The Basics • Monetary Policy: • regulating the economy by controlling the amount of money in circulation and the level of interest rates • Fiscal Policy: • government spending • taxing • borrowing Definition of Monetary Policy Monetary policy refers to the use of instruments under the control of the BSP to regulate the availability, cost and use of money and credit. According to Johnson, “Monetary policy is defined as policy employing central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy.” Source: www.bsp.gov.ph Monetary Policy, Defined … refers to the measures or actions taken by the BSP to influence the general price level and the level of liquidity in the economy. Source: www.bsp.gov.ph Objective of the Monetary Policy To promote a low and stable inflation conducive to a balanced and sustainable economic growth. Source: www.bsp.gov.ph Monetary Policy Tools • Reserve Requirements: – Determines the minimum $ that banks must have at all times • Discount rate: – interest rate the fed charges to member banks – Lower rate more likely to borrow from BSP = more money in the economy = more loans – Higher rate = less money in the economy loans more difficult to obtain • Open-market operations: – Purchase or sale of bonds on the open market – Bonds: certificates issued by the government to a lender from whom it has borrowed money – Increases money in the economy by buying bonds; decreases money by selling bonds MONETARY POLICY AND EQUILIBRIUM GDP Real rate of interest, i Sm1 Sm2 Sm3 10 10 8 8 6 6 Dm 0 Quantity of money demanded and supplied P3 P2 P1 0 Amount of investment, i If the money supply increases to stimulate the economy… Interest Rate Decreases Investment Increases AD & GDP Increases AD3(I=₱25) with slight inflation AD2(I= ₱20) Increasing money supply AD1(I= ₱15) continues the growth – Real domestic output, GDP but, watch price level. AS Price level Investment Demand Impact on Net Export Settings of Monetary Policy Expansionary Contractionary Intends to increase the level of liquidity/money supply in the economy and which could result in a relatively higher inflation path for the economy. Intends to decrease the level of liquidity/money supply in the economy and which could also result in a relatively lower inflation path for the economy. Source: www.bsp.gov.ph In cases of unemployment, recession, and deflation Remedy is to increase money in circulation and inducing spending. Government actions: buying bonds in the open market and reducing interest rates. In times of inflation Remedy is to reduce money in circulation. Government actions: selling bonds in the open market and increasing interest rates. Open Market Operations - the sale or purchase of government securities by the BSP to withdraw liquidity or inject liquidity into the system. Monetary Policy Instruments Source: www.bsp.gov.ph • Primary: overnight reverse repurchase (borrowing rate) and overnight repurchase * (lending) rate; • Raisings policy/reducing the BSP’s policy interest rates; • Increasing/decreasing the reserve requirement; • Encouraging/discouraging deposit in the special deposit account (SDA)* facility by banks and trust entities of BSP-supervised financial institutions; • Increasing/decreasing rediscount rates • Outright sales/purchases of the BSP’s holdings of government securities. * As of 3June 2016, replaced with overnight lending facility (OLF) and overnight deposit facility (ODF), respectively. BSP Terms: • Reverse Repurchase Rate (RRR) - the policy rate at which the BSP borrows from banks with government securities as collateral. • Reserve Requirement – the proportion of banks’ deposits and deposit substitute liabilities that banks are required to hold as reserves. • Special Deposit Accounts (SDA) – fixed term deposits with the BSP by banks and trust entities of BSP-supervised financial institutions . • Rediscounting – a special refinancing facility of central banks wherein a financial institution borrows money from the BSP using promissory notes and other loan papers of its borrowers as collateral. Source: www.bsp.gov.ph Previous Monetary Policy Frameworks: • Past. Monetary aggregate targeting approach - control of inflation by targeting money supply. (Measuring the volume of money in circulation.) • Adopted January, 2002. Inflation targeting – focused mainly on achieving price stability. Entails the announcement of an explicit inflation target that the BSP promises to achieve over a given time period. Source: www.bsp.gov.ph Instruments under the Iinterest rate corridor system 1. Open Market Operations (OMO) • Reverse Repurchase/Repurchase transactions • Outright purchases and sales of securities • Foreign exchange swaps 2. Acceptance of term deposits • Term Deposit Facility (TDF) 3. Standing Liquidity Facilities • Overnight Deposit Facility • Overnight Lending Facility Source: www.bsp.gov.ph Fiscal Policy Macroeconomic Policy Understanding Fiscal Policy Fiscal Policy Fiscal policy is the use of government spending and revenue collection to influence the economy National Budget…plan for the reception and spending of government revenues Fiscal year…12 month period that begins on a specific date Actions of Fiscal Policy Expansionary policy Fiscal policy that encourages economic growth Higher spending, tax cuts Contractionary Policy Fiscal policy that reduces economic growth Lower spending, higher taxes Actions of Fiscal Policy Expansionary policy Fiscal policy that encourages economic growth Higher spending, tax cuts Contractionary Policy Fiscal policy that reduces economic growth Lower spending, higher taxes Limits of Fiscal Policy Hard for the government to change spending levels Hard to predict the future Sometimes, action is too late Delayed time…changes don’t happen overnight Review 1. Fiscal policy is (a) the national government’s use of taxing and spending to keep & make the economy stable. (b) a plan by the government to spend its revenues. (c) a check by Congress over the President. 2. Two types of expansionary policies are (a) raising taxes and increasing government spending. raising taxes and decreasing government spending. (b) cutting taxes and decreasing government spending. cutting taxes and increasing government spending. Fiscal Policy Options Fiscal Policy Options Classical Economics…the idea that the free market regulates itself Great Depression pointed out the weakness of this thought Keynesian Economics (John Maynard Keynes) The idea that the government should increase spending to spark demand and help the economy Know as demand side economics Demand Side Economics Results in the multiplier effect Idea that $1 spending by the government results in many more in the private sector Automatic Stabilizers If set up properly, fiscal policy can automatically stabilize the economy Taxes Low income…lower taxes and more transfer payments High income…more taxes and fewer transfer payments Supply Side Economics Belief that the economy should work to increase supply Too much government control will reduce productivity Taxes that are too high will discourage work Shown by the Laffer Curve Calls for less government spending and tax cuts Budget Deficits and the National Debt Deficits and National Debts The national budget is rarely balanced Either running a surplus or a deficit Two ways to combat the deficit Create money May lead to hyperinflation Borrow money Sell bonds Borrowing increases the debt Problems with the National Debt Borrowing money creates a national debt Debt is not the same as the deficit Problems arise with the national debt Creates investment competition for private business This is known as the crowding out effect Servicing the debt Paying off interest on the debt is an opportunity cost http://www.usdebtclock.org/ TRADE POLICIES The Need f o r Trade • I f we look around us, we will see many items we use which are imported f r o m abroad or which have components imported abroad. Countries trade because… • they cannot produce a product domestically. • to have a wider variety of goods available to consumers. • even if a they can produce a product, if another country specializes it that item, buying it from them may increase quality and decrease the price. • they wish to conserve limited resources. • other countries have an advantage. Specialize- a task assigned to one person or group that does it more efficiently Reasons for Trade ●Differences in Factor endowments ●Variety and quality of goods ●Gains from specialization ●Political reasons ⦿ Specialization: In international trade, specialization refers to a country’s decision to major in the production of a certain good or list of goods because of the advantages it possesses in their production. ⦿ Opportunity cost: refers to what you sacrifice in making an economic choice. Adam Smith and David Ricardo (Great philosophers). ⦿ Adam Smith (5 June 1723 – 19th July, 1790) was a Scottish moral philosopher and a pioneer of political economy. The ideas that became associated with Smith not only became the foundation of the classical school of economics but also gained him a place in history as the father of economics. His work served as the basis for other lines of inquiry into the economics field, including the theory of absolute advantage and even after his death, his great ideas he promoted lives on. ⦿ ⦿ David Ricardo David Ricardo, a British, lived between 18-4- 1772 and 11-09-1823. Ricardo’s interest in economic questions arose in 1799 when he read Adam Smith’s Wealth of Nations. David Ricardo’s aspects that made him to be known across the world is his contribution to the law of comparative advantage. He wrote his first economics article at age thirty-seven and then spent the following fourteen years—his last ones—as a professional economist. Is t h e r e a “World Economy”? • With t h e growing interdependence o f nations, a “world economy” started t o exist. Through time, this interdependence has become more and more pronounced. Trade as a “Primary instrument o f development” • Trade is called a “primary instrument o f development” because this has been its proven role t h r o u g h o u t history. Trade became even more important f o r several reasons. ⦿ Trade: According to a definition given by wealth of Nations (WN ), a book written by Adam Smith; trade is the consequence of the human “propensity to truck, barter, and exchange one thing for another. What is Trade? • A basic economic concept t h a t involves multiple parties participating in t h e voluntary negotiation and t hen t h e exchange o f one's goods and services f o r desired goods and services t h a t someone else possesses. International Trade The process of buying goods and services from the rest of the world (importing) and that of selling goods and services to the rest of the world (exporting) is referred to as international trade What is International Trade? • Th e process o f exchanging goods and services between countries. I t involves t h e buying and selling o f imports and exports. International Trade Models • Mercantilism; • The Classical Theories: – The Principle of Absolute Advantage – The Principle of Comparative Advantage • The Heckscher-Ohlin-Samuelson Model; • Alternative Trade Theories Theory It can be defined as a belief that can guide behaviour or a well-substantiated explanation of some aspect of the natural world; an organized system of accepted knowledge that applies in a variety of circumstances to explain a specific set of phenomena. Mercantilism • Mercantilism is a political- economic movement originating in t he period 1500-1750 whose paramount goal o f national policy is t o make t he nation r ich and powerful t he means o f which consisted mainly in t he protection o f domestic industry and t h e regulation o f trade. Mercantilism A school of thought dominant before the 19th century, which advocated restrictive trade policies, so as to maximize exports and minimize imports for the sake of accumulating gold and foreign exchange Type of Advantage There are 2 types of advantage. •Absolute Advantage •Comparative Advantage Advantage- a condition or circumstance that puts one in a favorable position The Principle of Absolute Advantage “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the product of our own industry, employed in a way in which we have some advantage” -Wealth of Nations, Adam Smith Even if one party is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies. Theory o f Absolute Advantage • A count r y has an absolute advantage over another i f i t can produce, w i t h a given amount o f capital and labor, a larger o u t p u t t han its rival o r in o t h e r words t o produce more o f a good o r service t han competitors, using t h e same amount o f resources. Absolute Advantage Absolute Advantage- the concept that if 2 countries or businesses have the same amount of resources, one country can produce more than the other using fewer resources. Country A has and Absolute Advantage over Country X Country A can produce 1 million gallons of milk per year Country X can produce ½ million gallons of milk per year COMPARATIVE ADVANTAGE Comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. The conclusion drawn is that each party can gain by specializing in the good where it has comparative advantage, and trading that good for the other. The Principle of Comparative Advantage “A nation, like a person, gains from trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage.” David Ricardo Theory o f Comparative Cost advantage • Nations should specialize in th e production o f goods in which they have comparative advantage and import those products o f which i t has t h e least advantage . The Law of Comparative Advantage Mutually beneficial trade is possible whenever relative prices (opportunity costs) between two goods differ in two countries. Comparative Advantage Comparative Advantage- the concept that one country or business can produce a good or service at a lower opportunity cost than the other. Country X has and Comparative Advantage Country A can produce 1 million gallons of milk per year at $1.25 per gallon Country X can produce ½ million gallons of milk per year at $1 per gallon The US can make more televisions than China , which among the 2 countries has comparative advantage? According to The US Department of Labor, the minimum wage is $7.25 per hour. In China, individual provinces set the minimum wage. There is no national minimum wage. In one of the highest paying provinces Shenzhen, minimum wage in 1,300 Yuan per month which works out to approximately $1.29 per hour. If it takes a 6 hours of labor to build a television it would cost: $43.50 in labor if made in the US $7.74 in labor if made in China Because labor is so much cheaper in China, it makes sense that they would specialize in manufacturing products that required a great deal of low skilled labor, while the US specializes in producing goods and services that require a great deal of human and physical capital. The Gains From Trade A nation’s gains from trade consists of two components: the gain from the reallocation of consumption; and the gain from specialization in production. The fact that a nation unequivocally gains from international trade does not mean that all groups within the nation necessarily gain: in fact some groups will lose. Who Gains? Producers and workers in the export industry gain as a result of higher world prices and a larger volume of trade; Consumers of the import competing good gain as a result of lower world prices and a larger supply; and Firms which use imported components and materials in their production process gain as a result of lower import prices. Who Loses? Producers and workers in the import-competing industry lose due to increased competition from imports; Consumers of the export good lose due to the smaller supply available to the local market and higher world prices; and Firms which use exportable components and materials in their production process lose due to increased prices. Trade practices and policies • Philippine exports have been th e main dollar earner o f t h e country. In recent years, i t has c o n trib u te d about f i f t y percent o f t o t a l dollar receipts o f t h e country. Expo rt s • are goods or merchandise t h a t we sell t o other countries t o earn dollars. These dollars t h a t we earn will later be used t o buy goods we need f r o m abroad. Other sources o f dollars • Dollars from gold • Dollars from invisibles I mport s • The dollars we earn through exports and o th e r sources are used mainly t o import goods and services we need. M o s t o f o u r imports are composed o f industrial and manufactured items. Balance o f payments • O u r balance o f payments is considered favorable i f dollar inflows or receipts exceed outflows or payments. Balance of trade • The balance of trade is called favorable if exports exceed imports. • The balance of trade is called unfavorable if imports exceed exports.
