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Macroeconomic PoliciesMacroeconomic Policies
Dr. George NortonAgricultural and
Applied EconomicsVirginia Tech
Copyright 2009
AAEC 3204AAEC 3204
Objectives Objectives
• Discuss influences of fiscal and Discuss influences of fiscal and monetary policies on agriculturemonetary policies on agriculture
• Discuss effects of key macro-prices Discuss effects of key macro-prices on agricultureon agriculture
• Why governments pursue particular Why governments pursue particular macroeconomic policiesmacroeconomic 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 Why do governments pursue particular macroeconomic policies?particular macroeconomic policies?
• Distribute income in a particular way Distribute income in a particular way (political expediency)(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 Stimulate growth in economy (often short
run) or in a sector (provide incentives)run) or in a sector (provide incentives)• React to changing world conditionsReact to changing world conditions• CorruptionCorruption
Fiscal and Monetary PolicyFiscal and Monetary Policy
Fiscal PolicyFiscal Policy – relates to – relates to government spending and taxinggovernment spending and taxing
Developing countries often go in debt Developing countries often go in debt because of many pressing needs and because of many pressing needs and limited tax revenuelimited tax revenue
Monetary PolicyMonetary Policy – Relates to – Relates to government monetary supply and government monetary supply and interest rate policy interest rate policy
Monetary PolicyMonetary Policy
Can finance deficits through:Can finance deficits through:
(a) increasing money supply (printing (a) increasing money supply (printing money) or (b) borrowing from abroadmoney) or (b) borrowing from abroad
What are the effects?What are the effects?
Y = P x Q = C + I + G + X - MY = P x Q = C + I + G + X - MY = money value of output or incomeY = money value of output or income
P = price index of all goods and servicesP = price index of all goods and services
Q = quantity index of all goods and servicesQ = quantity index of all goods and services
C = consumption expenditures (private)C = consumption expenditures (private)
I = investment expenditures (private)I = investment expenditures (private)
G = government expendituresG = government expenditures
X = value of exportsX = value of exports
M = value of importsM = value of imports
Assume country has a deficitAssume 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 Q can rise to meet this if resources are idleidle
• If shortage of capital or land, either M If shortage of capital or land, either M must go up or P must go upmust go up or P must go up
• If P up, this means inflationIf P up, this means inflation
• Inflation can also result if import Inflation can also result if import prices are risingprices are rising
Connections between macro policy and food Connections between macro policy and food policypolicy
Macroeconomic policy
Fiscal and monetary policy
Budgetary policy
Macroprice policy
Inflation
Food programs
Producers Consumers
Agricultural policy
Exchange rate Interest rate Wage rate
Agricultural pricepolicy
Rural-urban termsof trade
Trade policy
Governments use macro prices to affect inflation, Governments use macro prices to affect inflation, provide incentives, and distribute incomeprovide incentives, and distribute income
• Foreign exchange Foreign exchange ratesrates
• Interest ratesInterest rates• Wage ratesWage rates
• Land pricesLand prices• Prices for agr. Prices for agr.
Versus industrial Versus industrial goodsgoods
Government can Government can try to set thesetry to set these
Affected Affected indirectly by indirectly by government government
policiespolicies
Exchange RatesExchange Rates
• What are they?What are they?• How do they become overvalued?How do they become overvalued?• What are the effects of an What are the effects of an
overvalued exchange rate?overvalued exchange rate?
Foreign Exchange RatesForeign Exchange Rates
Value of a nation’s currency relative to value Value of a nation’s currency relative to value of the currency of another countryof the currency of another country
Exchange rates in developed countries Exchange rates in developed countries determined in international currency determined in international currency marketsmarkets
Exchange rates in developing countries Exchange rates in developing countries often set by government and “pegged” to often set by government and “pegged” to currency of a major developed countrycurrency of a major developed country
Many developing countries Many developing countries overvalue their currencyovervalue their currency
Why?Why?
• Keep downward pressure on pricesKeep downward pressure on prices
• Fixed against another country’s Fixed against another country’s currency to stabilize price of goods currency to stabilize price of goods traded with that countrytraded with that country
Purchasing Power Parity TheoryPurchasing Power Parity Theory
t
tt P
Prr
2
10
rt = exchange rate between 2 countries at time t
r0 = exchange rate in base periodP = general price level in country 1, 2P1t/P2t = measure of differential rates of
inflation (if rates of inflation from 0 to t are the same then P1t/P2t = 1)
rate of change in the exchange rate
difference in rates of inflation
*2
*1
* PPr
*2
**1: PrPTherefore
So country tries to manipulate r*
What are the Effects of an What are the Effects of an Overvalued Exchange Rate?Overvalued Exchange Rate?
• Raises price of exports and reduces Raises price of exports and reduces price of importsprice of imports
• Temporarily can keep inflation down Temporarily can keep inflation down • Creates balance of payments Creates balance of payments
problemproblem
FIXED Versus FLEXIBLE FIXED Versus FLEXIBLE Exchange RatesExchange Rates
• Why do countries choose one Why do countries choose one exchange rate regime or another?exchange rate regime or another?
• How do exchange rates become How do exchange rates become over-valued?over-valued?
Interest RatesInterest Rates
• RoleRole
• High versus lowHigh versus low
• Difference Difference between nominal between nominal and real ratesand real rates
Wage Rates and Land PricesWage Rates and Land Prices
Wage ratesWage rates
• How are they determined?How are they determined?
• Effects of minimum wage legislation?Effects of minimum wage legislation?
Land pricesLand prices
• How do macro policies affect?How do macro policies affect?
Rural – Urban Terms of TradeRural – Urban Terms of Trade
• Relative output and input prices in Relative output and input prices in rural compared to urban sectorrural compared to urban sector
• How affected by exchange rate and How affected by exchange rate and by fiscal and monetary policies?by fiscal and monetary policies?
• Rural – urban price differences Rural – urban price differences influence rural – urban income influence rural – urban income differencesdifferences
• Interest rates,Interest rates,• Capital movements,Capital movements,• Exchange rates,Exchange rates,• Trade, andTrade, and• Inflation Inflation are are
interconnectedinterconnected
How?How?
International InteractionsInternational 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 Higher exchange rate reduces demand for exports and increases supply of importsexports and increases supply of imports
• Exports down and imports up mean more Exports down and imports up mean more goods at homegoods at home
• More goods on the market compared to More goods on the market compared to demand keeps inflation downdemand keeps inflation down
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
Low U.S. interest rates have contributed Low U.S. interest rates have contributed to recent dollar weaknessto 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 World Macroeconomic RelationshipsRelationships
• Bloc – floating exchange ratesBloc – floating exchange rates• Integrated world capital marketsIntegrated world capital markets• Cross – country effects of monetary Cross – country effects of monetary
and fiscal policiesand fiscal policies• Changes in comparative advantage Changes in comparative advantage
and competitive advantageand competitive advantage• Long-term Debt and short-term Long-term Debt and short-term
financial crisesfinancial crises