MACROECONOMICS

1. MACROECONOMICS Enrico C. Mina

2. Introduction • 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.

3. Course Objectives • At the end of this course, the participants would be able to: • Understand how a free enterprise system works • Identify and apply basic concepts and principles • Understand the relevance, limitations, and implications of these basic concepts and models applied to current economic problems and issues.

4. Economics 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.

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

6. Opportunity 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.

7. 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.

8. Payments for Resources Payments for Goods Services Services Taxes & fees Taxes & fees Resources Goods Resources Payments for Resources Goods Payments for Goods The Circular Flow Government Households Firms

9. 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.

10. Three Basic Macroeconomic Questions • What goods will be produced, and in what quantities? • How will they be produced? • For whom will they be produced?

11. 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.

12. 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.

13. 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?

14. P D Q 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.

15. 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.

16. P Q 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. S

17. 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.

18. P S Pe D Qe Q Basic Demand and Supply (3) • Interaction of Demand and Supply

19. 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.

20. How Free Enterprise Answers the 3 Basic Questions (2) • 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.

21. 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.

22. 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.

23. S2 P2 P Q2 Q Inflation (2) • Cost-push inflation S1 P1 D Q1

24. P2 D2 Q2 Inflation (3) • Demand-pull inflation S P P1 D1 Q1

25. Inflation (4) • 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.

26. P S2 S1 P2 D2 P1 D1 Q Q2 Q1 Stagflation • Stagflation is a combination of high inflation and economic stagnation or recession. It is a recipe for social disaster.

27. S1 S2 P P1 P2 D Q2 Q1 Q Fighting Inflation (1) • Improve productivity (e.g., through application of science and technology, easing entry of competition)

28. P2 D2 Q2 Fighting Inflation (2) • Reduce money supply to reduce demand S P P1 D1 Q1

29. P Q Do Price Controls Work? • The effect of price controls is to create shortages and black-markets. S Pe Qs < Qd = shortage Pc D Qs Qd

30. P Q How about Price Support? • Price support creates a surplus. S Pf Pe Qs > Qd = surplus D Qd Qs

31. 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).

32. Gross Domestic Product (2) • 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)

33. Gross Domestic Product (3) • 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.

34. Gross Domestic Product (4) Nominal GDPt x 100 Real GDPt = CPIt YearGDPn GRCPIGDPr GR 1985 555.9 100.00 555.9 1986 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%

35. Gross Domestic Product (5) • 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.

36. Derivatives 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.

37. Managing GDP Growth • GDP = C + I + G + (X - M) Dependent on price & income Monetary Policy Fiscal Policy Trade Policy

38. 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.

39. Economic Policies (2) • Trade Policy is the set of policies that seeks to affect the level of imports and exports of the economy.

40. 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.

41. Consumption and Income (2) • 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

42. Consumption and Income (3) • 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

43. 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.

44. 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.

45. The Income Multiplier (1) • Additional investments trigger several rounds of additional spending in the economy through the multiplier: Y = I • k 1 1 where k = MPS or (1 - MPC)

46. The Income Multiplier (2) MPCMPSk 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

47. 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.

48. Monetary Policy (2) • 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.

49. Monetary Policy (3) • 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.

50. 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