Macroeconomic PoliciesMacroeconomic Policies

Dr. George NortonAgricultural and

Applied EconomicsVirginia Tech

Copyright 2009

AAEC 3204AAEC 3204

Objectives Objectives

• Discuss influences of fiscal and Discuss influences of fiscal and monetary policies on agriculturemonetary policies on agriculture

• Discuss effects of key macro-prices Discuss effects of key macro-prices on agricultureon agriculture

• Why governments pursue particular Why governments pursue particular macroeconomic policiesmacroeconomic policies

Three descriptions of a macroeconomy.

Wages

+Interest

+Rents

+Profits

Gross Domestic Product (GDP)

Income Description

Agricultural production

+Industrial production

+Production of services

+Government production

Gross Domestic Product (GDP)

Supply Description

Consumption

+Private investment

+Government expenditures

+Excess of exports over imports

Gross Domestic Product (GDP)

+Net income transfers abroad

Gross National Product (GNP)

Demand Description

Why do governments pursue Why do governments pursue particular macroeconomic policies?particular macroeconomic policies?

• Distribute income in a particular way Distribute income in a particular way (political expediency)(political expediency)

• Correct past problems (i.e. pay off debts)Correct past problems (i.e. pay off debts)• Keep inflation down (budget problem)Keep inflation down (budget problem)• Stimulate growth in economy (often short Stimulate growth in economy (often short

run) or in a sector (provide incentives)run) or in a sector (provide incentives)• React to changing world conditionsReact to changing world conditions• CorruptionCorruption

Fiscal and Monetary PolicyFiscal and Monetary Policy

Fiscal PolicyFiscal Policy – relates to – relates to government spending and taxinggovernment spending and taxing

Developing countries often go in debt Developing countries often go in debt because of many pressing needs and because of many pressing needs and limited tax revenuelimited tax revenue

Monetary PolicyMonetary Policy – Relates to – Relates to government monetary supply and government monetary supply and interest rate policy interest rate policy

Monetary PolicyMonetary Policy

Can finance deficits through:Can finance deficits through:

(a) increasing money supply (printing (a) increasing money supply (printing money) or (b) borrowing from abroadmoney) or (b) borrowing from abroad

What are the effects?What are the effects?

Y = P x Q = C + I + G + X - MY = P x Q = C + I + G + X - MY = money value of output or incomeY = money value of output or income

P = price index of all goods and servicesP = price index of all goods and services

Q = quantity index of all goods and servicesQ = quantity index of all goods and services

C = consumption expenditures (private)C = consumption expenditures (private)

I = investment expenditures (private)I = investment expenditures (private)

G = government expendituresG = government expenditures

X = value of exportsX = value of exports

M = value of importsM = value of imports

Assume country has a deficitAssume country has a deficit

• If financed by printing money, G If financed by printing money, G

• Q can rise to meet this if resources are Q can rise to meet this if resources are idleidle

• If shortage of capital or land, either M If shortage of capital or land, either M must go up or P must go upmust go up or P must go up

• If P up, this means inflationIf P up, this means inflation

• Inflation can also result if import Inflation can also result if import prices are risingprices are rising

Connections between macro policy and food Connections between macro policy and food policypolicy

Macroeconomic policy

Fiscal and monetary policy

Budgetary policy

Macroprice policy

Inflation

Food programs

Producers Consumers

Agricultural policy

Exchange rate Interest rate Wage rate

Agricultural pricepolicy

Rural-urban termsof trade

Trade policy

Governments use macro prices to affect inflation, Governments use macro prices to affect inflation, provide incentives, and distribute incomeprovide incentives, and distribute income

• Foreign exchange Foreign exchange ratesrates

• Interest ratesInterest rates• Wage ratesWage rates

• Land pricesLand prices• Prices for agr. Prices for agr.

Versus industrial Versus industrial goodsgoods

Government can Government can try to set thesetry to set these

Affected Affected indirectly by indirectly by government government

policiespolicies

Exchange RatesExchange Rates

• What are they?What are they?• How do they become overvalued?How do they become overvalued?• What are the effects of an What are the effects of an

overvalued exchange rate?overvalued exchange rate?

Foreign Exchange RatesForeign Exchange Rates

Value of a nation’s currency relative to value Value of a nation’s currency relative to value of the currency of another countryof the currency of another country

Exchange rates in developed countries Exchange rates in developed countries determined in international currency determined in international currency marketsmarkets

Exchange rates in developing countries Exchange rates in developing countries often set by government and “pegged” to often set by government and “pegged” to currency of a major developed countrycurrency of a major developed country

Many developing countries Many developing countries overvalue their currencyovervalue their currency

Why?Why?

• Keep downward pressure on pricesKeep downward pressure on prices

• Fixed against another country’s Fixed against another country’s currency to stabilize price of goods currency to stabilize price of goods traded with that countrytraded with that country

Purchasing Power Parity TheoryPurchasing Power Parity Theory

t

tt P

Prr

2

10

rt = exchange rate between 2 countries at time t

r0 = exchange rate in base periodP = general price level in country 1, 2P1t/P2t = measure of differential rates of

inflation (if rates of inflation from 0 to t are the same then P1t/P2t = 1)

rate of change in the exchange rate

difference in rates of inflation

*2

*1

* PPr

*2

**1: PrPTherefore

So country tries to manipulate r*

What are the Effects of an What are the Effects of an Overvalued Exchange Rate?Overvalued Exchange Rate?

• Raises price of exports and reduces Raises price of exports and reduces price of importsprice of imports

• Temporarily can keep inflation down Temporarily can keep inflation down • Creates balance of payments Creates balance of payments

problemproblem

FIXED Versus FLEXIBLE FIXED Versus FLEXIBLE Exchange RatesExchange Rates

• Why do countries choose one Why do countries choose one exchange rate regime or another?exchange rate regime or another?

• How do exchange rates become How do exchange rates become over-valued?over-valued?

Interest RatesInterest Rates

• RoleRole

• High versus lowHigh versus low

• Difference Difference between nominal between nominal and real ratesand real rates

Wage Rates and Land PricesWage Rates and Land Prices

Wage ratesWage rates

• How are they determined?How are they determined?

• Effects of minimum wage legislation?Effects of minimum wage legislation?

Land pricesLand prices

• How do macro policies affect?How do macro policies affect?

Rural – Urban Terms of TradeRural – Urban Terms of Trade

• Relative output and input prices in Relative output and input prices in rural compared to urban sectorrural compared to urban sector

• How affected by exchange rate and How affected by exchange rate and by fiscal and monetary policies?by fiscal and monetary policies?

• Rural – urban price differences Rural – urban price differences influence rural – urban income influence rural – urban income differencesdifferences

• Interest rates,Interest rates,• Capital movements,Capital movements,• Exchange rates,Exchange rates,• Trade, andTrade, and• Inflation Inflation are are

interconnectedinterconnected

How?How?

International InteractionsInternational Interactions Example:Example:

• Interest rates up attracts capital from abroadInterest rates up attracts capital from abroad

• Capital inflow drives up exchange rateCapital inflow drives up exchange rate

• Higher exchange rate reduces demand for Higher exchange rate reduces demand for exports and increases supply of importsexports and increases supply of imports

• Exports down and imports up mean more Exports down and imports up mean more goods at homegoods at home

• More goods on the market compared to More goods on the market compared to demand keeps inflation downdemand keeps inflation down

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

Low U.S. interest rates have contributed Low U.S. interest rates have contributed to recent dollar weaknessto recent dollar weakness

Percent€/$

Euro / $

Interest rate spread

Difference between U.S. and Euro 6-month interbank rate, €/$ exchange rate

Source: World Bank

World Macroeconomic World Macroeconomic RelationshipsRelationships

• Bloc – floating exchange ratesBloc – floating exchange rates• Integrated world capital marketsIntegrated world capital markets• Cross – country effects of monetary Cross – country effects of monetary

and fiscal policiesand fiscal policies• Changes in comparative advantage Changes in comparative advantage

and competitive advantageand competitive advantage• Long-term Debt and short-term Long-term Debt and short-term

financial crisesfinancial crises

ConclusionConclusion

Macroeconomic policies and prices Macroeconomic policies and prices have as large an effect on have as large an effect on agricultural prices as do agricultural agricultural prices as do agricultural sector policies sector policies