INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 1
COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and
fiscal policies are discussed including public and international economic issues. It introduces
basic models of macroeconomics and illustrates principles based on the experience of the
Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus
on the basic concepts about economics and the overview of macroeconomics. National income
and output will be discussed in Chapter 3 while monetary and fiscal policies will be discussed in
Chapter 4 and Chapter 5, respectively. The last three (3) chapters will focus on the theories of
growth and development; unemployment and inflation and international trade, exchange rate and
balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in

evaluating the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making
this world a better place for them, their families, and their communities.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 1

BASIC CONCEPTS

Learning Outcomes: At the end of this chapter students are expected to:

1. Define the fundamentals of economics

2. Explain demand and supply concepts
3. Apply the tools of economic analysis to a range of issues
1.1 Nature of Economics
⚫ A study of how individuals and society generally make choices that involve the use of
scarce resources from among the alternative wants that need to be satisfied.
⚫ Resources include inputs such as labor, capital, land, and the entrepreneur.
1. Land includes all of the natural resources, such as mineral deposits, water resources,
wild animals and trees from the forest. Payments for the use of land are called rents.
2. Labor refers to the physical and mental exertions of man to produce goods and
services. Wages is a general term used as payments for the use of labor.
3. Capital includes man –made resources used to produce other goods. These include
all types of structures used in the process of production such as buildings, equipment,
and machineries, land improvements such as the site of Mall of Asia and PICC and
rest of building along Roxas Boulevard. Interest is the payment for the use of capital.
4. Entrepreneurs are people who combine land, labor, and capital to produce goods and
services. They are the ones who assume the risks in the quest for profits.
Entrepreneurs are also the managers, the supervisors, or the innovators. They are
also the risk-bearers.

⚫ Choice entails sacrifices. The more government budget allotted for travels of government
officials abroad, the fewer socialized houses that will be constructed for the poor. In other
words, a choice involves a sacrifice of its alternative uses which is also known as trade-
offs or opportunity cost.

1.2. Economic Methodology

Like other social sciences and physical and life sciences, economics make use of other
scientific methods which consists of different step by step elements mentioned below:

There are specific steps that must be followed when using the scientific method.
Economics follows these steps in order to study data and build principles:

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1. Identify the problem - in the case of economics, this first step of the scientific method
involves determining the focus or intent of the work. What is the economist studying? What
is he trying to prove or show through his work?
2. Gather data - economics involves extensive amounts of data. For this reason, it is
important that economists can break down and study complex information. The second
step of the scientific method involves selecting the data that will be used in the study.
3. Hypothesis - the third step of the scientific method involves creating a model that will be
used to make sense of all of the data. A hypothesis is simply a prediction. What does the
economist think of what the overall outcome of the study will be?
4. Test the hypothesis - the fourth step of the scientific method involves testing the
hypothesis to determine if it is true. This is a critical stage within the scientific method. The
observations must be tested to make sure they are unbiased and reproducible. In
economics, extensive testing and observation is required because the outcome must be
obtained more than once in order for it to be valid. It is not unusual for testing to take some
time and for economists to make adjustments throughout the testing process.
5. Analyze the results - the final step of the scientific method is to analyze the results. First,
an economist will ask himself if the data agrees with the hypothesis. If the answer is "yes,"
then the hypothesis was accurate. If the answer is "no," then the economist must go back
to the original hypothesis and adjust the study accordingly. A negative result does not
mean that the study is over. It simply means that more work and analysis is required.

The continuous testing of hypothesis against facts would accumulate favorable results that
would evolve the hypothesis into a theory or an economic theory. A very well tested and widely
accepted theory is called an economic law or principle. Combinations of such laws or principles
would become an economic model which is defined as the simplified representation of how
something works or behaves.

Relationships between facts, theories, and policies in economics

Being a science, economics uses scientific methods in gathering data, analyzing data and
making conclusions. Descriptive economics involves compiling data or gathering of data relevant
to a particular problem. Data may come from primary or secondary sources. Primary data is what
one collects by himself using direct observation, surveys, and interviews. Secondary data is

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

collected from external sources such TV, radio, internet, magazine, newspapers, research articles
and stories told by people whom one knows.

The facts are then studied, arranged and generalized upon to come up with an economic
theory.
An economic theory is a generalization based on a variety of facts about why or how an economic
event occurs. Theory is a generalization because it explains how economic variables generally
behave when certain conditions exist. For example, an economic theory would be “if the price of
something goes up, people will buy less of it.”

Economic theories or principles are useful because they explain certain economic
behavior or conditions. These are helpful in solving economic problems or serve as guide in
economic planning and formulating economic programs. Theories or principles of economics are
represented by models in the form of verbal statements, graphs, numerical tables, or
mathematical equations.

An economic theory or principle which is put into action becomes an economic policy or
applied economics. Economics policies are typically implemented and administered by the
government. Examples of economics policies include decisions made about government
spending and taxation, about the redistribution of income from rich to poor, and about the supply
of money.

Normative versus Positive Economics

The effectiveness of economic policies can be assessed in one of two ways, known as
positive and normative economics.

Positive Economics

Positive economics is a branch of economics that focuses on the description and

explanation of phenomena, as well as their casual relationships. It focuses primarily on facts and
cause-and-effect behavioral relationships, including developing and testing economic theories.
As a science, positive economics focuses on analyzing economic behavior. It avoids economic
value judgments. For example, positive economic theory would describe how money supply
growth impacts inflation, but it does not provide any guidance on what policy should be followed.
"The unemployment rate in France is higher than that in the United States" is a positive economic
statement. It gives an overview of an economic situation without providing any guidance for
necessary actions to address the issue.

Normative Economics

Normative economics is a branch of economics that expresses value or normative

judgments about economic fairness. It focuses on what the outcome of the economy or goals of
public policy should be. Many normative judgments are conditional. They are given up if facts or
knowledge of facts change. In this instance, a change in values is seen as being purely scientific.
Welfare economist Amartya Sen explained that basic (normative) judgments rely on knowledge
of facts.

Example

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

• The price of rice should be increased to improve the well-being of farmers (normative)
• After a good harvest, the price of rice will fall. But after a bad harvest, the price of rice
will increase(positive)

1.3. Circular Flow of Economic Activity

The circular flow model shows the interaction among consumers and producers as they
exchange goods and services in the product market (upper loop) and the exchange of factors of
production in the resource market (lower loop).
Figure above show that there are two groups of people interacting in an industry, the
FIRMS and HOUSEHOLDS. The FIRM produces goods and services which are provided to
HOUSHOLDS as shown by the arrow in the diagram.

On the other hand, FIRMS cannot produce the output without the inputs (land, labor,
capital, and the entrepreneur) owned by the HOUSEHOLDS. These inputs will be combined to
produce the output hence; corresponding money comes out from the FIRMS in the form of rent,
wages, interest, and normal profit. The money that comes out from the FIRMS is called cost,
and this money when received by the HOUSEHOLDS is called income payment.

The interaction of the FIRMS and HOUSEHOLDS in the upper loop is done in the product
market where producer is the supplier and consumer the demander.

Looking at the lower loop, FIRMS and HOUSEHOLDS has a reverse function, the
producer becomes the demander of the factors of production and consumers become the supplier
in the factor market.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1.4. Demand and Supply Analysis

DEMAND

❖ Demand indicates how much of a good that consumers are willing and able to buy at
each possible price during a given time period, other things constant. Buyer wants a low
price rather than a high price, given all other things constant or equal.

Law of Demand
❖ Says that quantity demanded varies inversely with price, other things constant
❖ The higher the price, the smaller the quantity demanded
❖ The lower the price, the larger the quantity demanded

Demand which shows the inverse relations between price and the quantity can be
illustrated by a demand schedule and a demand curve.

Notice that the demand curve is downward sloping which reflects an inverse
relation between quantity demanded and price. At point a, the quantity demanded is 8
units and the price is at P15.00 and as price goes down to P12.00 at point b, quantity
demanded increases from 8 to 14 units.

Other Determinants of Demand

The demand curve reflects the relationship between price and quantity purchased of a
given commodity; but price of a product is not the only variable or factor that can influence the

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

consumer’s willingness to buy a certain product. Other non-price determinants of demand or the
other factors that may affect demand are as follows:

1. Income – direct relation for normal goods but if the product is an inferior good, then,
its relationship to demand is inversely related. Products for which demand is directly
related to income are called normal goods. As the income rises, the demand for
normal goods will also increase. On the other hand, there are products for which
demand rises as income or budget declines. We call these goods inferior goods.
Dried fish (tuyo) and sardines, eggs, and noodles are products whose demand
increases when income of buyers declines.
2. Tastes and preferences – direct relation. If one’s taste is in favor of the product, the
higher will be the demand.

3. Prices of related goods and services – for substitute goods like rice and bread, relation
is direct but inverse for complementary goods like bread and butter.

4. Buyer's expectations about future prices – direct relation to demand. If price is expected
to increase, people tend to panic buy, hence increases demand.

5. Number of Buyers – direct relation to demand. The more the number of buyers the
higher the demand, hence higher quantity demanded.

SUPPLY
❖ Supply refers to the relation between the price and quantity supplied as reflected by the
supply schedule or the supply curve
❖ Quantity supplied refers to a particular amount offered for sale at a particular price,
indicated by a particular point on a given supply curve

The law of supply demonstrates the quantities that will be sold at a certain price. But unlike
the law of demand, the supply relationship shows an upward slope. This means that the higher
the price, the higher the quantity supplied. Producers supply more at a higher price because
selling a higher quantity at higher price increases revenue.

Supply Schedule and Supply Curve:

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The illustration above shows that if the price is P 9.00, sellers would sell 20 units,
and if the price increases to P12.00, Qs increases to 24 units and so on.

Other Determinants of Supply

Aside from the price of the product there are non-price factors that determine or affect
the supply of a product.
1. Production costs - inverse relation to supply. Higher production cost discourages
sellers, hence, a decrease in supply.
2. The technology used in production - direct relation to supply. An improved technology
encourages the producer, hence, an increase in supply.
3. The price of related goods or price of competing products – inverse. For farmers, rice
and corn are competing products; if the price of palay increases farmers will plant rice
rather than corn, its competing product, to take advantage of the higher price of palay.
4. Changes in Producer Expectations- When a good can be easily stored, expecting
future prices to be higher may reduce current supply. More generally, any change
expected to affect future profitability could shift the supply curve.
5. Number of suppliers – Since market supply sums up the amounts supplied at each
price by all producers, the market supply depends on the number of producers in the
market
1. If that number increases, supply increases
2. If the number of producers decreases, supply decreases

1.5. Equilibrium in the Market

❖ When the quantity consumers are willing and able to pay equals the quantity producers
are willing and able to sell, the market reaches equilibrium

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The intersection of the demand curve D and supply curve S at point c indicates
that the equilibrium price is P9.0 and equilibrium quantity is 20 units.

A surplus is the excess of the quantity supplied over quantity demanded. Example,
at P12, the buyers would be willing to purchase 14 units, but producers would have
produced and offered 24 units. The difference brings a surplus of 10 units. The surplus
would push down prices as sellers would compete to enable them to sell their product,
and in so doing, reduce quantity supplied and increase quantity demanded until
equilibrium is achieved.

When the quantity demanded is higher than quantity supplied, there is a shortage
of the product. At price P6, buyers demand 26 units but producers are willing to sell only
16 units, hence a shortage of 10 units.

The shortage in the market is due to lower price and would drive prices up as
buyers would compete among themselves to get hold of the available product and in so
doing, may increase Qs and decrease Qd until equilibrium is achieved at P =9.0 and
quantity 20 units in which QS = Qd

1.6. Changes in Equilibrium

❖ Once a market reaches equilibrium, that price and quantity will prevail until one of the
determinants of demand or supply changes
❖ A change in any one of these determinants will usually change equilibrium price and
quantity in a predictable way

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Shifts of the Demand Curve

❖ Given an downward-sloping demand curve, an increase in demand leads to a rightward

shift of the demand curve, increasing both the equilibrium price and quantity
❖ Alternatively, a decrease in demand leads to a leftward shift of the demand curve,
reducing both the equilibrium price and quantity
Shifts of the Supply Curve

❖ An increase in supply: a rightward shift of the supply curve reduces equilibrium price but
increases equilibrium quantity
❖ A decrease in supply: a leftward shift of the supply curve increases equilibrium price but
decreases equilibrium quantity
❖ Given a downward-sloping demand curve, a rightward shift of the supply curve
decreases price, but increases quantity
❖ A leftward shift increases price, but decreases quantity

Simultaneous Shifts in Demand and Supply

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Effects of the Simultaneous Change Between Demand and Supply

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. Identification:

__________1. A good or service whose consumption declines as income rises (and conversely),
price remaining constant.
__________2. The principle that, other things equal, an increase in the product price will reduce
the quantity demanded, and conversely for a decrease in price.
__________3. The amount by which the quantity supplied of a product exceeds the quantity
demanded at a specific price.
__________4 A market in which products are sold by firms and bought by households.
__________5. A shift in the demand curve to the right or to the left because of the non-price
determinants of demand is called_______.
__________6. It occurs when the market price is above the equilibrium price.
__________7. It states the inverse relationship between price and quantity demanded.
__________8. Products and services that are used together; when the price of one fall, the
demand for the other increases.
_________9. The price in a competitive market at which the quantity demanded and the quantity
supplied are equal, there is neither a shortage nor a surplus, and there is no tendency for price to
rise or fall.
_________10. Refers to the relation between the price and quantity supplied as reflected by the
supply schedule or the supply curve

2. Discuss the relationships of facts, theories and policies in economics. Explain this by giving
an example.

3. Show graphically the effects of the following on the equilibrium price and quantity
b. Increase in demand and increase in supply
c. Decrease in demand and decrease in supply
d. Increase in demand and decrease in supply
e. Decrease in demand and increase in supply

4.Differentiate the product market from the resource market.

5. Discuss positive and normative statements. Give 5 examples for each.

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COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 2

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 2

OVERVIEW OF MACROECONOMICS

Learning Outcomes: At the end of this chapter students are expected to:

1. Identify the different macroeconomic fundamentals

2. Identify the basic economic goals that a country must set and attain to
address the economic problems
3. Enumerate and explain aggregate demand and aggregate supply
concepts.
2.1. Macroeconomics versus Microeconomics

Macroeconomics is the study of aggregate economic behavior. Economics, as a science,

follows the scientific method in order to study data, observe patterns, and predict results of stimuli.
The prefix macro means large, indicating that macroeconomics is concerned with the study of
the market system on a large scale. Macroeconomics considers the aggregate performance of
all markets in the market system and is concerned with the choices made by the large subsectors
of the economy—the household sector, which includes all consumers; the business sector, which
includes all firms; and the government sector, which includes all government agencies.

The prefix micro means small, indicating that microeconomics is concerned with the
study of the market system on a small scale. Microeconomics looks at the individual markets
that make up the market system and is concerned with the choices made by small economic units
such as individual consumers, individual firms, or individual government agencies.
2.2. Model Building

A model is defined as a theoretical construct that represents economic processes through

a set of variables and a set of quantitative relationships between the two variables. A model of
individual or aggregate economic behavior represents a simplification of real-world economic
complexities. For example, in analyzing the level of economic output, it is useful to divide the
economy into four sectors: household, business, government and foreign sector. Once the level
of spending of each sector is specified, the economist is able to predict the level of aggregate
output.
HOUSEHOLD
(Consumption)

BUSINESS
(Investment) Aggregate GDP
Spending
Government
(Government Spending)

Foreign Sector
(Exports-Imports)
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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The most formal and abstract of the economic models are the purely mathematical
models. These are systems of simultaneous equations with an equal or greater number of
economic variables. Some of these models can be quite large. Even the smallest will have five or
six equations and as many unknown variables. The manipulation and use of these models require
a good knowledge of algebra or calculus.

For example, a very simple microeconomics model would include a supply function
(explaining the behavior of producers, or those who supply commodities to the market), a demand
curve (explaining the behavior of purchasers) and an equilibrium equation, specifying the simple
conditions that must be met if the model’s equilibrium is to be satisfied.
The variables in a model like this represent a type of economic activity (such as demand)
or data (information) that either determines or is determined by that activity (such as price or
interest rate).

2.3. Endogenous and Exogenous Variables

Variables can usually be classified as endogenous or exogenous. An endogenous variable
is one that is determined within the model, or by the model's solution. Its value becomes known
when the model is solved. For example, if the final level of demand is determined by the model's
solution, demand is an endogenous variable. On the other hand, if the value of a variable comes
from outside the model, if its value is preset, it is an exogenous variable. In macroeconomics,
many policy variables, such as the income tax rate or money supply growth rate, are treated as
exogenous. For example, the money supply growth rate is regarded as exogenous because it is
set by policy-makers rather than determined by the dynamics of the model.

2.4. Economic Goals

Any economy, whether developed or developing and regardless of whatever economic

system it has adopted, must face and hurdle certain common economic goals. These are as
follows:
1. Economic growth- This refers to the increase in the total output of the economy. The
economic indicator normally used to measure the performance of the economy is the
Gross Domestic Product (GDP).
2. Full employment- This goal refers to the availability of jobs for the numerous Filipinos
belonging to the nation’s workforce (ages 15 years old & over). Two important economic
indicators to measure the attainment of said goal are the “unemployment” and the
“underemployment rate.”
3. Price stability-There must be no frequent and substantial movement in prices of goods
and services. More familiar to many consumers is the inflation rate used as an indicator
of upward trend in prices whereas deflation rate indicates downward price movement.
4. Economic freedom- This goal encompasses the degree of freedom that consumers,
business firms, the government, and the citizenry in general have attained in making
economic choices.
5. Equitable distribution of income- To ensure that no group of citizens faces poverty while
most others enjoy abundance and prosperity. Ideally, an economy should strive towards
the strengthening of the middle -income class and the reduction of the proliferation of the
other two extreme classes: the rich and the poor.

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6. Economic security- Feeling economically secure means not having to worry whenever one
faces the situations mentioned above. Provisions have been undertaken either by the
government or by the private sector in such regard.
7. Balance of trade- It is the difference between a country's imports and its exports. Exports
are goods and services produced domestically but sold to foreigners, while imports are
goods and services produced by foreigners but sold domestically. A country has a trade
deficit if its imports are more than its exports; the opposite scenario is a trade surplus.
2.5. The Millennium Development Goals
The Millennium Development Goals (MDGs) are associated with the United Nations
development agenda, where leaders from both developed and developing countries gathered
and agreed to achieve a set of concrete, measurable development objectives in year 2015. The
Philippines is among the many developing countries that are continuously exerting efforts to be
on track with the well- defined MDG targets. These are;
Goal 1. Eradicate extreme poverty and hunger-Halve between 1990 and 2015, the
proportion of people whose income is less than the poverty threshold
Goal 2. Achieve universal primary- Ensure that, by 2015, children everywhere, boys
and girls alike, will be able to complete a full course of primary schooling.
Goal 3. Promote gender equality and empower women- Eliminate gender disparity in
primary and secondary education, preferably by 2005, and in all levels of education no
later than 2015.
Goal 4. Reduce child mortality- Reduce by two-thirds, between 1990 and 2015, the
mortality rate
Goal 5. Improve maternal health- Reduce by three quarters, between 1990 and 2015,
the maternal mortality ratio.
Goal 6. Combat HIV/AIDS, malaria and other diseases-Have halted by 2015 and begun
to reverse the spread of HIV/AIDS.
Goal 7: Ensure environmental sustainability- Integrate the principle of sustainable
development into country policies and programs and reverse the loss of environmental
resources.
Goal 8: Develop a global partnership for development- Develop further an open, rule-
based, predictable, non-discriminatory trading and financial system.

2.6. Sustainable Development Goals (SDGs)

The Philippines, together with 192 other United Nations (UN) member states are
committed to achieve the 17 Sustainable Development Goals (SDGs).

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

2.7. AmBisyon Natin 2040

This represents the collective long-term vision and aspirations of the Filipino people for
themselves and for the country in the next 25 years. It describes the kind of life that people want
to live, and how the country will be by 2040.

The life of all Filipinos in 2040: Matatag, Maginhawa at Panatag na Buhay

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2.8. Aggregate Demand and Aggregate Supply

Aggregate Demand (AD) Curve

Demand and supply of all goods and services produced by an economy is the focus in
macroeconomics. Aggregate demand is the demand for all individual goods and services while
aggregate supply is the supply of all individual goods and services in an economy. Like the
demand and supply for individual goods and services, the aggregate demand and aggregate
supply for an economy can be represented by a schedule, a curve, or by an algebraic equation.

The aggregate demand curve represents the total quantity of all goods (and services)
demanded by the economy at different price levels. An example of an aggregate demand curve
is given in Figure 1.

General Price Level

AD

Real GDP

The price level of all final goods and services is represented by the vertical axis. The
general price level is measured by the CPI. The real quantity of all goods and services purchased
as measured by the level of real GDP or the level of output is represented by the horizontal axis.
Observe that the aggregate demand curve, AD, like the demand curve for individual goods, is
downward sloping, implying that there is an inverse relationship between the general price level
(prices of all goods) and the quantity demanded of real GDP or the level of output (Y).

Reasons for a downward-sloping aggregate demand curve.

Three reasons that explain the downward sloping aggregate demand curve;

1. Wealth Effect/Real Balance Effect. As the price level rises, the purchasing power or the real
value of money falls. As buyers’ real value of money declines, they reduce their purchases of all
goods and services. On the contrary, as the price level falls, the purchasing power of money rises.
Buyers become wealthier and are able to purchase more goods and services than before. The
wealth effect/real balance effect explains the inverse relationship between the price level and real
GDP or the level of output(Y).

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

2. Interest Rate Effect. Households and firms need more money to handle their transactions as
the price level rises. Holding the supply of money constant, an increase in the demand for money
causes the price of money, the interest rate, to rise. As the interest rate rises, investment
spending and consumption expenditures will decline. Higher interest rates make borrowing more
expensive; it discourages firms to borrow funds that may be used for new plants and equipment.
Higher interest rates might also dampen consumer spending especially expenditures on durable
goods such as cars and furniture, which are often bought thru credit. Therefore, the interest rate
effect provides another reason for the inverse relationship between the price level and the
demand for real GDP (Y).

3. Foreign Purchases Effect. Foreign-made goods become relatively cheaper so that the
demand for imports increases as the domestic price level rises. Conversely, the rise in the
domestic price level also means that locally-made goods are relatively more expensive to foreign
buyers so that the demand for exports decreases. When exports decrease and imports increase,
net exports (exports - imports) decrease. The demand for real GDP declines as net exports
decline since net exports are components of real GDP (Y) .

Changes in Aggregate Demand

Changes in aggregate demand are represented by shifts of the aggregate demand curve.
An illustration of the two ways in which the aggregate demand curve can shift is provided in Figure
__ . A rightward shift of the aggregate demand curve from AD1 to AD2 means that at the same
price level the demand for output (Real GDP) has increased and a leftward shift of the aggregate
demand curve, from AD1 to AD3, means that at the same price levels the demand for output has
decreased.

General Price Level

AD2
AD1
AD3

Real GDP
Shifts in Aggregate Demand (AD)

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Aggregate Demand is equivalent to Aggregate Expenditures, which is the sum of C, I, G

and Xn, therefore any change in these expenditures will shift the AD curve.

Changes in Consumption

1. Consumer spending - consumers decide to save less income and consume more,
AD shifts to the right.
2. Real Wealth - if consumers’ wealth increases, consumers spend more, AD shifts
to the right.
▪ People have lower wealth because pension plans and investments are
lower in value, AD shifts to the left.
3. Consumer expectations
▪ If consumers are optimistic about the future, they may spend more now,
increasing AD, shifting it to the right.
▪ If consumers are pessimistic about the future, they may reduce their
spending, AD shifts to the left.
▪ If a consumer is expecting layoffs, a tough job market, etc., he is more likely
to reduce spending and increase savings thus, AD shifts to the left
4. Household debt -
▪ If households have low debt, they can increase their spending by borrowing
more, causing aggregate demand to shift to the right.
▪ If households have high debt, they may lower their spending in order to pay
it back, causing AD to shift to the left.
5. Taxes
▪ Government increases taxes, disposable income falls, so households have
to consume and save less, AD shifts to the left.
▪ Government decreases taxes, disposable income increases, so
households can consume and save more, thus, AD shifts to the right.

Changes in Investment

1. Real interest rates

▪ Households - invest in more new houses, new cars, and appliances, when
real interest rates are low
▪ Not caused by a change in the price level
▪ Businesses - invest in more structures, machines, and equipment
▪ AD increases and shifts rightward

2. Expected Returns (or Profits) - businesses invest more if they expect future profits

o Businesses are optimistic about the future business climate

Economy is growing along with consumers' demands

o Businesses adopt new technologies

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Technology lowers production costs, increases workers' productivity, or increases

quality
o Businesses are using their capital at full capacity
Businesses invest in more capital in order to increase the capacity level
o Taxes - if government decreases taxes, then businesses may invest more

Government - government is a large sector of economy

o If government increases spending, then AD increases and shifts to the right.
o If government decreases spending, then AD decreases and shifts to the left.

International sector
o If net exports increase

▪ Either exports increase and/or imports decrease

▪ More products and services are produced here and exported, causing AD
to shift rightward
o Foreign income - if a foreign country becomes richer, they import more
▪ Our exports increase, causing AD to shift to the right
o Exchange rates
▪ If peso appreciates (or becomes stronger), then exports decrease,
imports increase then AD shifts leftward

Aggregate Supply (AS) Curve

The aggregate supply curve shows the quantity of real GDP or the level of output that is
supplied by the economy at different price levels. There are two types of aggregate supply curves,
the short-run aggregate supply curve and the long-run aggregate supply curve. In the long-run,
the aggregate supply curve is vertical, whereas in the short-run, the aggregate supply curve is
upward sloping.

Short-run Aggregate Supply Curve. The aggregate supply curve is upward sloping
because nominal wages are slow to adjust because of the changing economic conditions due to
long-term contracts between workers and firms that fix nominal wages. Suppose the price level
increased by 10% in a year and wage remains at P428.00. Because price level increased, the
firm gets 10% more than expected for the units of output that the firm sells. The cost of labor, in
contrast, is fixed at P428. During the short-run, sellers of final goods are receiving higher prices
for their products, without a proportional increase in the cost of their inputs. The higher the price
level, the more these sellers will be willing to supply. The SAS curve is upward sloping, reflecting
the positive relationship that exists between the price level and the quantity of goods supplied in
the short-run.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

General Price Level

AS

Real GDP

Long-run aggregate supply curve. The long-run aggregate supply (LAS) curve describes
the economy's supply schedule in the long-run. As prices of final good increase, workers would
be asking for additional wage, thus, the increase in prices that sellers receive for their final goods
is completely offset by the proportional increase in the prices that firms pay for inputs. The result
is that the supply of real GDP is not affected by the changes in the price level. The long run supply
curve is the natural level of real GDP or level of output that arises when the economy is fully
employing all of its available resources.

General Price Level

AS

Real GDP

Factors Affecting the Aggregate Supply Curve

1. Change in the input prices- For example, the price of oil, an input good, increased
dramatically in the 1970s due to efforts by oil-exporting countries to restrict the quantity of
oil sold. Many final goods and services use oil or oil products as inputs. Suppliers of these
final goods and services faced rising costs and had to reduce their supply at all price
levels.
2. Economic growth. Positive economic growth results from an increase in productive
resources, such as labor and capital. With more resources, it is possible to produce more
final goods and services, and hence, the natural level of real GDP increases. Positive
economic growth is therefore represented by a shift to the right of the LAS curve. Similarly,
negative economic growth decreases the natural level of real GDP, causing the LAS curve
to shift to the left.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

3. Technology. A technological advancement shifts the aggregate supply curve to the right

2.9. Combining AD and AS Supply Curves

Figure 4 shows the intersection of the aggregate demand curve and the short-run
aggregate supply curve that determines the equilibrium price level, denoted by P0, and the
equilibrium level of real GDP, denoted by Y0.

General Price Level

SAS
AD

P0

Y0 Real GDP (Y)

Figure 4. Equilibrium in the aggregate demand-aggregate supply model

Different situations result from changes in AD or AS:
Situation 1 – Aggregate Demand increases and shifts rightward
• If the economy was at full employment (FE) and aggregate demand increases due to
increase in investment by businesses and government increases spending or lowers
income taxes, then Gross Domestic Product increases and the price level increases
• Creates Demand Pull Inflation

Situation 2 – Aggregate demand decreases and shifts leftward

• Business investment decreases
• Government decreases spending (not typical)
• Government increases taxes on incomes
• Note - prices in an economy tend not to decrease
o If prices could fall (deflation), then economy is in a recession at Q1
o If prices do not fall, then economy is in a recession at Q2

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

▪ The recession is worse

General Price Level

AD0 SAS

AD1

P0

P1

Situation 3 - AS decreases and shifts leftward Real GDP (Y)

• War
• Natural disaster
• Energy price shock
o Example is OPEC
• Leads to lower output and a higher price level
o Cost Push inflation
o Stagflation

General Price Level

SAS1
AD0 SAS0

P1

P0

Real GDP (Y)

Situation 4 - AS increases and shifts right

o Producers adopt new technology
o Increased immigration, which lowers wages in the host country
o Output increases
▪ If prices could fall, then economy grows to Q1

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

▪ If prices are rigid, then economy grows larger to Q2

▪ Prices may not fall because of the reasons for Case 2

General Price Level

SAS0
SAS1

P0

P1

Real GDP (Y)

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. Multiple Choice. Identify the choice that best completes the statement or answers the
question.

____ 1. The aggregate supply curve shows the relationship between the aggregate price
level and
a. aggregate output supplied.
b. the aggregate money supply.
c. the aggregate unemployment rate.
d. aggregate employment.
e. average worker productivity.

____ 2. The short-run aggregate supply curve is positively sloped because:

a. business people suffer from money illusion.
b. wages are sticky or don't readily adjust to changes in economic conditions in the
short run.
c. workers care about nominal wages, not real wages.
d. of diminishing returns to labor.
e. productivity is positively related to wages.

____ 3. Which of the following will shift the short-run aggregate supply curve to the right?
a. An economy-wide decrease in commodity prices
b. An increase in nominal wages
c. A decrease in productivity
d. A decrease in government purchases of goods and services
e. A decrease in personal income taxes

____ 4. A decrease in energy prices will:

a. increase aggregate demand.
b. decrease the quantity of aggregate output supplied in the short run.
c. decrease aggregate demand.
d. increase the quantity of aggregate output demanded.
e. increase short-run aggregate supply.

____ 5. The long-run aggregate supply curve is:

a. upward sloping.
b. downward sloping.
c. horizontal.
d. initially upward sloping, but approaches horizontal as GDP increases.
e. vertical.

____ 6. According to the long-run aggregate supply curve, when _________, the quantity
of aggregate output supplied _________.
a. nominal wages rise; falls
b. the aggregate price level rises; does not change
c. the aggregate price level rises; falls
d. the price of commodities falls; rises
e. the unemployment rate rises; does not change

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

____ 7. The short-run aggregate supply curve is:

a. an inverted U-shaped curve.
b. vertical.
c. horizontal.
d. downward sloping.
e. upward sloping.

_____ 8. The relationship between the aggregate price level and the quantity of aggregate
output demanded by households, businesses, the government, and the rest of the world is
called:
a. market demand.
b. surplus demand.
c. aggregate demand.
d. simple demand.
e. factor demand.

_____ 9. In general, an increase in the aggregate price level, all other things unchanged,
causes:
a. an upward movement along the aggregate demand curve.
b. A downward demand curve
c. both a downward movement along the aggregate demand curve and a downward shift in
the curve.
d. no change in the purchasing power of assets.
e. an upward shift of the aggregate demand curve.

_____ 10. The _____ curve shows the negative relationship between the aggregate price level
and the quantity of aggregate output demanded in the economy.
a. aggregate demand
b. short-run aggregate supply
c. long-run aggregate supply
d. investment demand
e. Phillips curve

_____ 11. According to the wealth effect, when the price level decreases, the purchasing power
of assets:
a. decreases and consumer spending decreases.
b. increases and consumer spending decreases.
c. decreases and consumer spending increases.
d. remains constant and consumer spending is unchanged.
e. increases and consumer spending increases.

____ 12. The interest rate effect of an aggregate price level change causes:
a. the long-run aggregate supply curve to be vertical.
b. the aggregate demand curve to be negatively sloped.
c. the short-run aggregate supply curve to be positively sloped.
d. the aggregate demand curve to be positively sloped.
e. the short-run aggregate demand curve to be vertical.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

____ 13. An increase in government spending, all other things unchanged, will cause the
aggregate demand curve to:
a. become positively sloped.
b. remain constant.
c. shift to the right.
d. shift to the left.
e. become horizontal.

____ 14. Suppose that consumer assets and wealth decrease in real value. How will this
affect the aggregate demand curve?
a. Aggregate demand shifts to the left.
b. There will be a movement upward along the fixed aggregate demand curve.
c. There will be a movement downward along the fixed aggregate demand curve.
d. Aggregate demand shifts to the right.
e. The aggregate demand curve will become flatter and nearly horizontal.

____ 15. When the aggregate price level rises, this will, other things equal:
a. lead to a rightward shift in the AD curve.
b. lead to a leftward shift in the AD curve.
c. result in a decrease in the quantity of aggregate output demanded.
d. result in an increase in the quantity of aggregate output demanded.
e. result in a decrease in the quantity of aggregate output supplied.

____ 16. The wealth effect explains why:

a. the aggregate demand curve slopes downward since changes in aggregate price
levels change the purchasing power of peoples' assets.
b. the short-run aggregate supply curve slopes upward since an increase in wealth
leads to more consumption.
c. the short-run aggregate supply curve shifts since changes in wealth affect
production.
d. the aggregate demand curve slopes upward since wealth allows consumers to
purchase more regardless of the price level.
e. the long-run aggregate supply curve is vertical as there is no relationship between
aggregate price level and aggregate output in the long run.

____ 17. Which of the following will shift the AD curve to the right?
a. an increase in wealth
b. pessimism about the future of the economy
c. a decrease in government spending.
d. a decrease in productivity
e. an increase in commodity prices.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

2. Aggregate Demand and Aggregate Supply Theory

How will the aggregate demand in the Philippine economy be affected by the following events?
In each case, assume ceteris paribus (i.e. other factors held constant)

Economic Event Likely impact on aggregate

demand
(rise / fall )

1 The government decides to increase the basic

percentage rate of income tax from 18% to 20%

2 There is a sustained fall in the real value of Phil

property prices

3 The government announces a temporary two-year

reduction in the standard rate of value - added tax
(VAT) from 12% to 10%

4 There is a sustained increase in the value of the peso

against the US dollar on the foreign exchange market

5 A South Korean company announces that it will build

a factory in the Phil to supply both the Phil market
and the market for the rest of Europe

6 Phil households reduce their consumption of

imported goods as they pay back some of their debts

7 There is an increase in interest rates when the

exchange rate is rising

▪ Short run aggregate supply is a relationship between quantity of real GDP supplied and the
aggregate price level when we hold constant the level of wages and the prices of other
factors of production

A change in costs in the economy will cause a shift in the short run aggregate supply curve

How will the aggregate supply curve be affected by the following events?

In each case, assume ceteris paribus (i.e. other factors held constant)

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Impact on the economy’s

Economic Event aggregate supply curve (SRAS)
Choose one of the following
Outward shift / inward shift
1 The government announces a 10% rise in the
level of the minimum wage

2 There is a fall in the global price of oil from $100

a barrel to $80 a barrel

3 The six major energy suppliers in the Phil

announce a 15% rise in the retail price of gas
and electricity for Phil businesses
4 A fall in the cost of semi - conductor chips used
in the computer industry and other related
industries

5 The Phil agrees to a reduction in import tariffs for

imports coming from Brazil, India, and China

6 The value of the peso against the dollar falls by

15% over a period of 12 months

7 There is a significant rise in net inward migration

of skilled workers from Asian countries

3. Evaluate the performance of the Philippine economy vis-à-vis the Millennium Development
and Sustainable Development Goals.

4. Choose one Asian country that will be the focus of your analysis. Compare the
macroeconomic performance of the Philippines and the chosen country according to:
• inflation rate
• GDP growth rate
• unemployment rate

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

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 INSTRUCTIONALMATERIALFORECON30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 3

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and fiscal policies
are discussed including public and international economic issues. It introduces basic models of
macroeconomics and illustrates principles based on the experience of the Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus on the
basic concepts about economics and the overview of macroeconomics. National income and output will be
discussed in Chapter 3 while monetary and fiscal policies will be discussed in Chapter 4 and Chapter 5,
respectively. The last three (3) chapters will focus on the theories of growth and development;
unemployment and inflation and international trade, exchange rate and balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in evaluating
the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making this world
a better place for them, their families, and their communities.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 3
NATIONAL INCOME AND OUTPUT

Learning Outcomes: At the end of this chapter students are expected to:

1. Discuss the components to compute the National Income

2. Identify the different cycles in business and how it can be addressed through
government policies
3. Discuss the different components/ approaches in solving the national income
4. Explain the consumption and savings functions
5. Discuss the investment and the factors affecting it
6. Use the concept of multipliers to determine the economy’s output

1.1. National Income Accounting

In national income accounting, it is important to understand the transactions between the

different economic agents. This focuses on the measurement of indicators of aggregate output or
income.

GROSS DOMESTIC PRODUCT

GDP is defined as the market value of all final goods and services produced domestically in a single
year and the single most important measure of macroeconomic performance. The word domestic means
within the country, hence, productions within the Philippine jurisdiction are included in estimating GDP.

The market value (MV) is derived by taking the product of its per unit price and the quantities that were
produced.

MV = Pi  Qi

In order to calculate GDP, we simply take the sum of the market values of all final goods and services that
were produced during the period.

GDP only measures current production and does not include production in the other periods.

Transfer payments are excluded because no current production takes place in return for the payment.

Final Goods and Services versus Intermediate Goods and Services

• Final goods and services are goods and services that have been purchased for final use or goods
and services that will not be resold or used in production within the year.
• Intermediate goods and services, which are used in the production of final goods and services,
are not included in estimating GDP because expenditures on intermediate goods and services are
included in the market value of expenditures made on final goods and services. Including
expenditures on both intermediate and final goods and services would lead to double counting and
an exaggeration of the true market value of GDP.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

A related measure of the economy's total output product is gross national product (GNP), which
is the market value of all final goods and services produced by a nation in a single year.

GDP or GNI

• GDP includes only goods and services produced by a nation's own citizens and firms. Goods and
services produced outside a nation's boundaries by the nation's own citizens and firms are included
in GNP but are excluded from GDP.
• Goods and services produced within a nation's boundaries by foreign citizens and firms are
excluded from GNP but are included in GDP.

GNP = GDP + Net Factor Income from Abroad

Net Factor Income from Abroad or Net Primary Income measures the difference
between the earnings of the Philippine residents in other countries and foreign residents in the
Philippines. It represents the earnings from labor services and ownership of asset.

For example, Ms. Kris Aquino has business in Singapore and since she is residing in the Philippines,
any profits from her business in Singapore will be remitted in the Philippines. The remittances from
Singapore is not part of the GDP of the Philippines but Philippine’s GNP.

These remittances from the rest of the world to the Philippines are part of inflows while foreign
investors in the Philippines also remit their profits to their mother country, which becomes a part of the
Philippines’ outflows or payment. The difference between outflows and inflows is the NFIA.

Three Approaches in Estimating GDP

1. Expenditure Approach. The expenditure approach adds up the market value of all domestic
expenditures made on final goods and services in a single year. Final goods and services are
goods and services that have been purchased for final use or goods and services that will not be
resold or used in production within the year. Intermediate goods and services, which are used in
the production of final goods and services, are not included in the expenditure approach to GDP
because expenditures on intermediate goods and services are included in the market value of
expenditures made on final goods and services. Including expenditures on both intermediate and
final goods and services would lead to double counting and an exaggeration of the true market
value of GDP.

Total expenditure on final goods and services is broken down into four large expenditure
categories, according to the type of good or service purchased. The sum total of these four
expenditure categories equals GDP. These four expenditure categories are

a. Personal Consumption expenditures: This is spending by households on goods and services

which comprise the largest share of total expenditure. Goods include household spending on
durable goods appliances and automobiles, and nondurable goods, such as food and clothing.
Services include intangible items such as manicure, haircuts, and legal advice.
b. Government expenditures: Government expenditures on consumption and investment goods
and services are treated as a separate category in the expenditure approach to GDP. Examples
of government expenditures include the hiring of civil servants and military personnel and the
construction of roads and public buildings. Social security, welfare, and other transfer

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

payments are not included in government expenditures. Recipients of transfer payments do

not provide any current goods or services in exchange for these payments. Hence, government
expenditures on transfer payments do not involve the purchase of any new goods or services
and are therefore excluded from the GDP.
c. Net exports: Exports are goods and services produced domestically but sold to foreigners,
while imports are goods and services produced by foreigners but sold domestically. In the
expenditure approach to GDP, expenditures on exports are added to total expenditures, while
expenditures on imports are subtracted from total expenditures. Alternatively, one can calculate
net exports, which are defined as expenditures on exports minus expenditures on imports, and
add the value of net exports to the nation's total expenditures.

2. Income Approach. The income approach to measuring GDP adds up all the income earned by
households and firms in a single year. The rationale behind the income approach is that total
expenditures on final goods and services are eventually received by households and firms in the
form of wage, profit, rent, and interest income. Therefore, by adding together wage, profit, rent,
and interest income, one should obtain the same value of GDP as is obtained using the expenditure
approach.
3. Industrial-Origin/Value Added Approach. The difference between the sale price and the
production cost of a product is the value added per unit. Summing value added per unit over all
units sold is total value added.

GDP is broken down into Agriculture, Fishery and Forestry, Industry, and Service Sectors.
The Agriculture, Fishery and Forestry sector represents value added of three sub-sectors.
Agriculture captures value added from the production of agricultural crops such as rice, corn, etc.,
ornamental plants and livestock. Fishery includes commercial and municipal fishing, aquaculture
and the harvesting of marine products. Forestry represents activities such as logging and gathering
of forestry products.

The Industry sector represents value added of firms engaged in mining, quarrying,
manufacturing, construction and utilities.

The Services sector is made up of the following sub-sectors: transportation, communication

and storage, trade, finance, ownership of dwellings and real estate, private services, and
government services.

Nominal GDP, Real GDP, and Price Level

Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will include all
of the changes in market prices that have occurred during the current year due to inflation or deflation.
Inflation is defined as a rise in the overall price level, and deflation is defined as a fall in the overall price
level. In order to abstract from changes in the overall price level, another measure of GDP called real GDP
is often used. Real GDP is GDP evaluated at the market prices of some base year. For example, if the
year 2000 were chosen as the base year, then real GDP for 2005 is calculated by taking the quantities of
all goods and services purchased in 2005 and multiplying them by their 2000 prices.

Other Concepts in National Income Accounting

There are two types of expenditures, however, that are included in the expenditure approach to
GDP measurement but do not provide households or firms with any form of income: depreciation

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

expenditures and indirect business taxes. Depreciation expenditures, made to replace existing but
deteriorated investment goods, do increase the incomes of those providing the replacement goods, but
they also decrease the profit incomes of those purchasing the replacement goods. The result is that
aggregate income remains unchanged. Indirect business taxes consist of sales taxes and other excise
taxes that firms collect but are not regarded as a part of firms' incomes. Consequently, indirect business
taxes are not included in the income approach to GDP measurement but are included in the expenditure
approach.

In order to finetune value for a more accurate accounting of the economy’s final product,
depreciation expenditures are deducted from GNP.

(1) Net National Product (NNP)=GNP-Depreciation

(2) National Income (NI) =Net National Product-Indirect Business Taxes (IBT)
National income is the income earned by the different sectors in the economy-households,
business, and government sector-after deducting indirect business taxes.
(3) Personal Disposable Income (PI)=NI-(UCP+CT+GI) +TP
Where: NI=national income, UCP=undistributed corporate profits, CT=corporate tax, TP=transfer
payments
Personal disposable income is the individual’s income that is available for consumption and
savings.
(4) PI=Personal Consumption (C) + Personal Savings (S)

Growth rate of GDP. What is interesting is the annual growth rate, or year-to-year percentage change,
in the value of GDP. To calculate the percentage change in a statistic, such as GDP, one needs to know
the value of the statistic at two dates in time. Suppose that the value of GDP last year was GDPL and the
value of GDP in the current year is GDPC. Then, the percentage change, or growth rate, of GDP is given
 GDPC − GDPL 
by   x100%
 GDPL 

A positive growth rate of GDP implies that the economy is expanding, while a negative growth rate of GDP
implies that the economy is contracting. An expanding economy is said to be in a boom/peak, while a
contracting economy is said to be in a recession/contraction.

3.2. Business Cycle Pattern

The four parts of a business cycle are contraction/recession, expansion, peak/boom, and trough.
The red line, which presents a hypothetical tracking of real GDP, is used to illustrate the alternative parts
of a business cycle. Long-run trend is the straight, blue line. The long-run trend represents the production
capacity of the economy and full employment.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1. Contraction- A period of decline in which economic activity decreases for at least six months
is termed a contraction. Contractions, are also termed recessions. During the recession
economic output declines, therefore unemployment is rising and inflation is declining.
2. Trough- The end of a contraction and transition to an expansion is designated a trough.
During the trough economic output is at its lowest, therefore, unemployment is at its highest
and inflation at its lowest.
3. Expansion- A period of growth in which economic activity tends to increase from month to
month and year to year is termed an expansion. The early part of an expansion is often
termed a recovery. During recovery economic output increases, therefore, unemployment
is declining and inflation is rising.
4. Peak- The end of an expansion and the transition to a contraction is designated a peak.
During the peak of the business cycle economic activity (output) is at its highest, therefore
unemployment is very low, but inflation is high.

The primary causes of the changes in output reflected in the business cycle are changes in spending. This
could be changes in consumer spending (C), government spending (G), business spending on new capital
(I), or purchases by foreigners (Xn).

3.3. Stabilization Policies

Government policies designed to reduce unemployment and/or inflation.

There are two major types of stabilization policies:

1. demand-management policies
2. supply-side policies

Demand-Management Policies

Policies designed to shift the AD curve in order to reduce unemployment or to reduce

inflation. Some of the determinants of aggregate demand can be manipulated by the government
to achieve these goals.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

There are two types of demand-management policies depending upon who conducts the policy:

1. fiscal policy is undertaken by the President and Congress, and

2. monetary policy is undertaken by the Bangko Sentral ng Pilipinas (monetary authority)

FISCAL POLICY

There are two types of fiscal policy:

1. expansionary fiscal policy

2. contractionary fiscal policy

Fiscal Policy and the Crowding-Out Effect

Crowding out occurs when an increase in government spending results in less spending by the
private sector. This occurs when the government borrows more when interest rates are low to finance its
expenditures, thus pushing interests upward. Business firms that wanted to borrow at the lower interest
rates, no longer borrow when the interest rates went up, thus business spending falls.

Expansionary Fiscal Policy

Problem: Recession/Unemployment

Expansionary Fiscal Policy

Increase in domestic interest rate Investments Decline

Increase Demand for Domestic

Currency

Domestic Currency Appreciates

Net Exports Decline

Aggregate Expenditures Decreases

partially offsetting the expansionary
fiscal policy

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The goal of expansionary fiscal policy is to reduce unemployment; therefore, the tools would be an increase
in government spending and/or a decrease in taxes. This would shift the AD curve to the right increasing
real GDP and decreasing unemployment, but it may also cause some inflation.

Contractionary Fiscal Policy

Problem: Inflation

Contractionary Fiscal Policy

Decrease in domestic interest rate Investments

increase
Decrease Demand for Domestic
Currency

Domestic Currency Depreciates

Net Exports Increase

Aggregate Expenditures Increase

partially offsetting the contractionary
fiscal policy

The goal of contractionary fiscal policy is to reduce inflation; therefore, the tools would be a decrease in
government spending and/or an increase in taxes. This would shift the AD curve to the left decreasing
inflation, but it may also cause some unemployment.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Monetary Policy for Recession and Inflation

A. Easy Monetary Policy

Problem: Recession

Central Bank buys bond, lowers reserve

requirement or lowers discount rate

Excess Reserves Increase

Money supply increases

Interest rate declines

Investment spending increases

Aggregate Demand Increases

Real GDP rises

The goal of an easy monetary policy is to reduce unemployment during a recessionary period.
Therefore, the tool would be an increase in the money supply. To increase money supply, the Central Bank
will take some combination of the following actions; buy government securities from banks and the public,
lower the reserve requirement and lower the discount rate. The outcome would be an increase in excess
reserves and thus, an increase in money supply. An increase in money supply will lower interest rate,
increasing investment, aggregate demand and real GDP. This would shift the AD curve to the right
decreasing unemployment, but it may also cause some inflation.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

B. Tight Monetary Policy

Problem: Inflation

Central Bank sells bond, increase reserve

requirement or increase discount rate

Excess Reserves decrease

Money supply Decreases

Interest rate rise

Investment spending decreases

Aggregate Demand decreases

Real GDP falls

The goal of a tight monetary policy is to reduce inflation. Therefore, the tool would be a decrease
in the money supply. Central Bank will sell government securities to the banks and the public, increase the
reserve requirement or increase the discount rate in order to decrease the supply of money. Banks will
then realize that their reserves are below than those required by the Central Bank. The Central Bank needs
to reduce their checkable deposits by refraining from issuing new loans, thus, lowering the supply of money.
The decrease in money supply will result to an increase in interest rate. The higher the interest rate will
discourage investment, lowering aggregate demand and restraining inflation. This would shift the AD curve
to the left decreasing inflation, but it may also cause some unemployment.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Monetary Policy and the Net Export Effect

A. Easy Monetary Policy

Problem: Recession

Easy Monetary Policy

Decrease Demand for

Domestic Currency/Increase
demand for Foreign Currency

Domestic Currency
Depreciates/Foreign Currency
Appreciates

Net Exports
Increase/Aggregate Demand

The adoption of an easy monetary policy during recession has an effect on the level of exports and
imports in an economy. When the Central Bank uses an easy monetary policy, the demand for domestic
currency will decrease because of the decline in the level of interest rate. The decrease in interest rate will
discourage foreign investors to invest in the country, thus, resulting to a decrease in the demand for
domestic currency but an increase in the demand for foreign currency because domestic investors will
bring their investments to other countries that offer a higher interest rate. The decline in the demand for
domestic currency leads to the depreciation of the domestic currency which makes the domestic products
attractive to other countries, therefore, the level of exports and aggregate demand will increase.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

B. Tight Monetary Policy

Problem: Inflation

Tight Monetary Policy

Increase Demand for

Domestic Currency/Decrease
demand for Foreign Currency
(Dollar)
Domestic Currency
Appreciates/Foreign Currency
Depreciates

Net Exports
Decrease/Aggregated Demand
Decreases

A tight monetary policy results to an increase in the interest rate which encourages capital inflows.
Investors see that investing in a country that offers a higher interest rate is profitable. This results to an
increase in the demand for domestic currency which in turn leads to the appreciation of the domestic
currency. The effect of the appreciation of the domestic currency is an increase in the level of
imports/decrease in exports.

"Supply-Side Economics"

Supply-Side economic policy occurs when the government tries to increase aggregate supply. This
will reduce both unemployment and inflation. Examples of these policies are removing regulation,
promoting competition among firms, providing incentives for firms, maintaining an efficient legal system
and encouraging technological progress.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

3.4. Aggregate Expenditure (AE) and National Income

For analytical purposes, aggregate expenditure (AE) is the sum of Consumption (C), Investment
(I), Government Expenditures (G) and Net Exports (Xn). AE represents planned spending while GDP
represents actual output. Such distinction also applies to the different expenditure components. For
instance, consumption spending in the national accounts indicates that households spend in a given period.
In contrast, consumption spending as a component of AE represents how much households want or plan
to spend. We would not be surprised to find a discrepancy between national income (Y) or the actual output
and AE. One reason for this is that firms formulate their production plans with an estimate of the quantities
that people want to buy. A mistake on their part will cause production to exceed or fall below the amounts
that people want to buy. In addition, unanticipated changes in the economic climate can induce economic
agents to alter their spending plans. Hence, if firms initially made correct production estimates, such
revisions may cause actual output to differ from AE. Discrepancies between AE and actual output are likely
to cause unintended changes in the inventory stocks of firms. When people want to buy less than what has
been produced, or AE is less than Y, firms will accumulate inventories. On the other hand, the stock of firm
inventories may decline if actual production is less than the quantities that people want to buy. In this case
firms may be forced to draw down on their existing stock of inventories in order to meet the unforeseen
demand for their products. Discrepancies between AE and Y serve as a signal for firms to adjust production.
If AE is greater than Y, firms will raise production in order to prevent their stock of inventories from falling
below the desired level. If AE is equal to Y, unintended changes in inventories are equal to zero. The stock
of inventories is equal to the desired level of output of firms; there is no reason to adjust production. The
absence of pressure to adjust production suggests that the economy is in equilibrium.

The Two-Sector Economy

This model assumes an economy with only two sectors: household and business. Therefore,
National Income (Y) is assumed to be equal to Disposable Income (Yd). Net Exports (Xn) will be zero.

Consumption, Saving, and Income

According to the Keynesian model, consumption is positively related to the level of disposable
income. Consumer spending rises with the level of income- but is normally assumed to rise less quickly
than disposable income.

Disposable Income
Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)
Income after taxes or net income
DI = Gross Income – Taxes

With disposable income, households can either

 Consume (spend money on goods & services)
• Save (not spend money on goods & services)

Consumption
The ability to consume is constrained by the amount of disposable income and the propensity to
save.
The consumption function is as follows:

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

C = Co + b Yd where,
C= Consumer expenditure
Co = autonomous consumption. This is the level of consumption that would take place even if
income was zero. If an individual's income fell to zero some of his existing spending could be sustained by
using savings. This is known as dissaving.
b = marginal propensity to consume (mpc). This is the change in consumption divided by the change
in income. Simply, it is the percentage of each additional peso earned that will be spent. There is a positive
relationship between disposable income (Yd) and consumer spending (C). The slope of the consumption
curve gives the marginal propensity to consume. As income rises, total consumer demand rises also. A
change in the marginal propensity to consume causes a pivotal change in the consumption function. In this
case the marginal propensity to consume has fallen leading to a fall in consumption at each level of income.
A change in autonomous consumption can also shift the consumption function upwards or
downwards. This is shown below.

A Shift in the Consumption Function

Consumption
45-degree line

C2

C1

C3

Disposable Income

The diagram shows that the MPC has not changed but Co has changed. A change in factors other
than disposable income can cause the consumption curve to shift, that is, a change in the intercept of the
C function (Co). A rise in household wealth or a rise in consumer's expectations might lead to an increased
level of consumer demand at each income level (an upward shift in the consumption curve from C1 to C2).

Average propensity to consume (APC) = Total consumption divided by total income

Savings

Income that consumers earn but do not spend on consumption; part of income that is saved in some
form.
Yd = C + S

If the consumption function is C = Co + bYd

Then the savings function is given by: S = -Co + (1-b) Yd

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Income=spending
Consumer
Spending
C=Co+ (1-b)Yd
& Saving
Yd = C
(C, S) Yd > C

Co C > Yd S = -Co + (1-b) Yd

45° S=0 S>0

S<0 Disposable
income (Yd)
-C0

Average propensity to Save (APS) = Total savings divided by total income (also known as the Saving Ratio)

Formula for APC & APS

APC + APS = 1
1 – APC = APS
1 – APS = APC
APC > 1
APS < 0 or -APS: Dissaving

Formula for MPC & MPS

Marginal Propensity to Consume

o ΔC/ΔYd
o % of every extra peso earned that is spent
Marginal Propensity to Save
o ΔS/ΔYd
o % of every extra peso earned that is saved

MPC + MPS = 1
1 – MPC = MPS
1 – MPS = MPC
0 ≤ MPC ≤ 1
MPS

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Example 1. Consumption, Saving and Income

Level MPS= MPC= APC= APS=

Change in Change in Change in
of
Consumption Saving income ( saving consumption S C C S
Disposable
(C) (S)
Income Y ) ( S ) ( C ) Y Y
(Y) Y Y

0 200 -200 - - - - - - -
200 350 -150 200 50 150 0.25 0.75 1.75 -0.75
400 500 -100 200 50 150 0.25 0.75 1.25 -0.25
600 650 -50 200 50 150 0.25 0.75 1.08 -0.08
800 800 0 200 50 150 0.25 0.75 1.00 0.00
1000 950 50 200 50 150 0.25 0.75 0.95 0.05
1200 1100 100 200 50 150 0.25 0.75 0.92 0.08
1400 1250 150 200 50 150 0.25 0.75 0.89 0.11
1600 1400 200 200 50 150 0.25 0.75 0.88 0.12
Note that the MPS and MPC do not change as the level of income increases while the APC and
APS change as the level of income increases. The APC falls while the APS rise as the level of income
rises.

Investment Spending

It consists of spending on new buildings, machinery, plant and equipment. Investment spending is
a part of total spending or aggregate expenditures. Any increase in investment would necessarily increase
total spending or aggregate expenditures.

3 Types of Investment Spending

• Business fixed investment includes the equipment and structures that businesses buy to use in
production.
• Higher interest rates increase the cost of capital and reduce business

fixed investment.
• Improvements in technology and in tax policies such as the corporate income tax and
investment tax credit will shift the business fixed investment function.
• Residential investment includes new housing that people buy to live in and that landlords buy to
rent out.

1) An increase in the interest rate increases the cost of borrowing for home

buyers and reduces residential housing investment.

2) An increase in population increases the demand for residential housing investment.

3) During a boom in the business cycle, higher income raises the demand for housing and
increases residential investment.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

• Inventory investment includes those goods that businesses put aside in storage, including
materials and supplies, work in progress, and finished goods that have not been sold for the current
year.

Aggregate Expenditure (AE) and Equilibrium in the Two-Sector Economy

Since the economy is composed of households and firms only aggregate expenditure (AE) is equal
to the sum of consumption (C) and investment (I). That is

AE = C + I or Y = C + I

Saving and Investment

Formula for Saving:

S = Y – C. S stands for saving, Y for disposable and national income as well and C for
consumption.
Formula for Investment:

I = Y – C, where I stands for investment, Y for income and C for consumption.

Equation for Saving and Investment:

S = Y - C ...................(i)

I = Y - C ....................(ii)

Taking, Y - C which is common from both equations (i) and (ii). So we have:

S=I

Saving = Investment

"Saving is equal to investment at the equilibrium level of income".

Y = C + I .................. (i)

Income (Y) is also equal to consumption plus saving.

Y = C + S ................ (ii)

From equations (i) and (ii), we have:

C+I=C+S

C will cancel from both sides of the equation, so:

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

I=S

Investment = Saving

The basic idea of explaining equality between saving and investment is that it is brought about
by changes in income. When people save more than what the investors think it worthwhile to invest, the
demand for consumer and producer goods falls down. When the goods produced are not profitably sold,
the entrepreneurs curtail production of goods and the national income falls. If investment is more than
saving, the national income rises. The process of changes is income, saving and investment continues till
saving and investment are in equilibrium. The saving and investment equality is explained with the help of
the schedule shown below:

Example 2. Consumption, Investment and the Equilibrium Level of Income

Change in AE=Y Income

Level of Consumption Saving Investment consumption( Movements
Or
Income(Y) (C) (S) (I)
C ) C+I = Y
0 200 -200 100 - 300
200 350 -150 100 150 450
400 500 -100 100 150 600
Expansion
600 650 -50 100 150 750
800 800 0 100 150 900
1000 950 50 100 150 1050
1200 1100 100 100 150 1200 Equilibrium
1400 1250 150 100 150 1350
1600 1400 200 100 150 1500 Contraction
1800 1550 250 100 150 1650

As seen from the table, the level of investment has not changed with the level of income unlike
consumption and saving. Investment, then, is autonomous (I0) of the level of income.

In the schedule, it is shown that as long as investment is higher than saving, the income level
continues to rise. When income is P1200, saving and investment are equal to P100 each. After this
equilibrium point, saving exceeds investment, income contracts until equilibrium is reached at an income
level of P1200.

Algebraic Computation of the Equilibrium level of income

C = C O + bYd , I = I O , Y = Yd

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Y =C+I
Y = C O + bYd + I O
Y − bYd = C O + I O
Y (1 − b) = C O + I O
CO + I O
Y=
1− b
Example 3. Let consumption function equals C=200+0.75Yd, and investment I=100.

200 + 100
Y=
1 − 0.75
Y = 1200

The Effects of a Change in Investment and the Multiplier (m)

A change in investment leads to a change in aggregate expenditure; this results to a change in the
equilibrium level of income. Let us say that investment (I) increases to 150:

Example 3. C, Change in I and the Equilibrium Level of Income

Investment
Level of Consumption Saving Investment
AE=Y I2 = I1 + ∆I AE=Y
Income(Y) (C) (S) (I1)
(I)
0 200 -200 100 300 150 350
200 350 -150 100 450 150 500
400 500 -100 100 600 150 650
600 650 -50 100 750 150 800
800 800 0 100 900 150 950
1000 950 50 100 1050 150 1100
1200 1100 100 100 1200 150 1250
1400 1250 150 100 1350 150 1400
1600 1400 200 100 1500 150 1550
1800 1550 250 100 1650 150 1700

Why is the increase in the equilibrium level of income greater than the increase in investment? To address
this question, it is important to discuss the concept of the multiplier.

The multiplier measures the change in the level of income as a result of a one-peso change in the
sum of autonomous components of aggregate expenditure. In the present analysis, the change in the level
Y
of income ( Y ) is due to a change in investment spending (∆I) m = =200/50=4. This implies that the
I
multiplier is 4. This means that a one-peso increase in investment leads to a four-peso increase in the
equilibrium level of income.

Algebraic Computation of the Multiplier

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Y =C+I
Y = C O + bYd + I O
CO + I O
Y=
1− b
I
Y =
1− b
Y 1
= or m = _ 1__
I 1 − b 1-b

Example 4. Let consumption function equals C=200+0.75Yd, and investment increased from I=100 to
I=150.

Y 1
=
50 1 − 0.75 or

Y
=4
50
Y = 200
∆Y = m · ∆I

= 4 · 50

=2

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

When an autonomous component of aggregate demand changes, equilibrium output (Y) will change. The
change in output will be even larger than the initial change in aggregate demand. For example, if the
marginal propensity to consume (MPC) is 0.75 and autonomous investment increases by P50, equilibrium
output will ultimately change by P200, not 50. The simple output multiplier assumes that there are no
proportional taxes; all expenditures are for domestically produced goods and services, and the price level
is fixed.

TABLE 1
Initial Change Change in Change in
Round in Investment Output Consumption
1 P100 P100.00 P75.00
2 0 P75.00 P56.25
3 0 P56.25 P42.19
4 0 P42.19 P31.64
5 0 P31.64 P23.73
6 0 P23.73 P17.80
7 0 P17.80 P13.35
8 0 P13.35 P10.01
9 0 P10.01 P7.51
10 to inf. 0 P30.03 P22.52
Total P100 P400 P300.00
Let us work through an example of the multiplier process using Table 1. Suppose the MPC is 0.75. PUP
decides to build a new building worth P100 million. Construction workers earn P100 million in income, and
they spend 75 percent--or P75 million--dining out, going to the movies, shopping, and buying new
appliances. The increased spending of P75 million becomes income to the owners and employees of the
restaurants, movie theatres, shopping malls, and appliance dealers. In turn, these people spend 75 percent
of the new P75 million, or P56.25 million, on other goods and services. The P56.25 million becomes income
to others in the community, and the process continues. Table 1 shows the impact of the multiplier through
various rounds. When all the effects are summed up, output will increase by P400 million because the
value of the output multiplier is equal to 1/(1-0.75) = 4. Remember that the initial increase in aggregate
demand for the new building was just P100 million. I0 unit,

_∆Y_ = __1__
∆I 1-b

∆Y_ = ___1___
100 1 – 0.75

∆Y = 400

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Equilibrium in the Three-Sector Economy

In the presence of the government, consumption and saving are affected because of the income
taxes which were imposed by the government sector. Households have no control over income taxes, thus,
the disposable income of households (Yd) becomes income (Y) less income taxes (Tx). In the three-sector
economy, income is allocated to consumption (C), saving (S) and income taxes (Tx).
In reality, income taxes tend to increase with the level of income. In other words, households that received
higher income pay more taxes. In such a case, income taxes also affect the extent to which changes in
income affect consumption. An increase in income has a smaller effect on consumption if a portion of the
increase in income goes to taxes. Let’s say, that a 20% tax is imposed on their income. A 100-peso increase
in income leads to a 20-peso increase in income taxes. This implies an 80-peso increase in disposable
income. Multiplied by the marginal propensity to consume (MPC) of 50%, this suggests an increase in
consumption of 40 pesos.
Aggregate expenditure (AE) is equal to the sum of consumption, investment, and government
expenditures, (Y=C+I+G). It also suggests that, other variables held constant, an increase in government
expenditures lead to an increase in aggregate expenditures.
Graphical Illustration of the three-sector equilibrium

C, I, G S, I, G

C+I+G S

C+ I
C1 +I0 G0
S1 I+G
C0 +I0
S0 I

0
Y0 Y1 Income

Y0 Y1 Income
(a) (b)

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The addition of government spending, ceteris paribus, increases the equilibrium level of income in the
figure above from Y0 to Y1. The saving investment approach in figure b shows that the deficit caused by
government spending must be financed by an increase in private saving of S1-S0.

C, I, G

C+I+G S, Tx, I, G
C+I+G-Tx
S+Tx
C1 +I0 +G0
C2+ I0+ (G0-Tx0) S
I0 +G0 I+G

0
Y2 Y1 Income

Y2 Y1 Income
(a) (b)

An increase in taxes, ceteris paribus, lowers the level of income. In figure a, the introduction of taxes,
lowers aggregate spending since the government is receiving revenue that it is not spending. In figure b,
taxes that are not spent are a part of government saving and can be added to private saving.

Example 5. Income and Aggregate Expenditure

Let’s say income taxes (Tx) = 100 regardless of the level of income. In other words, we have an
economy with lump-sum taxes. Since equilibrium requires the equality between income and aggregate
expenditure, the table below suggests that the equilibrium level of income is equal to 1,300 pesos.
Level of Tax YD Consumption Investment Government Saving S+Tx I+G Income
Income(Y) (Tx) (C) (I) (G) AE=C+I+G (S) Movements
100 100 0 200 100 100 400 -200 -100 200
200 100 100 275 100 100 475 -175 -75 200
400 100 300 425 100 100 625 -125 -25 200
600 100 500 575 100 100 775 -75 25 200 Expansion
800 100 700 725 100 100 925 -25 75 200
1000 100 900 875 100 100 1075 25 125 200
1200 100 1100 1025 100 100 1225 75 175 200
1300 100 1200 1100 100 100 1300 100 200 200 Equilibrium
1400 100 1300 1175 100 100 1375 125 225 200
1600 100 1500 1325 100 100 1525 175 275 200
1800 100 1700 1475 100 100 1675 225 325 200 Contraction
2000 100 1900 1625 100 100 1825 275 375 200
2200 100 2100 1775 100 100 1975 325 425 200

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If income (Y) or the level of output is less than aggregate expenditures, firms are experiencing unexpected
reductions in their inventory of stocks. Therefore, the firms will expand production to reach equilibrium level.
However, if income (Y) or the level of output is greater than aggregate expenditures inventory of goods will
pile up so firms will cut their production.
The table shows that at the equilibrium level of income, the sum of investment and government
expenditures are equal to the sum of saving and income taxes. Investment and government expenditures
are considered as inflows in the income stream while saving and income taxes are considered as outflows
or leakages. For a given level of income, higher saving or income taxes reduce aggregate expenditures.
Hence, an increase in S+Tx tends to pull down the equilibrium level of income. On the other hand, higher
I+G tends to raise aggregate expenditures.

Algebraic Computation of Equilibrium Level of Income in the Three-Sector Economy

C = CO + bYd , I = I O , Yd = Y − Tx , G = GO

Y =C + I +G
Y = CO + b(Y − Tx) + I O + GO
CO − bTx O + I O + GO
Y=
1− b
Example 5. Let consumption function equals C=200+0.75Yd, investment I=100, government expenditure
G=100, tax (Tx)=100.

200 − 0.75(100) + 100 + 100

Y=
1 − 0.75
Y = 1300
Example 6. What happens to the equilibrium level of income if government expenditures increased by 25?

The equilibrium level of income will increase by 100, i.e. from 1300 to 1400.

Algebraic Computation of the Multiplier for Government Expenditures

Y =C + I +G
Y = C O + b(Y − Tx) + I O + G0
C O − bTx + I O + GO
Y=
1− b
G
Y =
1− b
Y 1
=
G 1 − b

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Algebraic Computation of the Tax Multiplier

Y =C + I +G
Y = C O + b(Y − Tx) + I O + G0
C O − bTx + I O + GO
Y=
1− b
− bTx
Y =
1− b
Y −b
=
Tx 1 − b
When the government imposes taxes, the multiplier works in reverse because now money is leaving the
circular flow. If there is a tax-CUT, then the multiplier is positive, because there is now more money in the
circular flow.

Balanced Budget Multiplier

An equal increase in government taxes and spending raises the equilibrium level of income
while a decrease lowers it. The effect of equal changes in government spending and taxes
is called the balanced budget multiplier.
G − bTx
Y =
1− b
Assuming a balanced budget where G = Tx
G − bG
Y =
1− b
G (1 − b)
Y =
1− b
Y = G
Y
=1, the multiplier for equal changes in G and Tx
G
The balanced budget multiplier always = 1

The Four-Sector Economy

Trade is an important aspect of a nation’s economy. Trading occurs between and among countries
because not one sovereign state in the world can supply all of its needs for products and services. With
regards to raw materials, labor force and other resources needed for production, every nation is inadequate
in at least one. Because of this condition, nations around the world continue to trade and exchange goods
and services among themselves. Let us now look at an open economy that incorporates exports (X) and
imports (M). For this part, our concern would be on the net exports. Net exports are measured by
subtracting the expenditures on imports from the expenditures on exports. Exports are goods and services
produced domestically but sold to the foreign market. Imports, on the other hand, are goods and services
produced by foreigners but sold domestically. When exports exceed imports there is a balance of trade
surplus. In contrast, when a nation’s imports exceed exports, the country is said to have a balance of trade
deficit.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Trade surplus and trade deficit play an important part in the economic growth of a nation. A balance
of trade surplus contributes to a nation’s productivity. As demand for a country’s exported goods increases
in the world market, firms would need to cope with the demand by increasing their production. Increased
production can also lead to a higher employment rate as demand for labor increases. In addition, as exports
grow, national income also increases because money from foreign buyers would enter the country’s
economy which could be used for further growth and development.

A balance of trade deficit represents loss for a nation because this indicates that more money has
left the country than has entered to it through trade. Too much dependence on imported goods can have
negative effects on the economy. When imports exceed exports, it means that the aggregate demand for
locally made goods in the international market has decreased. Also, in the local market, imported goods
are usually lower priced than the local products. Because of this situation, local firms may find it difficult to
compete with imported goods. This can contribute to a rise in the unemployment rate as local firms decide
to lower production cost by reducing the number of workers.

Equilibrium in the Four-Sector Economy- Introduction of the Foreign Sector

Level of Tax YD Consumption Investment Government Exports Imports Saving S+Tx+M I+G+X
Income(Y) (Tx) (C) (I) (G) (X) (M) (S)
100 100 0 200 100 100 50 25 -200 -75 250
200 100 100 275 100 100 50 25 -175 -50 250
400 100 300 425 100 100 50 25 -125 0 250
600 100 500 575 100 100 50 25 -75 50 250
800 100 700 725 100 100 50 25 -25 100 250
1000 100 900 875 100 100 50 25 25 150 250
1200 100 1100 1025 100 100 50 25 75 200 250
1300 100 1200 1100 100 100 50 25 100 225 250
1400 100 1300 1175 100 100 50 25 125 250 250
1600 100 1500 1325 100 100 50 25 175 300 250
1800 100 1700 1475 100 100 50 25 225 350 250
2000 100 1900 1625 100 100 50 25 275 400 250
2200 100 2100 1775 100 100 50 25 325 450 250

Table shows that the equilibrium level of income is 1400. Since there is a positive net exports, the
level of income rises from the original level of 1300. In equilibrium, aggregate demand (C+I+G+X-M) is
equal to income. Also, outflows (S+Tx+M) equal inflows (I+G+X).

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Graphical Illustration of the four-sector equilibrium where imports (M) and exports (X) are
autonomous variables

C, I, G, X S, I, G,X

C+I+G+X S

C+ I+G
C1 +I0 +G0+X0

C0 +I0+G0 I+G+X
I+G

0
Y0 Y1 Income

Y0 Y1 Income

(b) (b)

The addition of exports in the model, ceteris paribus, increases the equilibrium level of income in
figures a and b from Y0 to Y1.
C, I, G,M S, Tx, I, G

C+I+G
C+I+G-M
S+Tx+M
C1 +I0 G0
C2+ I0+ G0-M0 S+Tx
I+G

0
Y2 Y1 Income

Y2 Y1 Income
(b) (b)

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The addition of imports in the model, ceteris paribus, decreases the equilibrium level of income in
figures a and b from Y1 to Y2.

Algebraic Computation of Equilibrium Level of Income in the Four-Sector Economy

Let us assume that exports and imports are autonomous variables

C = CO + bYd , I = I O , Yd = Y − Tx , G = GO , X=XO, M=MO

Y =C + I +G+ X −M
Y = CO + b(Y − Tx) + I O + GO + X O − M O
CO − bTx O + I O + GO + X O − M O
Y=
1− b
Example 7. Let consumption function equals C=200+0.75Yd, investment I=100, government expenditure
G=100, tax (Tx)=100, X=50, M=25

200 − 0.75(100) + 100 + 100 + 50 − 25

Y=
1 − 0.75
Y = 1400
Algebraic Computation of the Multiplier for Exports

Y =C + I +G+ X −M
Y = C O + b(Y − Tx) + I O + G0 + X O − M O
C O − bTx + I O + GO + X O − M O
Y=
1− b
X
Y =
1− b
Y 1
=
X 1 − b

An Import Function and the Expenditure Multiplier

As income increases, consumption of domestic and foreign goods rises. In addition, the need for
imported materials is directly related to production levels. Thus, we assume that imports are positively
related to income M= M0+mY, where M0 is autonomous imports and m is the marginal propensity to import.
Exports, by assumption, remain an exogenous variable.
Let us assume that exports are autonomous variable while imports are dependent on the level of income.
C = CO + bYd , I = I O , Yd = Y − Tx , G = GO , X=XO, M=M0+mY
Y = C + I + G + X − (M 0 + mY )
Y = C O + b(Y − Tx) + I O + GO + X O − M O − mY
C O − bTx O + I O + GO + X O − M O
Y=
1− b + m
For autonomous changes in C, I, G, X, the expenditure multiplier is

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1 1
multiplier = or m =
1− b + m 1− b + m
For autonomous changes in M, the expenditure multiplier is
−1 −1
multiplier = or m =
1− b + m 1− b + m
For autonomous changes in Tx, the tax multiplier is
−b −b
multiplier = or mtx =
1− b + m 1− b + m
3.5. Injections and Leakages
Injections into the income-expenditures stream equal the leakages from the income stream. For an
open economy, saving, importing and paying taxes are all uses of income that subtract from potential
consumption but exports, government purchases and investments are injections into the income-
expenditure stream.
Exports
Expenditures

Investments

Consumption Expenditure
Goods and Services Banks

Households Firms

Land, Labor, Capital, Entrepreneur

Wage, Rent, Interest, Profit Governme
nt

Foreigne
rs
Saving

Taxes

Imports

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Households do not usually spend all of their incomes on goods and services. A part is saved and
paid to the government in the form of taxes. Another part of household’s expenditure is paid out to foreign
firms for imported goods and services. All these—savings, taxes, and imports do not remain in the circular
flow. They are leakages and therefore, constitute outflows or withdrawals from the circular flow. The same
is also true for the firm. It saves, pays taxes, and imports economic resources if need be.
Conversely, part of the savings goes to financial institutions, like banks, which lend out funds to
users, both the firms and the households, who send the money back into the circular flow when they buy
economic resources or goods and services. Taxes which are received as income by the government are
spent on maintaining government services. Exports also retrieve funds from the circular flow through the
receipts from the sales of the products to the rest of the world.

3.6. Inflationary and Recessionary Gaps

The full employment level of income or output (Yf) represents the level of income when the
resources in the economy are fully utilized. In other words, the economy is operating at full capacity.

Inflationary Gap
Recessionary Gap
AE1
AE0 AE0

AE1

Full
employment
(Y
Full employment

450 450

1300 1500 1500 1600

0 Yf Yf

Recessionary gap exists when aggregate expenditures are less than the full employment level.
Resources in the economy are not fully utilized. The figure above shows that a 50-peso recessionary gap
causes a 200-peso negative GDP gap, assuming a multiplier equal to four, thus, 4 (-50) = 200.

Inflationary gap is a condition when the equilibrium level of income is beyond the full employment,
that is, aggregate expenditures are greater than the full employment level of income. Since the economy
cannot produce beyond the full employment, an inflationary gap exerts pressure on the general price level.
In other words, it causes inflation. The figure shows a 25-peso inflationary gap, thus, 4(25)=100 The gap
can be eliminated if aggregate expenditures fall such that the full employment level of income(Y=1500)
becomes the economy’s equilibrium level of income. This requires a downward shift in the aggregate
expenditures schedule from AE1 to AE0. The autonomous component of aggregate expenditures must fall
to bring about the downward shift to AE.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. Multiple Choice: Encircle the letter of the best answer.

1. If the government lowers taxes and spending by P10, then with an MPC of 0.90 the income level will fall
by
a. P9 b.P80 c. P10 d. P20
2. The tax multiplier is
a. greater than the government expenditure multiplier
b. equal to the government expenditure multiplier
c. less than the government expenditure multiplier
d. equal to investment expenditure multiplier
3. If there is an increase in taxes and government spending, then
a. the S+Tx schedule shifts upward and I+G schedule shifts upward
b. the S+Tx schedule shifts downward and I+G schedule shifts downward
c. the S+Tx schedule shifts downward and I+G schedule shifts upward
d. the S+Tx schedule shifts upward and I+G schedule shifts downward
4. If there is an equal increase in taxes and government spending,
a. C+I+G is shifting upward
b. C+I+G is shifting downward
c. C+I+G does not shift
d. C+I+G either shift upward or downward
5. Given a 3-sector (C+I+G) model, equilibrium income occurs where
a. I+S=Tx+G b. I+G=S+Tx c. I+Tx=S+G d. S=I+Tx+G
6. A contractionary fiscal policy is a policy that:
a. reduces aggregate demand by decreasing government purchases.
b. reduces aggregate demand by decreasing money supply.
c. reduces aggregate demand by decreasing interest rates.
d. reduces aggregate demand by decreasing taxes.

7. If the MPC is 0.8 and the government spending decreases by P50 million, then equilibrium GDP will
decrease by:
a. P40 million b. P50 million c. P200 million d. P250 million

8. Suppose the economy is experiencing a recessionary gap. To move equilibrium aggregate output closer
to the level of potential output, the best fiscal policy option is to:
a. decrease government purchases b. decrease taxes
c. decrease government transfers d. increase real interest rates

9. Fiscal policy involves:

a. changes in interest rates
b. changes in government spending.
c. changes in the quantity of money.
d. changes in the quantity of money and interest rates.

10. In the basic equation of national income accounting, the government directly controls _____ and
influences ______.
a. G ; C and I b. T ; G and C
c. C ; X and M d. I ; G and T

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

11. Automatic stabilizers are government spending and taxation rules that:
a. cause fiscal policy to be expansionary when the economy contracts.
b. cause fiscal policy to be contractionary when the economy contracts.
c. cause fiscal policy to be neutral when the economy contracts.
d. cause fiscal policy to be ineffective when the economy contracts.

12. If the increase in exports exceeds the increase in imports, ceteris paribus, the level of income will
a. fall b. rise c. stay the same d. either rise or fall

13. An autonomous increase in exports will result in

a. an equal increase in imports if imports are a function of income
b. imports increasing more than exports if imports are a function of income
c. imports increasing less than exports if imports are a function of income
d. none of the above.

14. If imports increase, ceteris paribus,

a. the domestic spending schedule shifts upward
b. the domestic spending schedule shifts downward
c. there is a movement along the domestic spending schedule
d. there is no change in domestic spending

15. If exports equal imports and the import function reads M=M0+mY, a tax cut will
a. increase imports
b. decrease imports
c. have no effect on the level of imports
d. cause the income level to fall

16. Suppose the economy is currently operating at an output level of P4,000 billion. Assume furthermore
that potential output is P5,000 billion and the marginal propensity to consume is 0.75. Which of the
following would be required to close this recessionary gap?
a. A P25 billion increase in government spending.
b. A P25 billion increase in taxes.
c. A P250 billion increase in government spending.
d. A P1,000 billion increase in government spending.
e. A P500 billion increase in transfer payments.

17. The marginal propensity to consume is equal to:

a. the proportion of consumer spending as a function of disposable income
b. the change in saving divided by the change in disposable income
c. one
d. the change in saving divided by the change in consumer spending
e. the change in consumer spending divided by the change in disposable income
18. If the MPS = .1, then the value of the multiplier equals:
a. 1 b. 5 c. 9 d. 10 e. 100

19. If the multiplier equals 4, then the marginal propensity to save must be equal to:
a. 1/4 b. 1/2 c. 3/4 d. 1/3 e. 1/5

20. If the marginal propensity to save is 0.3, the size of the multiplier is:

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

a. 3.3 b. 2.3 c. 1.3 d. 0.7 e. 10

21. The marginal propensity to save is:
a. savings divided by aggregate income
b. the fraction of an additional peso of disposable income that is saved
c. 1+MPC
d. 1/MPC
e. Equal to 1
22. Suppose investment spending increases by P50 billion, and as a result the equilibrium income
increases by P200 billion. The multiplier is:
a. 8 b. 10 c. 4 d. ¼ e. 3
23. Suppose investment spending increases by P50 billion, and as a result the equilibrium income increases
by P200 billion. The value of the MPC is:
a. 0.8 b. 0.4 c. 0.75 d. 4 e. 0.5
24. If the size of MPS is decreasing, it will:
a. make the multiplier smaller
b. make the multiplier larger
c. not affect the value of the multiplier
d. increase the interest rate
e. cause the MPC to also decrease
25. You have been trying to develop a linear equation that describes the local household consumption
function as a function of disposable income. You have finished the project and the consumption function is:
C = 100 + .75(Yd). Your job is to explain this result to your supervisor. According to this consumption
function, what is the marginal propensity to consume?
a. 100 b. 0.75 c. 4 d. 0.25 e. 0.5

26. You have been trying to develop a linear equation that describes the local household consumption
function as a function of disposable income. You have finished the project and the consumption function is:
C = 100 + .75(Yd). Your job is to explain this result to your supervisor. According to this consumption
function, how much consumption spending would occur if a household had a disposable income of P1000?
a. P750 b. P4000 c. P850 d. P350 e. P7600
27. Suppose the marginal propensity to consume changes from 0.75 to 0.90. How will this affect the
consumption function?
a. The slope will get steeper
b. Autonomous consumption will increase
c. The function will exhibit a parallel shift upward
d. The slope will get steeper and autonomous consumption will increase
e. The function will exhibit a parallel shift downward
28. Consider a simple economy: MPC = 0.75, income =P400 billion and aggregate consumption spending=
P400 billion. The autonomous consumption is:
a. 0 b. P100 billion c. P300 billion d. P200 billion e. P400 billion
29. A fall in the market interest rate makes any investment project:
a. less profitable if the funds were borrowed and more profitable if it came from retained earnings
b. less profitable, regardless of whether the funds were borrowed or came from retained earnings
c. more profitable, more profitable, regardless of whether the funds were borrowed or came from
retained earnings.
d. more profitable only if the funds were borrowed
e. more profitable if the funds come from retained earnings than if the funds are borrowed.
30. If planned investment spending is P2 trillion and inventories decrease by P0.5 trillion then, actual
investment spending is:
a. P2.5 trillion b. 1.5 trillion c. P2 trillion d. P3 trillion e. -P1.5 trilli

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Fill-in Questions and Identification

Injections in the income-expenditures stream equal the leakages from the income stream.
For an open-economy, 1.__________, 2__________, 3_________ are all uses of income that
subtract from potential consumption but 4_________, 5__________ and 6___________ are
injections into the income-expenditures stream.

Identification
__________7. Exists when the equilibrium domestic output is greater than the full-employment
real domestic output.
__________8. An economy that does not interact with economies in the world.
__________9. A variable is said to be ___ when it is determined outside the model and assumed
to be independent of income.
__________10. A negative budget surplus or an excess of expenditure over revenue.

3. Assuming marginal propensity to consume is constant, complete the table below.

Y C S I AE=Y
0 -50 50
100 130 50
200 50
300 50
400 50
500 50
600 50
700 50
800 50
900 50
1000 50
Consider an economy that is described by the equations derived from the table in #1.

a. find the equilibrium level of income

b. find the value of the multiplier
c. calculate the effects of a 500-peso decrease in investment.

4. The fundamental equations in an economy are given as:

Consumption Function C = 200 + 0.8Yd
Investment I = 300
Tax T = 120
Government Expenditure G = 200
Exports X = 100
Imports M = 50

Find the following.

a. The equilibrium level of income
b. The net exports

5. Write a reflection paper on the performance of the Philippine economy during the 1st and
2nd quarter of 2020. Enumerate 4 possible measures to address the issue/s.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 4

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and
fiscal policies are discussed including public and international economic issues. It introduces
basic models of macroeconomics and illustrates principles based on the experience of the
Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus
on the basic concepts about economics and the overview of macroeconomics. National income
and output will be discussed in Chapter 3 while monetary and fiscal policies will be discussed in
Chapter 4 and Chapter 5, respectively. The last three (3) chapters will focus on the theories of
growth and development; unemployment and inflation and international trade, exchange rate and
balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in

evaluating the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making
this world a better place for them, their families, and their communities.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 4

MONEY, BANKING AND MONETARY POLICY

Learning Outcomes: At the end of this chapter students are expected to:

1. Identify the concepts of money and interest rates

2. Discuss the role of banks in determining the supply and demand of
money
3. Distinguish the effects of money on prices and output

1.1. Definitions and Functions of Money

Money facilitates the exchange of goods and services through its various functions, namely:
(1) as a medium of exchange; (2) a unit of account; (3) as a store of value; and (4) as a standard
for deferred payments.

▪ Medium of exchange

In a barter system, goods would be traded for other goods in transactions arranged on the
basis of mutual need. But with the presence of money, it eliminates the need for the double
coincidence of wants. Money as a medium of exchange is used for buying and selling goods and
services. The presence of money promotes economic efficiency by reducing the amount of time
of exchanging goods and services.

▪ Unit of account

Money serves as the unit at which goods are valued in terms of a given currency. The value
of money is expressed in terms of a monetary unit for example the peso. The advantage of using
money as a unit of account is that trade becomes fair since the value of goods is measured in
terms of a monetary unit. The value of goods and services in the Philippines is measured in terms
of a given price per unit of measurement, such as P175.00 per kilo of chicken and P15.00 for a
LRT ride from Monumento to Baclaran.

▪ Store of value

As a store of value, money is used to transfer purchasing power over time; the purchasing
power of money being measured in the terms of the quantity of goods that it can buy. Is money
a good store of value? Money is a good store of value if its purchasing power is stable while its
value declines during inflation. During inflation people hold other assets such as stocks, bonds,
land and jewelry that can function as a store of value rather than money.

▪ Standard for deferred payments

Money enables people to buy goods on credit. Goods and services can be obtained at the
present time in exchange for a promise to pay at a future date. Money becomes the basis for
goods and services that are paid on installment basis.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1.2. Demand for Money

• The demand for money represents the desire of households and businesses to hold
assets in a form that can be easily exchanged for goods and services.
• Liquidity is the most important characteristic of money that distinguishes it from other
types of assets. For this reason, the demand for money is sometimes called the demand
for liquidity.

The Quantity Theory of Money

This theory holds that there is a direct and powerful link between the quantity of money
and the level of prices. This theory was developed by Irving Fisher. (Fisher’s equation of
exchange)

MV = PY
M - is the money supply
V - is the velocity of circulation of money
P - is the overall price level (transactions for the economy during
the period)
Y - is the amount of goods and services produced (income level)

Fisher believed that in the long run an increase in the quantity of money brings about an
equal percentage increase in the price level.

Liquidity Preference Theory

This theory was formulated by John Maynard Keynes, Keynes believed that there are
three motives why people want to hold money.

I. Transactions Motive. The primary reason why people hold money is because they
expect to use it to buy something sometime soon. In other words, people expect to
make transactions for goods or services. How much money a person holds onto should
probably depend upon the value of the transactions that are anticipated. Thus, a
person on vacation might demand more money than on a typical day. Wealthier people
might also demand more money because their average daily expenditures are higher
than the average person.
We are not interested so much in an individual's demand for money, but rather in
what determines the aggregate, economy-wide demand for money. GDP, the value of
all goods and services produced during the year, will influence the aggregate value of
all transactions since the GDP produced will be purchased by someone during the
year. As GDP rises, there will be a demand for more money to make the
transactions necessary to buy the extra GDP. If GDP falls, then people demand
less money for transactions.

II. Precautionary Motive. Money is demanded to cover unexpected items of

expenditure. Unexpected expenses, such as medical or car repair bills, often require
immediate payment, thus, people want to hold on to cash balances as a safety net for
their unexpected expenditures.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

III. Speculative Motive. People may hold money not for transaction purposes but for
purchasing other financial assets, especially so when they are expected to fall in price.
Keynes demonstrated that there was an inverse relationship between the price of
a bond and the rate of interest. For example, suppose a bond is issued for P200 and
its annual return (coupon) is P20. The annual rate of interest is 10%. If the market rate
of interest falls to 5% the price of the bond will increase to P400. The rationale behind
this is that in order to secure the same return of P20 in any other financial asset, P400
would have to be invested. Conversely, if the rate of interest increases, the price of
bonds will fall.
At high rates of interest, individuals expect interest rates to fall and bond prices to
rise. To benefit from the rise in bond prices individuals use their speculative balances
to buy bonds. Thus, when interest rates are high speculative money balances are low.
At low rates of interest, individuals expect interest rates to rise and bond prices to
fall. To avoid the capital losses associated with a fall in the price of bonds individuals
will sell their bonds and add to their speculative cash balances. Thus, when interest
rates are low speculative money balances will be high.
There is an inverse relationship between the rate of interest and the
speculative demand for money.

The Demand for Money (MD) and the Interest Rate (i)

MD = f (Y , i )

1. Money Demand and Increases in Real GDP

❖ Consider an economy experiencing a sustained economic growth. Rising

production and increasing numbers of people employed will increase the demand
for money at each rate of interest. Therefore, an increase in real GDP or level of
output causes an outward shift in the demand for money from MD1 to MD2. See
figure below.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

2. Demand for Money and Financial Innovation

❖ Financial innovation has reduced the demand for money because most people
finance their purchases using debit cards and credit cards rather than carrying
around large amounts of cash. Demand for money decreases from MD1 to MD2.

1.3. Money Supply (MS) and Measures of Money

Money supply is much easier to describe because just imagine that the level of money
balances available in an economy is simply set by the actions of the Bangko Sentral ng Pilipinas.
The BSP defines money on the basis of its components, and there are four measures, namely
narrow money (M1), broad money (M2), total domestic liquidity (M3), and M4.

a. M1 or Narrow Money – consists of currency in circulation (or currency outside

depository corporations; basically, these are coins and paper bills) and peso
demand deposits. Currency is a liability of the BSP while peso demand
deposits or checkable deposits are liabilities of and created by commercial
banks and deposit money banks.
b. M2 or Broad Money – consists of M1 plus peso savings and time deposits.
c. M3 or Broad Money Liabilities – consists of M2 plus peso deposit substitutes,
such as promissory notes and commercial papers (i.e., securities other than
shares included in broad money).
d. M4 - includes M3 and foreign currency deposits of non-bank residents.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1.4. The Money Market

Equilibrium in the money market exists when the quantity demanded for money equals the
quantity supplied of money at a given interest rate.

Money Market Equilibrium

i MS
The diagram shows that the equilibrium interest
rate is determined by the intersection of the
money demand and money supply at interest
rate i0. Money supply, MS, is drawn as a vertical
line because changes in the interest rate will
not affect the money supply in the economy.
Money demand (MD) is downward sloping
i0 because of the inverse relationship between
money demand and the interest rate.
MD

Quantity of money

Effects of Expansionary
Monetary Policy on Interest
Rates

i MS0 MS1 Expansionary monetary policy refers to any policy

initiative by a country's central bank to raise, or
expand, its money supply. This can be
accomplished with open market purchases of
government bonds, with a decrease in the reserve
requirement or with a decrease in the discount rate.
In the diagram below, suppose that money supply
increased from MS0 to MS1, which is shown by a
i0 rightward shift from MS0 to MS1, interest rate falls
i1 MD0 from i0 to i1. On the other hand, a decrease in money
supply a leftward shift from MS1 to MS0 will result to
an increase in the interest rate.
Quantity of money

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Effect of a Real GDP Increase

(i.e., Economic Growth) on An increase in GDP will raise the
Interest Rates demand for money because
MS0 people will need more money to
make transactions. In other words,
money demand rises due to the
transactions demand effect. This
increase is reflected in the diagram
below as a rightward shift of the
i1 money demand function from MD0
to MD1. Thus, an increase in real
MD1 GDP (i.e., economic growth) will
i0 cause an increase in the average
MD0 interest rates in an economy. In
contrast, a decrease in real GDP (a
recession) will cause a decrease in
the average interest rates in an
Quantity of money economy.

1.5. Money Creation Process

The money creation process involves the interaction of the banking system i.e., the BSP
and all banks and the general public. It starts with the printing and issuance of currency by the
BSP. This enters into the financial system as cash holdings of banks or the general public. Part
of the holdings of the general public is deposited with banks. Banks, after setting aside a portion
for reserve requirements, lend out or invest the remaining deposits of the public, along with part
of their own cash holdings. These funds eventually find their way back to the banking system as
deposits and the process continues. Through this mechanism, the contraction/expansion in
money supply or M3 becomes a multiple of the contraction/expansion in the monetary base.

Suppose the Central Bank prints P100, 000 and decided to deposit it in Bank X. Bank X
sets aside a portion of that P100, 000 that is required reserves (a specific amount that banks must
hold as reserves on all deposits), say 10%. The remaining 90%, P90,000 becomes excess
reserves. Bank X can lend that P90,000 to Customer A, who deposits into his account in Bank Y.
At this step, the original P100,000 remains in the system, and we can now add Customer A’s
P90,000. Bank Y sets aside 10%, and lends out the rest. If one were to follow this multiple
deposit expansion process to its completion, the end result would be that the bank's deposits
would increase by P1 million, its loans would increase by P900,000, and its reserves would
increase by P100,000, all due to the initial deposit of P100,000. This can be summarized in the
table shown below

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

TABLE Multiple Expansion of Deposits

Round New deposits New reserves New loans

1 P100,000 P10,000 P90,000
2 90,000 9,000 81,000
3 81,000 8,100 72,900
4 72,900 7,290 65,610
5 65,610 6,561 59,049
. . . .
. . . .
. + . + . + .
P1,000,000 P100,000 P900,000

The money multiplier (k) is defined as the ratio between M3 and MB.

M3 C+D
k= or k=
MB C+R

Where: M3 = Broad Money Liabilities

MB = Money Base
C= Currency
D = Deposits
R = Resource

Hence, the supply of liquidity can be expressed as the product of the money multiplier (k)
and MB. In the Philippines, MB is used in determining the level of domestic liquidity or M3 rather
than reserve money (RM) only because MB is considered a broader measure of bank’s reserves
with the central bank.

M 3 = k * MB

Each component of k may be divided by the total deposits (D) on the assumption that
these components are proportional to total deposits. Thus,

(C / D) + ( D / D)
k=
(C / D) + ( R / D)

c +1
k=
c+r

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Where: c= currency in circulation to deposit ratio

r = required reserves against deposits or reserve requirement

The ratio of currency in circulation to deposits (c) measures the desire of the public (non-
banks) to hold cash relative to keeping their money in savings or time deposits, while the ratio of
reserves to deposits (r) provides a measure of the ability of the central bank to expand or limit the
loanable funds (excess reserves) of the banks. Although the central bank decides on the regular
and liquidity reserve requirement of banks, banks determine how much excess reserves to hold.

The money multiplier is determined by the required reserve ratio (r) and by the currency
drain (c). The equation above tells us that a reduction in r could lead to an increase in the supply
of money or M3. When the central bank lowers the reserve requirement, banks would have more
funds available for lending. Higher lending, in turn, could lead to an increase in the supply of
money. It could be noted that (r) should be between 0 and 1 (that is, 0<r<1). The reserve
requirement cannot be equal to zero because in such situation, the BSP would lose its control
over money supply and it cannot be also equal to one because at such level of (r) banks will not
be able to act as intermediaries for funds.

1.6. Bangko Sentral ng Pilipinas

The Bangko Sentral ng Pilipinas (BSP) was established on July 3, 1993 pursuant to the
provisions of the 1987 Philippine Constitution and the New Central Bank Act of 1993. The BSP
enjoys fiscal and administrative autonomy from the National Government in the pursuit of its
mandated responsibilities.

The primary objective of the Bangko Sentral ng Pilipinas is to maintain price stability
conducive to a balanced and sustainable economic growth. Price stability refers to a condition of
low and stable inflation. By keeping inflation low, the BSP helps in ensuring a strong and
sustainable economic growth. Prices of goods and services do not rise too quickly, thus people
have a degree of certainty when deciding how to spend, save or invest their money.

The BSP also aims to promote and preserve monetary stability and the international
convertibility of the national currency.

Functions of the BSP

Bangko Sentral ng Pilipinas performs the following functions;

1.Currency issue. The national currency, such as notes and coins, which are fully guaranteed
by the Government and are considered legal tender for all private and public debts, is solely
produced and issued by the BSP.

2. Liquidity Management. In order to achieve the primary objective of the BSP i.e., to maintain
price stability, the BSP must formulate and implement monetary policy aimed at influencing
money supply.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

3. Financial Supervision. There is a regular monitoring and examination in the operations of the
member banks being done by the BSP.

4. Lender of last resort. In case the member banks suffer from financial problems which directly
threaten monetary and financial stability, the BSP provides loans or advances to these banks.

5. Banks of banks. BSP only accept deposits from and grant loans to banks and not to the public.

6. Management of foreign currency reserves. The BSP seeks to maintain sufficient

international reserves to meet any foreseeable net demands for foreign currencies in order to
preserve the international stability and convertibility of the Philippine peso.

7. Determination of exchange rate policy. The BSP determines the exchange rate policy of the
Philippines. Currently, the BSP adheres to a market-oriented foreign exchange rate policy.

8. Other activities. The BSP functions as the banker, financial advisor, and official agent of the
Government, its political subdivisions and instrumentalities and government-owned and -
controlled corporations. As government banker, the BSP may conduct the banking account of the
government. As government agent, the BSP performs the function of providing the foreign
exchange required to meet governmental purchases of imports and serving foreign debts. Lastly,
as financial advisor it provides assistance by informing the government on monetary and price
movements.

The BSP has several instruments to carry out its monetary policy.

1. Open market operations (OMO) – Is one of the instruments used in order to expand or
contract the supply of money in circulation. It involves the buying or selling of government
securities from banks and financial institutions of the BSP in order. For instance, an open
market purchase of securities by the BSP from banks results in an increase in the banks
excess reserves and an increase in the supply of money. Moreover, an open market sale
of securities by the BSP to banks results in a decrease in the banks’ excess reserves and
a decrease in the supply of money.

Repurchase (repo)/reverse repurchase (reverse repo) agreements and outright

purchases and sales of securities are the two instruments used by the BSP in the conduct
of the open market operation.

Repurchase Agreements (RPs) are transactions wherein the CB buys government

securities from banks with a commitment to sell them after a specified period for a certain
consideration e.g., interest rate. In contrast, Reverse RPs (RRPs) are transactions
whereby CB borrows funds from banks using its holdings or inventory of government
securities in its portfolio as collateral with an agreement to repay the loan (and hence buy
back the securities) at a specified rate and period of time. A repurchase transaction
expands the level of money supply as it increases the bank’s level of reserves while
reverse repo contracts the supply of money.

The effect of both Repos is only temporary because the parties involved commit
to reverse the transaction at an agreed future date. At present, the BSP enters into repo

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

agreements for a minimum of one (1) day (overnight) for both repos and a maximum of 91
days and 364 days for repo and reverse repo agreements, respectively.

Outright purchases and sales of securities. This involves the direct purchase/sale
of government security by the BSP from/to the market for the purpose of
increasing/decreasing money supply on a more permanent basis. In such a transaction,
there is no commitment for both parties to reverse the transaction in the future, creating a
more permanent effect on the banking system’s level of money supply.

2. Rediscounting is a standing credit facility provided by the BSP to help banks meet
temporary liquidity needs by refinancing the loans they extend to their clients. The
rediscounting facility allows a financial institution to borrow money from the BSP using
promissory notes and other loan papers of its borrowers as collateral. If an individual
borrowed Php 1,000,000.00 from Land Bank of the Philippines at 10% using his title of
land as a collateral, he will only receive Php 900,000.00. Consequently, the LBP’s cash
on vault is reduced by Php 900,000.00. If LBP avails of a 5% rediscounting rate, by
passing the collateral to BSP, LBP will receive Php 950,000.00. Without waiting for a
month-long period, it earned Php 50,000.00. By availing of this, the bank can use that
money for another client and earn more.
3. Reserve Requirement is employed as a protection to depositors by ensuring liquidity or
solvency and to meet the withdrawals of depositors. Let’s say Mrs. Samaniego deposits
P1,000, 000.00 the in the Land Bank of the Philippines. The BSP requires LBP to keep
10% of deposits, for instance, in its reserves. Therefore, LBP can use only P900, 000.00
of Mrs. Samaniego’s money for its loans and investments while if BSP imposes 20%
reserve requirement it can use only P800,000.00 for its activities. Changes in reserve
requirements have a significant effect on money supply in the banking system, making
them a powerful means of liquidity management.
4. Moral Suasion - This is defined as the influence that the Central Bank exercises to induce
or convince banks to conduct operations in a manner that would contribute to the
attainment of monetary goals but may not contradict profit maximization objectives of
banks in the short run. It may take the form of a request for voluntary restraint on overall
lending or a suggested priority in lending to different sectors of the economy.

1.7. Monetary Policy Framework of the Bangko Sentral ng Pilipinas

Inflation targeting is an approach to monetary policy by the Bangko Sentral ng Pilpinas

that involves the use of a publicly announced inflation target set by the Government, which the
BSP commits to achieve over a two-year horizon. 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. The inflation targets have been set at 3.5 percent with a tolerance interval of + 1.0
percentage point for 2009 and 4.5 percent with a tolerance interval of + 1.0 percentage point for
2010.

Inflation targeting was formally adopted as a framework for monetary policy by the BSP in
January 2002. The Philippines joined the list of inflation targeters such as Australia, Canada,
Finland, Sweden, New Zealand, United Kingdom, Israel, Brazil, Chile and Thailand. Inflation
targeting focuses mainly on achieving price stability as the ultimate objective of monetary policy.
The diagram below illustrates the process involved in making inflation targeting operational.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Inflation Targeting Framework

BSP sets inflation target 2 Publish highlights

years in advance of Monetary
YES Board (MB)
meetings on
monetary policy
BSP announces inflation
target
Is inflation forecast in
line with the target?
Adjust policy
interest rate
Issue open letter to
BSP the President
▪ Assesses monetary
conditions
NO
▪ Forecasts inflation
▪ Decides on monetary policy

www.bsp.gov.ph

1.8. The Philippine Financial System

The financial system is composed of the BSP, all types of banks and non-banking
institutions.

Functions of the Financial System

The financial system plays the key role in the economy by stimulating economic growth,
influencing economic performance of the actors affecting economic welfare. This is achieved by
financial infrastructure, in which entities with funds allocate those funds to those who have
potentially more productive ways to invest those funds. A financial system makes possible a more
efficient transfer of funds. The basic function of the financial system is to provide channels to
transfer funds from savers with an excess of funds to spenders facing a shortage of funds. The
most important suppliers or savers of funds are households, while firms, the government, and
foreigners sometimes find themselves with excess funds and so lend them out. Funds may flow
from lenders to borrowers via direct and indirect finance.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

In direct or market-based finance, debtors borrow funds directly from lenders in the
financial markets by selling them financial instruments, which are claims on the borrowers’ future
income or assets. In the indirect or bank-based finance, financial intermediaries play an additional
role in channeling funds.
Direct lending-involves the transfer of funds from the ultimate lender to the ultimate
borrower, most often through a third party. An example is a person purchasing the securities
issued by a firm. The securities are usually sold to the public through an underwriter, someone
who purchases them from the issuer with the intention of reselling them at a profit. The underwriter
negotiates the terms of the contract, typically a commercial bank, to monitor compliance.
Indirect lending- involves lending by the ultimate lender to a financial intermediary who
pools the funds of many lenders in order to re-lend with a mark - up over the cost of the funds.
The ultimate borrowers are usually unknown to the ultimate lenders. A lender faces lower risk
because as a specialist in the field, he knows that the financial intermediary has a well-established
expectation in the business of lending.

The Philippine Financial System

The Bangko Sentral ng Pilipinas is responsible for implementing monetary policy and
regulation of the banking system while the Insurance Commission (IC) supervises the operations
of the insurance companies. On the other hand, the Securities and Exchange Commission (SEC)
works with the BSP and IC in supervising and regulating the activities of the financial institutions
in the country.

Banking Institutions

Universal and commercial banks represent the largest single group, resource-wise, of
financial institutions in the country. They offer the widest variety of banking services among
financial institutions. Commercial banks are organized primarily to accept drafts and issue letters
of credit, discount, and negotiate promissory notes, drafts, bills of exchange, and other evidences

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

of indebtedness, receive deposits, buy and sell foreign exchange and lend money on a secured
or unsecured basis. In addition to the function of an ordinary commercial bank, universal banks
are also authorized to engage in underwriting and other functions of investment houses, and to
invest in equities of non-allied undertakings.

The thrift banking system is composed of savings and mortgage banks, private
development banks, stock savings and loan associations and microfinance thrift banks. Thrift
banks are engaged in accumulating savings of depositors and investing them. They also provide
short-term working capital and medium- and long-term financing to businesses engaged in
agriculture, services, industry and housing, and diversified financial and allied services, and to
their chosen markets and constituencies, especially small- and medium- enterprises and
individuals.
a. Savings banks- are banks organized for the purpose of accumulating saving deposits
and investing them for specified purposes.
b. Private development banks-are banks that are organized primarily to cater to the
capital needs and demand for investment credit or medium to long-term loans for the
promotion of growth of industry and agriculture at reasonable costs.
c. Stock savings and loan associations -are institutions engaged in the accumulation of
savings mainly of stockholders in specified undertakings. They are primarily
concerned with servicing the needs of the household by providing personal finance
and long-term financing for home building and development.
d. Microfinance banks- are banks that provide a broad range of financial services such
as deposits, loans, payment services, money transfers, and insurance products to the
poor and low-income households for microenterprise and small businesses to raise
their income levels and improve their living standards.

Rural and cooperative banks are the more popular type of banks in the rural
communities. Their role is to promote and expand the rural economy in an orderly and effective
manner by providing the people in the rural communities with basic financial services. Rural and
cooperative banks help farmers through the stages of production, from buying seedlings to
marketing of their produce. Rural banks and cooperative banks are differentiated from each other
by ownership. While rural banks are privately owned and managed, cooperative banks are
organized/owned by cooperatives or federation of cooperatives.

Specialized Government Banks are organized to serve a particular purpose. The

existing specialized banks are the Development Bank of the Philippines, Land Bank of the
Philippines and Al-Amanah Islamic Bank of the Philippines

Non-bank Financial Intermediaries

Non banks with quasi-banking functions consist of institutions engaged in the borrowing of
funds from 20 or more lenders for the borrower's own account through issuances, endorsement
or assignment with recourse or acceptance of deposit substitutes for purposes of relending or
purchasing receivables and other obligations.
a. Investment Houses-are financial enterprises primarily engaged in the underwriting of
securities of other enterprises including securities issued by the National Government and
its instrumentalities.
b. Financing Companies-are companies engaged in extending credit facilities to consumers
and agricultural enterprises either by discounting or factoring commercial papers or

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

accounts receivables or other evidences of indebtedness or by leasing motor vehicles,

machinery and equipments, appliances, and other movable properties.
c. Securities Dealers/Brokers-securities dealers refer to persons or financial entities
authorized to engage in business of effecting transactions in securities for their own
account. They do not get commission but derive income from trading, representing the
difference between the buying and selling prices of securities. Brokers refer to those
engaged in the business of effecting transactions in securities for the account/risk of
others. They earn commissions out of their intermediary transactions.
d. Investment Companies-are institutions primarily engaged in investing, reinvesting or
trading securities. Investment companies pool money from a large group of investors who
have similar objectives, allowing small investors to participate in the capital market as this
call for a low initial investment requirement.

Non-banks without quasi-banking functions

a. Lending investors- pertain to individuals or entities engaged exclusively in the business of
extending secured or unsecured direct loans to individuals and enterprises. They use their
own capital for the purpose of extending all types of loans.
b. Pawnshops-are business establishments engaged in lending money on personal property
delivered as security or pledge.
c. Insurance Companies-are corporations which undertake to indemnify another against
loss, damage or liability arising from an unknown or contingent event by a contract of
insurance, and which holds a certificate of authority from the Insurance Commission. The
activities of insurance companies include general insurance, life insurance, non-life
insurance and reinsurance.
d. Venture capital corporations- are entities organized jointly by private banks, the National
Development Corporation (NDC) and Technology and Livelihood Resource Center
(TLRC) and other government agencies as may be authorized by the appropriate body..
Their primary purpose is to develop, promote, and assist, through debt or equity financing
or any other means, any small and medium scale enterprise in the country.
http://www.bsp.gov.ph/banking/bspsup.as

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. Choose the letter of the correct answer.

1. The demand curve for money will shift to the right because of a:
A) fall in the interest rate.
B) rise in real GDP.
C) rise in the interest rate
D) fall in real GDP.

2. The money demand curve is _________ because a lower interest rate ___________.
A) upward-sloping; increases the opportunity cost of holding money
B) downward-sloping; increases the opportunity cost of holding money
C) upward-sloping; decreases the opportunity cost of holding money
D) downward-sloping; decreases the opportunity cost of holding money

3. Suppose a bank has excess reserves of P800 and the reserve ratio is 10%. If Diana deposits
P1,500 of cash into her checking account and the bank lends P600 to Russell, that bank can lend
an additional:
A) P1,550 B) P1,300 C) P2,000 D) P1,350

4. To increase the money supply, the central bank could:

A) lower the discount rate.
B) make open-market purchases.
C) lower reserve requirements.
D) lower the discount rate, make open-market purchases, or lower reserve requirements.

5. A decrease in the supply of money, with no change in demand for money, will lead to_______
in the equilibrium quantity of money and ______ in the equilibrium interest rate.
A) an increase; an increase
B) an increase; a decrease
C) a decrease; an increase
D) a decrease; a decrease

6. Holding everything else constant, if the required reserve ratio falls, then:
A) a P1 loan can lead to a smaller change in the money supply than before the change in the
required reserve ratio.
B) the money multiplier increases.
C) the amount of excess reserves falls also.
D) the money multiplier decreases.

7. When the BSP decreases bank's reserves through an open-market operation: A) deposits
increase, currency in circulation increases, and the monetary base remains the same.
B) the monetary base decreases, the money multiplier decreases, and the money supply
increases.
C) loans increase, the federal funds rate rises, and the discount rate rises.
D) the monetary base decreases, loans decrease, and the money supply decreases.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

8. All of the following are functions of money, EXCEPT:

A) a measure of wealth.
B) a medium of exchange.
C) a unit of account.
D) a store of value.

9. When an individual decides to hold money instead of other assets:

A) that individual is giving up the interest that could have been earned by holding other types of
assets.
B) that individual becomes more likely to suffer from money illusion.
C) that individual is not affected by unanticipated inflation.
D) that individual is able to maintain a higher standard of living.

10. Which type of demand for money will tend to fall as the returns on the other financial assets
rises?
A. transactions-related
B. precautionary
C. speculative
D. All of the above

2. Identification:
__________1. The amount of money people wants to hold as a store of value; this amount varies
inversely with the interest rate.
__________2. Actions of the Bangko Sentral ng Pilipinas (BSP) to increase the money supply
and expand real GDP.
__________3. The most narrowly defined money supply, equal to currency in the hands of the
public and the checkable deposits of commercial banks and thrift banks.
__________4. The market in which the demand for and supply of money determine the interest
rate.
__________5. An asset set aside for future use; one of the three functions of money.
__________6. Bangko Sentral ng Pilipinas actions that contract the growth of the nation’s money
supply for the purpose of reducing or eliminating inflation.
__________7. A standard unit in which prices can be stated and the value of goods and services
can be compared; one of the three functions of money.
__________8. Demand for money to meet unexpected expenses.
__________9. A minimum amount of reserves that banks must hold against deposits.
__________10. The tendency for increases in the price level to increase the demand for money,
raise interest rates, and, as a result, reduce total spending and real output in the economy.
__________11. The BSP’s buying or selling of government bonds.
__________12. The sum of the transaction, precautionary, and asset demand for money.
__________13. The tendency for increases in the price level to lower the real value of financial
assets with fixed money value, as a result, to reduce total spending and real output.
__________14. The government agency that oversees the banking system and is responsible for
the amount of money and credit supplied in the economy.
__________15. Monetary policy characterized by an increase in money supply that results in
lower interest rate.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 5

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and
fiscal policies are discussed including public and international economic issues. It introduces
basic models of macroeconomics and illustrates principles based on the experience of the
Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus
on the basic concepts about economics and the overview of macroeconomics. National income
and output will be discussed in Chapter 3 while monetary and fiscal policies will be discussed in
Chapter 4 and Chapter 5, respectively. The last three (3) chapters will focus on the theories of
growth and development; unemployment and inflation and international trade, exchange rate and
balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in

evaluating the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making
this world a better place for them, their families, and their communities.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 5
GOVERNMENT AND FISCAL POLICY
Learning Outcomes: At the end of this chapter students are expected to:

1. Analyze the role of government

2. Explain the budget and fiscal policy
3. Discuss the implications of deficits and debts

5.1. Major Fiscal Functions

1. Resource Allocation Function- It is the role of the government to bring about an

efficient allocation of economic resources within the economy, to avoid deadweight
losses, brought about by government policies. Government has to provide for public
goods. Public goods such as national defense, government administration,
maintenance of peace and order and so on are different from private goods.
2. Distribution Function- government policies aimed at changing the final distribution
of goods/services across consumers, usually with the intention of realizing a “fairer”
apportionment of consumption/income/wealth. Through its tax and expenditure policy,
government affects distribution of personal income of households in a manner which
is just and fair. As such, it taxes the rich and spends for the schemes which benefit the
poor more. There are two broadly different ways to directly “redistribute”
income/wealth.
• Income Support-monetary payments (such as unemployment benefits and social
security payments) made to certain individuals, which directly alter the distribution of
income within a society.
• Redistribution In-Kind–public provision of goods/services (such as healthcare,
education, housing, food) for certain individuals, which alter the consumption of
individuals.

Conditional Cash Transfer Program (CCT)

This is also known as the Pantawid Pamilyang Pilipino Program (4Ps)
which was launched in February 2008 by the Department of Social Welfare and
Development (DSWD). Pantawid Pamilyang Pilipino Program is a poverty
reduction and social development strategy of the national government that
provides conditional grants to extremely poor households to improve their health,
nutrition, and education particularly of children aged 0-14.
4Ps Dual Objectives
• Social Assistance-to provide cash assistance to the poor to alleviate their
immediate needs (short-term poverty alleviation)
• Social Development-to break the intergenerational poverty cycle through
human investments in human capital.
Criteria in the Selection of Beneficiaries
• Residents of the poorest municipalities based on the 2003 Small Area
Estimates of the National Statistical Coordination Board (NSCB)
• Households whose economic condition is equal to or below the provincial
poverty threshold
• Households that have children 0-14 years old and/or have a pregnant
woman at the time of assessment
• Households that agree to meet conditions specified in the program.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Conditions to be complied with to remain in the Program

• Pregnant women must avail of pre-and-post-natal care and be attended
during childbirth by a trained health professional.
• Parents must attend responsible parenthood sessions, mother’s classes
and parent effectiveness seminars.
• 0-5 year old children must receive regular preventive health check-ups and
vaccines.
• 3-5 year old children must attend day care or pre-school classes at least
85% of the time.
• 6-14 year old children must enroll in elementary or high school and must
attend at least 85% of the time.
• 6-14 years old children must receive deworming pills twice a year.
4Ps Offer the following conditional grants:
• P6,000 a year or P500 per month per household for health and nutrition
expenses;
• P3,000 for one school year or 10 months or P300/month per child for
educational expenses. A maximum of three children per household is
allowed.
• A household with three qualified children receives a subsidy of
P1,400/month during the school year or P15,000 annually as long as they
comply with the conditionalities.

3. Stabilization Function-Attainment of economic stability is one of the major goals of

economic stability. When problems of unemployment and inflation are not present,
then the economy is said to be stable. The government through the fiscal tools of
taxation, borrowings and expenditures can minimize or eliminate the problems of
unemployment and inflation. For example, the government should focus on projects
which are very efficient in generating jobs and incomes for the people.
Moreover, taxation can help in reducing inflation rate. If the kind of inflation is
caused by oversupply of money in relation to the number of goods available in the
economy, the government must increase taxes in order to reduce the disposable
income of buyers. However, most individuals are not happy about such fiscal policy.
They believe that taxes should be lowered during inflation because their purchasing
power falls. What they do not understand is that when there is an oversupply of money,
demand for goods and services increases. Since supply is limited, prices go up. The
tax increase should only be temporary just enough to control the demand for goods
and services while efforts are being done by the government in increasing the supply
of goods and services.

5.2. Sources of Government Revenue

In the Philippines, government revenues cover tax and non-tax items. The major sources
of government revenues are taxes which represent compulsory payments to finance government
operations.

Tax revenues
1. Income taxes. Example: Personal Income
2. Property taxes. Example: Real property, Property transfers
3. Taxes on goods and services. Example: Business taxes and licenses, Franchise tax,
Motor vehicle taxes

4
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

4. Taxes on international trade and transactions. Example: Import duties, Export and
premium duties
5. Other taxes. Example: Documentary stamp taxes, Charges on forest products,
Immigration tax, Mining tax

Non-Tax Revenues
On the other hand, non-tax revenues are those earned or realized from regular operations
and services rendered, government business or proprietary operations, sales of assets, and
grants/aids, whether actually collected in cash or accrued resulting in addition to or increases in
the net assets of the government. Specifically, these revenues are the following:
1. Operating and service income. Example: Government services, Government business
operations, Interests, Commissions, Insurance/fiduciary bond premiums
2. Income from public enterprises/investments. Example: Interest on loans, Dividends on
stocks, Interest on bonds, Interest on treasury notes/bills, Interest on promissory notes,
Gains on sale of acquired assets/stocks/bonds
3. Sale of Assets. Example: Public domain, Fixed assets
4. Grants and aids. Example: From foreign countries, from other levels of governments

Government BorrowingsThe government also relies on borrowings as a major source of

government fund. Borrowings come from domestic and foreign sources. Domestic borrowings are
sourced from auction of Treasury bills, notes and bonds. Foreign borrowings are classified either
as project and program loans being offered by the Asian Development Bank(ADB) and the
International Bank for Reconstruction and Development (IBRD) which is now the World Bank.
Project loans are foreign loans obtained to finance a specific project such as building of roads
and bridges, while program loans are multi-purpose foreign loans for the enhancement of a
specific sector and conditioned on basic changes in certain economic, monetary or fiscal policies,
among others.

5.3. Government Expenditures

Government expenditure is a term used to describe money that a government spends.
Expenditure occurs on every level of government, from local city councils to national
organizations. There are different types of government expenditure, including the purchase and
provision of goods and services, investments, and money transfers.
Expenditures by expense class
1. Current Operating expenditure- These are expenses for the purchase of the products
and services for the current fiscal year, including office supplies, wages of government
employees, and overhead expenses.
2. Capital Expenditures- These are expenses that include the construction of
infrastructure and investments in corporations owned or controlled by the government.
Expenditures by sector
1. Economic Services-This refers to expenditures for increasing the productivity of
agriculture and industry, infrastructure development, promotion of trade and tourism,
natural resources use and conservation and other activities.
2. Social Services- This includes expenses to promote social welfare like education, health,
housing and community development.
3. Administrative or General Public Administration- This includes all the cost of running the
government machinery itself; departments and offices and the salaries of the civil
servants.

5
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

4. Defense- These are expenses for maintaining peace and order and restraining external
or internal threats against national security.
5. Debt Servicing-This represents interest and amortization payments for both foreign and
domestic loans that fall under debt servicing.

5.4. Fiscal Policy

Fiscal policy is imposed when the government uses its power to influence total spending
either directly changing its purchases of goods and services or indirectly altering the disposable
income of persons through changes in the level of tax or transfer payments. Expansionary fiscal
policy is defined as an increase in government expenditures and/or a decrease in taxes that
causes the government's budget deficit to increase or its budget surplus to decrease.
Contractionary fiscal policy is defined as a decrease in government expenditures and/or an
increase in taxes that causes the government's budget deficit to decrease or its budget surplus
to increase.
During periods of recession and unemployment, economic policy dictates a budget deficit.
This means that the government can or should spend more than what it collects through its taxes.
For example, if the budget of the government is 500 billion, during a period of recession, the
government should spend more than 500 billion. Spending more would mean more money
injected, thus, promoting more spending which can be translated into more sales, more
employment, more income and higher levels of production. Also during this period a tax reduction
can be used. Tax reduction means taxes imposed on persons and businesses are cut. If this
happens, persons would have greater disposable income and corporations would retain higher
income. Higher incomes would be injected into more inflows in the circular flow, thus, pump
priming the economy through higher consumer and business spending.
BS = Tx − G − Tr
Where: BS= budget surplus
T x=Tax
G=government expenditure
Tr = Transfer payments

During times of inflation, economic policy dictates a budget surplus. Budget surplus is
realized when government expenditures are less than tax revenues in a given year. Spending
less would mean that the aggregate demand would become less, thus, dampening the demand
for goods and services. During this period, a tax increase can also be used, thus, less income is
left in the hands of consumers and business firms. Less consumer and business demand would
mean lower economic activity.
In the case where government expenditures are exactly equal to tax revenues in a given
year, the government is running a balanced budget for that year.

6
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. Choose the letter of the correct answer.

1. What type of budget is adopted when the government spends more than its revenue?
a. balanced budget
b. surplus budget
c. deficit budget
d. none of the above
2. This represents spending by the government on the infrastructure of the economy-roads,
railways, ports and so on without which production is not possible
a. economic services
b. administrative services
c. social services
d. current operating expenditures
3. Which of the following is not true?
a. tax is a burden
b. government raises revenue through tax collection
c. taxes increase disposable income
d. a or b
4. Which of the following is not part of non-tax revenue?
a. income tax
b. car registration fee
c. operating and service income
d. income from public enterprise
5. This includes expenses to promote social welfare like education, health, housing and
community development.
a. Social services
b. Economic services
c. Administrative Services
d. All of the above

2. Discuss the following

1. What factors might prevent the government from effectively fine tuning the economy?

2. What is fiscal policy? How do you differentiate it from monetary policy?

7
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

8
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 6

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

1
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and
fiscal policies are discussed including public and international economic issues. It introduces
basic models of macroeconomics and illustrates principles based on the experience of the
Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus
on the basic concepts about economics and the overview of macroeconomics. National income
and output will be discussed in Chapter 3 while monetary and fiscal policies will be discussed in
Chapter 4 and Chapter 5, respectively. The last three (3) chapters will focus on the theories of
growth and development; unemployment and inflation and international trade, exchange rate and
balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in

evaluating the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making
this world a better place for them, their families, and their communities.

2
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 6
ECONOMIC GROWTH AND DEVELOPMENT
Learning Outcomes: At the end of this chapter students are expected to:

1. Discuss economic growth and development

2. Differentiate the different theories of economic growth

1.1. Economic Growth versus Economic Development

Economic growth is best defined as a long-term expansion of the productive potential of
the economy. Sustained economic growth should lead to a higher real living standards and rising
employment. Short term growth is measured by the annual percentage (%) change in real GDP.

Economic development is a broad term that does not have a single, unique definition. In
this introductory study, we look at some interpretations of the meaning of economic
development. Economist Michael Todaro specified three objectives of development:

1.Life sustaining goods and services: To increase the availability and widen the distribution
of basic life-sustaining goods such as food, shelter, health and protection.

2. Higher incomes: To raise levels of living, including, in addition to higher incomes, the
provision of more jobs, better education, and greater attention to cultural and human values, all
of which will serve not only to enhance material well-being but also to generate greater
individual and national self-esteem.

3. Freedom to make economic and social choices: To expand the range of economic and
social choices available to individuals and nations by freeing them from servitude and
dependence not only in relation to other people and nation-states but also to the forces of
ignorance and human misery.

6.2. Theories of Economic Growth

1. Development as Growth and the Linear –Stages Theories

a. Rostow’s Stages of Growth

• Advocated by an American Economic Historian Walt W. Rostow, says that, the
transition from underdevelopment to development can be described in terms
of a series of steps or stages through which all countries must proceed.

• Five Categories of Growth:

1. Traditional Society
2. Pre-Conditions for Take-off into self-sustaining growth
3. Take-off
4. Drive to maturity
5. Age of High Mass Consumption

3
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

• The advanced countries had all passed the stage of “take-off into self-
sustaining growth”. While, underdeveloped countries are still in either the
traditional society or in the preconditions stage.

• Principle strategy of development necessary for any takeoff was the

mobilization of domestic and foreign saving in order to generate sufficient
investment to accelerate economic growth, the Harrod-Domar Growth Model.

b. Harrod-Domar Growth Model

• Every economy must save a certain proportion of its national income, if only to
replace worn-out or impaired capital goods (buildings, equipment, and
materials), however, in order to grow, new investments representing net
additions to the capital stock are necessary.
• Y = s
Y k The simplified version of the Harrod-Domar Theory, states simply
that the rate of growth of GDP( Y/Y) is determined jointly by the net national
savings ratio, s, and the national capital-output ratio, k.

• In the absence of government, the growth rate of national income will be

directly or positively related to the savings ratio (i.e., the more an economy is
able to save- and invest- out of a given GDP, the greater the growth of that
GDP will be) and inversely or negatively related to the economy’s capital-
output ratio i.e., the higher k is, the lower the rate of GDP growth will be.

• Rostow and others defined the take-off stage in countries that were able to
save 15-20% of GDP.

2. Structural Change Model

• Structural Change Theory focuses on the mechanism by which underdeveloped
economies transform their domestic economic structures from a heavy emphasis
on traditional subsistence agriculture to a more modern, more urbanized, and more
industrially diverse manufacturing and service economy.

• Lewis Theory of Development-formulated by Nobel Laureate W. Arthur Lewis

in the mid-1950’s and later modified, formalized, and extended by John Fei and
Gustav Ranis.

• In Lewis’ two-sector model, underdeveloped economy consists of two sectors:

1. Traditional, overpopulated rural subsistence sector- characterized by zero
marginal labor productivity, which Lewis classified as Surplus Labor which can
be withdrawn from the traditional agricultural sector without any loss of output.

4
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

2. High productivity modern Urban Industrial Sector into which labor from
subsistence sector is gradually transferred.

3. International-Dependence Revolution

1. NEO-COLONIAL DEPENDENCE MODEL

• An indirect outgrowth of Marxist thinking. Attributed the existence and continuance

of underdevelopment primarily to the historical evolution of a highly unequal
international capitalist system of rich country-poor country relationships.
• Attributes the large part of the developing world’s continuing poverty to the existence
and policies of the industrial capitalist countries of the northern hemisphere and their
extensions in the form of small but powerful elite or comprador groups in the less
developed countries.
• Believes that international special-interest power groups such as multinational
corporations, national bilateral-aid agencies, and multilateral assistance organizations
like World Bank or the International Monetary Fund (IMF) inhibit any genuine reform
efforts that would benefit the wider population and, in some cases, actually lead to
even lower levels of living and to the perpetuation of underdevelopment.

• Underdevelopment is an externally induced phenomenon, in contrast to the linear

stages and structural-change theories that stressed on internal constraints such as
insufficient savings and investment or lack of education and skills.

• Revolutionary struggles or at least a major restructuring of the world capitalist system

is therefore required to free dependent developing nations from the direct and indirect
economic control of their developed-world and domestic oppressors.

2. FALSE-PARADIGM MODEL

• Attributes underdevelopment to faulty and inappropriate advice provided by well-

meaning but often uninformed, biased, and ethnocentric international “expert”
advisers from developed-country assistance agencies and multinational donor
organizations. There experts are said to offer complex but ultimately misleading
models of development that often lead to inappropriate or incorrect policies.

• Also, leading university intellectuals, trade unionists, high-level government

economists, and other civil servants all get their training in developed country
institutions where they are unwittingly served an unhealthy dose of alien concepts
and elegant but inapplicable theoretical models.

5
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

University economics courses, entails the perpetuation of the teaching of many

”irrelevant” Western concepts and models. While, in government policy discussions,

too much emphasis is placed on attempts to measure capital-output ratios, to

increase savings and investment ratios, institutional and structural reforms are

neglected or given only cursory attention.

3. DUALISTIC-DEVELOPMENT THESIS

• Dualism represents the existence and persistence of substantial and even

increasing divergences between rich and poor nations and rich and poor peoples on
various levels.

6
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. Compare and contrast the different theories of economic growth.

2. Cite five (5) major issues of economic development in the world today.

3. Evaluate the Philippine economy using Rostow’s stages of growth.

7
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

8
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 7

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

1
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and
fiscal policies are discussed including public and international economic issues. It introduces
basic models of macroeconomics and illustrates principles based on the experience of the
Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus
on the basic concepts about economics and the overview of macroeconomics. National income
and output will be discussed in Chapter 3 while monetary and fiscal policies will be discussed in
Chapter 4 and Chapter 5, respectively. The last three (3) chapters will focus on the theories of
growth and development; unemployment and inflation and international trade, exchange rate and
balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in

evaluating the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making
this world a better place for them, their families, and their communities.

2
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 7
INFLATION AND UNEMPLOYMENT

Learning Outcomes: At the end of this chapter, students are expected to:

1. Explain the different causes of unemployment and its impact

2. Compute the different measures of inflation and determine its
implications

1.1. Definition of Unemployment

Unemployment may be defined as a condition in the economy where a significant number
in the labor force are out-of-work. It is a situation in the economy whereby, for one reason or
another, available resources are not fully used for productive purposes.

Unemployment Rate
The unemployment rate measures the percentage of the total civilian labor force that are
currently unemployed. The formula for the unemployment rate is given by

1.2. Types of Unemployment

There are three types of unemployment and these are:

1. Frictional unemployment. Frictional unemployment is the term used to describe

unemployment that results from difficulties in matching qualified workers with new jobs. Many
qualified workers seeking work are not able to find new jobs right away, usually because of a lack
of complete information about new job openings. While it is likely that qualified workers will soon
be matched with new jobs, these workers are considered frictionally unemployed during the time
that they spend searching for their new jobs.

2. Structural unemployment. Structural unemployment results from structural changes in the

economy that causes workers to lose jobs. The same structural changes also prevent these
workers from obtaining new jobs. Structurally unemployed workers are not qualified for the new
job openings that are available, mainly because they lack the education or training needed for the
new jobs. Consequently, the structurally unemployed tend to be out of work for long periods of
time, usually until they learn the skills needed for the new jobs or until they decide to relocate.
There are two major reasons that cause an absence of demand for workers in particular
industry:

• Changes in Technology - as personal computers replaced typewriters, typewriter

factories shut down. Workers in typewriter factories become unemployed and had to
find other industries to be employed in.

• Changes in Tastes - if bagpipes become unpopular, bagpipe companies will go

bankrupt and their workers will be unemployed.
3. Cyclical unemployment. Unemployment caused by the recession phase of the business
cycle. An economy that is in recession faces higher levels of unemployment. When this happens,

3
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

there are more unemployed workers than job openings due to the breakdown of the economy.
This type of unemployment is heavily concentrated on the activity of the economy i.e. inadequate
total spending. Cyclical unemployment is a very serious problem when it occurs.

1.3. Economic and Non-economic Costs of Unemployment

The costs of unemployment are both economic and social. The existence of
unemployment implies that the nation is not using its scarce resources as effectively as possible.
This is reflected in the opportunity cost of unemployed resources, which is the loss of all the goods
and services that these resources could be producing if they were employed. Moreover,
unemployed workers lose the income, respect, and self-esteem they would enjoy if they were
working. Widespread joblessness increases poverty, heightens racial and ethnic tensions, and
reduces hope for material advancement.

1.4. Definition of Inflation

Inflation refers to the sustained or continuous rise in the general price level or, alternatively,
as a sustained or continuous fall in the value of money.

Calculating the rate of inflation or deflation. Suppose that in the year following the base year,
the GDP deflator is equal to 110. The percentage change in the GDP deflator from the previous
(base) year is obtained using the same formula used to calculate the growth rate of GDP. This
110 − 100 
percentage change is found to be   x100% = 10% implying that the GDP deflator index
 100 
has increased by 10%.

Another way of describing this finding would be to say that the inflation rate in the year following
the base year was 10%. More generally, if the percentage change in the GDP deflator over some
period is a positive X%, then the rate of inflation over the same period is X%. If the percentage
change in the GDP deflator over some period is a negative X%, then the rate of deflation over
that period is X%.

Consumer price index. The GDP deflator is not the only index measure of the price level. Among
the many other price indices, the consumer price index (CPI) is the most frequently cited. The
CPI differs from the GDP deflator in two important ways. First, the CPI measures only the change
in the prices of a “basket” of goods consumed by a typical household. Second, the CPI uses base
year quantities rather than current year quantities in calculating the price level index value. The
formula for the CPI is given as; CPI= (base year basket quantities x current year prices/base
year basket quantities x base year prices) x 100%.

Construction of a price index. As an example of a CPI index, assume for the sake of simplicity
that the basket of goods consumed by a typical household consisted of just three goods: pizza,
soda, and ice cream. The quantities consumed of each of these three goods in the base year are
given in Table 1 along with the prices of these three goods in both the base year and the current
year.

4
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Data for A CPI Index

Good Base year Base year Base year Current year Current year
quantity price (P) expenditure(P) price (P) expenditure (P)
Pizza 12 11.25 135.00 12.00 144.00
Soda 25 1.55 38.75 1.45 36.25
Ice 15 2.95 44.25 3.05 45.75
cream
218.00 226.00

The base year expenditure figures are found by multiplying the base year quantities by the base
year prices. Similarly, the current year expenditure figures are found by multiplying the base year
quantities by the current year prices. In order to calculate a CPI for this basket of three goods,
one needs only the total base year and current year expenditures on all three goods. The CPI
value for the current year may then be calculated as follows:
current year CPI=(226/218)x100=103.76%
The CPI value for the base year is always equal to 100. In this case, (218/218)x100=100%

Thus, the percentage change in the current year CPI from the base year CPI is

In other, words, the rate of inflation in the current year is 3.67%

1.5. Types of inflation

1. Demand-pull inflation–occurs when the level of spending in the economy exceeds the
amount firms are capable of producing. Excess demand pulls the general price level.

2. Cost- push and supply shock inflation

Cost push inflation is the term used when labor unions demand for higher wages. It is the
inflation from the supply side.

Supply shock inflation occurs when a vital resource becomes scarce, causing its price to
rise and raising the costs of production for firms.

3. Monetary Inflation– if the value of transaction remains the same as it would at full
employment, and the velocity of money is constant, an increase in money supply results
in a rise in the price level.

Losers in Inflation

5
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

1. Holders of Securities– those who have investment in both bonds and stocks lose during
the time of inflation. The value of their money depreciates in terms of purchasing power.

2. Pension Holders – elderly received fixed monthly pensions; any increase in inflation will
reduce the amount of goods and services that their pensions can purchase.

3. Fixed Income Earners– laborers who receive a fixed amount of money monthly cannot
keep up with the accelerating inflation.

Winners in Inflation

1. Windfall to Fixed Asset Owners– land owners gain during inflation as the value of land
and other fixed assets appreciate.

2. Producers– their income increases when inflation takes place: the increase in the price of
commodities results to higher returns for business firms.

1.6. Purchasing Power of Peso

The purchasing power of the peso shows how much the peso in the base period is worth
in another period. It gives an indication of the real value of the peso in a given period relative to
the peso value in the base period.
Formula: PPP = (1 / CPIa) * 100
Where: PPP = Purchasing Power of the Peso
CPIa = Consumer Price Index for All Items

6
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

EXERCISES AND ASSESSMENT

1. The following table shows the price and output over a five-year period for an economy
that produces only one good. Assume that year 2 is the base year.

Year Units of Output Price per Unit (in Pesos)

1 16 P5

2 20 6

3 30 7

4 36 8

5 40 9

________1. Give the price index for year 4.

________2. Give the nominal GDP for year 5.
________3. State which years you would inflate nominal GDP. Explain.
________4. State which years you would deflate nominal GDP. Explain.

7
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

8
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics

INSTRUCTIONAL MATERIAL
FOR ECON 30023
MACROECONOMICS

CHAPTER 8

COMPILED BY

NORIE L. MANIEGO
AILEEN L. CAMBA

1
 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Course Overview

This course, Macroeconomics, will provide an overview of macroeconomic issues: the

determination of income and output, employment, interest rates, and inflation. Monetary and
fiscal policies are discussed including public and international economic issues. It introduces
basic models of macroeconomics and illustrates principles based on the experience of the
Philippines and other economies.

This, Instructional Material, is divided into eight (8) parts. The first two (2) chapters focus
on the basic concepts about economics and the overview of macroeconomics. National income
and output will be discussed in Chapter 3 while monetary and fiscal policies will be discussed in
Chapter 4 and Chapter 5, respectively. The last three (3) chapters will focus on the theories of
growth and development; unemployment and inflation and international trade, exchange rate and
balance of payments.

Course Outcomes

At the end of this course, students are expected to;

1. Employ the tools of economic thinking in explaining macroeconomic phenomena and in

evaluating the relative effectiveness of fiscal and monetary policies;
2. Discuss the relevance of economic analysis to real-world economic problems;
3. Apply enduring macroeconomic principles in their personal lives to contribute in making
this world a better place for them, their families, and their communities.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

CHAPTER 8

INTERNATIONAL TRADE, EXCHANGE RATE, AND BALANCE OF PAYMENTS

Learning Outcomes: At the end of this chapter students are expected to:

1. Explain the role of international trade and exchange rates in the

economy.
2. Discuss the different theories of trade and identify the most
appropriate to apply in the country.
3. Analyze and evaluate the status of the country’s BOP standing and
come up with policies to have a more favorable condition for the
country

8.1. International Trade

International trade allows countries to expand their markets for both goods and services
that otherwise may not have been available domestically. As a result of international trade, the
market is more competitive which results in more competitive pricing which brings home a cheaper
product to the consumer.

Absolute vs comparative advantage

Absolute advantage looks at the efficiency of producing a single product. This analysis
helps countries avoid the production of products that would yield little or no demand, leading to
losses. A country’s absolute advantage, or disadvantage, in a particular industry, can play an
important role in the types of goods it chooses to produce. For example, Japan and Italy can both
produce automobiles, but Japan can produce sports cars of a higher quality and at a faster rate
with greater profit, thus, Japan is said to have an absolute advantage in that particular industry.
In this example, Italy may be better served to devote the limited resources and manpower to
another industry or other types of vehicles, such as electric cars, in which it may enjoy an absolute
advantage, rather than trying to compete with Japan's efficiency.

A country has a comparative advantage when a good can be produced at a lower cost in
terms of other goods. The question each country or company should be asking when it trades is
this: “What do we give up to produce this good?” It should be no surprise that the concept of
comparative advantage is based on this idea of opportunity cost. For example, assume that China
has enough resources to produce either smartphones or computers. China can produce 10
computers or 10 smartphones. Computers generate a higher profit. Therefore, the opportunity
cost is the difference in value lost from producing a smartphone rather than a computer. If China
earns $100 for a computer and $50 for a smartphone then the opportunity cost is $50. If China
has to choose between producing computers over smartphones it will select computers.

8.2. Exchange Rate

When you travel to a foreign country like the US, you must convert your money into the
currency of that country to transact business in that country. Even if you stay at home, your peso
cannot directly buy goods from another country. For example, if you import foreign books from

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the US, for example, the peso you paid for the book must be converted into dollars. The peso
equivalent of one unit of the dollar is called the exchange rate.
The exchange rate is the price of a unit of foreign currency in terms of the domestic
currency. In the Philippines, the exchange rate is expressed as the value of one US dollar in terms
of the peso. There are always two currencies involved in every exchange rate quotation, for
example P43.80/$1, this means that one US dollar can be bought (or is equivalent to) for P43.80.
Importance of the Exchange Rate
• Exchange Rate serves as a basic link between the local and the overseas market for
various goods, services, and financial assets. Two countries are able to compare prices
of goods and services, and assets quoted in different currencies by using a common
standard, that is, the exchange rate.
• It measures the external value of a country’s currency.
• It establishes the cost of a country’s import and export.

Exchange Rate Determination

The value of one currency relative to another currency is determined based on the
exchange rate system adopted by a country. At present, the Philippines follows a floating
exchange rate system. The value of the peso against one US dollar is determined by how much
US dollars are supplied and demanded in the Philippine foreign exchange market. This
arrangement is also termed as a flexible exchange rate. The Peso appreciates in value when the
amount of pesos to acquire a US dollar becomes smaller. The peso is more valuable when it
appreciates. Conversely, the peso depreciates when the price of the US dollar increases in terms
of pesos or more pesos are needed to acquire one US dollar. This means that the purchasing
power of the pesos in terms of foreign money falls
On the other hand, under a fixed exchange rate regime, the government through the CB
specifies exactly the rate at which the peso will be converted into dollars. In the case where there
is a surplus or shortage of foreign currency in the market, the Central Bank must engage in the
buying or selling of foreign currency in order to maintain the fixed rate. Devaluation is often a term
used to indicate an official action of the government to reduce the value of currency in terms of
another while revaluation is the opposite.

Supply of Foreign Exchange

⚫ Consists of receipts of dollars that the country earns or receives
⚫ Export earnings, foreign tourism in the country, use of services sold by Philippine
companies: transport, telecommunication, banks, remittances coming into the country
from Filipinos living or working abroad (OFWs), proceeds from foreign loans, inflows of
foreign capital for investments in the country, deposit of foreign money in any Philippine-
based banks

Demand for Foreign Exchange

• Imports of Goods and Services-Foreign Exchange is demanded to make the payment for
imports of goods and services.
• Tourism-Foreign exchange is needed to meet expenditure incurred in foreign tours.
• Unilateral Transfers sent abroad-Foreign exchange is required for making unilateral
transfers like sending gifts to other countries.
• Purchase of Assets in Foreign Countries-It is demanded to make payment for purchase
of assets, like land, shares, bonds, etc. in the foreign countries.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

• Speculation-Demand for foreign exchange arises when people want to make gains -from
appreciation of currency.

Flexible Exchange Rate System

The flexible exchange rate is determined by the demand for and supply of a foreign
currency, in this case, the US dollar. The exchange rate changes if the demand and/or supply of
US dollars change. The diagrams below illustrate the changes in the exchange rate
(depreciation/appreciation of the Philippine peso.)

Interaction of Demand and Supply

Peso/US Dollar
Peso/US Dollar
S0
S0
S1
45/$

43/$
43/$

41/$
D1

D0 D0

100 200
Quantity of $ 100 200 Quantity of $

Fig. Peso Depreciates

Fig. Peso Appreciates

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

Peso-Dollar Exchange Rate

Change in the Quantity of Dollars Effect of the peso currency

Increase in the demand for dollars Peso currency becomes cheaper (depreciate)

Increase in the supply of dollars Peso currency becomes expensive

(appreciates)

Decrease in the demand for dollars Peso currency becomes expensive

(appreciate)

Decrease in the supply of dollars Peso currency becomes cheaper (depreciate)

Factors Affecting the Supply and Demand for Dollars

Relative income changes. An increase in the real GDP of the Philippines because of good
economic management increases the purchasing power of the Filipinos which may induce higher
imports from other countries like the US. This means that the demand for US dollars also
increases. As a result, the price of the US dollar rises and the value of the Philippine peso falls.

Relative price changes. In case prices of goods and services are relatively higher in the
Philippines than in the US, Filipinos are inclined to buy from the US. This results to a greater
demand for US dollars, and so the exchange rate of the peso for the dollar increases making the
value of the peso to fall.

Relative interest rate changes. Suppose the interest rates are relatively higher in the Philippines
than in the US, this will reduce Filipino investments in the US while American and other foreign
investors increase their investments in the Philippines, thereby increasing the supply of US dollars
in the country.

Other factors such as political management and external shocks may influence the peso-dollar
exchange rates. Political leadership with control-strong mandates and credible political leadership
may strengthen the peso while weak political leadership because of issues of governance and
corruption may weaken the peso. Favorable policy shocks transmitted from outside sources make
the peso strong whereas unfavorable policy shocks transmitted to the country make the peso
weak.

8.3. The Balance of Payments (BOP)

Private individuals, firms and government agencies of one country transact business with
other persons, businesses and governments in other countries. These transactions are known as
international transactions or payments. The Balance of Payments summarizes all international
transactions that a country makes. The Balance of Payments is divided into three accounts; Cu
current Account, Capital Account and Overall BOP Position.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The Balance of Payments (BOP) is a summary of the economic transactions of a country

for a specific period of time with the rest of the world. It serves as an accounting statement of the
economic dealings between residents and non-residents of a country.
Any transaction may represent an inflow or an outflow. An inflow is a credit item and
represents the supply or an addition to foreign currency (foreign exchange reserves) while an
outflow is a debit item and represents the demand for foreign currency or a reduction in foreign
exchange reserves.
The Balance of Payments may be used as an indicator of economic and political stability
of a country. For example, if a country has a consistently positive BOP, this could mean that there
is significant foreign investment within that country. It may also mean that the country does not
export much of its currency.

The Current Account consists of trade and transfers. This account measures the net
transfer of real resources between the domestic economy and the rest of the world. Trade refers
to transactions merchandise or goods and non-merchandise or service involving exports and
imports of merchandise items are the commodity items that can be seen under exports and
imports. Balance of trade is the difference between a country's imports and its exports. Balance
of trade is the largest component of a country's Balance of Payments. Debit items include imports,
foreign aid, domestic spending abroad and domestic investments abroad since these represent
an outflow of foreign currency. Credit items include exports, foreign spending in the domestic
economy and foreign investments in the domestic economy which represent an inflow of foreign
currency. A country has a trade deficit if it imports more than it exports; the opposite scenario
results to a trade surplus. (Current account surplus, current account deficit)
Transfers include remittances of Overseas Filipino Workers, interest and royalties
received from investment from other countries which also represent an inflow of foreign currency.
TheCapital and Financial Account is divided into two main categories: the capital account
and the financial account. The capital account covers capital transfers and acquisition/disposal of
non-produced, non-financial assets while financial account covers transactions associated with
financial assets and liabilities.
The Overall BOP Position can be a surplus, a deficit or a balance. A BOP surplus arises
when inflows are greater than outflows while a BOP deficit is incurred when outflows exceed
inflows. When inflows and outflows are equally matched, the BOP position is in balance.
Operationally, the BOP position is computed using two approaches: (i) as the sum of the balances
in the current, capital and financial accounts (referred to as above-the-line items); or (ii) as the
change in the net international reserves that is attributed to transactions (referred to as below-the
line items). Ideally, both approaches should yield the same result. However, because of data
limitations particularly in the first approach, the overall BOP position is determined using the
second approach and any discrepancy between the two approaches is termed as Net Unclassified
Items.

Net Unclassified Items (or errors and omissions) is an offsetting account to

bring above-the-line and below-the-line into balance. Discrepancy arises because data sources
are inadequate or inconsistent with one another in terms of coverage, time of recording and
valuation. A positive discrepancy or Net Unclassified Items denotes an understatement of inflows
and/or an overstatement of outflows. Conversely, a negative entry denotes an overstatement of
inflows and/or understatement of outflows

Cash Account or international Reserve Account

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

The cash account is a balancing item, if the total payment exceeds the total income in the current
and the capital account; there is decrease in the balancing amount. In other words, it shows the
net outflow of foreign reserves. The errors and omissions adjust the statistical discrepancies. A
country receives international cash reserve in the following forms:-
1. The foreign currency is received when the quantity sold abroad exceeds the quantity
purchased abroad.
2. Gold purchased or mined in the country itself.
3. The deposit with the International Monetary Fund (IMF).

Balance of Payments Deficit

This happens when all the payment outflows exceed inflows. It means that the country’s
international reserves are falling in order to pay for the deficit.
Balance of Payments Surplus
The surplus of foreign currency will increase the country’s asset holdings and that the
surplus will eventually cause the accumulation of new reserves of foreign currency.

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EXERCISES AND ASSESSMENT

1. Multiple Choice: Encircle the correct answer.

1. This tells meaningfully whether the country earned more than it paid out during the period in
terms of trade.
a. Balance sheet b. current account c. balance of trade d. capital account

2.The exchange rate

a. enables one to know the value of the foreign currency.
b. establishes the international value of a currency in international transactions.
c. serves as a connecting link between the price levels of one country with the rest
of the world.
d. all of the above.

3. If exchange rates are high

a. it will stimulate exports
b. discourage the level of imports
c. stimulate both exports and imports
d. both a and b.

4.People who engage in the buying and selling of foreign exchange and who makes profit out of
the difference between the buying and selling of foreign exchange.
a. Foreign exchange dealers b. Foreign exchange suppliers
c. Foreign exchange users d. all of the above

5.Trade in services is a component of

a. current account b. capital account c. official reserves d. none of the
above

6. Being the lender of last resort, the ____ holds international reserves for the foreign exchange
requirements of the country in case supply from domestic commercial banks falls short of the total
demand.
a. Bangko Sentral ng Pilipinas b. Asian Development Bank
c. World Bank Group d. International Monetary Fund

Please refer to the figure below for #s 7-10.

7. Which of the following statements is true?

a. The quantity of pounds demanded falls when the dollar appreciates.
b. The quantity of pounds supplied declines as the dollar price of the pound rises.
c. At the equilibrium exchange rate, the pound price of $1 is ½ pound
d. The dollar appreciates if the demand for pounds increases.

8. At the price of$2 for 1 pound in this figure:

a. the dollar –pound exchange rate is unstable.
b. the quantity of pounds supplied equals the quantity demanded.
c. the dollar price of 1 pound equals the pound price of $1.
d. US goods exports to Britain must equal US goods imports from Britain.

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 INSTRUCTIONAL MATERIAL FOR ECON 30023 MACROECONOMICS

9. Other things equal, a leftward shift of the demand curve in this figure:
a. would depreciate the dollar
b. would create a shortage of pounds at the previous price of $2 for 1 pound.
c. might be caused by a major recession in the United States.
d. might be caused by a significant rise of real interest rates in Britain.

10. Other things equal, a rightward shift of the supply curve in this figure would:
a. depreciate the dollar and might be caused by a significant rise of real interest rates in
Britain.
b. depreciate the dollar and might be caused by a significant fall of real interest rates in
Britain.
c. appreciate the dollar and might be caused by a significant rise of real interest rates in
US.
d. appreciate the dollar and might be caused by a significant fall of real interest rates in
US.

4
dollar price of 1 pound

3
2
S1
1
0 D1
5 10 15
quantity of pounds

2. Identification:

__________1. The price of one currency in terms of another currency.

__________2. The exchange rate that is determined directly by market forces.
__________3. Statement that summarizes all international transactions or payments of one
country with the ROW.
__________4. A BOP situation in which credit items are less than the debit items.
__________5. BOP account that shows movements of long-term capital between countries, such
as foreign direct investments, portfolio investments and loans.
__________6. Refers to a deliberate increase in the exchange rate by the nation’s monetary
authorities from fixed or pegged level to another.

Identify whether the following transactions are inflows or outflows in the Balance of Payments.
______7. Profits and dividends brought by foreigners to their home countries.
______8. A Canadian Citizen purchased a Philippine Treasury Bills.
______9. A Hongkong pension fund buys stocks in the Philippine Stock Market.
______10. A foreign company purchases the assets of a power generating plant which was
offered for sale by the Philippine government.
______11. All payments for foreign debts liabilities.
______12. A Filipino citizen buys McDonald stock abroad.

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______13. A Filipino businessman invests in shopping centers in China.

______14. Balikbayan arrivals in the Philippines.
______15. Purchases made by the United States of Philippine garments.
______16. Foreign banks lending to the Philippines.
______17. Jollibee investments in Brunei.
______18. Bangko Sentral ng Pilipinas borrows funds from International Monetary Fund.
______19. Filipino tourists abroad.
______20. Fare paid for travel to Tokyo of Filipino businessmen on Philippine Airlines.

COURSE GRADING SYSTEM

Class Standing (portfolio/e-portfolio, projects, case analysis,

quizzes, summative test (long or unit test) 70%

Midterm / Final Examinations 30%

100%

Midterm Grade + Final Term Grade = FINAL GRADE

REFERENCES

Books
Dornbusch, Rudiger, Fischer, Stanley & Startz, Richard (2010), Macroeconomics, 11th ed.,
McGraw-Hill/Irwin

McConnel, Campbell and Brue, Stanley (2014), Macroeconomics: Principles, Problems and
Policies, 20th ed. McGraw Hill

Sexton, Robert L.(2012), Exploration of Macroeconomics, 6th ed., Cengage Learning Asia Pte
Ltd, 1st Phil. Reprint.

Websites

www.bsp.gov.ph
www.un.org
www.neda.gov.ph
https://faculty.washington.edu/danby/notes/notes12.html
https://www.sparknotes.com/economics/macro/aggregatedemand/section2/
www.slideshare.net demand-and-supply analysis
https://www.economicsdiscussion.net/money/top-5-theories-of-demand-for-money

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