Chapter 12-13: Business Cycle, Unemployment, and Inflation PDF

ADV. MACRO PROF. FLORDELIZA GERARDO | MIDTERM EXAM CHAPTER 12: – Business cycle is a characteristic of BUSINESS CYCLE, UNEMPLOYMENT, AND industrialized and developing capitalistic economies; INFLATION....

ADV. MACRO PROF. FLORDELIZA GERARDO | MIDTERM EXAM CHAPTER 12: – Business cycle is a characteristic of BUSINESS CYCLE, UNEMPLOYMENT, AND industrialized and developing capitalistic economies; INFLATION. economic fluctuations occurred long before Every nation had gone through the ups and modern economies. downs in economy. Even the richest country in the world like the United States of America has suffered – Fluctuations in economic activities are too depression. complex and too different to be incorporated into a The biggest economic problems of a single universal theory applicable to every country. business cycle are unemployment Even if the same explanation for business cycle and inflation. holds in highly industrialized countries (i.e., U.S.A.) BUSINESS CYCLE and in developing countries (i.e., Philippines), it is not easy to determine the causes of a business cycle. – The country's economy can be described by a chain of modest economic growth proceeded by an PHASES OF A BUSINESS CYCLE abrupt downturn in economic activities. 1. Peak/Prosperity. – This series of events in the economy is – This is a phase where business activities are apparent in the last half of the 21st century that in their temporary maximum. The economy at this results to mediocre growth for most of the period. phase is at full employment and the level of real Although the economy has recorded growth above output is at its full capacity, and there is the tendency 4% in the last six years, its structural problems for the price level to rise. forestall any chances to break from a cycle of boom- bust that afflicts it for the last two decades and 2. Recession. prevents it from moving to a higher and sustained growth. – A phase in business cycle that is characterized by a decline in total output, income, – What seems to be typical of the Philippine trade, and ultimately, employment. Therefore, during economy from other countries is that it has short this phase, unemployment is induced. periods of average levels of economic growth while having an extended period of severe contractions 3. Trough/Depression. and slower pace of recovery. This pattern of fluctuations in economic activities is referred to as – It is the turning point of recession, or when the business cycle economic activity is at its lowest. In this phase of the business cycle, unemployment is so severe. – Business cycle is defined as the diffusion of fluctuations in aggregate economic activities all over 4. Expansion. the economy and not just on a single industry. – In this phase, there is a recovery in the – The economy of any given country is a economy wherein income, output, trade, interest system of closely interrelated parts, and to rate, wage, and employment are rising, understand business cycle is to know the workings meaning, unemployment is low. of an economic system organized largely in a network of free enterprise searching for profits. …. ASHNIA SULTA | 1  followed by a notable economic growth at the beginning of 1997. – The second cycle is around third quarter of 1997, and the other from 2000 to 2007. Figure 12. Phases of a Business Cycle – Notice the third cycle has the deepest and BUSINESS CYCLE IN THE PHILIPPINES longest recession in the economy compared to the first cycle, while the second cycle has shorter length During the early times, the business cycle was but with a deep impact as well on the economy. already operating. Primitive communities had periods of good and bad harvests, and their hunting Several factors with various natures can be attributed and farming were greatly affected by the weather. A to the formation of the cycles; the first cycle was good amount of rain and sunshine improved their mainly caused by insufficient power supply in the farming and hunting outputs, while vagaries of country at the beginning of the 1990s causing weather depressed their output. widespread blackouts that crippled different industries and the entire economy. At the end of the In today's advancement of the Philippine Aquino administration, newly elected President Fidel economy, it does not follow a steady course of good V. Ramos entered into different contracts with business condition. different private electric power companies with the objective of ending the power crisis in the country. – Its performance is highly correlated with the performance of other economies due to its openness The second cycle was instigated by the Asian to international trade. financial crisis causing currencies in the region to depreciate significantly. The Philippine peso in – The major export earnings of the country particular was adversely affected. Before the crisis, are tied up with the U.S., Taiwan, South Korea, the peso-US. Dollar rate was 25 pesos to 1 dollar, as Japan, and some European countries. When these a result of the financial crisis, the exchange rate countries enjoy prosperity, it trickles down to the against the US dollar depreciated to 45. This caused Philippine economy through more hefty export prices of goods and services in the country to go up revenues. But if the demand for these goods and significantly. services is reduced to poor economic performances of the trading partners, the country’s economy will be The third cycle was due to the lingering political affected with lower export receipts. instability in the country from the turn of the century when President Joseph Estrada was ousted from Malacañang because of corruption. He was replaced by then Vice President Gloria Macapagal Arroyo who assumed office. After the assumption of President Arroyo to power, corruption issues didn’t die down in her administration causing spurts of coup d’etat that adversely affected the economy. Figure 12.1 shows the business cycles in the Philippines for the period 1990-2009. Interestingly, …..,.,., the observed graph comprises three business cycles of different lengths and depths; – The first cycle covers the period 1990 to ……………. 1997 characterized by a deep recession in 1993 2 SELECTED CLASSICAL THEORIES EXPLAININ – According to Wesley Mitchell, one phase of BUSINESS CYCLES the business cycle grows out of the preceding phase. For example, the period of prosperity grows to a There are various explanations of the crisis. business cycle in the economic literature. – This crisis develops into depression and this Particularly, there are two opposing theories that condition will lead to recovery and eventually to provide rationalization in the business cycle theories prosperity. such as the endogenous (internal) and exogenous – These different phases of the business cycle (external) are series of cumulative changes by which one condition is a product of another. ENDOGENOUS THEORIES – These theories explain the causes of business cycles within rather 4. Underconsumption theory. than outside the economy. – This theory comprises the older explanations The following are specific explanations of the of the business cycle. causes of business cycle: – Economists subscribing to the underconsumption view attribute the deficiency in 1. Real structural hypothesis (RSH). purchasing power. This is due to the fact that purchasing power typifies all business contractions, – This hypothesis is based on the explanation and if in some fashion, society could sustain the that aggressive investment plans, together with demand for goods, then prosperity could endure. import dependence, attain a normal frontier in the – The underconsumptionists have brooded weak (structural) ability to bring in foreign exchange. excessively over the role of savings. – This results to a period of low growth as investment – A downward turn of production could is suppressed and large price adjustments affect the conceivably result if the accumulated savings of the economy. society were not invested, or if, through savings, the – Investment is stimulated as foreign credit is demand for consumer goods were forced below a reestablished, and a new cycle begins. level of profitable production. 2. Innovation theory. 5. Monetary theory. – This theory was based on the ideas put – If inflation is threatening the economy, the forward by Joseph Schumpeter. This theory holds Central Bank (CB) should slow the rate of growth of that innovation is a fundamental cause of business money supply. But this action of the CB will adversely cycle. – Innovation is defined as enhancement of an affect economic growth as recession will ensue. If existing production system that leads to new and inflation is no longer a threat, the CB can now better products. accelerate money growth to promote economic – This innovation will bring higher profits for recovery. producers as prices are reduced because of a more efficient production. EXOGENOUS THEORIES – These theories explain – High profitability attracts more producers in the causes of business cycle as disturbances outside the industry. Too many players will reduce individual the economy. profit, making others withdraw especially those who are unable to meet with efficiency, making the It has been said that when the economy of industry profitable again. United States catches cold, the Philippine economy contracts pneumonia. The reason behind this is that the country’s economy is so dependent on the demand of the United States for our products. 3. Self-generating theory. 3 – In fact, the United States remains as our top 1. Without work, i.e., had no job or business trading partner, so any decline in their economic during the basic survey reference periods; activities will definitely generate fluctuations in the 2. Currently available for work, i.e., were economy. available an willing to take up work in paid employment or self-employment during the – Another exogenous factor that will create basic survey reference period, and/or would fluctuations in the economy would be conflicts in be available and willing to take up work in other nations or regions such as the Middle East. paid employment or self-employment within two weeks after the interview date; and – Since the Philippines relies heavily in this 3. Seeking work, i.e., had taken specific steps region for our oil supply, any political unrest will to look for a job or establish a business during create higher prices of crude oil in the world market the basic survey reference period; or not which eventually leads to higher prices of gasoline seeking work due to the following reasons; and diesel in the local market. These higher prices a. tired/believe no work is available, i.e., the will generate economic woes for the households and discouraged workers who looked for work industries. within the last six months prior to the interview date. UNEMPLOYMENT b. Awaiting result s of previous job – Why do Filipinos want to go abroad instead of application. staying here in the country and work? c. Temporary illness/disability – Why do Filipinos have to take the life-threatening d. Bad weather risk in the Middle East countries like Kingdom of e. Waiting for rehire/job recall Saudi Arabia, United Arab Emirates, Iraq, and Kuwait to work? Unemployment Rate – is the proportion in – Or why do they choose to be away from their percent of the total number of unemployed families for a long time just to leave the country? persons to the total persons in the labor force. – Hava you ever asked these questions? – Unemployment rate in the Philippines for the The answer is simple: unemployment, but its past three years (2008-2010) is shown in solution is difficult to achieve. Figure 12.2. During the trying times of high inflation in the 1970s, Labor Force – includes all persons 15 years old the late Senator Blas Ople who was then the and over as of their last birthday who contribute to Minister of Labor opened the labor market to the the production of goods and services in the country countries in the Middle East as a temporary solution whether employed or unemployed. to the ballooning unemployment in the Philippines. But more than three decades after, this country is still Mathematically: relying on other countries for help. Labor Force = Employed + Unemployed – Unemployment represents sheer waste – the Philippine society loses the goods and services which might have been produced by those out of However, not all persons who are 15 years work. The loss of this country is the gain of other old and over can be considered part of the labor countries as they progress with the help of the force. Filipinos who work for them. There are persons who are considered outside the labor force: Unemployed – is officially defined as all those who are 15 years old as their last birthday and during the – if they are neither employed nor reference period and are reported as: unemployed, i.e., persons who are not 4  working and are not available during the California Manufacturing Corporation moved its reference week, and persons who are not factories from Sucat to Laguna, hundreds or even a available and are not looking for work thousand workers were displaced because some because of the reasons other than those were unwilling to be relocated to its new location. – previously mentioned (e.g., temporary Changes in technology cause this type of illness/ disability, bad weather, etc.). unemployment. During the early 90s, the "in" thing Examples are was the pager. With the advent of the cellular phone, – housewives, a lot of pager operators were displaced caused by – full- time students, the advancement in technology in the – permanently disabled, telecommunication industry. – retired persons, – The skills may be also lacking in the labor – seasonal workers, among others. force. In the Philippines, the jobs that are available are in the agricultural sector, so the country needs The Labor Force Participation Rate – The more agriculturists and other skills related to this percentage of the total number of persons in the sector. Colleges and universities, however, produce labor force to the total population of 15 years old more business graduates, nurses, and the like that and over is called the labor force participation rate. are not related to agriculture. This results to structural unemployment. Mathematically: c. Cyclical unemployment. Labor Force – Unemployment caused by the recession Participation Rate = TotalNumber of persons in the Labor force x 100 phase of the business cycle. It is caused by Total population of 15 yrs old and over inadequate total spending. – As the overall demand for goods and services decreases, unemployment rises. TYPES OF UNEMPLOYMENT 2. AVOIDABLE UNEMPLOYMENT. There are two types of unemployment, and – This refers to unemployment usually these are: associated with insufficient demand for workers caused by many factors such as poor performance 1. AVOIDABLE UNEMPLOYMENT – There are of the economy. three types of unavoidable unemployment: a. Frictional unemployment. HOW MUCH IS FULL EMPLOYMENT? – It is a temporary unemployment associated with the changes in the economy. – It happens for – Full employment does not mean that the a number of reasons. unemployment rate is 0%. – Some new entrants into the labor force take – Full employment is unavoidable time to find jobs, such as a new B.S. Economics unemployment or if cyclical unemployment is zero. graduate taking a one-month vacation before – The full employment rate of unemployment is hunting for a job. – Some workers quit their current referred to as the natural rate of unemployment. jobs to look for something better. Still, some others are unemployed because of temporary disturbance UNDEREMPLOYMENT (weather, temporary shutdown for renovation of the There are persons who are already employed plant or building). but they express the desire to have additional hours b. Structural unemployment. of work in their present job on in an additional job, or – It occurs when the location and qualifications to have a new job longer with longer working hours. do not match the available jobs. For example, when Those persons are called underemployed. 5 There are two classifications of underemployed – What is difficult about inflation is that prices persons: rise unevenly. Some commodities rise, others decline while others do not change at all. 1. Invisibly underemployed. – A person is considered invisibly underemployed if Mathematically, it is expressed as follows: the person already worked 40 hours during the reference week but still want additional hours of work, and Inflation Rate = CPI current – CPI previous x 100 CPI previous 2. Visibly underemployed. – A person is considered visibly underemployed if the person worked less than 40 hours during the The above formula gives the percentage of reference week and wanted additional hours of work. change in the CPI or consumer price index. Okun’s Law It is used as an indicator of the change in the average price of a fixed standard basket of goods and This was developed by Arthur Okun who services commonly purchased by households was a macroeconomist and served in the economic relative to a base year. This standard basket contains council of President Lyndon Johnson. He developed hundreds of consumption items whose price the relationship between GDP and unemployment. movements are monitored to determine the change As a result of his findings, he concluded that for every in the CPI or the level of inflation. 2-3% movement in GDP, unemployment changes by 1% in both opposite directions. The kind of inflation rate that the Bangko INFLATION Central ng Pilipinas monitors under its inflation targeting approach is called the headline inflation To be the president of the Philippines, a and not the core inflation: political should only promise on thing: to reduce the 1. Headline Inflation – is calculated as the price of rice. For politician to stay in the power, he change in the weighted overall average should keep the price of rice low. The standard of prices of all goods and services in the CPI living and inflation has a high correlation: when the basket. prices of basic commodities are low, there is a higher 2. Core Inflation – is an alternative measure of standard and vice versa. – While it is true that inflation that is calculated as the rate of unemployment poses a greater problem than change in the CPI that excludes the items inflation because as we have mentioned earlier, that have transitory effects on the CPI. unemployment represents sheer waste, in inflation, there are winners and losers, not taking away the fact that so much resentment is also tagged to it. These items or commodity groups and their corresponding CPI weights are listed as follows: – When prices rise, producers are given the incentive to produce more, but buyers suffer, and – rice (9.4 percent) they will need more money (in nominal terms) to – corn (0.9 percent) cope with higher prices. – fruit and vegetables (5.3 percent) – Even though there is inflation, it does not – LPG (1.3 percent) necessarily mean that all commodities have higher – kerosene (0.3 percent) prices; in some instances, the prices of some – oil, gasoline, and diesel (1.3 percent). commodities fall even if there is inflation. The excluded items account for 18.4 percent of the CPI. The excluded items are subject to volatile price 6 movement and are also affected by supply-side gainers and losers. The primary assumption of this factors and the price changes are not within the redistributive effect is that inflation is unanticipated. control of monetary policy. Loser and winner in inflation Therefore, core inflation is used to capture the permanent component if the inflationary process Losers during inflation are individuals who that can be influenced by monetary policy. are hurt when prices are increasing. CAUSES OF INFLATION The following are considered losers during unanticipated inflation: 1. Demand Pull Inflation - This inflation is characterized by “too much spending 1. Fixed income earners (including pensioners). chasing too few goods”. Pressures on inflation are caused by relatively higher – Laborers and office workers who are getting a fixed demand compared to the available supply of amount of money monthly cannot keep up with the goods and services. Excess demand pulls high prices because their nominal income does not the general price level. rise with prices. Therefore, the real income of these 2. Supply Shocks to Inflation - These are workers diminishes, and they feel the impact of pressures on inflation resulting from inflation. shortages in supply and increases in the cost 2. Savers. of production without a corresponding expansion in output. Example of these are – The interest rate of savings deposits may not cover bad weather, natural calamities and the cost of inflation. If the amount of money that was disasters, wage increases not matched by saved will be withdrawn during the time when the higher productivity of labor, hikes in prices are high, that money will lose purchasing international oil prices, increases in prices of power. imported raw materials, and hikes in rental rates. These tend to limit or decrease supply 3. Creditors. and, assuming no decline in demand for goods and services, push prices up. – Same with the situation being faced by savers, Conversely, an oversupply of commodities creditors are hurt because by the time they will tends to induce the opposite effect on prices. receive the payment, the amount of goods and 3. Profit-Push Inflation - These are pressures services that can be bought by the sum of money has on inflation resulting to higher markups by less purchasing power during inflationary times. businesses. They are somehow receiving "cheap" pesos. It happens whenever interest payments may be less Markup is the difference between the original than the inflation rate. price and the selling price. 4. Holders of securities. EFFECT OF INFLATION – People who have investment in bonds and or Inflation has an effect on the real income of stocks lose during the time of inflation because the individuals in the economy. It may reduce the real value of their money invested in securities income (purchasing power) of an individual or depreciates in terms of purchasing power. individuals but does not necessarily follow that it reduces the real income of the whole economy. Gainers during inflation are the groups of individuals that are helped by unanticipated Inflation results to redistributive effects, inflation: meaning, the effects of inflation are redistributed to different individuals, and as such, there will be 1. Debtors. 7 – They are paying back "cheap" pesos to their purchase a bag of grocery, or a bar of chocolate cost creditors that have less purchasing power. 50,000 Bolivian pesos. The cause of this hyperinflation is the 2. Fixed Asset Owners. planeload of printed money that arrived in that country from Germany and Britain every month. – Landowners gain during inflation as the value of land and other fixed assets appreciate PHILIPS CURVE To show the concept of Phillips curve, let 3. Producers. us look at Figure 12.5 where the short-run aggregate supply (AS) is constant, while – The income of producers increases when inflation aggregate demand (AD) is increasing from AD1 to takes place. As the price of commodities increases, AD3 The shift in AD from AD1 to AD2 increases business firms gain higher returns. national output from Q1 to Q2 but the short-run price IS DEFLATION BETTER THAN INFLATION? level also increases from P1 to P2; this increase in output resulted to an increase in employment. We can generalize this simple illustration, with AS Deflation is a sustained decease in the constant, a high rate of inflation is accompanied by a average price level. This is in sharp contrast to high rate of employment (or low unemployment) inflation. because output expands. – Is deflation good for the economy? No. If there is deflation in the economy, producers will lose and eventually will shut down their businesses, because a substantial decrease in price will adversely affect their incomes. – The obvious reaction they will take when losing profits is to cut down their labor cost. The effect will be higher unemployment, lower output, taxes, national output. – An inflation rate of 2-3% is good for both consumers and producers. It will give incentives for producers to produce, and at the same time a 2- 3% increase in inflation is not burdensome to consumers because it is very minimal. TRADE-OFFS HYPERINFLATION Inflation and unemployment have an Hyperinflation refers to a period of extremely existing short-run trade-offs, and there is policy high inflation reaching 100,000 and above. implication on this. According to this concept, full An example of this is the case of Germany employment cannot be attained without the after World War I where the Deutschmark (currency existence of inflation. of Germany) lost its value due to the increase in its circulation from 50 billion to 500 billion in just four – As seen in figure 12.6, there is an inverse years. Because money was so plentiful, people relationship between inflation and rushed to spend it because it was practically unemployment. worthless. Inflation reached 116,000% in Bolivia in the early 80s, where a sack of money could only 8 – A low level of unemployment rate will accompany a high level of inflation rate; the inverse relationship connotes trade-offs between the two. – Policy makers are faced with dilemma in deciding which will be favored, because if they support policies reducing unemployment, they will be confronted with the problem of rising prices. – Or if policies will be geared towards the elimination of inflation, unemployment will suffer. In dealing with inflation and unemployment, aggregate demand is influenced, and the tools being used are fiscal policy and monetary policy. STAGFLATION can occur due to various factors, including: SUPPLY SHOCKS For example, a sudden increase in oil prices can raise production costs, leading to higher prices (inflation) while also slowing economic growth. POOR ECONOMIC POLICIES Inappropriate fiscal or monetary policies can contribute to inflation without stimulating economic growth. DECREASED PRODUCTIVITY When productivity declines, it can lead to higher costs for businesses, resulting in both inflation and stagnation. 9 CHAPTER 13: – According to this theory, for a nation to become INTERNATIONAL ECONOMICS wealthy, it should encourage exports and restricts imports. CONCEPTS AND PRINCIPLES – The goal of this mercantile system would be an The rules of trade between nations at a inflow of bullion, or precious metals, primarily gold global or near global level are governed by the and silver. The more gold a nation had, the richer World Trade Organization (WTO). Its principles and more powerful it was. However, since not all regarding multilateral trading system should be nations can do this, they acquired precious metal at without: the expense of weaker nations, thus will result to - discrimination zero-sum game. - freer - predictable 2. Law of Absolute Advantage (ADAM SMITH) - more competitive, and - more beneficial for less developed – In the Wealth of Nations Adam Smith, rejected the countries. views of mercantilism and advocated free trade as the best policy for the nations of the world. Since 1995, after the accession of the Philippines to the WTO, it is becoming more – He stressed that when nation is more efficient immersed with globalization. The country actively than (or has an absolute advantage over) participates in numerous Regional Trade another in the production of one commodity but is Agreements (RTAs) such as Asian of Southeast less efficient than (or has an absolute Asian Nations Free Trade Area (AFTA), ASEAN- disadvantage with respect to) the other nation in Australia-New Zealand Free Trade Area producing a second commodity, then both nations (AANZFTA), among others, one of the objectives can gain by specializing in the production of one of RTAs and multilateral trade agreements is to commodity of its absolute advantage and ensure free flow of trade by eliminating or reducing exchanging part of its output with other nations for trade barriers (tariffs and non-tariffs barriers). the commodity of its absolute disadvantage. The international specialization of factors of production But are we gaining from these trade would increase the world output. agreements or are just sinking deeply into the mire of poverty or misery? Free trade in world markets 3. Law of Comparative Advantage (David brings misfortune to labor unions and Ricardo) businesspeople whose products lose to others. – The law states that even if a nation had an However, less developed countries such as the absolute advantage in the production of both Philippines were able to acquire intermediate commodities with respect for the other nations, technologies that contribute to the economic mutually advantageous trade could still take place. development of these countries. – The first nation should specialize in the SELECTED THEORETICAL BASES OF production and export of the commodity in which INTERNATIONAL TRADE absolute disadvantage is smaller (comparative advantage) and import the commodity in which 1. Mercantilism (THOMAS MUNN) absolute disadvantage is greater (comparative disadvantage). – From the 17th and 18th century, mercantilism – On the other hand, the second nation should was the predominant economic philosophy on specialize in the production and export of the international trade particularly in Great Britain, the commodity in which its absolute advantage is Netherlands, Spain, and France. greater (comparative advantage), and import the commodity in which its absolute advantage is smaller (comparative disadvantage). 10 4. HECKSHER-OBLIN (HO) THEORY. TYPES OF TRADE PROTECTIONS – Factor endowments and their corresponding 1. TARIFF prices differ among nations. Highly developed – This is a tax on imported products. It raises the countries have abundant capital, while less costs to foreign suppliers and reduces their revenues developed countries are abundant with excess thereby reducing the import spending of the country. labor. Since capital is abundant in highly developed nations, the price of capital is low, the same is true 2. QUOTA with the price of labor in less developed countries – This is a fixed limit placed on the quantity of imports due to its abundance. allowed into a country. Although the volume of – The HO theory postulates that each nation will imports is limited, their price may be forced because export the commodity intensive in its relative of the scarcity, thus the spending on imports may not scarcity and expensive factor. It is also called fall too much. proportions or factor endowment theory. 3. GOVERNMENT REGULATIONS 5. HECKSHER-OBLIN-SAMUELSON THEOREM – These are forms of protections arising from health and safety standards and preservation of the – The HO theorem was extended by Paul environment. Samuelson by incorporating the effects of international trade to the factor payments, interest 4. EXCHANGE CONTROLS rate (capital), and wage (labor). – The Bangko Sentral ng Pilipinas restricts the sale – According to this theorem, international trade will of dollars (and other forms of currency) to importers. eliminate or reduce any difference in relative and Only those importers who have permits are allowed absolute homogeneous factors across nations. to obtain dollars due to the necessity of the product they are importing. – International trade will cause the wages and ARGUMENTS FOR THE IMPOSITION OF TARIFF interest rate to be the same in all trading nations. PROTECTION – HOS theorem is also known as factor price 1. Infant Industry Agreement equalization theorem. This argument asserts that a temporary imposition of tariff will cut down imports while local THE NEED FOR TRADE PROTECTION OF industries will learn how to produce at low costs to DEVELOPING NATIONS compete without the help of a tariff. This is the most Poorer countries dependent on the export valid argument for an industrializing country. Here in of few primary agricultural products are wary about the Philippines, many industries have been protected the exploitative power of rich nations which have during the time of Marcos, but these industries never grew up. They continue to be "infants" in spite of the highly industrial bases. Without a certain level of opportunity afforded them go compete with foreign protection from rich nations, these developing countries will find themselves trapped in being "poor" products. for a long period of time. 2. Higher Standard of Living Argument. Time policies being implemented in the A tariff will promote high wages because different in trading blocks are influenced by local industries cannot provide competition with developed countries such as the US, European foreign competitors and pay high wages at the same countries, and Japan. Therefore, all trading time. High wages and a large number of workers agreements and disputes shall favor and advance secure a high standard of living for most of the their interest. population. But this argument lost its steam when it was observed that higher wages is a result of higher productivity. 11 3. Increased Employment Argument – The exchange rate is made the same in all This argument contends that tariff creates markets by arbitrage. employment opportunities for labor. Goods that should have been imported can now be produced at – Foreign exchange arbitrage is the buying of a home (import substitution) and therefore would currency when its price is low and selling it when it is increase the demand for labor. But the weakness of high. this argument lies in the fact that if imports decrease, exports will decrease also, and employment will – When the value of a currency declines/increases decrease as an outcome. because of market forces (demand and supply factor), it is referred to as currency 4. Self-sufficiency Argument depreciation/currency appreciation. This argument is advocated to secure economic interdependence or national self- – On the other hand, when the value of a currency sufficiency. If war erupts, a country cannot depend declines/increases due to legislation, it is referred to upon other countries for a continuous supply of as currency devaluation/currency appraisal. essential commodities. Important industries should In the Philippines, for instance, the exchange be strengthened to ensure self-sufficiency in case of rate is conventionally expressed as the value of one conflict. US dollar in peso equivalent. For example, US $1 - Php 45.62. Therefore, there are always two FOREIGN EXCHANGE MARKET currencies involved in every exchange rate quotation. a Filipino and a Chinese communicating with each other an interpreter to converse. Just like IMPORTANCE OF EXCHANGE RATE different people with different languages, different nations have different currencies. The exchange rate is important for several reasons: – The exchange rate acts like a translator for currencies, such as the price of the Philippine peso 1. It serves as the basic link between the local and to a dollar or other currencies in terms of unit. the overseas market for various goods, services, and financial assets. Prices of goods, services and – If an American wants to buy Philippine products, he assets quoted in different currencies (US dollar, has to sell his dollars in exchange for pesos in a British pound, euro, Swiss frane, Japanese yen, foreign exchange market. Hong Kong dollar, etc.) can be compared to the prices in the Philippines using the exchange rates. – A foreign exchange market is the organizational framework wherein individuals, businesses, and 2. Exchange rate movements can affect actual banks buy and sell foreign exchange. inflation as well as expectations about future price movements. Domestic prices of imported goods and – The foreign exchange market for the Philippine services are directly affected by the appreciation or peso is located in places where there are Filipinos depreciation of the peso. Once the peso depreciates, and where trading occur. it raises the peso prices of imported goods as well as – The main function of foreign exchange is to transfer import-intensive services such as the transport and funds of purchasing power from the Philippines to telecommunication systems. other countries or vice versa. 3. Exchange rate movements can affect the country's THE FOREIGN EXCHANGE RATE external sector through their impact on foreign trade. The level of competitiveness of Philippine exports – The Foreign exchange rate is the price of a unit will be greatly affected by the changes in the peso of foreign currency in terms of the domestic currency. exchange rates with other currencies. A favorable change in the peso (appreciation) could lower the price competitiveness of the Philippines exports 12 versus the products of those competitor exporters … whose currencies have not changed in value. 2. THE CRAWLING PEG SYSTEM 4. The exchange rate affects the cost of servicing (principal and interest payments) on the country's – The pegged exchange rate is changed often foreign debt. A peso depreciation increases the (maybe monthly) according to the discretion of the amount of pesos needed to buy foreign exchange to BSP or some economic indicators (such as inflation, pay interest and maturing obligations on foreign balance of payments, and reserves). debts. – At present, the country's exchange rate policy DETERMINATION OF EXCHANGE RATE supports a freely floating exchange rate system (adopted since 1970) whereby the BSP leaves the – If the Bangko Sentral ng Pilipinas (BSP) does determination of the exchange rate to market forces. not intervene in the market to defend the currency against its depreciation, we have a floating exchange – Under a market-determined exchange rate rate. framework, the BSP does not set the foreign exchange rate but instead allows the value of the – This system is market-driven, determined by the peso to be determined by the supply and demand of interaction of the demand for dollars and the supply foreign exchange. for it. – Thus, the BSP's participation in the foreign – There is no need for the BSP to buy or sell dollars exchange market is limited to temper sharp to achieve a desirable exchange rate (BSP uses the fluctuations in the exchange rate. international reserve in selling dollars). – On such occasions of excessive movements, the We have two types of floating or Flexible BSP enters the market mainly to maintain order and exchange rates, stability. 1. THE MANAGE FLOAT – Under manage float, – When warranted, the BSP also stands steady to the BSP will intervene in the market to smooth provide some liquidity and ensure that legitimate out short-run fluctuations in the foreign exchange demands for foreign currency are satisfied. market without affecting the long-run movement of the exchange rate. – The floating rate system is consistent with the 2. THE DIRTY FLOAT – the country will artificially current regime’s national strategy of achieving keep their currency to induce its exports. In the external competitiveness through efficiency, which is fixed exchange rate system, the BSP allows the also a central theme of the recent bold liberalization exchange rate to move within a range of values efforts. and permits that rate to fluctuate in that range. DEMAND AND SUPPLY IN THE FOREIGN There are two types of fixed exchange rates, EXCHANGE MARKET 1. THE ADJUSTABLE PEG SYSTEM – To comprehend how a country's exchange rate fluctuates, we will use the same kind of analysis used – In the adjustable peg system, the BSP will set up a in the competitive market. maximum and minimum value of the currency. – The determination of the equilibrium price (which is – If there is too much inflow or outflow of foreign the exchange rate) is the interaction of the demand currency due to an expansion or reduction of exports and supply, and there are forces that lie behind the respectively, the BSP will adjust the currency to demand and supply curves. correct a surplus or a shortage. – Within the foreign exchange market, people buy money for various reasons such as trading of goods and services, and they are making or receiving 13 payments for these goods and services. Some are – Policymakers are guided by the sources of engaged in financial transactions of buying and imbalances as presented in the BOP and therefore selling assets where they need to convert one become better equipped in determining and currency to another. implementing adjustment measures. – A country's exportation of goods and services – National development programs could be generates a supply for foreign currency. For directed to increase competitiveness in the global example, the Philippines exports electronic products market for local products and/or develop new to the U.S.; American importers will sell U.S. dollars industries that will produce import substitutes. in the foreign exchange market to obtain Philippine pesos and be able to pay Filipino exporters who DETAILS OF BALANCE OF PAYMENTS demand Philippine pesos as payment for their products. Economic transactions are grouped into two major categories: – In this case, Philippine export of goods and (1) current account, services will create a supply of foreign currency (2) capital and financial account (specifically U.S. dollars) and a demand for Current Account Philippine pesos. Importing goods and services to Goods and Services the U.S. by Filipinos causes the Philippine peso to be - Exports (electronic products) sold in the foreign exchange market to acquire the - imports (raw inputs to electronic products) - Services (travel, transportation, communication, insurance, computer and U.S. dollars. Information, business and professional services) – Just like Filipino exporters, American exporters Income - Overseas Filipino earnings (job contracts do not exceed one year) prefer to be paid in American dollars. Thus, - Investment income Philippine import of goods and services causes a - Interest payments to foreign creditors demand for foreign currency (U.S. dollars in our Current example) and 2 supply of Philippine pesos. - Remittance of OFWs (job contracts for one year or more as well as coming from migrants) - Gift, grants, and donations (consumption purposes, e.g., food, clothing, supplies, – The same reasoning is also applied to financial and materials). transactions of assets between nations. Capital and Financial Account Capital Account THE BALANCE OF PAYMENTS - Capital Transfers Grains and donations (investment purposes, e.g., machinery and equipment, buildings and structures) – The balance of payments (BOP) is a summary of the economic transactions of a country with the rest Financial Account of the world, for a specific time period. - Direct Investment - Portfolio holdings Stocks, bonds, and notes – It serves as an accounting statement on the Money market instruments economic dealings between residents and Other investments nonresidents of the country. - Financial Derivatives - Loans (trades and non-trade) – It is compiled quarterly but with a monthly - Holdings of currency and deposits - Other Investments breakdown. Net Unclassified – It is released to the public electronically via the Items Overall BOP Position Change in Reserve Assets (Gross International Reserves) Bangko Sentral ng Pilipinas (BSP) website or in - Foreign Issued Securities the form of hard copies about 12 weeks after the - Monetary Gold - Foreign Exchange (US Dollar, Japanese Yon, Euros, and other foreign currencies) reference quarter accompanied by a press release. Change in Reserve Liabilities – The BOP is one of the most important tools for - Use of Fund Credits (borrowings from the IMF) national and international policy formulation at - Short-term countries have increasingly become interdependent. …. 14  The overall BOP position is a summary measure of the performance of the country's external transactions. This can be estimated using two approaches: 1. Current Account Balance + Capital and Financial Account Balance; or 2. Change in Net International Reserves due to transactions (change in reserve assets and change in reserve liabilities). Ideally, these two approaches should yield the same result. However, in reality, they do not equate due to data imperfections (e.g., lag in reporting) in the current account and the capital and financial account. The discrepancy between the two approaches is termed as the "net unclassified items" or "errors and omissions" as shown in Table 13.4. Since the level of international reserves is based on a more rigid book accounting, the overall BOP position is determined by the second approach. 15