basic concepts and models applied to current economic problems and issues.

Economics DefinedEconomics Defined

Economics is the social science that deals with the maximum satisfaction of human material needs and wants through the optimal use of scarce material resources.

Material ResourcesMaterial Resources

Land Labor Capital (equipment, materials, & funds) Information Entrepreneurial/managerial capabilities Time All these are scarce and therefore carry a price tag.

Opportunity CostOpportunity Cost

Opportunity cost is defined as the sacrifice of alternative benefits. It is the benefit given up because a scarce resource had to be allocated to one use and thus is no longer available for another. Two conditions:

The decision involves a scarce resource.This resource has alternative uses.

The Economic System (1)The Economic System (1)

A system is an integrated whole made up of distinct but interacting and interdependent parts.

The smallest productive unit of society is the firm or enterprise. Each firm plays a specialized role and produces certain goods and/or services.

Households/consumers buy outputs of firms.

The Circular FlowThe Circular Flow

Households Firms

Payments for Goods

Government

Payments for Resources

Resources

Taxes & fees Taxes & fees

ServicesServices

Resources

Payments for Resources Payments for Goods

The Economic System (2)The Economic System (2)

The individual firms and households interact and transact with the others and with the government, forming the national economy.

National economies are also part of a regional economy, a group of economies linked by geographical proximity.

Regional economies comprise the global economy that links economies to one another and makes them interdependent.

Three Basic Macroeconomic QuestionsThree Basic Macroeconomic Questions

What goods will be produced, and in what quantities?

How will they be produced? For whom will they be produced?

Alternative Economic Systems (1)Alternative Economic Systems (1)

Socialist, centrally planned economies attempt to answer the three basic questions through strong state control over the national economy and its components. The state plans the goods and their quantities, the technology to be used, and the distribution of the outputs.

Alternative Economic Systems (2)Alternative Economic Systems (2) Capitalist, free enterprise economies permit

the different enterprises and households to freely make economic decisions and allow market forces to determine the answers to the three basic questions. The market forces are demand and supply.

Which Model Works Better?Which Model Works Better?

Consider the contrast between West and East Germany, and between South and North Korea -- same people, same language and culture, but different economic and political systems.

Why did Communism collapse in Eastern Europe? What is China’s economic system: centrally planned or free enterprise?

Basic Demand and Supply (1)Basic Demand and Supply (1)

The Law of Demand says that as price increases, the quantity that buyers want to buy decreases, and vice versa, all other things being equal.

Why Does Demand Slope Downward?Why Does Demand Slope Downward?

As price rises, affordability suffers. As price falls, more people have the ability to purchase.

As price rises, buyers are forced to encounter higher opportunity costs. They are forced to trade off other goods to buy a particular one whose price is higher.

Basic Demand and Supply (2)Basic Demand and Supply (2) The Law of Supply says that as price

increases, the quantity that sellers want to sell increases, and vice versa, all other things being equal.

Why Does Supply Curve Upward?Why Does Supply Curve Upward? Sellers are motivated by profit. A higher price

increases the probability or the amount, or both, of profit.

The line curves upward because of the Law of Diminishing Marginal Productivity.

As successive units of a variable input are added to a fixed amount of another input, the marginal product tends to decline. Therefore, marginal cost tends to rise.

Basic Demand and Supply (3)Basic Demand and Supply (3)

Interaction of Demand and Supply

How Free Enterprise Answers the 3 Basic Questions (1)

What goods and quantities - The economy will produce those goods, and only those goods, for which there exists a big enough demand and which suppliers can produce and sell at a profit. The quantity of each good is the equilibrium quantity determined by the interaction between demand and supply.

How they will be produced - Producers want to make a profit. But they are also aware that (1) buyers have a downward sloping demand curve, and (2) competition exists. Therefore, there is pressure to produce through the most efficient or least-cost process or combination of inputs.

How Free Enterprise Answers the 3 Basic Questions (3) For whom - A free enterprise economy

produces goods not necessarily for those who need them most, but for those who have the purchasing power (ability and willingness to buy). A problem arises when some members of society have great needs but very little purchasing power (e.g., the poor). Government often has to fill the gap.

Inflation (1)Inflation (1)

Inflation is defined as a sustained general trend of rising prices. It is expressed as the percentage increase in prices in one year vs. the same period in the previous year.

For example, if the government reports that the inflation rate in 2001 was 4.5%, it means that on the average, prices in 2001 were 4.5% higher than in 2000.

Cost-push inflation

Demand-pull inflation

If either type of inflation persists over time, it is described as structural or chronic.

Monetary authorities in most countries worldwide are continually worried about inflation. They generally try to keep inflation under control (at a single-digit rate) because a high rate is destabilizing and can lead to social unrest.

StagflationStagflation Stagflation is a combination of high inflation and

economic stagnation or recession. It is a recipe for social disaster.

Fighting Inflation (1)Fighting Inflation (1)

Improve productivity (e.g., through application of science and technology, easing entry of competition)

Fighting Inflation (2)Fighting Inflation (2)

Reduce money supply to reduce demand

Do Price Controls Work?Do Price Controls Work?

The effect of price controls is to create shortages and black-markets.

PeQs < Qd = shortage

How about Price Support?How about Price Support?

Price support creates a surplus.

PeQs > Qd = surplus

Gross Domestic Product (1)Gross Domestic Product (1)

Defined as the total market values of all the final goods and services produced by an economy in a given period (month, quarter, or year).

Value is measured in money terms. Nominal GDP uses current prices, which may include the effects of inflation. Real GDP uses constant base-year prices (year 2000 at this time).

Using the expenditure approach, GDP is the total value of the following categories of output:

Consumption of goods and services (C)Private investments (I)Government expenditures (G)Net exports, or exports minus imports (X-M)

The Consumer Price Index is a measure of the changes in prices of consumer goods and services. It takes into consideration the list of items (or “market basket”) that an “average” household buys, measures the changes in their prices, and computes for an overall weighted average. It is used to deflate nominal into real GDP.

Nominal GDPt x 100

Real GDPt = CPIt

Year GDPn GR CPI GDPr GR

1985 555.9 100.00 555.91986 596.6 7.3% 103.06 578.9 4.1%1987 673.9 13.0% 110.71 608.8 5.1%1988 795.7 18.1% 121.92 652.6 7.2%

The annual growth rate of real GDP is the most basic indicator of the state of health of an economy.

A progressive economy grows at a rate at least triple the rate of population growth, so that per capita GDP growth is accelerating and the standard of living is improving.

Derivatives of GDPDerivatives of GDP

Gross National Product (GNP) is GDP plus “Net factor income from abroad” (the incomes earned by Filipinos overseas and remitted here, less the incomes earned by aliens here and remitted abroad).

National Income (NI) is GNP minus the sum of two accounts: indirect taxes net of subsidies, and depreciation allowance.

Managing GDP GrowthManaging GDP Growth

GDP = C + I + G + (X - M)

Dependent on price & income

Monetary Policy

Fiscal Policy

Trade Policy

Economic Policies (1)Economic Policies (1)

Monetary Policy is the set of policies that tend to affect savings and investments and bring them into desired levels.

Fiscal Policy is the set of policies that tend to affect taxes (and other forms of government revenues), government spending, and public borrowing.

Economic Policies (2)Economic Policies (2)

Trade Policy is the set of policies that seeks to affect the level of imports and exports of the economy.

Consumption and Income (1)Consumption and Income (1)

The strongest determinants of consumption spending are price and income.

When price levels are rising, people tend to cut back on spending in order to conserve their limited resources, ceteris paribus. The reverse happens when prices fall. Purchasing power is dependent on the inflation rate.

Price Elasticity of Demand measures the sensitivity of quantity demanded to changes in price.

Q2 - Q1

Ep = (Q2 + Q1)/2

P2 - P1

(P2 + P1)/2

If Ep > 1, elastic

Ep < 1, inelastic

Ep = 1, unitary

Income Elasticity of Demand measures the sensitivity of quantity demanded to changes in income level.

Q2 - Q1

Ey = (Q2 + Q1)/2

Y2 - Y1

(Y2 + Y1)/2

If Ey > 0, normal good

0 < Ey < 1, necessity

Ey > 1, luxury good

Ey < 0, inferior good

Investments and Income (1)Investments and Income (1) Investments create income. This income is

either spent or saved. Marginal Propensity to Consume (MPC) is the

proportion of additional income that households tend to spend.

Marginal Propensity to Save (MPS) is the proportion of additional income that households tend to save.

Investments and Income (2)Investments and Income (2)

MPC + MPS = 1 In developing countries like ours, MPC tends to

be high. People spend a large proportion of additional income. In more developed countries, e.g., Japan, MPS is fairly high.

The Income Multiplier (1)The Income Multiplier (1)

Additional investments trigger several rounds of additional spending in the economy through the multiplier:

Y = I • k

1 1where k = MPS or (1 - MPC)

The Income Multiplier (2)The Income Multiplier (2)

MPC MPS k 0.95 0.05 20 0.90 0.10 10 0.80 0.20 5.0 0.70 0.30 3.3

0.60 0.40 2.5 0.50 0.50 2.0

Monetary Policy (1)Monetary Policy (1)

Money is the medium of exchange in an economy.

It is also the unit of account for future or deferred transactions (such as buying on credit).

It also serves as a store of value (such as a bank deposit).

Currency is an economy’s monetary unit.

Currency notes and coins are issued exclusively by the economy’s monetary authority and are its liabilities. In the Philippines, this is the Bangko Sentral ng Pilipinas, which was created to replace the old Central Bank of the Philippines.

Currency is legal tender; it has value because the monetary authority says so.

Unlike the old CBP, the BSP enjoys fiscal and administrative autonomy.

The BSP is governed by the 7-member Monetary Board, its highest policy-making body. Five of the seven are appointed from the private sector. All enjoy the security of a fixed tenure. The MB, not Malacañang, is the architect of monetary policy in the Philippines.

Money Supply (1)Money Supply (1)

M1 = currency notes and coins in circulation plus demand deposits in the

banking system M2 = M1 + savings and time deposits and

deposit substitutes that can be made liquid fairly easily

M3 = M2 + trust accounts

Money Supply (2)Money Supply (2) Note that total money supply is created both by

the BSP and the banking system. The level of money supply represents

aggregate demand for goods and services. The larger M is, the bigger AD is also.

The relationship between money supply and the value of an economy’s output is given by the Quantity Theory of Money.

Quantity Theory of Money (1)Quantity Theory of Money (1)

PQ = MV

where P = the average price level Q = quantity of aggregate final output M = money supply V = the velocity (turnover) of money

PQ is in effect GDP.

Quantity Theory of Money (2)Quantity Theory of Money (2)

Velocity (V) is fairly constant, changing slowly over time. It is affected most by the technology of monetary exchange. It is slowest with cash transactions and fastest with electronic fund transfers.

If PQ or GDP is to grow, M must grow to support it. However, if M grows too fast, what will increase is P, not Q (inflation).

How the BSP Controls M (1)How the BSP Controls M (1)

Reserve requirements - The BSP requires all banks to keep a certain percentage of deposits either locked up in their vaults or deposited in the BSP itself. The higher this percentage is, the less is the amount of funds that banks can lend out (and use to create more money). The lower it is, the greater money supply becomes. Each 1% change in rr changes MS by P15B.

The amount of money the banking system creates is equal to the aggregate deposits times the reciprocal of the reserve requirement.Mb = Deposits • 1

Rediscounting - Banks can turn around their loans by going to the BSP and borrowing against their clients’ loan documents. The BSP can open or close the rediscounting window, selectively allow rediscounting for loans to certain priority sectors, and determine the discount rate. A high rate means less funds for the bank.

Open market operations - The BSP can sell or buy its own securities in the open market. If it sells, it reduces money supply. If it buys back, it increases money supply.

Moral suasion - The BSP can exert “gentle pressure” on banks to do certain things and refrain from doing others.

Money Supply, Interest Rate, & Investments (1)Money Supply, Interest Rate, & Investments (1) Interest is the price for the use of money. It is

greatly dependent on money supply.i

Money Supply, Interest Rate, & Investments (2)Money Supply, Interest Rate, & Investments (2) The MS line is vertical because the BSP controls

it and sets a fixed target until a change is justified.

A decrease in money supply (e.g., tight credit to fight inflation) raises interest rates. An increase in money supply has the opposite effect.

Money Supply, Interest Rate, & Investments (3)Money Supply, Interest Rate, & Investments (3) Investments vary inversely with interest rates, all

other things being equal. High interest rates increase investment risk and cost.

High interest rates also serve as a disincentive for wealthy individuals to invest productively in job-creating ventures.

The Role of SavingsThe Role of Savings

Savings are the primary source of investible or loanable funds in the banking system.

Savings are positively correlated with interest rates.

Financial intermediaries take the savings of households and business enterprises and “recycle” them into loans and investment capital.

Fiscal Policy (1)Fiscal Policy (1)

Fiscal Policy is concerned with the management of the revenues and expenditures of the government.

Government is the single biggest buyer and employer in the economy. Tax policies influence consumption spending, investments, and international trade.

Fiscal Policy (2)Fiscal Policy (2) The primary tool of fiscal policy is the

governmental budget. If R > E, the budget is in surplus, and funds are

taken away from the system. If R < E, the budget is in deficit, and funds are

pumped into the system. If R = E, the budget is in balance, and money

supply does not change.

Fiscal Policy (3)Fiscal Policy (3)

The budget is proposed by the President and deliberated on and passed as a law by Congress.

Government revenues and loans are managed by the Department of Finance.

Government expenditures are managed by the Department of Budget and Management.

Taxation (1)Taxation (1)

The primary source of government revenue is taxation. Fees for services, permits, and licenses are a supplemental source.

It is a forced payment; non-payment of a tax due is a criminal offense.

A tax is direct if paid directly and borne by the taxpayer (e.g., income tax).

A tax is indirect if the taxpayer can shift the burden to others even if he is directly paying (e.g., VAT and excise taxes).

A tax is composed of a rate and a tax base. A tax is ad valorem if based on the monetary

value. It is specific if based on the physical volume.

Taxation (3)Taxation (3) Two philosophies on who should bear the

burden of taxation:The benefit approach - the burden should fall on whoever receives the benefits of government spending and servicesThe ability to pay approach - the burden should fall on those who can afford to pay.

What if those who will benefit most are the least able to pay?

The burden of tax rates can be classified as:Progressive - the rate increases as the income of the taxpayer increases.Proportional - the rate is the same, regardless of incomeRegressive - those receiving lower incomes shoulder a heavier burden percent-wise than those receiving higher incomes.

CPSD (1)CPSD (1)

The Consolidated Public Sector Fiscal Position (CPSFP) is the aggregate or total financial position of the National Government, local government units, Constitutional agencies, and government-owned and controlled corporations. If negative, it is called the CPSD; if positive, CPSS.

A large and chronic CPSD is a heavy burden on the economy.

CPSD (2)CPSD (2)

Options to overcome CPSD:1.0 Raise government revenues 1.1 Create new taxes

1.2 Increase tax and fee rates 1.3 Reduce/eliminate tax exemptions 1.4 Expand coverage

1.5 Increase the tax base

CPSD (3)CPSD (3)

2.0 Reduce government expenditures2.1 Downsize government workforce2.2 Defer/cancel infrastructure projects2.3 Privatize government functions2.4 Re-engineer government processes

2.5 BOT 3.0 Sell/privatize government assets

CPSD (4)CPSD (4)

4.0 Borrow 4.1 Domestically4.2 Internationally 4.3 Multilateral and bilateral agencies

5.0 Seek foreign aid 6.0 Print more money

International Trade (1)International Trade (1)

The Principle of Comparative Advantage -- An economy should focus on the production of those goods which its resource endowments and capabilities enable it to produce at less cost and better quality than other economies. It should buy the rest of its requirements from those other economies that can make them cheaper and better.

This principle implies that no economy can be completely self-sufficient.

It is the basis for win-win international trade. Economies that are active in international trade

are able to provide their citizens a higher quality of life and at lower overall cost.

COUNTRYY

TariffsTariffs

A tariff is a tax levied at the border on each unit of an imported good.

Ql’ Qt’

Long-term Effects of High Tariffs Long-term Effects of High Tariffs Penalize consumers and reward local producers, even

the inefficient ones Remove the incentive to improve productivity and

quality, making local producers uncompetitive Encourage smuggling Encourage corruption at BOC Make government reluctant to give up a source of

revenue

Quotas and EmbargoesQuotas and Embargoes

A quota is a maximum annual limit on the quantity of a good that can be imported.

An embargo is a total ban on the importation of a particular good.

These, together with high tariffs, are protectionist measures designed to shield local suppliers from foreign competition.

Foreign Exchange (1)Foreign Exchange (1)

Trade among economies has to be settled in a common currency.

The predominant trading currency is the US dollar, with the Japanese yen, and recently the euro of 17 EU countries as feasible alternatives.

An exchange rate is the price of one currency stated in the units of another.

Foreign Exchange (2)Foreign Exchange (2) Two general ways of setting exchange rates:

Fixed - The government or CMA defines the exchange rate of its currency vs. another (e.g., the US $). It then commits to buy or sell foreign currency at that rate + a narrow band. Examples are Hong Kong and PR of China.Floating - Exchange rates are set by the interaction of market forces (supply of and demand for foreign currency).

A variation is the managed float, whereby the CMA generally leaves the market alone but intervenes either as a buyer or a seller of foreign currency if the rate fluctuation exceeds a certain pre-defined limit.

Foreign Exchange (4)Foreign Exchange (4) In a fixed rate system, there is more stability.

Adjustments are seldom but tend to be sudden, large, and disruptive.

A devaluation is an official declaration of the reduction of the local currency’s value vs. a foreign currency (e.g., the US $).

A revaluation is an official declaration of an increase in this value.

Foreign Exchange (5)Foreign Exchange (5) In a floating rate system, there is less stability

and greater sensitivity. More frequent but smaller adjustments are made.

A depreciation is a reduction in value of the local currency vs. a foreign one due to market forces.

An appreciation is an increase in such value again due to market forces.

A floating rate is set by the market (through the Philippine Dealing System).

Demand for foreign exchange:Payment for importsInvisibles payments to other countries (tourism, services, compensation, etc.)Payments of foreign loan principal and interestRepatriation of foreign capitalRepatriation of profits

Foreign Exchange (8)Foreign Exchange (8) Supply of foreign exchange:

Revenues from exportsInvisibles remittances (tourism, remittances from overseas Filipinos, services, income from foreign investment, etc.)Monetization of goldNew foreign loansForeign investments (direct and portfolio)ODA grants

Balances of Trade and PaymentsBalances of Trade and Payments

Balance of Trade (BOT) is the difference between total exports (X) and total imports (M). If X > M, BOT is in surplus; if the reverse, BOT is in deficit.

Balance of Payments (BOP) is the country’s overall net foreign exchange position after adding all the inflows and deducting all the outflows. The BOT is a major component.

Gross International ReservesGross International Reserves Gross International Reserves (GIR) are the

total foreign exchange holdings of the BSP. BSP policy sets the minimum level equivalent to 3 months’ imports.

A BOP surplus adds to the GIR. A deficit subtracts from it.

Chronic BOP deficits deplete the GIR and increase the pressure for depreciation.

Foreign Investments (1)Foreign Investments (1)

Two types:Direct: Funds of foreign nationals invested in tangible productive assets (e.g., factories, service centers, etc.) There is control or influence over the management. Tends to be stable and long-term.Portfolio: Funds of foreign nationals invested in securities (stocks or bonds) and other financial assets. Income only, no control. Tends to be volatile and short-term.

Why the need?Domestic capital shortageTechnology transferAccess to world marketAccess to raw materialsGreater competitiveness of local enterprises

Possible disadvantages:May lead to the demise of local firms that are unable to competeAbuses in transfer pricingExorbitant royalties and licensing feesMay have restrictions against exports to other markets where the company already has a presence

Foreign Loans (1)Foreign Loans (1) By source:

Multilateral: from institutions like the IMF, WB, ADB. Usually developmental and with concessionary terms but with sometimes stringent conditions.Bilateral: from financial institutions of partner countries (e.g., US Eximbank). May have concessionary terms but with conditions favoring nationals of lending country.

Foreign Loans (2)Foreign Loans (2)

Commercial: From private sources (banks mostly). Rates are commercially determined, usually LIBOR or US Prime Rate, plus a premium based on country rating (e.g., Standard & Poor)

All foreign loans are repaid in the original currency and therefore carry a foreign exchange rate risk.

Trade Pacts / Trade Blocs (1)Trade Pacts / Trade Blocs (1)

ASEAN FREE TRADE AREA (AFTA) - composed of the members of the Association of South East Asian Nations.

Establish Common Effective Preferential Tariff (CEPT). Tariffs on goods made in each other’s territory will be levied 0 - 5% tariff by 2001 (fast track) and 2003 (normal track)

General Agreement on Tariffs and Trade-Uruguay Round & World Trade Organization (GATT/WTO) - the most far-reaching, ambitious, and comprehensive trade agreement ever reached. Covers agreements in tariff binding, agricultural goods, services, investment measures, and intellectual property rights. Created the WTO.

The Asia-Pacific Economic Cooperation (APEC) is a grouping of economies bordering on the Pacific Ocean. It accounts for 42% of the world’s GNP and 44% of its total trade. Goal is to reduce tariffs among members to 0 by 2010 (for developed economies) and by 2020 (for developing economies).

MACROECONOMICS

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