Subject: Economic Development and Policies

Topic : ECONOMIC POLICIES

I. Learning Objectives:
n Articulate the importance of economic policies.
n Understand each and every economic policies.
n Determine the role of Bangko Sentral na Pilipinas to the economy.
II. Motivation:
Activity #1 ( 1st week)
RECALL!
Q: Recall the eight goals of economics, which among these goals are made for
economic policies? Explain your answer?
I
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III. Discussion:
Economic policies are broad rules or guides for actions. They are made for the
administration of a project, program or the whole economy. The most important
economic objectives of any democratic society are:
1. Economic growth
2. Full employment
3. Economic freedom
4. Equitable distribution of wealth and income
5. Economic security
6. Economic stability
1. FISCAL POLICY
What is fiscal policy?
Refers to the use of government spending and tax policies to influence economic
conditions, especially macroeconomic conditions, including aggregate demand
for goods and services, employment, inflation, and economic growth.
This is largely based on ideas from John Maynard Keynes, who argued
governments could stabilize the business cycle and regulate economic output.
During a recession, the government may employ expansionary fiscal policy by
lowering tax rates to increase aggregate demand and fuel economic growth.
In the face of mounting inflation and other expansionary symptoms, a
government may pursue contractionary fiscal policy.
Fiscal Policy Functions
u Allocation-It is the process by which total resource use is divided between
private and social goods and which the mix of social goods is chosen.
u Distribution-The distribution of income and wealth is shaped by the
distribution of the factors of production. Fiscal policy is directed toward
correcting this income and wealth.
ex. High tax for rich, low tax for poor, favourable public policies on
agrarian reform, wages, Labor and employment
u Stabilization-Instability may be due to changes in prices of major imports,
cost of foreign borrowings, and the availability of foreign borrowings
which lead to huge deficits in the budget and balance of payments and
trade. Using expenditure and tax policies for stabilization in developing
countries may be more difficult. An increase in expenditures may entail
either additional taxes or more borrowing. The low tax base and
inefficient tax administration makes a case of public borrowings.
 u Development-Development is an expensive endeavour. For it to be
achieved by developing countries, a radical shift in revenue and
expenditure priorities is called for.
Understanding Fiscal Policy
Fiscal policy is largely based on the ideas of British Economist John Maynard
Keynes between 1883-1946, who argued that economic recessions are due to a
deficiency in the consumption spending and business investment components of
aggregate demand. Keynes believed that governments could stabilize the
business cycle and regulate economic output by adjusting spending and tax
policies to make up for the short falls of the private sectors. His theories were
developed in response to the Great Depression, which defied classical economics’
assumptions that economic swings were self-correcting. Keynes’ ideas were
highly influential and led to the new deal in the U.S., which involved massive
spending on public works projects and social welfare programs.
In Keynesian economics, aggregate demand or spending is what drives the
performance and growth of the economy. Aggregate demand is made up of
consumer spending, business investment spending, net government spending,
and net exports. According to Keynesian Economist, the private sector
components of the aggregate demand are too variable and too dependent on
psychological and emotional factors to maintain sustained growth in the
economy.
Pessimism, fear, and uncertainty among consumers and businesses can lead to
economic recessions and depressions, and excessive exuberance during good
times can lead to an overheated economy and inflation, However according to
Keynesians, government taxation and spending can be managed rationally and
used to counteract the excesses and deficiencies of private sector consumption
and investment spending in order to stabilize the economy.
When private sector spending turns down, the government can spend more
and/or tax less in order to directly increase aggregate demand. When the private
sector is over optimistic and spends too much, too fast on consumption and new
investment projects, the government can spend less and/or tax more in order to
decrease aggregate demand.
This means to help stabilize the economy, the government should run large
budget deficits during economic downturns and run budget surpluses when the
economy is growing. These are known as expansionary or contractionary fiscal
policies, respectively.
Expansionary Policies
To illustrate how the government can use fiscal policy to affect the economy,
consider an economy, consider an economy that’s experiencing a recession. The
government might issue tax stimulus rebates to increase aggregate demand and
fuel economic growth.
The logic behind this approach is that when people pay lower taxes, they have
more money to spend or invest, which fuels higher demand. That demand leads
firms to hire more, decreasing unemployment, and to compete more fiercely for
Labor. In turn, this serves to raise wages and provide consumers with more
income to spend and invest. It’s a virtues cycle, or positive feedback loop.
Rather than lowering taxes, the government may seek economic expansion
through increases in spending (without corresponding tax increases). By building
more highways, for example, it could increase employment, pushing up demand
and growth.
Expansionary fiscal policy is usually characterized by deficit spending, when
government expenditures exceed receipts from taxes and other sources. In
practice, deficit spending tends to result from a combination of tax cuts and
higher spending.
The Downsides to Expansion
Mounting deficits are among the complaints lodged about expansionary fiscal
policy, with critics complaining that a flood of government red ink can bpweigh
on growth and eventually create the need for damaging austerity. Many
economists simply dispute the effectiveness of expansionary fiscal policies,
arguing that government spending too easily crowds out investment by the
private sector.
Expansionary policy is also popular - to a dangerous degree, say some
economists. Fiscal stimulus is politically difficult to reverse. Whether it has the
desired macroeconomic effects or not, voters like low taxes and public spending.
Due to the political incentives faced by policy makers, there tends to be a
consistent bias toward engaging in more-or-less constant deficit spending that
can be in part rationalized as “good for the economy”.
Eventually, economic expansion can get out of hand-rising wages lead to
inflation and asset bubbles begin to form. High inflation and the risk of wide-
spread defaults when debt bubbles burst can badly damage the economy and
this risk in turn leads governments (or their central banks) to reverse course and
attempt to “contract” the economy.
Contractionary Policies
In the face of mounting inflation and other expansionary symptoms, a
government can pursue contractionary fiscal policy, perhaps even to the extent
of inducing a brief recession in order to restore balance to the economic cycle.
The government does this by increasing taxes, reducing public spending, and
cutting public-sector pay or jobs.
Where expansionary fiscal policy involves deficits, contractionary fiscal policy is
characterized by budget surpluses. This policy is rarely used, however, as it is
hugely unpopular politically. Public policy makers thus face a major symmetry in
their incentives to engage in expansionary or contractionary fiscal policy. Instead,
the preferred tool for reining in unsustainable growth is usually contractionary
monetary policy, or raising interest rates and restraining the supply of money and
credit in order to rein in inflation.
2. MONETARY POLICY
Professor James Boughton of Indiana University defined monetary policy as
the process whereby the monetary authority attempts to achieve a desired set of
economic goals by controlling either the money supply, the cost and availability
of credit or the allocation of credit to its various uses. Monetary policy-making
body of the government is the Monetary Board headed by the Central Bank
governor.
Bangko Sentral ng Pilipinas (BSP) was created by RA 7653 in 1993 in place of the
Central Bank of the Philippines (createdbby RA 265 in 1949); mandates to:

n Maintain price stability conducive to a balanced sustainable growth of the

economy

n Promote and maintain monetary stability and convertibility of the peso.

n To control any expansion or contraction in the monetary aggregates which is

prejudicial to the attainment or maintenance of price stability.

TARGETS OF MONETARY POLICY - Given the effect of MP on the inflation rate,

interest rates and levels of output and employment and growth, monetary
authorities try to target some variables in order to achieve a certain inflation rate
or GNP growth.
MONETARY AGGREGATES - Refer to the different measures of money. As per
the Quantity Theory of Money, money supply increases do tend to raise the
inflation rate.
INTEREST RATES - BSP uses the policy interest rates for Repurchase Agreements
(Repos) and Reverse Repos (RRPs) to Signal to the market their intention to
tighten or loosen monetary policy or simply maintain the status quo.
INFLATION TARGETING - The government’s inflation target is defined in terms of
the average year-on-year change in the consumer price index (CPI) over the
calendar year. Focused mainly on achieving a low and stable inflation.
PRICE INDEX - An average of prices of commoditie in relation to their prices in a
specified base year.
Computing an index.
Price of Rice (per kg). Price Index (Rice)
2000*. 14.00 (14/14) X 100 = 100.0
2003 15.40 (15.40/14) X 100 = 110.0
2004. 16.17 (16.17/14) X 100 = 115.5
Annual Increase (%) Annual increase (%)
2003 - 2004 = (16.17-15.40). 2003-2004 = (115.5 x 110)
15.40 110
= 5.0% = 5.0%
Three elements in the construction of an average price index
l The items in the market basket
l The weight of each item
l The base year used as the point of comparison
INFLATION YARDSTICKS
Ø GNP deflator is a measure, which shows the general price level of the final
output of goods and services by Philippine Nationals for a given period.
Ø Producers Price Index (PPI), Measures the price changes of finished goods,
intermediate materials and crude materials at the level of the factory or
production unit.
Ø Consumer Price Index (CPI) is a measure of the changes in prices of
consumer goods and services.
MAJOR MONETARY TOOLS
( monetary policy instruments used by the BSP to ease and tighten credit in the
economy thus promote price stability and increase or reduce liquidity in the
financial system)
1. Tools aimed at Monetary Aggregates
a. Purchase/Sale of Foreign Exchange in the FOREX Market in order to ensure
that banks are able to provide ample liquidity in the market but, at the same
time, conduct their business in a sound manner, and guard against speculative
activity, limits on their “net open foreign exchange position” are instituted. “Open
Foreign Exchange Position” shall refer to the extent that banks’ foreign exchange
assets do not match their foreign exchange liabilities. An open position may
either be: “positive”, “long”, or “overbought” or “negative”, “short”, or “oversold”.
Any excess of the allowable limit shall be settled on a daily basis. Penalties on
excess overbought and oversold positions of banks when PDS trading is
suspended shall be waived.
b. Open Market Operations are a key component of monetary policy
implementation. These consist of repurchase and reverse repurchase
transactions, outright transactions, and foreign exchange swaps.
Repurchase and reverse repurchase:
 In a repurchase or repo transaction, the BSP buys government securities from
a bank with a commitment to sell it back at a specified future date at a
predetermined rate. The BSP’s payment to the bank increase the latter’s reserve
balances and has an expansionary effect on liquidity. In a reverse repo the BSP
acts as the seller of government securities and the bank’s payment has a
contractionary effect on liquidity.
2. Tools Aimed at influencing the Multiplier or Interest Rate
a. Reserve Requirements - refers to the percentage of bank deposits and
deposit substitute liabilities that banks must keep on hand or in deposits with the
BSP and therefore may not lend. Money multiplier is inversely related to the
required reserves percentage. If the required reserves are low, banks can lend
more of their deposit and the multiplier is high. If it is increased, banks can lend
less and the multiplier goes down. Changes in reserve requirements have a
significant effect on money supply in the banking system, making them a
powerful means of liquidity management. Reserve requirements apply to peso
demand, savings,time deposit and deposit substitutes (including long-term non-
negotiable tax exempt certificates of time deposit of universal banks and
commercial banks (KBs) and May be kept in the form of cash in vault, deposits
with the BSP and government securities.
The aforementioned monetary tools can either expand or contract money supply
to suit the needs or conditions of the economy. For instance, if there is inflation,
the policy is to contract money supply by increasing the reserve requirements,
selling government securities, and by appealing to the banks to control their
loans. This is a tight money policy. On the other hand, if the economy needs an
expansion of the money supply, a reverse monetary policy is adopted.
3. SUPPLY-SIDE POLICY
Are designed to increase LONG-RUN AGGREGATE SUPPLY (LRAS), also known
as the full employment level of output. It will focus on improving the structural
long term performance/competitiveness of an economy and improve the
production potential/capacity. The aims of the policies are to positively affect the
production side of the economy by improving the institutional framework and
the capacity to produce.
Advantages of Supply-side policies
² Lower Inflation is shifting aggregate supply to the right will cause a lower
price level. By making the economy more efficient supply-side policies will help
reduce cost-push inflation.
² Lower unemployment - supply side policies can help reduce structural,
frictional and real-wage unemployment and therefore help reduce the natural
rate of unemployment.
² Improved economic growth - supply-side Policies will increase economic
growth by increasing AS.
² Improved trade and balance of payments - firms will become more
competitive so they will be able to export more.
Two Categories
I. Interventionist supply-side Policies
a. Investment in human capital
Governments might invest in education and training of people. Improve the
level of schools or make education free. Also, provide various training schemes.
In the short run, such policies increase agg demand, but importantly - shift the
LRAS curve to the right. This happens because people’s skills improve. Hence,
productivity increases.
b. Investment in new technology
Governments could invest in research and development of new technologies.
Again, that would increase aggregate demand in the short run, however, in the
long run LRAS would increase. That happens because new technology can
increase productivity.
c. Investment in infrastructure
Government expenditure might go towards infrastructure.
d. Industrial policies
Governments might target specific economic areas through tax cuts, tax
allowances and subsidised borrowing which would promote growth of those
areas.
II. Market-based supply side policies
a. Policies to encourage competition
ü Deregulation
ü Privatization
ü Trade liberalisation
ü Anti-monopoly regulation
b. Labor market reforms
ü Reducing the power of labour unions
ü Reducing unemployment benefits
ü Removing minimum wages
c. Incentive related policies
ü Cutting the income tax - the idea is that your leisure becomes more
expensive after the tax cut and so you are start working more.
ü Cutting the business tax - firms get to keep more of their profit, that is an
incentive to invest, find more efficient ways of production.
EVALUATION OF SUPPLY-SIDE POLICIES
All supply side policies mentioned above can be evaluated in terms of :
1. Time lags - some supply sided policies can take years to take effect. (E.g.
investing in human capital), others - much shorter.
2. Ability to create employment- think whether a certain policy creates
employment. E.g. Investing in new technology can actually lead to technology
substituting workers.
3. Reducing inflationary pressure-can a certain policy help deal with high
inflation? Try not to make a rather unrealistic argument that “ governments could
invest in better education and that would lead to higher productivity and
eventually lower prices”. To see the effects of that investment on inflation can
take up to 15 years, so thus it really deal with inflation? Maybe in the very very
long run it does...
4. Impact on economic growth-how certain policies can affect growth, which
affect growth more than others and why.
5. Impact on the government budget - Some Policies may be very costly:
investing in infrastructure. However, privatization might lead to short-term
budget improvements (but remember that possible long term benefits are given
up).
6. Effect on equity- How will a certain policy affect the distribution of income?
Think about removing or changing the minimum wage, unemployment benefits.
7. Effect on the environment- could deregulation lead to higher pollution or over
all quicker degradation of the natural environment? Think about policies which
could lead to increase negative externalities.
IV. Evaluation/Assessment
a. Activity #2 (2nd - 3rd week)
1. Explain the nature of the economic policies.
2. Comment on our own economic policies.
3. Give some features of a good economic policies. Explain one.
4. Define Monetary policy. What are the monetary goals of the Bangko Sentral
na Pilipinas?
5. Explain the nature of fiscal policy?
6. State the effects of fiscal policy in the economy, how are these related to
economic development?
7. Explain how the categories of the supply-side policy may improve the inflation
rate, employment rate, economic growth and the balanced of payment of the
country.

b. Activity #3 (4th week)

Read the “Realizing the AmBisyon” as issued by the National Economic
Development Authority, then answer the question given below.

2003-2004 = (16.17 - 15.40)

15.40

Question: Do you think even without the COVID - 19, we will attain the
AmBisyon 2040 of the present administration applying the concept of the
important policies stated?
Answer:
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To God be all the glory!