Macroeconomic Stabilization and Structural Reform An Overview Thorvaldur Gylfason

Outline Micro Microeconomics of supply and demand  Examples from agriculture and computers Macro Macroeconomics of aggregate supply and demand Macroeconomic adjustment Policy application: Macroeconomic adjustment through aggregate demand management  Monetary and fiscal policy; exchange rates Structural reforms Structural reforms on the supply side

Introduction Micro 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

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 macroeconomic problems  Microeconomics not well suited to deal with macroeconomic problems

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

Excess demand Price Quantity Supply Demand Excess demand Equilibrium Producers have power Why? Consumers cannot buy all they want

Excess supply Price Quantity Supply Demand Excess supply Equilibrium Consumer is king Why? Producers cannot sell all they want

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

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

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

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

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

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 Quantity Supply Demand (elastic)

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

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

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

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

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

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

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

Experiment: Export boom Price level GNP AS AD

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

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

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

Comments on experiment X 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: C  Consumption C (e.g., through lower taxes) I  Investment I (e.g., via lower interest rates) G  Government spending G GNP will rise when AD increases  as long as AS curve slopes up

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

Economic policy Economic policy instruments  Exogenous variables Fiscal policy Fiscal policy: Government spending, taxes Monetary policy Monetary policy: Money, credit, interest rates Exchange rate policy 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 financial programming  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 aggregate demand Begin with aggregate demand  Show how it depends on G, t, M, e aggregate supply Then add aggregate supply  Show how it depends on structural reforms balance of payments 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) am a and m reflect income elasticities bc b and c reflect price elasticities e represents foreign currency content of domestic currency

Aggregate demand k 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 Aggregate demand schedule slopes down real exchange rate  Via real balances and the real exchange rate... and shifts in response to changes in exogenous variables, including policy Domesticcredit AD schedule slopes down Monetary expansion shifts AD schedule right 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 Aggregate supply schedule slopes up real wages  Through real wages... and shifts in response to changes in exogenous variables, including wages

Aggregate supply Output Employment Real wage Employment Labor demand Production function An increase in the real wage reduces employment and output A B A B Therefore, a decrease in the price level, by increasing the real wage, also reduces employment and output

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

Monetary or fiscal expansion Price level GNP AS AD M up; G up; t down A B An increase in M or G or a decrease in t increases both Y and P AD’

An increase in wages Price level GNP AS AD W up AS’ A B An increase in W increases P, but reduces Y An increase in the price of imported oil has the same effect

Devaluation Price level GNP AS AD e down W up AD’ AS’ A B 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

Effects of demand management and supply shocks: An overview GtMeW 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 monetaryfiscal restraint YPe F  Must apply monetary or fiscal restraint in order to decrease Y or P or decrease e (devaluation) or increase F (capital inflow).

Price level GNP AS AD Balance of payments adjustment I A Suppose, at A, there is a deficit in the balance of payments (B  0) Then, to reduce deficit, consider lowering e (devaluation) to strengthen current account: this increases demand (shifts AD right) M or G down, t up e down 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 Need to offset increase in demand by reducing M or G or raising t to prevent inflation from weakening B again

Price level GNP AS AD Balance of payments adjustment II A Suppose, at A, there is a deficit in the balance of payments (B  0) Then, to reduce deficit, consider reducing M or G or raising t to reduce demand (shift AD left) M or G down, t up e down 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 Can offset decrease in aggregate demand by lowering e

Price level GNP AS AD Balance of payments adjustment III 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

Price level GNP AS AD Macroeconomic adjustment and structural reform A Start, at A, with a deficit in the balance of payments (B  0) To reduce deficit, consider stimulating supply (shifting AS right) as well as reducing demand M or G down, t up 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 Stimulate supply side by liberalization, stabilization, privatization, education, etc. E AS’ AD’ Case in point: Marketing boards

Conclusion The End financial programming monetaryfiscalstructural 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. good for growth Theory and experience indicate that such measures are generally good for growth These slides will be posted on my website: