Aggregate Demand and Supply Model

8/10/2019 Aggregate Demand and Supply Model

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The AggregateDemand and Supply

Model: Fitting BH

MacroeconomicData

2014

Course:EC245, Intermediate Macroeconomics

Course Co-ordinator:Adisa Omerbegovi-ArapoviStudent:LEJLA HODI


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Table of Contents

1. INTRODUCTION........................................................................................................ 2

2. BH MACROECONOMIC DATA...3

2.1.Main aggregates of national accounts for B&H ....................................................... 3

2.2.Principal population characteristics ......................................................................... 5

2.3.Average annual inflation rate7

3. FITTING THE BH MACROECONOMIC DATA................................................... 8

3.1.The 2007-2009 Financial Crisis....8

3.2.B&H macroeconomy in the period 2010-2012 ...................................................... 11

3.3.Evaluation of the B&Hs macroeconomy.............................................................. 13

4. CONCLUSION....15


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1.

INTRODUCTION

The aggregate demand and supply model is a macroeconomic model that explains

inflation and aggregate output through the relationship of aggregate demand and aggregate

supply. Aggregate demand and supply analysis is a powerful tool for studying short-run

fluctuations in the macroeconomy. Moreover, it is also strong device in analyzing how

aggregate output and inflation are determined.

The aggregate demand and supply analysis is of great importance for interpreting episodes

in the business cycle such as recent severe recession 2007-2009 and in analyzing how

economic policies were conducted. Therefore, the subject of this research is macroeconomy

of Bosnia and Herzegovina. Moreover, the purpose of this research project is gathering the

macroeconomic data for Bosnia and Herzegovina, fitting that data into the demand and supply

model and finally doing an analysis on how the data fits the model and does it actually fit as

suggested in the period from 2007 until now.


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2.

BH Macroeconomic Data

2. 1. MAIN AGGREGATES OF NATIONAL ACCOUNTS FOR B&H

Main aggregates of national accounts include analysis of data on Gross domestic product by

different structural components, for example, by type of expenditure, kind of economic

activity, major area, region and entity as well as per capita and as growth rates. Other

statistical information covered includes gross national income, gross national disposable

income. For the purpose of this project, only the gross domestic product is component which

is of great importance and which will be considered in fitting the BH macroeconomic data.

However, the tables purpose below is to have a broader view of the Bosnia and

Herzegovinas macroeconomy.

Figure 1: Main aggregates of national accounts in the period 2005-2008


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Figure 2: Main aggregates of national accounts for period 2009-2012

Figure 3: Graphical representation of the B&H's GDP growth from 1994-2012

Note: the data on main aggregates of national accounts that include gross domestic product,

gross national product, gross national disposable income, gross domestic product per capita,

for the years 2013 and 2014 are not available for the public.


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2. 2. PRINCIPAL POPULATION CHARACTERISTICS

Principal population characteristics include qualities and characterization of various types of

populations within a social or geographic group. In this project, the emphasis is on geographic

group, namely on residents of Bosnia and Herzegovina. In the tables below it is shown the

number of total population, as well as differentiation by gender, working age population,

labor force, person in employment, unemployed people and those who are not active.

However, only the unemployment rate, as a relevant indicator, will help in analyzing how and

if the data corresponds to what aggregate demand and supply predicts. It is believed that a

decrease in inflation results in soaring the unemployment rates.

Figure 4: Main population characteristics for the period 2006-2008


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2. 3. AVERAGE ANNUAL INFLATION RA TE

2006 2007 2008 2009 2010 2011 2012 2013

Inflationrate 6.12 7.72 7.4 2.3 2.1 3.7 1.8 -1.10

Table 1: Average annual inflation rate for the period 2006-2013 reported by Agency for Statistics B&H

Figure 7: Graphical representation of Bosnia and Herzegovinasinflation rates for the period 2011-2014

Based on the table and graph above, it can be stated that there is a decreasing trend in annual

inflation rates of Bosnia and Herzegovina. Furthermore, it is clearly shown that Bosnia and

Herzegovina is experiencing deflation, rather than inflation.


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3.

Fitting the BH Macroeconomic

Data

To begin the process of fitting BH Macroeconomic data to aggregate demand and supply

model, it is important to have relevant factors for the analysis at one place. Therefore, the

table below is created to show trends (increasing or decreasing) in the unemployment and

inflation rate as well as in the aggregate output. Since the aggregate demand and supply

analysis is a powerful tool which can help in interpreting episodes in recent severe recession

in 2007-2009, the table is made before, during and after the recession in order to correctly

evaluate B&Hs performance.

Year Unemployment rate (%) Inflation rate (%) Aggregate Output (mil. $)

2006 31.1 6.12 12.548

2007 29.0 7.72 15.436

2008 23.4 7.40 18.691

2009 24.1 2.30 17.278

2010 27.2 2.10 16.845

2011 27.6 3.70 18.329

2012 28.0 1.80 16.900

2013 27.5 -1.10 unavailableTable 2: Unemployment, Inflation and Aggregate Output, 2006-2013

The table, as stated previously, illustrates trends in unemployment rate, inflation rate and in

aggregate output. However, to begin with the analysis, it is valuable to refer to the situation

in B&H before the mentioned years. With the beginning of 1990s, Bosnia and Herzegovina

had a very turbulent socio-economic situation. In macroeconomic terms, there was global

economic instability, decrease in production and hyperinflation. To put the hyperinflation

under control and to lower inflationary expectations new framework of monetary policy was

defined and it is known as Currency Board Arrangement (CBA). By doing that the KM was

tied, and still is, to the EURO. At the first glance, the hyperinflation was stabilized. However,

inflation maintained to rise at a steady pace until 2007, when it reached its peak of 7.72%. To


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fight high inflation rate, the Central Bank of B&H raised reserve requirements to 18% hoping

that the credit growth will decrease. From that year there is apparent decreasing trend in

inflation rate which was slightly interrupted in 2010. This trend led to a deflation in 2013.

However, this kind of measurement against inflation led to high levels of unemployment,

which is indicated by the unemployment rates in the table. They somewhat remind on Milton

Friedmans recipe for the fight against inflation, who stated that in order to cure the inflation,

the growth rate of total spending should be lowered.( N., 2007) In addition, it is important to

point out that B&H by changing the monetary policy can do little, almost nothing, since it has

CBA.

3.1. THE 2007-2009 FINANCIAL CRISIS

Year Unemployment rate (%) Inflation rate (%) GDP (000 $)

2007 29.0 7.72 15 436

2008 23.4 7.40 18 691

2009 24.1 2.30 17 278Table 3: GDP, Unemployment and Inflation Rate during the financial crisis

As in the United States, United Kingdom and the most of the Europe, the sharp rise in the oil

price in 2007 led to, or at least should have lead, along with increases in other commodity

prices, a negative supply shock in Bosnia and Herzegovina. Negative supply shock results in

shifting the short-run aggregate supply curve upward, which means lower output and higher

inflation rate than in previous years. However, that was not the case with Bosnia and

Herzegovina. In B&H there was an increase in the inflation rate, but also increase in the

aggregate output in 2007, which does not correspond to the predictions of aggregate demand

and supply model. It means that the aggregate demand curve shifts rightward, from AD1 to

AD2. Furthermore, the negative supply shock that occurred in the most of the world should

cause a contraction in both household and business spending which is known as the negative

demand shock. The negative demand shock shifts the aggregate demand curve to the left.


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However, at the beginning, the financial crisis did not have a strong impact on spending in

Bosnia and Herzegovina, so the aggregate demand curve did not shift because of that

reasoning. In 2008 B&H had decreased inflation and increased aggregate output, which

corresponds to what the aggregate demand and supply model predicts. These numbers

illustrate that the short-run aggregate supply curve shifted downward from AS1 to AS2 and

this is because in the year 2008 oil prices fell sharply. However, later that year the bankruptcy

of Lehman Brothers, which affected not only USA but also the whole world, caused a

decrease in aggregate demand. As a result, in 2009 the economy suffered from increased

unemployment and a low inflation rate, which corresponds to aggregate supply and demand

predictions, which can also be seen in the graph below. It is important to emphasize that, for

the purpose of the project it is assumed that Bosnia and Herzegovina was below its long-run

potential.

Figure 8: Aggregate Demand and Supply Analysis for B&H during the Financial Crisis

AD3

Inflation Rate

ercent

Aggregate Output Y

millions of dollars

LRASAS1

AD1

$15.436

AD2

7.72 %

$18.691

AS2

7.40 %

2.30 %

$17.278

Initial equilibrium

Equilibrium after

the crisis


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In conclusion, Bosnia and Herzegovina partially fits the model of aggregate demand and

supply and its predictions in the period of severe recession in years 2007, 2008 and 2009.

Bosnia and Herzegovinas macroeconomic data show that in the year 2008, because of the

excess slack in the market labor, the aggregate supply curve shifted downward thereby

decreasing inflation and trying to return the economy to the potential level of output.

However, year 2009 caused a shift in the aggregate demand curve which again led B&H to be

below its potential level of output. Therefore, it can be concluded that even after the recession

Bosnia and Herzegovina is not at its long-run equilibrium. The non-correspondence of BH

macroeconomic data to the demand and supply analysis may be due to the currency board

arrangement.

3.2. B&H MACROECONOMY IN THE PERIOD 2010-2012

Year Unemployment rate (%) Inflation rate (%) Aggregate output (mil. $)

2010 27.2 2.10 16.8452011 27.6 3.70 18.329

2012 28.0 1.80 16.900Figure 9: Inflation Rate, Unemployment Rate and Aggregate Output of B&H in the period 2010-2012

It is clear that the increasing trend in the unemployment rate in Bosnia and Herzegovina still

persists in the years after the recession. However, the inflation rate is not consistent with the

increase in unemployment. In 2010, there was a decrease in the aggregate output of the

country, as well as in the inflation rate, meaning that the aggregate demand curve shifts

leftward, from AD1to AD2. However, in the next year, both inflation rate and the output rose,

indicating that the aggregate demand shifts to the right to AD3. In the 2012, output again fell

at almost the same level as it was in 2010, with a difference of $65, but causing inflation to go

down even further than in the mentioned year. This is shown by a leftward shift of aggregate

demand curve, from AD3 to AD4and by a downward shift of aggregate supply curve, from


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AS1 to AS2. Although this shift corresponds to the predictions of aggregate demand and

supply model, the resulting equilibrium is even below the initial equilibrium, meaning it is

further away from its potential output. In the graph below it is shown how Bosnia and

Herzegovinas aggregate output and inflation rate fluctuate after the recession and it can be

concluded that in these years BH macroeconomic data fit the aggregate demand and supply

analysis, in a sense that they experience self-correcting mechanism. However, it was assumed

that B&H is below its long-run potential, and it can be concluded that B&H remained there.

Figure 10: Aggregate Demand and Supply Analysis for B&H in the period 2010-2012

LRAS

AS2

AD3Inflation Rate

ercent

Aggregate Output Y

millions of dollars

AS1

AD1

AD2

3.70%

2.10%

$16.845 $18.329

AD4

$16.900

1.80%

Initial equilibrium

Equilibrium in year 2012


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Overall, it is shown that B&H was affected by another recession in 2012. Consequence of

lowering the inflation rate was high unemployment. This type of fight against the inflation

reminds of Milton Friedmans principals.At the end of 2012, Bosnia and Herzegovina was

even further from its potential level of output, which means that the actions that were

conducted in order to stabilize inflation led to even larger deviation of aggregate output from

potential.

3.3. EVALUATION OF THE B&Hs MACROECONOMY

The macroeconomic indicators: unemployment rate, income per capita, economic growth rate

and inflation rate indicate that B&H is not in the perfect situation. From Table 2 and Figure 8

it can be concluded that the macroeconomic equilibrium (the aggregate demand and aggregate

supply equilibrium, i.e. price level stability) with high unemployment is not perfect scenario

for the economy of B&H. The latest equilibrium that could be obtained is from year 2012.

This is because the data about the aggregate output for year 2013 are not yet available for

public. The obtained equilibrium shows that Bosnia and Herzegovina is below its potential

level of output, and the situation illustrates even worse scenario than it was at the beginning of

2012, or at the end of 2007-2009 financial crisis. The (in)stability of nominal macroeconomic

indicators (inflation rate, public debt, budget deficit, exchange rate) in Bosnia and

Herzegovina is not a consequence of economic development but very restrictive

macroeconomic policy (currency board system, hard budget policy) and impossibility of

domestic producers to increase prices because of high foreign competition. Bosnia and

Herzegovina in such situation should apply theory of expansive Keynesian economics

(combination ofbudget deficit because of investing into infrastructure that is a base for

industrialization, moderate inflation which can be under control of monetary policy and


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national currency depreciation which is a complementary to inflation and instrument for

export encouragement), as well as effective custom protection to protect domestic economy.

The effective custom protection is also instrument for direction with a domestic

unemployment resources and FDI as additional source of economic growth into certain

sectors where Bosnia and Herzegovina has potential comparative advantages. But, the

neoclassical concept of economic development (Washington Consensus) which is applied

in Bosnia and Herzegovina with a total liberalization of foreign trade and macroeconomic

stability is not logical in economic sense according to existing economic situation. Both the

economic theory and historical experiences show that Bosnia and Herzegovina should

implement different kind of economic development. However, according to the report of the

World Bank, Bosnia and Herzegovina, along with Albania, Former Yugoslav Republic of

Macedonia, Kosovo and Serbia, is slowly recovering from the 2012 recession. Even though

the recovery has brought growth to the country, it is still unable to create jobs and lower the

unemployment. In order to this, Bosnia and Herzegovina needs to take action in financial and

fiscal sectors. It needs to reduce public debt in order to stimulate the economic activity.

However, the most important issue that needs to be considered is strengthening domestic

macroeconomic fundamentals and policies that boost productivity, which means that

macroeconomic and fiscal position of the country should be stabilized for creation of jobs,

working on improving the competitiveness and connectivity and strengthen governance and

anti-corruption. Moreover, B&H should choose policy that would change current public

expenditure structure. Its aim should be reducing high administrative costs, thereby reducing

significant part of public expenditure and increasing productive investments.


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4.

CONCLUSION

The main purpose of this project was to investigate does the macroeconomic data of

Bosnia and Herzegovina and increases and decreases in the data correspond to what is

predicted by the aggregate demand and supply model.

To sum up, Bosnia and Herzegovina partially fits the aggregate demand and supply

model. Bosnia did experience certain self-correcting mechanism action; however, it did not

succeed in moving closer to potential level of aggregate output. The actions conducted created

even larger deviation of aggregate output from potential, leading to B&H to be in even worse

situation at the end of 2012 than it was during the financial crisis. This is possibly because

B&H is very limited in autonomous macroeconomic policies conducting (custom policy,

monetary policy, fiscal policy and exchange rate policy) and it is a consequence of the

strictest macroeconomic policy implementation, which is implementation of the Currency

Board Arrangement (CBA), hard budget policy and foreign trade liberalization. Bosnia and

Herzegovina cannot as quickly adjust to certain shocks as it could have without currency

board arrangement. With CBA, monetary authority in B&H does not determine the money

supply and thereby cannot encourage economic growth by proposing certain monetary policy.

Bosnia and Herzegovina was, and still is, below its long-run potential. However, after the

crisis B&H achieved its one of many goals, which was to push down the inflation rate. The

consequence of accomplishing this goal was and remained high level of unemployment.

Possible solutions for the B&Hsmacroeconomy is changing its macroeconomic program

from neoclassical to expansive Keynesian economics that represents a combination of budget

deficit, moderate inflation and national currency depreciation as well as effective custom

protection of domestic economy.


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List of Figures and Tables

Figures

Figure 1: Main aggregates of national accounts in the period 2005-2008 ............................................. 3

Figure 2: Main aggregates of national accounts for period 2009-2012 .................................................. 4

Figure 3: Graphical representation of the B&H's GDP growth from 1994-2012 ..................................... 4

Figure 4: Main population characteristics for the period 2006-2008 ..................................................... 5



Figure 7: Graphical representation of Bosnia and Herzegovinas inflation rates for the period 2011 -

2014 ......................................................................................................................................................... 7

Figure 8: Aggregate Demand and Supply Analysis for B&H during the Financial Crisis ........................ 10

Figure 9: Inflation Rate, Unemployment Rate and Aggregate Output of B&H in the period 2010-2012

............................................................................................................................................................... 11

Figure 10: Aggregate Demand and Supply Analysis for B&H in the period 2010-2012 ........................ 12

Tables

Table 1: Average annual inflation rate for the period 2006-2013 reported by Agency for Statistics

B&H ......................................................................................................................................................... 7

Table 2: Unemployment, Inflation and Aggregate Output, 2006-2013 .................................................. 8

Table 3: GDP, Unemployment and Inflation Rate during the financial crisis .......................................... 9


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References

Agency for Statistics of B&H, (2014), Bosnia and Herzegovina, Agency for Statistics, date

accessed: 06.06.2014,http://www.bhas.ba/index.php?lang=en

Ingram, K. Joseph, n.d. The World Bank Role in the Development of a Financial Market in

Bosnia and Herzegovina; date accessed: 05.06.2014,http://www.worldbank.org/

Mishkin, S. Frederic, (2012), Macroeconomics: Policy and Practice, Courier, Kendallville

USA, Pearson Education
http://www.bhas.ba/index.php?lang=enhttp://www.bhas.ba/index.php?lang=enhttp://www.bhas.ba/index.php?lang=enhttp://www.worldbank.org/http://www.worldbank.org/http://www.worldbank.org/http://www.worldbank.org/http://www.bhas.ba/index.php?lang=en

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Aggregate Demand and Supply Model