Synthesis for Macroeconomics Summary of Aggregate Demand and Aggregate Supply Relevance of Fiscal and Monetary Policy. Fernando Nandy T. Aldaba, Ph.

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1 Synthesis for Macroeconomics Summary of Aggregate Demand and Aggregate Supply Relevance of Fiscal and Monetary Policy Fernando Nandy T. Aldaba, Ph.D Senior Executives Class Batc 3 Sinagtala APPLIED PUBLIC SECTOR ECONOMICS (APSE) MODULE September 17-19, 2014

2 Aggregate Demand and Supply Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level Aggregate supply (AS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period

3 Aggregate Demand Policies AD = C + I + G + (X-M) Where C = Consumption Expenditures I = Investment Expenditures G = Government Expenditures (X-M) = Exports Imports Aggregate demand policies aim to increase or decrease spending on its key components; major policies include fiscal and monetary policies.

4 Aggregate Supply Policies AS = a * f (K, L, N) Where a = Technology K = Physical Capital L = Labor N = Natural Resources Aggregate supply policies aim to increase productivity and efficiency of the economy; examples include education and training policies, infrastructure policies, R&D policies, etc.

5 The Macroeconomy The macroeconomy or aggregate economy will be at that level where aggregate demand meets aggregate supply. The typical measure is what we call the Gross Domestic Product found in the National Income Accounts of the Government. The National Statistical and Coordination Board (NSCB) releases GDP figures every quarter. GDP is computed from its expenditure components or from the value of production of key economic sectors.

6 The Macroeconomy in Graph AS curve is upward sloping in the short run and vertical in the long run.

7 GDP by Industrial Origin 3Q 2011 INDUSTRY/INDUSTRY GROUP Q Q Growth % Agriculture, Hunting, Forestry and Fishing 149, , Industry Sector 447, , Service Sector 783, , GROSS DOMESTIC PRODUCT 1,380,231 1,423, Source: NSCB

8 GDP growth Philippines Real GDP Growth, Percent Death of Aquino and Political Crisis Balance of Payments Crisis Asian Financial Crisis Global Financial Crisis

9 Macroeconomic Instabilities Boom and bust cycles of the economy recessions and depressions. Crisis brought about by domestic and/or international factors. Price volatilities due to internal and external factors. Government uses tools to stabilize the economy fiscal and monetary policies. These could be expansionary or contractionary policies.

10 Fiscal Policies Influence the level of economic activity though manipulation of government income and expenditure. Influence Aggregate Demand (AD) a. Tax regime influences consumption (C) and investment (I) b. Government Spending (G) Also used to influence non-economic objectives and provide framework for supply side policy development e.g. academy education of the philippines and health, poverty reduction, welfare reform,

11 Two Effects of Fiscal Policy on AD Multiplier Effect: increase in government spending generates increase in GDP greater than the initial amount spent Crowding Out Effect: a phenomenon occurring when government spending causes interest rates to rise, thereby reducing investments i.e. increase in government spending crowds out investment spending

12 Fiscal Policy & Aggregate Supply Most economists believe the short-run effects of fiscal policy mainly work through aggregate demand. A cut in the tax rate gives workers incentive to work more, so it might increase the quantity of goods & services supplied. Government spending on infrastructure like roads may increase business productivity, which increases the quantity of goods & services supplied Supply side economic policies Reaganomics

13 Fiscal Policy and Equity Taxation can be used for equity goals e.g. Luxury taxes, progressive income taxes. Government spending can be used for poorer sectors of society e.g. Poverty programs.

14 Monetary Policy The process by which the monetary authority (BSP) of a country controls the supply of money supply, often targeting a rate of interest or inflation for the purpose of promoting economic growth and stability Basically, the decrease or increase of money supply will affect the interest rate which in turn will affect the aggregate demand

15 The Money Market & Interest Rate The Interest Rate r is determined by the intersection of money demand (MD) and money supply (MS). MS is usually determined by the central bank (BSP) through various tools of monetary policy 1. increasing or decreasing policy interest rate 2. buying or selling government securities 3. increasing or decreasing reserve requirement

16 Using Policy to Stabilize the Economy Economic stabilization has been a goal of Philippine government as enshrined in the constitution. Economists debate how active a role the government should take to stabilize the economy

17 The Case for Active Stabilization Policy John Maynard Keynes: Animal spirits cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment.

18 The Case for Active Stabilization Policy Also, other factors cause fluctuations, e.g., booms and recessions abroad stock market booms and crashes political instabilities here and abroad Real estate bubbles If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers.

19 The Case for Active Stabilization Policy Proponents of active stabilization policy believe the government should use policy to reduce these fluctuations: When GDP falls below its potential, use expansionary monetary or fiscal policy to prevent or reduce a recession. When GDP rises above its potential ( overheating ), use contractionary policy to prevent or reduce an inflationary boom.

20 The Case Against Active Stabilization Policy Monetary policy affects economy with a long lag: Firms decide investment plans in advance, so I takes time to respond to changes in r. Many economists believe it takes at least 6 months for monetary policy to affect output and employment.

21 The Case Against Active Stabilization Policy Fiscal policy also works with a long lag: Changes in G and T require Acts of Congress. The legislative process i.e. passing a law can take months or years

22 The Case Against Active Stabilization Policy Taxes also affect the economy in the following ways: A tax on a good reduces the market quantity of that good. A tax causes a deadweight loss (a loss in consumer and producer welfare)

23 The Case Against Active Stabilization Policy Due to these long lags, critics of active policy argue that such policies may destabilize the economy rather than help it: By the time the policies affect aggregate demand, the economy s condition may have changed. These critics contend that policymakers should focus on long-run goals like economic growth and low inflation.