Macroeconomic Policies Dr. George Norton Agricultural and Applied Economics Virginia Tech Copyright 2009 AAEC 3204

Objectives Discuss influences of fiscal and monetary policies on agriculture Discuss influences of fiscal and monetary policies on agriculture Discuss effects of key macro-prices on agriculture Discuss effects of key macro-prices on agriculture Why governments pursue particular macroeconomic policies Why governments pursue particular macroeconomic 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 particular macroeconomic policies? Distribute income in a particular way (political expediency) Distribute income in a particular way (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 run) or in a sector (provide incentives) Stimulate growth in economy (often short run) or in a sector (provide incentives) React to changing world conditions React to changing world conditions Corruption Corruption

Fiscal and Monetary Policy Fiscal Policy – relates to government spending and taxing Fiscal Policy – relates to government spending and taxing Developing countries often go in debt because of many pressing needs and limited tax revenue Monetary Policy – Relates to government monetary supply and interest rate policy Monetary Policy – Relates to government monetary supply and interest rate policy

Monetary Policy Can finance deficits through: (a) increasing money supply (printing money) or (b) borrowing from abroad What are the effects?

Y = P x Q = C + I + G + X - M Y = money value of output or income P = price index of all goods and services Q = quantity index of all goods and services C = consumption expenditures (private) I = investment expenditures (private) G = government expenditures X = value of exports M = value of imports

Assume 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 idle Q can rise to meet this if resources are idle If shortage of capital or land, either M must go up or P must go up If shortage of capital or land, either M must go up or P must go up If P up, this means inflation If P up, this means inflation Inflation can also result if import prices are rising Inflation can also result if import prices are rising

Connections between macro policy and food policy

Governments use macro prices to affect inflation, provide incentives, and distribute income Foreign exchange rates Foreign exchange rates Interest rates Interest rates Wage rates Wage rates Land prices Land prices Prices for agr. Versus industrial goods Prices for agr. Versus industrial goods Government can try to set these Affected indirectly by government policies

Exchange Rates What are they? What are they? How do they become overvalued? How do they become overvalued? What are the effects of an overvalued exchange rate? What are the effects of an overvalued exchange rate?

Foreign Exchange Rates Value of a nation’s currency relative to value of the currency of another country Exchange rates in developed countries determined in international currency markets Exchange rates in developing countries often set by government and “pegged” to currency of a major developed country

Many developing countries overvalue their currency Why? Why? Keep downward pressure on pricesKeep downward pressure on prices Fixed against another country’s currency to stabilize price of goods traded with that countryFixed against another country’s currency to stabilize price of goods traded with that country

Purchasing Power Parity Theory r t = exchange rate between 2 countries at time t r 0 = exchange rate in base period P = general price level in country 1, 2 P 1t /P 2t = measure of differential rates of inflation (if rates of inflation from 0 to t are the same then P 1t /P 2t = 1)

rate of change in the exchange rate difference in rates of inflation So country tries to manipulate r*

What are the Effects of an Overvalued Exchange Rate? Raises price of exports and reduces price of imports Raises price of exports and reduces price of imports Temporarily can keep inflation down Temporarily can keep inflation down Creates balance of payments problem Creates balance of payments problem

FIXED Versus FLEXIBLE Exchange Rates Why do countries choose one exchange rate regime or another? Why do countries choose one exchange rate regime or another? How do exchange rates become over-valued? How do exchange rates become over-valued?

Interest Rates Role Role High versus low High versus low Difference between nominal and real rates Difference between nominal and real rates

Wage Rates and Land Prices Wage rates Wage rates How are they determined?How are they determined? Effects of minimum wage legislation?Effects of minimum wage legislation? Land prices Land prices How do macro policies affect?How do macro policies affect?

Rural – Urban Terms of Trade Relative output and input prices in rural compared to urban sector Relative output and input prices in rural compared to urban sector How affected by exchange rate and by fiscal and monetary policies? How affected by exchange rate and by fiscal and monetary policies? Rural – urban price differences influence rural – urban income differences Rural – urban price differences influence rural – urban income differences

Interest rates, Interest rates, Capital movements, Capital movements, Exchange rates, Exchange rates, Trade, and Trade, and Inflation are interconnected Inflation are interconnected How? How?

International 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 exports and increases supply of importsHigher exchange rate reduces demand for exports and increases supply of imports Exports down and imports up mean more goods at homeExports down and imports up mean more goods at home More goods on the market compared to demand keeps inflation downMore goods on the market compared to demand keeps inflation down

Low U.S. interest rates have contributed to 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 Relationships Bloc – floating exchange rates Bloc – floating exchange rates Integrated world capital markets Integrated world capital markets Cross – country effects of monetary and fiscal policies Cross – country effects of monetary and fiscal policies Changes in comparative advantage and competitive advantage Changes in comparative advantage and competitive advantage Long-term Debt and short-term financial crises Long-term Debt and short-term financial crises

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