LESSON 1 INFLATION

WHAT IS INFLATION?

 INFLATION IS AN ECONOMIC CONCEPT THAT REFERS TO INCREASES IN THE PRICE LEVEL OF

GOODS OVER A SET PERIOD OF TIME. THE RISE IN THE PRICE LEVEL SIGNIFIES THAT THE
CURRENCY IN A GIVEN ECONOMY LOSES PURCHASING POWER (I.E., LESS CAN BE BOUGHT
WITH THE SAME AMOUNT OF MONEY).

THE CAUSES FOR INFLATION IN THE SHORT TERM AND MEDIUM TERM REMAIN A
CONTESTED ISSUE AMONG ECONOMISTS ALL OVER THE WORLD. HOWEVER, THERE IS A
CONSENSUS THAT, IN THE LONG TERM, INFLATION IS CAUSED BY CHANGES IN THE MONEY
SUPPLY. (CFI)

 INFLATION IS A GENERAL AND ONGOING RISE IN THE LEVEL OF PRICES IN AN ENTIRE

ECONOMY. (OPENTEXT)

HOW IS INFLATION CALCULATED?

INFLATION IS MOST COMMONLY CALCULATED BY OBSERVING CHANGES IN PRICE INDICES.

GENERALLY, CHANGES IN THE CONSUMER PRICE INDEX (CPI) ARE USED AS A PROXY FOR
INFLATION. LET’S SAY THAT THE CPI FOR A GIVEN NATION WAS 210 AT THE END OF 2017 (THE
BASE YEAR) AND 220 AT THE END OF 2018. CALCULATING THE PERCENT CHANGE IN THOSE
VALUES WILL PROVIDE US WITH THE INFLATION OVER THIS TIME PERIOD:

INFLATION = 220 – 210

------------ X 100 = 4.76%
210

THUS, WE CAN CONCLUDE THAT INFLATION WAS APPROXIMATELY 5% IN 2018.

CALCULATING AN ANNUAL RATE OF INFLATION

CONSIDER THE SIMPLE BASKET OF GOODS WITH ONLY THREE ITEMS BELOW. SAY THAT IN ANY
GIVEN MONTH, A COLLEGE STUDENT SPENDS MONEY ON 20 HAMBURGERS, ONE BOTTLE OF
ASPIRIN, AND FIVE MOVIES. PRICES FOR THESE ITEMS OVER FOUR YEARS ARE GIVEN IN THE
TABLE THROUGH EACH TIME PERIOD (PD). PRICES OF SOME GOODS IN THE BASKET MAY RISE
WHILE OTHERS FALL. IN THIS EXAMPLE, THE PRICE OF ASPIRIN DOES NOT CHANGE OVER THE
FOUR YEARS, WHILE MOVIES INCREASE IN PRICE AND HAMBURGERS BOUNCE UP AND DOWN.
EACH YEAR, THE COST OF BUYING THE GIVEN BASKET OF GOODS AT THE PRICES PREVAILING AT
THAT TIME IS SHOWN.

ITEMS HAMBURGER ASPIRIN MOVIES TOTAL INFLATION RATE

QTY 20 1 BOTTLE 5 – –
(PD 1) PRICE $3.00 $10.00 $6.00 – –
(PD 1) AMOUNT SPENT $60.00 $10.00 $30.00 $100.00 –
(PD 2) PRICE $3.20 $10.00 $6.50 – –
(PD 2) AMOUNT SPENT $64.00 $10.00 $32.50 $106.50 6.5%
(PD 3) PRICE $3.10 $10.00 $7.00 – –
(PD 3) AMOUNT SPENT $62.00 $10.00 $35.00 $107.00 0.5%
(PD 4) PRICE $3.50 $10.00 $7.50 – –
(PD 4) AMOUNT SPENT $70.00 $10.00 $37.50 $117.50 9.8%

TO CALCULATE THE ANNUAL RATE OF INFLATION IN THIS EXAMPLE:

STEP 1. FIND THE PERCENTAGE CHANGE IN THE COST OF PURCHASING THE OVERALL BASKET
OF GOODS BETWEEN THE TIME PERIODS. THE GENERAL EQUATION FOR PERCENTAGE CHANGES
BETWEEN TWO YEARS, WHETHER IN THE CONTEXT OF INFLATION OR IN ANY OTHER
CALCULATION, IS:

(LEVEL IN NEW YEAR−LEVEL IN PREVIOUS YEAR) LEVEL IN PREVIOUS YEAR=PERCENTAGE

CHANGE (LEVEL IN NEW YEAR−LEVEL IN PREVIOUS YEAR) LEVEL IN PREVIOUS
YEAR=PERCENTAGE CHANGE

STEP 2. FROM PERIOD 1 TO PERIOD 2, THE TOTAL COST OF PURCHASING THE BASKET OF
GOODS IN TABLE 2 RISES FROM $100 TO $106.50. THEREFORE, THE PERCENTAGE CHANGE
OVER THIS TIME—THE INFLATION RATE—IS:

(106.50−100)100.0 = 0.065 = 6.5% (106.50−100) 100.0 = 0.065 = 6.5%

STEP 3. FROM PERIOD 2 TO PERIOD 3, THE OVERALL CHANGE IN THE COST OF PURCHASING THE
BASKET RISES FROM $106.50 TO $107. THUS, THE INFLATION RATE OVER THIS TIME, AGAIN
CALCULATED BY THE PERCENTAGE CHANGE, IS APPROXIMATELY:

(107−106.50) 106.50 = 0.0047 = 0.47% (107−106.50) 106.50 = 0.0047 = 0.47%

STEP 4. FROM PERIOD 3 TO PERIOD 4, THE OVERALL COST RISES FROM $107 TO $117.50. THE
INFLATION RATE IS THUS:

(117.50−107) 107 = 0.098 =9.8% (117.50−107) 107 = 0.098 = 9.8%

THIS CALCULATION OF THE CHANGE IN THE TOTAL COST OF PURCHASING A BASKET OF GOODS
TAKES INTO ACCOUNT HOW MUCH IS SPENT ON EACH GOOD. HAMBURGERS ARE THE LOWEST-
PRICED GOOD IN THIS EXAMPLE, AND ASPIRIN IS THE HIGHEST-PRICED. IF AN INDIVIDUAL BUYS
A GREATER QUANTITY OF A LOW-PRICE GOOD, THEN IT MAKES SENSE THAT CHANGES IN THE
PRICE OF THAT GOOD SHOULD HAVE A LARGER IMPACT ON THE BUYING POWER OF THAT
PERSON’S MONEY. THE LARGER IMPACT OF HAMBURGERS SHOWS UP IN THE “AMOUNT SPENT”
ROW, WHERE, IN ALL TIME PERIODS, HAMBURGERS ARE THE LARGEST ITEM WITHIN THE
AMOUNT SPENT ROW.

IF INPUTS TO PRODUCE HIGH-DEMAND, INELASTIC GOODS INCREASE IN PRICE, SUPPLIERS WILL

BE COMPELLED TO RAISE THEIR PRICES TO COMPENSATE. THIS CAN BE DUE TO A NUMBER OF
REASONS, SUCH AS ENVIRONMENTAL CATASTROPHES, TARIFFS, GOVERNMENT SANCTIONS, OR
SCARCITY. IF WIDESPREAD ENOUGH, THE PHENOMENON CAN NUDGE THE CPI HIGHER,
RESULTING IN INFLATION.

THE OPPOSITE IS ALSO TRUE – WHEREBY LOWER INPUT COSTS CAN RESULT IN DEFLATION¹.

¹DEFLATION IS A DECREASE IN THE GENERAL PRICE LEVEL OF GOODS AND SERVICES. PUT
ANOTHER WAY, DEFLATION IS NEGATIVE INFLATION. WHEN IT OCCURS, THE VALUE
OF CURRENCY GROWS OVER TIME. THUS, MORE GOODS AND SERVICES CAN BE PURCHASED
FOR THE SAME AMOUNT OF MONEY.

HOW CHANGES IN THE COST OF LIVING ARE MEASURED

THE MOST COMMONLY CITED MEASURE OF INFLATION IS THE CONSUMER PRICE INDEX (CPI).
THE CPI IS CALCULATED BASED ON THE PRICES IN A FIXED BASKET OF GOODS AND SERVICES
THAT REPRESENTS THE PURCHASES OF THE AVERAGE FAMILY OF FOUR.
DEFINING AND CALCULATING CPI

THE CONSUMER PRICE INDEX (CPI) IS A STATISTICAL ESTIMATE OF THE LEVEL OF PRICES OF
GOODS AND SERVICES BOUGHT FOR CONSUMPTION BY HOUSEHOLDS. IT MEASURES CHANGES
IN THE PRICE LEVEL OF A MARKET BASKET OF GOODS AND SERVICES USED BY HOUSEHOLDS.
THE CPI IS CALCULATED BY COLLECTING THE PRICES OF A SAMPLE OF REPRESENTATIVE ITEMS
OVER A SPECIFIC PERIOD OF TIME. GOODS AND SERVICES ARE DIVIDED INTO CATEGORIES, SUB
CATEGORIES, AND SUB-INDEXES. ALL OF THE INFORMATION IS COMBINED TO PRODUCE THE
OVERALL INDEX OF CONSUMER EXPENDITURES. THE ANNUAL PERCENTAGE CHANGE IN A CPI IS
USED TO MEASURE INFLATION. THE CPI CAN BE USED TO INDEX THE REAL VALUE OF WAGES,
SALARIES, PENSIONS, AND PRICE REGULATION. IT IS ONE OF THE MOST CLOSELY WATCHED
NATIONAL ECONOMIC STATISTICS.

CALCULATING CPI USING A SINGLE ITEM

IN ORDER TO CALCULATE THE CPI USING A SINGLE ITEM THE FOLLOWING EQUATION IS USED:

CURRENT CPI = CURRENT ITEM PRICE × BASE YEAR PRICE × CURRENT CPI BASE YEAR CPI
CURRENT CPI = CURRENT ITEM PRICE × BASE YEAR PRICE × CURRENT CPI BASE YEAR CPI

CALCULATING THE CPI FOR MULTIPLE ITEMS

WHEN CALCULATING THE CPI FOR MULTIPLE ITEMS, IT MUST BE NOTED THAT MANY BUT NOT
ALL PRICE INDICES ARE WEIGHTED AVERAGES USING WEIGHTS THAT SUM TO 1 OR 100. WHEN
CALCULATING THE AVERAGE FOR A LARGE NUMBER OF PRODUCTS, THE PRICE IS GIVEN A
WEIGHTED AVERAGE BETWEEN 1 AND 100 TO SIMPLIFY CALCULATION. THE WEIGHTING
DETERMINES THE IMPORTANCE OF THE QUANTITY OF THE PRODUCT ON AVERAGE. THE
EQUATION FOR CALCULATING THE CPI FOR MULTIPLE ITEMS IS:

CPI FOR MULTIPLE ITEMS=COST OF CPI MARKET BASKET AT CURRENT PERIOD PRICESCOST OF
CPI MARKET BASKET AT BASE PERIOD PRICES×100.CPI FOR MULTIPLE ITEMS=COST OF CPI
MARKET BASKET AT CURRENT PERIOD PRICES COST OF CPI MARKET BASKET AT BASE PERIOD
PRICES×100.

FOR EXAMPLE, IMAGINE YOU BUY FIVE SANDWICHES, TWO MAGAZINES, AND TWO PAIRS OF
JEANS. IN THE FIRST PERIOD, SANDWICHES ARE $6 EACH, MAGAZINES ARE $4 EACH, AND JEANS
ARE $35 EACH. THIS WILL BE OUR BASE PERIOD. IN THE SECOND PERIOD, SANDWICHES ARE $7,
MAGAZINES ARE $6, AND JEANS ARE $45.

MARKET BASKET AT BASE PERIOD PRICES = 5(6.00) + 2(4.00) + 2(35.00) = 108.00.

MARKET BASKET AT CURRENT PERIOD PRICES = 5(7.00) + 2(6.00) + 2(45.00) = 137.00.

CPI FOR MULTIPLE ITEMS=137108×100=127CPI FOR MULTIPLE ITEMS=137108×100=127

THE CPI BASED ON CONSUMPTION IS 127.

HOW DO U.S. GOVERNMENT STATISTICIANS MEASURE THE CONSUMER PRICE INDEX?

WHEN THE U.S. BUREAU OF LABOR STATISTICS (BLS) CALCULATES THE CONSUMER PRICE INDEX,
THE FIRST TASK IS TO DECIDE ON A BASKET OF GOODS THAT IS REPRESENTATIVE OF THE
PURCHASES OF THE AVERAGE HOUSEHOLD. THIS IS DONE BY USING THE CONSUMER
EXPENDITURE SURVEY, A NATIONAL SURVEY OF ABOUT 7,000 HOUSEHOLDS, WHICH PROVIDES
DETAILED INFORMATION ON SPENDING HABITS. CONSUMER EXPENDITURES ARE BROKEN UP
INTO EIGHT MAJOR GROUPS, SHOWN BELOW, WHICH IN TURN ARE BROKEN UP INTO MORE
THAN 200 INDIVIDUAL ITEM CATEGORIES. THE BLS CURRENTLY USES 1982–1984 AS THE BASE
PERIOD.

FOR EACH OF THE 200 INDIVIDUAL EXPENDITURE ITEMS, THE BLS CHOOSES SEVERAL HUNDRED
VERY SPECIFIC EXAMPLES OF THAT ITEM AND LOOKS AT THE PRICES OF THOSE EXAMPLES. SO,
IN FIGURING OUT THE “BREAKFAST CEREAL” ITEM UNDER THE OVERALL CATEGORY OF “FOODS
AND BEVERAGES,” THE BLS PICKS SEVERAL HUNDRED EXAMPLES OF BREAKFAST CEREAL. ONE
EXAMPLE MIGHT BE THE PRICE OF A 24-OZ. BOX OF A PARTICULAR BRAND OF CEREAL SOLD AT
A PARTICULAR STORE. THE SPECIFIC PRODUCTS AND SIZES AND STORES CHOSEN ARE
STATISTICALLY SELECTED TO REFLECT WHAT PEOPLE BUY AND WHERE THEY SHOP. THE BASKET
OF GOODS IN THE CONSUMER PRICE INDEX THUS CONSISTS OF ABOUT 80,000 PRODUCTS;
THAT IS, SEVERAL HUNDRED SPECIFIC PRODUCTS IN OVER 200 BROAD-ITEM CATEGORIES.
ABOUT ONE-QUARTER OF THESE 80,000 SPECIFIC PRODUCTS ARE ROTATED OUT OF THE
SAMPLE EACH YEAR, AND REPLACED WITH A DIFFERENT SET OF PRODUCTS.

THE NEXT STEP IS TO COLLECT DATA ON PRICES. DATA COLLECTORS VISIT OR CALL ABOUT
23,000 STORES IN 87 URBAN AREAS ALL OVER THE UNITED STATES EVERY MONTH TO COLLECT
PRICES ON THESE 80,000 SPECIFIC PRODUCTS. A SURVEY OF 50,000 LANDLORDS OR TENANTS IS
ALSO CARRIED OUT TO COLLECT INFORMATION ABOUT RENTS.

THE CONSUMER PRICE INDEX IS THEN CALCULATED BY TAKING THE 80,000 PRICES OF
INDIVIDUAL PRODUCTS AND COMBINING THEM, USING WEIGHTS DETERMINED BY THE
QUANTITIES OF THESE PRODUCTS THAT PEOPLE BUY AND ALLOWING FOR FACTORS LIKE
SUBSTITUTION BETWEEN GOODS AND QUALITY IMPROVEMENTS, INTO PRICE INDICES FOR THE
200 OR SO OVERALL ITEMS. THEN, THE PRICE INDICES FOR THE 200 ITEMS ARE COMBINED INTO
AN OVERALL CONSUMER PRICE INDEX. ACCORDING THE CONSUMER PRICE INDEX WEBSITE,
THERE ARE EIGHT CATEGORIES USED BY DATA COLLECTORS:

THE EIGHT MAJOR CATEGORIES IN THE CONSUMER PRICE INDEX

1. FOOD AND BEVERAGES (BREAKFAST CEREAL, MILK, COFFEE, CHICKEN, WINE, FULL-SERVICE
MEALS, AND SNACKS)
2. HOUSING (RENTER’S COST OF HOUSING, HOMEOWNER’S COST OF HOUSING, FUEL OIL,
BEDROOM FURNITURE)
3. APPAREL (MEN’S SHIRTS AND SWEATERS, WOMEN’S DRESSES, JEWELRY)
4. TRANSPORTATION (NEW VEHICLES, AIRLINE FARES, GASOLINE, MOTOR VEHICLE INSURANCE)
5. MEDICAL CARE (PRESCRIPTION DRUGS AND MEDICAL SUPPLIES, PHYSICIANS’ SERVICES,
EYEGLASSES AND EYE CARE, HOSPITAL SERVICES)
6. RECREATION (TELEVISIONS, CABLE TELEVISION, PETS AND PET PRODUCTS, SPORTS
EQUIPMENT, ADMISSIONS)
7. EDUCATION AND COMMUNICATION (COLLEGE TUITION, POSTAGE, TELEPHONE SERVICES,
COMPUTER SOFTWARE AND ACCESSORIES)
8. OTHER GOODS AND SERVICES (TOBACCO AND SMOKING PRODUCTS, HAIRCUTS AND OTHER
PERSONAL SERVICES, FUNERAL EXPENSES)

EFFECTS OF INFLATION

1. DECREASE IN UNEMPLOYMENT

WHEN THE PRICE OF GOODS INCREASE, SO WILL REVENUES AND, SUBSEQUENTLY, PROFITS FOR
PRIVATE ENTERPRISES. THE INFLUX OF CAPITAL WILL ENABLE BUSINESSES TO EXPAND THEIR
OPERATIONS BY HIRING MORE EMPLOYEES.

2. DECREASE IN THE REAL VALUE OF DEBT

AS EXPLAINED ABOVE, INFLATION IS ASSOCIATED WITH A DECREASE IN INTEREST RATES. LOW

INTEREST RATES WILL CAUSE THE VALUE OF DEBT AND RELATED DEBT INSTRUMENTS TO
DECREASE. THIS MAY INCENTIVIZE CONSUMER SPENDING AS CONSUMERS MAY BE MORE
INCLINED TO TAKE ON MORE DEBT DURING THE PERIOD. ON THE OTHER HAND, BUSINESSES
MAY STRUGGLE TO SELL BONDS TO FINANCE THEIR OPERATIONS, AS BONDS WOULD BECOME
LESS ATTRACTIVE INVESTMENTS.
WHAT IS INFLATION TARGETING?

INFLATION TARGETING IS A COMMON PRACTICE AMONG CENTRAL BANKS GLOBALLY THAT

AIMS TO INFLUENCE THE LEVEL OF PRICES IN AN ECONOMY THROUGH THE USE OF SEVERAL
MONETARY POLICY TOOLS.

THE MAIN TOOLS USED FOR INFLATION TARGETING ARE INTEREST RATES, RESERVE
REQUIREMENTS, AND OPEN-MARKET TRANSACTIONS.

REAL OUTPUT AND NOMINAL OUTPUT

INFLATION INDEXES ARE USED TO SEPARATE CHANGES IN REAL OUTPUT FROM CHANGES IN
NOMINAL OUTPUT. ECONOMISTS MAKE USE OF THE TERM REAL WHEN DISCUSSING ABOUT
CONCEPTS THAT ARE ADJUSTED FOR INFLATION. REAL OUTPUT REFERS TO THE AGGREGATE
AMOUNT OF GOODS AND SERVICES PRODUCED, ADJUSTED FOR PRICED-LEVEL CHANGES. IT IS
THE MEASURES OF OUTPUT THAT WOULD KEEP GOING IF THE PRICE LEVEL HAD CONTINUED
CONSTANT. NOMINAL OUTPUT IS THE AGGREGATE AMOUNT OF GOODS AND SERVICES
MEASURED AT CURRENT PRICES.

FOR EXAMPLE, AGGREGATE OUTPUT INCREASES FROM PHP7.2 BILLION TO PHP9.0 BILLION.
NOMINAL OUTPUT HAS RISEN BY:

PHP9 BILLION – PHP7.2 BILLION PHP 1.8 BILLION

---------------------------------- = ----------------- X 100 = 25%
PHP 7.2.BILLION PHP 7.2 BILLION

SUPPOSE THE PRICE LEVEL HAS RISEN 20 PERCENT, FROM 100 PERCENT TO 120 PERCENT. THE
PRICE INDEX IS 120. SINCE THE PRICE INDEX ROSE, REAL OUTPUT (NOMINAL OUTPUT
ADJUSTED FOR INFLATION) HAS NOT RISEN BY 25 PERCENT; IT HAS RISEN BY LESS THAN THE
PRICE IN NOMINAL OUTPUT. TO PROVE HOW MUCH LESS, WE USE A FORMULA TO ADJUST THE
NOMINAL FIGURES TO EXPLAIN INFLATION. THIS IS CALLED DEFLATING THE NOMINAL FIGURES.
TO DEFLATE, WE DIVIDE THE CURRENT NOMINAL FIGURE, PHP 9 BILLION, BY THE PRICE INDEX
OF 120 PERCENT OF 1.2:

REAL OUTPUT = NOMINAL OUTPUT PHP 9 BILLION

------------------- X 100 ---------------- = PHP 7.5 BILLION
120 1.20
THAT THE PHP 7.5 BILLION IS THE MEASURE OF OUTPUT THAT WOULD HAVE CONTINUED IF
THE PRICED LEVEL HAS NOT ALTERED, THAT IS, THE MEASURE OF REAL OUTPUT. REAL OUTPUT
HAS ROSE FROM PHP 7.2 BILLION TO PHP 7.5 BILLION, OR BY PHP300 MILLION.

THE CONCEPTS REAL AND NOMINAL AND THE METHOD OF ADJUSTING FROM NOMINAL TO
REAL BY DIVIDING THE NOMINAL AMOUNT BY PRICE INDEX IS RECURRING. REMEMBER, THE
“REAL” AMOUNT IS THE NOMINAL AMOUNT DIVIDED BY THE PRICE INDEX.

LESSON 2 UNEMPLOYMENT
INTRODUCTION
UNEMPLOYMENT, ALSO REFERRED TO AS JOBLESSNESS, OCCURS WHEN PEOPLE ARE WITHOUT
WORK AND ACTIVELY SEEKING EMPLOYMENT.
THE TERM “UNEMPLOYMENT” IS OFTEN MISUNDERSTOOD, IT AS IT INCLUDES PEOPLE WHO
ARE WAITING TO RETURN TO A JOB AFTER BEING DISCHARGED, YET IT DOES NOT INCLUDE
INDIVIDUALS WHO HAVE STOPPED LOOKING FOR WORK IN THE PAST FOUR WEEKS DUE TO
VARIOUS REASONS SUCH AS LEAVING WORK TO PURSUE HIGHER EDUCATION, RETIREMENT,
DISABILITY, AND PERSONAL ISSUES. ALSO, PEOPLE WHO ARE NOT ACTIVELY SEEKING A JOB BUT
DO WANT TO WORK ARE NOT CLASSIFIED AS UNEMPLOYED.
UNEMPLOYMENT IMPOSES HIGH COSTS. UNEMPLOYED INDIVIDUALS SUFFER FROM LOSS OF
INCOME AND FROM STRESS. AN ECONOMY WITH HIGH UNEMPLOYMENT SUFFERS AN
OPPORTUNITY COST OF UNUSED RESOURCES. THE ADULT POPULATION CAN BE DIVIDED INTO
THOSE IN THE LABOR FORCE AND THOSE OUT OF THE LABOR FORCE. IN TURN, THOSE IN THE
LABOR FORCE ARE DIVIDED INTO EMPLOYED AND UNEMPLOYED. A PERSON WITHOUT A JOB
MUST BE WILLING AND ABLE TO WORK AND ACTIVELY LOOKING FOR WORK TO BE COUNTED
AS UNEMPLOYED; OTHERWISE, A PERSON WITHOUT A JOB IS COUNTED AS BEING OUT OF THE
LABOR FORCE. THE UNEMPLOYMENT RATE IS DEFINED AS THE NUMBER OF UNEMPLOYED
PERSONS DIVIDED BY THE NUMBER OF PERSONS IN THE LABOR FORCE (NOT THE OVERALL
ADULT POPULATION).
THE HUMAN COSTS OF UNEMPLOYMENT ALONE WOULD JUSTIFY MAKING A LOW LEVEL OF
UNEMPLOYMENT AN IMPORTANT PUBLIC POLICY PRIORITY. BUT UNEMPLOYMENT ALSO
INCLUDES ECONOMIC COSTS TO THE BROADER SOCIETY. WHEN MILLIONS OF UNEMPLOYED
BUT WILLING WORKERS CANNOT FIND JOBS, AN ECONOMIC RESOURCE IS GOING UNUSED. AN
ECONOMY WITH HIGH UNEMPLOYMENT IS LIKE A COMPANY OPERATING WITH A FUNCTIONAL
BUT UNUSED FACTORY. THE OPPORTUNITY COST OF UNEMPLOYMENT IS THE OUTPUT THAT
COULD HAVE BEEN PRODUCED BY THE UNEMPLOYED WORKERS.
WHO’S IN OR OUT OF THE LABOR FORCE?
SHOULD EVERYONE WITHOUT A JOB BE COUNTED AS UNEMPLOYED? OF COURSE NOT.
CHILDREN, FOR EXAMPLE, SHOULD NOT BE COUNTED AS UNEMPLOYED. SURELY, THE RETIRED
SHOULD NOT BE COUNTED AS UNEMPLOYED. MANY FULL-TIME COLLEGE STUDENTS HAVE
ONLY A PART-TIME JOB, OR NO JOB AT ALL, BUT IT SEEMS INAPPROPRIATE TO COUNT THEM AS
SUFFERING THE PAINS OF UNEMPLOYMENT. SOME PEOPLE ARE NOT WORKING BECAUSE THEY
ARE REARING CHILDREN, ILL, ON VACATION, OR ON PARENTAL LEAVE.
THE POINT IS THAT THE ADULT POPULATION IS NOT JUST DIVIDED INTO EMPLOYED AND
UNEMPLOYED. A THIRD GROUP EXISTS: PEOPLE WHO DO NOT HAVE A JOB, AND FOR SOME
REASON—RETIREMENT, LOOKING AFTER CHILDREN, TAKING A VOLUNTARY BREAK BEFORE A
NEW JOB—ARE NOT INTERESTED IN HAVING A JOB, EITHER. IT ALSO INCLUDES THOSE WHO DO
WANT A JOB BUT HAVE QUIT LOOKING, OFTEN DUE TO BEING DISCOURAGED BY THEIR
INABILITY TO FIND SUITABLE EMPLOYMENT. ECONOMISTS REFER TO THIS THIRD GROUP OF
THOSE WHO ARE NOT WORKING AND NOT LOOKING FOR WORK AS OUT OF THE LABOR
FORCE OR NOT IN THE LABOR FORCE.
DEFINITION:
EMPLOYED: CURRENTLY WORKING FOR PAY
UNEMPLOYED: OUT OF WORK AND ACTIVELY LOOKING FOR A JOB
OUT OF THE LABOR FORCE: OUT OF PAID WORK AND NOT ACTIVELY LOOKING FOR A JOB
LABOR FORCE: THE NUMBER OF EMPLOYED PLUS THE UNEMPLOYED
UNEMPLOYMENT: CALCULATION
THE UNEMPLOYMENT RATE IS NOT THE PERCENTAGE OF THE TOTAL ADULT POPULATION
WITHOUT JOBS, BUT RATHER THE PERCENTAGE OF ADULTS WHO ARE IN THE LABOR FORCE
BUT WHO DO NOT HAVE JOBS.
UNEMPLOYMENT IS CALCULATED AS A PERCENTAGE BY DIVIDING THE NUMBER OF
UNEMPLOYED INDIVIDUALS BY THE NUMBER OF ALL INDIVIDUALS CURRENTLY EMPLOYED IN
THE WORKFORCE. THE FINAL MEASUREMENT IS CALLED THE RATE OF UNEMPLOYMENT.
THE FORMULA FOR CALCULATING UNDEREMPLOYMENT IS:
UNDEREMPLOYMENT = NUMBER OF UNDEREMPLOYED
--------------------------------- X 100
TOTAL LABOR FORCE

THE UNEMPLOYMENT RATE IS NOT THE PERCENTAGE OF THE TOTAL ADULT POPULATION
WITHOUT JOBS, BUT RATHER THE PERCENTAGE OF ADULTS WHO ARE IN THE LABOR FORCE
BUT WHO DO NOT HAVE JOBS (OVER 16 YEARS OF AGE).

ILLUSTRATION:
THE TOTAL ADULT, WORKING-AGE POPULATION WAS 249.9 MILLION. OUT OF THIS TOTAL
POPULATION, 148.3 MILLION WERE CLASSIFIED AS EMPLOYED, AND 8.7 MILLION WERE
CLASSIFIED AS UNEMPLOYED. THE REMAINING 92.9 MILLION WERE CLASSIFIED AS OUT OF THE
LABOR FORCE.
PARTICULARS
MILLION
PERCENTAGE

TOTAL ADULT POPULATION OVER THE AGE OF 16

249.9

IN THE LABOR FORCE

157.0
EMPLOYED
148.3

UNEMPLOYED
8.7
5.5%

OUT OF THE LABOR FORCE

92.9

IN THIS EXAMPLE, THE UNEMPLOYMENT RATE CAN BE CALCULATED AS 8.7 MILLION

UNEMPLOYED PEOPLE DIVIDED BY 157 MILLION PEOPLE IN THE LABOR FORCE, WHICH WORKS
OUT TO A 5.5% RATE OF UNEMPLOYMENT.
CALCULATING LABOR FORCE PERCENTAGES
TO DETERMINE THE PERCENTAGE IN THE LABOR FORCE:
STEP 1.
DIVIDE THE NUMBER OF PEOPLE IN THE LABOR FORCE (157 MILLION) BY THE TOTAL ADULT
(WORKING-AGE) POPULATION (249.9 MILLION).

STEP 2.
MULTIPLY BY 100 TO OBTAIN THE PERCENTAGE.
PERCENTAGE IN THE LABOR FORCE = 157 /249.90 = .6282 X 100 = 62.82%
TO DETERMINE THE PERCENTAGE OUT OF THE LABOR FORCE:
STEP 1.
DIVIDE THE NUMBER OF PEOPLE OUT THE LABOR FORCE (92.9 MILLION) BY THE TOTAL ADULT
(WORKING-AGE) POPULATION (249.9 MILLION).

STEP 2.
MULTIPLY BY 100 TO OBTAIN THE PERCENTAGE.

PERCENTAGE IN THE LABOR FORCE = 92.9/249.9 = 0.3717 X 100 = 37.17%

TO DETERMINE THE UNEMPLOYMENT RATE:
STEP 1.
DIVIDE THE NUMBER OF UNEMPLOYED PEOPLE (8.7 MILLION) BY THE TOTAL LABOR FORCE (157
MILLION).

STEP 2.
MULTIPLY BY 100 TO OBTAIN THE RATE.

UNEMPLOYMENT RATE = 8.7/157 = 0.0554 X 100 = 5.54%

EFFECTS OF UNEMPLOYMENT
WHEN UNEMPLOYMENT RATES ARE HIGH AND STEADY, THERE ARE NEGATIVE IMPACTS ON
THE LONG-RUN ECONOMIC GROWTH. UNEMPLOYMENT WASTES RESOURCES, GENERATES
REDISTRIBUTIVE PRESSURES AND DISTORTIONS, INCREASES POVERTY, LIMITS LABOR MOBILITY,
AND PROMOTES SOCIAL UNREST AND CONFLICT. THE EFFECTS OF UNEMPLOYMENT CAN BE
BROKEN DOWN INTO THREE TYPES:
INDIVIDUAL: PEOPLE WHO ARE UNEMPLOYED CANNOT EARN MONEY TO MEET THEIR
FINANCIAL OBLIGATIONS. UNEMPLOYMENT CAN LEAD TO HOMELESSNESS, ILLNESS, AND
MENTAL STRESS. IT CAN ALSO CAUSE UNDEREMPLOYMENT WHERE WORKERS TAKE ON JOBS
THAT ARE BELOW THEIR SKILL LEVEL.
SOCIAL: AN ECONOMY THAT HAS HIGH UNEMPLOYMENT IS NOT USING ALL OF ITS RESOURCES
EFFICIENTLY, SPECIFICALLY LABOR. WHEN INDIVIDUALS ACCEPT EMPLOYMENT BELOW THEIR
SKILL LEVEL THE ECONOMIES EFFICIENCY IS REDUCED FURTHER. WORKERS LOSE SKILLS WHICH
CAUSES A LOSS OF HUMAN CAPITAL.
SOCIO-POLITICAL: HIGH UNEMPLOYMENT RATES CAN CAUSE CIVIL UNREST IN A COUNTRY.
REDUCING UNEMPLOYMENT
THERE ARE NUMEROUS SOLUTIONS THAT CAN HELP REDUCE THE AMOUNT OF
UNEMPLOYMENT:
DEMAND SIDE SOLUTIONS: MANY COUNTRIES AID UNEMPLOYED WORKERS THROUGH SOCIAL
WELFARE PROGRAMS. INDIVIDUALS RECEIVE UNEMPLOYMENT BENEFITS INCLUDING
INSURANCE, COMPENSATION, WELFARE, AND SUBSIDIES TO AID IN RETRAINING. AN EXAMPLE
OF A DEMAND SIDE SOLUTION IS GOVERNMENT FUNDED EMPLOYMENT OF THE ABLE-BODIED
POOR.
SUPPLY SIDE SOLUTIONS: THE LABOR MARKET IS NOT 100% EFFICIENT. SUPPLY SIDE SOLUTIONS
REMOVE THE MINIMUM WAGE AND REDUCE THE POWER OF UNIONS. THE POLICIES ARE
DESIGNED TO MAKE THE MARKET MORE FLEXIBLE IN AN ATTEMPT TO INCREASE LONG-RUN
ECONOMIC GROWTH. EXAMPLES OF SUPPLY SIDE SOLUTIONS INCLUDE CUTTING TAXES ON
BUSINESSES, REDUCING REGULATION, AND INCREASING EDUCATION.
TYPES OF UNEMPLOYMENT
CLASSICAL: OCCURS WHEN REAL WAGES FOR JOBS ARE SET ABOVE THE MARKET-CLEARING
LEVEL. IT CAUSES THE NUMBER OF JOB SEEKERS TO BE HIGHER THAN THE NUMBER OF
VACANCIES.
CYCLICAL: OCCURS WHEN THERE IS NOT ENOUGH AGGREGATE DEMAND IN THE ECONOMY TO
PROVIDE JOBS FOR EVERYONE WHO WANTS TO WORK. DEMAND FOR GOODS AND SERVICES
DECREASES, LESS PRODUCTION IS NEEDED, AND FEWER WORKERS ARE NEEDED.
STRUCTURAL: OCCURS WHEN THE LABOR MARKET IS NOT ABLE TO PROVIDE JOBS FOR
EVERYONE WHO WANTS TO WORK. THERE IS A MISMATCH BETWEEN THE SKILLS OF THE
UNEMPLOYED WORKERS AND THE SKILLS NEEDED FOR AVAILABLE JOBS. IT DIFFERS FROM
FRICTIONAL UNEMPLOYMENT BECAUSE IT LASTS LONGER.
FRICTIONAL: THE TIME PERIOD IN BETWEEN JOBS WHEN A WORKER IS SEARCHING FOR WORK
OR TRANSITIONING FROM ONE JOB TO ANOTHER.
HIDDEN: THE UNEMPLOYMENT OF POTENTIAL WORKERS THAT IS NOT TAKEN INTO ACCOUNT
IN OFFICIAL UNEMPLOYMENT STATISTICS BECAUSE OF HOW THE DATA IS COLLECTED. FOR
EXAMPLE, WORKERS ARE ONLY CONSIDERED UNEMPLOYED IF THEY ARE LOOKING FOR WORK
SO THOSE WITHOUT JOBS WHO HAVE STOPPED LOOKING ARE NO LONGER CONSIDERED
UNEMPLOYED.
LONG-TERM: USUALLY DEFINED AS UNEMPLOYMENT LASTING LONGER THAN ONE YEAR.

UNEMPLOYMENT AND OUTPUT

THE UNEMPLOYMENT RATES PROVIDE WITH GOOD INKLING OF HOW MUCH LABOR IS
AVAILABLE TO RAISE PRODUCTION AND TO THIS EXTENT GIVES A GOOD IDEA OF HOW FAST
THE ECONOMY COULD GROW.

CAPITAL IS THE SECOND IMPORTANT INPUT TO PRODUCTION. THE CAPITAL UTILIZATION RATE
IS THE RATE AT WHICH FACTORIES AND MACHINES ARE FUNCTIONING COMPARED TO THE
MAXIMUM SUSTAINABLE RATE AT WHICH THEY COULD BE USED IMPLIES HOW MUCH CAPITAL
IS READY TO BE USED FOR ECONOMIC GROWTH. POTENTIAL OUTPUT IS THE OUTPUT THAT
WOULD BECOME VISIBLE AT THE TARGET RATE OF UNEMPLOYMENT AND TARGET RATE OF
CAPACITY UTILIZATION.

THE OKUN’S RULE OF THUMB, STATES THAT A ONE-PERCENT POINT CHANGE IN THE
UNEMPLOYMENT RATE WILL BRING ABOUT OUTPUT IN THE ECONOMY TO CHANGE IN THE
OPPOSITE DIRECTION BY TWO PERCENT. FOR EXAMPLE, IF UNEMPLOYMENT INCREASES FROM
FIVE PERCENT TO SIX PERCENT, TOTAL OUTPUT PF PHP9 BILLION WILL FALL BY TWO PERCENT,
OR PHP180 MILLION, TO P8.8 BILLION.
LONG-TERM UNEMPLOYMENT VS. SHORT-TERM UNEMPLOYMENT
UNEMPLOYMENT THAT LASTS LONGER THAN 27 WEEKS EVEN IF THE INDIVIDUAL HAS SOUGHT
EMPLOYMENT IN THE LAST FOUR WEEKS IS CALLED LONG-TERM UNEMPLOYMENT. ITS EFFECTS
ARE FAR WORSE THAN SHORT-TERM UNEMPLOYMENT FOR OBVIOUS REASONS, AND THE
FOLLOWING ARE NOTED AS SOME OF ITS EFFECTS.
SOME 56% OF THE LONG-TERM UNEMPLOYED REPORTED A SIGNIFICANT DECREASE IN THEIR
NET WORTH.
FINANCIAL PROBLEMS ARE NOT THE ONLY EFFECTS OF LONG-TERM UNEMPLOYMENT AS 46%
OF THOSE IN SUCH A STATE REPORTED EXPERIENCING STRAINED FAMILY RELATIONSHIPS. THE
FIGURE IS RELATIVELY HIGHER THAN THE 39% PERCENT WHO WEREN’T UNEMPLOYED FOR AS
LONG.
ANOTHER 43% OF THE LONG-TERM UNEMPLOYED REPORTED A SIGNIFICANT EFFECT ON THEIR
ABILITY TO ACHIEVE THEIR CAREER GOALS.
SADLY, LONG-TERM UNEMPLOYMENT LED TO 38% OF THESE INDIVIDUALS LOSING THEIR SELF-
RESPECT AND 24% SEEKING PROFESSIONAL HELP.

UNDEREMPLOYMENT

WHAT IS UNDEREMPLOYMENT?
UNDEREMPLOYMENT OCCURS WHEN A PERSON DOES NOT WORK FULL TIME OR TAKES A JOB
THAT DOES NOT REFLECT THEIR ACTUAL TRAINING AND FINANCIAL NEEDS. THAT IS, THEIR JOB
DOESN’T USE ALL THEIR SKILLS AND EDUCATION, OR PROVIDES LESS THAN FULL TIME WORK.
THIS IS NOT THE SAME AS UNEMPLOYMENT, WHICH REFERS TO PEOPLE WHO ARE NOT
CURRENTLY EMPLOYED AT ALL.
CALCULATING UNDEREMPLOYMENT
THE FORMULA FOR CALCULATING UNDEREMPLOYMENT IS:

WHO IS CONSIDERED UNDEREMPLOYED?

UNDEREMPLOYMENT IS DIVIDED INTO THREE COMMON CATEGORIES, AS FOLLOWS:
SKILLED WORKERS IN LOW-INCOME JOBS
SKILLED WORKERS IN JOBS THAT DON’T FULLY UTILIZE THEIR SKILLS
PART-TIME WORKERS WHO WOULD RATHER WORK FULL-TIME
TYPES OF UNDEREMPLOYMENT
TWO TYPES OF UNDEREMPLOYMENT EXIST: VISIBLE AND INVISIBLE.
1. VISIBLE
VISIBLE UNDEREMPLOYMENT COMPRISES EMPLOYEES WHO WORK FEWER HOURS THAN WHAT
IS CONSIDERED NORMAL IN THEIR FIELD OR INDUSTRY. THEY POSSESS THE SKILLS TO WORK IN
A FULL-TIME POSITION BUT ARE UNABLE TO FIND REGULAR EMPLOYMENT. THEY USUALLY
WORK PART-TIME JOBS TO MAKE ENDS MEET.
2. INVISIBLE
INVISIBLE UNDEREMPLOYMENT REFERS TO PEOPLE WHO WORK IN JOBS THAT DON’T UTILIZE
THEIR SKILLS – SUCH AS A FINANCIAL ANALYST WORKING AS A WAITER IN A RESTAURANT. THIS
TYPE OF UNDEREMPLOYMENT IS VERY DIFFICULT TO MEASURE AND REQUIRES EXTENSIVE
RESEARCH AND SURVEYS.
IN ADDITION, A THIRD TYPE OF UNDEREMPLOYMENT EXISTS, WHICH IS CALLED “MARGINALLY
ATTACHED TO THE LABOR FORCE.” IT INCLUDES PEOPLE WHO HAVE LOOKED FOR
EMPLOYMENT IN THE PAST YEAR, WHO WOULD LIKE TO WORK, AND ARE AVAILABLE FOR
WORK, BUT ARE “DISCOURAGED WORKERS” OR THOSE WHO HAVE GIVEN UP LOOKING FOR
EMPLOYMENT ALTOGETHER BECAUSE OF THEIR PROLONGED INABILITY TO FIND WORK.
UNDEREMPLOYMENT ALSO INCLUDES PEOPLE WITH FULL-TIME EMPLOYMENT BUT WHO LIVE
BELOW THE POVERTY LINE. THEY ARE KNOWN AS THE “WORKING POOR.”
CAUSES OF UNDEREMPLOYMENT
THERE ARE MANY FACTORS THAT CAUSE UNDEREMPLOYMENT IN AN ECONOMY. FOLLOWING
ARE A FEW OF THE MOST COMMON CAUSES:
1. BUSINESS CYCLE
ONE OF THE MAIN REASONS FOR UNDEREMPLOYMENT IS THE BUSINESS CYCLE THE ECONOMY
CURRENTLY OPERATES IN. IF THE ECONOMY IS CURRENTLY IN A RECESSION OR ECONOMIC
DEPRESSION, IT IS UNLIKELY THAT ORGANIZATIONS WILL BE HIRING FOR MANY FULL-TIME
POSITIONS.
2. SUPPLY AND DEMAND
UNDEREMPLOYMENT ALSO OCCURS WHEN THE SUPPLY OF WORKERS IS GREATER THAN ITS
DEMAND. A FEW REASONS CAN BE AN INCREASE IN POPULATION GROWTH OR A DECREASE IN
THE DEMAND FOR A PRODUCT.
WHEN CERTAIN INDUSTRIES NO LONGER NEED WORKERS, PEOPLE WITH THE SKILLS THAT
MATCH THAT INDUSTRY MAY BE FORCED TO ACCEPT LOW-INCOME JOBS THAT DON’T FULLY
UTILIZE THEIR SKILLS. FOR EXAMPLE, THE DECLINE OF THE COAL INDUSTRY HAS FORCED MANY
FORMER MINING EMPLOYEES TO LOOK FOR WORK IN OTHER INDUSTRIES.
3. TECHNOLOGICAL CHANGES
SOMETIMES TECHNOLOGY TAKES THE JOB OF A WORKER WHO WOULD HAVE PREVIOUSLY
BEEN EMPLOYED IN A POSITION THAT HAS SINCE BECOME AUTOMATED. FOR EXAMPLE,
VENDING MACHINES HAVE TAKEN THE JOBS OF SOME CAFETERIA WORKERS AND CASHIERS,
AND ATMS HAVE REPLACED SOME BANK TELLERS.

DIFFERENCE BETWEEN UNEMPLOYMENT AND UNDEREMPLOYMENT

(HTPPS://WWW.DIFFERENCEBETWEEN.COM/DIFFERENCE-BETWEEN-UNEMPLOYMENT-AND-
VS-UNDEREMPLOYMENT)
MAY 11, 2017 POSTED BY DILI
4

KEY DIFFERENCE – UNEMPLOYMENT VS UNDEREMPLOYMENT

THE KEY DIFFERENCE BETWEEN UNEMPLOYMENT AND UNDEREMPLOYMENT IS

THAT UNEMPLOYMENT REFERS TO THE ECONOMIC SITUATION IN WHICH AN INDIVIDUAL WHO
IS ACTIVELY SEARCHING FOR EMPLOYMENT IS UNABLE TO FIND
WORK WHEREAS UNDEREMPLOYMENT IS A SITUATION WHERE THERE IS A MISMATCH
BETWEEN THE EMPLOYMENT OPPORTUNITIES AND THE SKILLS AND EDUCATION LEVEL OF THE
EMPLOYEES. BOTH UNEMPLOYMENT AND UNDEREMPLOYMENT RESULT IN ADVERSE
ECONOMIC CONDITIONS OF A COUNTRY AND SHOULD BE MANAGED EFFECTIVELY IN ORDER TO
REDUCE AND CONTROL ITS NEGATIVE EFFECTS. THUS, THE GOVERNMENT HAS A MAJOR ROLE
TO PLAY IN POLICY FORMATION IN ORDER TO RETAIN SKILLED EMPLOYEES.
DEFINING FULL EMPLOYMENT
FULL EMPLOYMENT IS DEFINED AS AN ACCEPTABLE LEVEL OF UNEMPLOYMENT SOMEWHERE
ABOVE 0%; THERE IS NO CYCLICAL OR DEFICIENT-DEMAND UNEMPLOYMENT. IT IS A STATE
WHEN AN ECONOMY HAS NO CYCLICAL OR DEFICIENT-DEMAND UNEMPLOYMENT.

FULL EMPLOYMENT REPRESENTS A RANGE OF POSSIBLE UNEMPLOYMENT RATES BASED ON

THE COUNTRY, TIME PERIOD, AND POLITICAL BIASES. IT IS OFTEN SEEN AS AN “IDEAL”
UNEMPLOYMENT RATE. IDEAL UNEMPLOYMENT EXCLUDES TYPES OF UNEMPLOYMENT WHERE
LABOR-MARKET INEFFICIENCY IS
REFLECTED. THE FULL EMPLOYMENT UNEMPLOYMENT RATE IS ALSO REFERRED TO AS
“NATURAL” UNEMPLOYMENT.
IN MACROECONOMICS, FULL EMPLOYMENT IS THE LEVEL OF EMPLOYMENT RATES WHERE
THERE IS NO CYCLICAL OR DEFICIENT-DEMAND UNEMPLOYMENT. MAINSTREAM ECONOMISTS
DEFINE FULL EMPLOYMENT AS AN ACCEPTABLE LEVEL OF UNEMPLOYMENT SOMEWHERE
ABOVE 0%. FULL EMPLOYMENT REPRESENTS A RANGE OF POSSIBLE UNEMPLOYMENT RATES
BASED ON THE COUNTRY, TIME PERIOD, AND POLITICAL BIASES.
INTERNATIONAL LABOR OFFICE

RELIABLE DATA ON LEAST DEVELOPED COUNTRIES (LDC) UNEMPLOYMENT ARE HARD TO

ACQUIRE (WORLD BANK (2003) AND SUBSEQUENT WORLD DEVELOPMENT INDICATORS IN
PAPER OR ON CD-ROM HAVE UNEMPLOYMENT FIGURES. THE PROBLEM WITH THESE FIGURES
IN LDCS IS THAT THOSE WITH LARGE AGRICULTURAL SECTOR HAVE LITTLE OPEN
UNEMPLOYMENT, THUS MAKING COMPARISON DIFFICULT. THE INTERNATIONAL LABOR
OFFICE’S ANNUAL WORLD EMPLOYMENT REPORT HAS INFORMATION ON STRUCTURE AND
EVOLUTION OF THE LABOR FORCE, LABOR FORCE PARTICIPATION, DISTRIBUTION OF THE
LABOR FORCE BY SECTOR, EMPLOYMENT GROWTH, REAL WAGES BY SECTOR, EMPLOYMENT OF
PROFESSIONALS AND TECHNICIANS, PUBLIC SPENDING ON EDUCATION AND VOCATIONAL
EDUCATION, ECONOMICALLY ACTIVE POPULATION, TRAINING PROGRAMS, EDUCATION AND
GROWTH, AND EMPLOYMENT OF WOMEN; THE ILO’S WORLD LABOR REPORT HAS DATA ON
LABOR MARKET DEMOGRAPHICS, DEPENDENCY RATIOS, AGING, FERTILITY, LIFE EXPECTANCY,
SOCIAL SECURITY EXPENDITURE, PENSIONS, HEALTH CARE, UNEMPLOYMENT BENEFITS,
POVERTY, AND INCOME DISTRIBUTION. THE ILO’S GLOBAL EMPLOYMENT TRENDS FOR WOMEN
2004 HAS DETAILED DATA ON THE EMPLOYMENT OF WOMEN. MORAWETZ (1974) ANALYZES
THE INABILITY OF MODERN INDUSTRY TO PROVIDE ADEQUATE EMPLOYMENT OPPORTUNITIES
FOR THE RAPIDLY GROWING LDC LABOR FORCE. KAO, ANSCHEL, AND EICHER (1964) HAVE A
COMPREHENSIVE REVIEW OF THE THEORETICAL AND EMPIRICAL LITERATURE ON DISGUISED
UNEMPLOYMENT IN AGRICULTURE. LEWIS (1954), HARRIS AND TODARO (1970), STARK (1984),
AND STARK AND LEVHARI (1982) DISCUSS THE DETERMINANTS OF MIGRATION FROM RURAL
AND URBAN AREAS. WORLD BANK (2003) DISCUSSES “GETTING THE BEST FROM CITIES,”
INCLUDING A SECTION ON RAILWAY DWELLERS IN MUMBAI MANAGING THEIR OWN
RESETTLEMENT. WILLIAMSON (1988) ANALYZES MIGRATION AND URBANIZATION.
LESSON 3 MONETARY POLICY
INTRODUCTION

DEFINITION
ECONOMICS, CONCEPTS, THEORIES, AND APPLICATIONS, NEBRES, ABRIEL, M, NATIONAL
BOOKSTORE, 2008
MONETARY POLICY IS A POLICY OF INFLUENCING THE ECONOMY THROUGH CHANGES IN THE
BANKING SYSTEM’S RESERVES THAT AFFECT THE MONEY SUPPLY AND CREDIT AVAILABILITY IN
THE ECONOMY. MONETARY AND BANKING REGULATIONS ARE THE COUNTENANCE OF
MONETARY POLICY BECAUSE THERE ARE INFLUENTIAL IN CONTROLLING THE VOLUME OF
MONEY AVAILABLE THROUGHOUT THE ECONOMIC SYSTEM. MONETARY POLICY IS
CONTROLLED BY THE CENTRAL BANK TO AFFECT THE AMOUNT, AVAILABILITY, AND USE OF
MONEY AND CREDIT.
HTTPS://EN.WIKIPEDIA.ORG/WIKI/MONETARY_POLICY_OF_THE_PHILIPPINES
MONETARY POLICY IS THE MONITORING AND CONTROL OF MONEY SUPPLY BY A CENTRAL
BANK. THIS IS USED BY THE GOVERNMENT TO BE ABLE TO CONTROL INFLATION, AND STABILIZE
CURRENCY. MONETARY POLICY IS CONSIDERED TO BE ONE OF THE TWO WAYS THAT THE
GOVERNMENT CAN INFLUENCE THE ECONOMY – THE OTHER ONE BEING FISCAL
POLICY (WHICH MAKES USE OF GOVERNMENT SPENDING, AND TAXES). MONETARY POLICY IS
GENERALLY THE PROCESS BY WHICH THE CENTRAL BANK, OR GOVERNMENT CONTROLS THE
SUPPLY AND AVAILABILITY OF MONEY, THE COST OF MONEY, AND THE RATE OF INTEREST.

GOALS OF MONETARY POLICY

CONTROLS EITHER THE COST OF VERY SHORT-TERM BORROWING¹ OF THE MONEY SUPPLY²,
OFTEN TARGETTING AN INFLATION RATE³ OR INTEREST RATE4 TO ENSURE PRICE STABILITY5
AND GENERAL TRUST IN THE CURRENCY.
CONTRIBUTE TO THE STABILITY OF GROSS DOMESTIC PRODUCT (GDP).
ACHIEVE AND MAINTAIN LOW UNEMPLOYMENT.
MAINTAIN PREDICTABLE EXCHANGE RATE6

¹SHORT-TERM BORROWING
SHORT-TERM BORROWING MEANS ALL INDEBTEDNESS IN RESPECT OF BORROWED MONEY
MATURING ON DEMAND OR WITHIN ONE YEAR FROM THE DATE OF CREATION THEREOF.

²MONEY SUPPLY
THE MONEY SUPPLY IS THE ENTIRE STOCK OF CURRENCY AND OTHER LIQUID INSTRUMENTS
CIRCULATING IN A COUNTRY’S ECONOMY AS OF A PARTICULAR TIME. THE MONEY SUPPLY CAN
INCLUDE CASH, COINS AND BALANCES HELD IN CHECKING AND SAVINGS ACCOUNT.

MONEY SUPPLY INDICATOR

MONEY SUPPLY INDICATORS ARE OFTEN FOUND TO CONTAIN NECESSARY INFORMATION FOR
PREDICTING FUTURE BEHAVIOR OF PRICES AND ASSESSING ECONOMIC ACTIVITY. MOREOVER,
THESE ARE USED BY ECONOMISTS TO CONFIRM THEIR EXPECTATIONS AND HELP FORECAST
TRENDS IN CONSUMER PRICE INFLATION. ONE CAN PREDICT, TO A CERTAIN EXTENT, THE
GOVERNMENT'S INTENTIONS IN REGULATING THE ECONOMY AND THE CONSEQUENCES THAT
RESULT FROM IT. FOR EXAMPLE, THE GOVERNMENT MAY OPT TO INCREASE MONEY SUPPLY TO
STIMULATE THE ECONOMY OR THE GOVERNMENT MAY OPT TO DECREASE MONEY SUPPLY TO
CONTROL A POSSIBLE MISHAP IN THE ECONOMY.

THESE INDICATORS TELL WHETHER TO INCREASE OR DECREASE THE SUPPLY. MEASURES THAT
INCLUDE NOT ONLY MONEY BUT OTHER LIQUID ASSETS ARE CALLED MONEY AGGREGATES
UNDER THE NAME M1, M2, M3, ETC.

M1: NARROW MONEY

M1 INCLUDES CURRENCY IN CIRCULATION. IT IS THE BASE MEASUREMENT OF THE MONEY
SUPPLY AND INCLUDES CASH IN THE HANDS OF THE PUBLIC, BOTH BILLS AND COINS, PLUS
PESO DEMAND DEPOSITS, TOURISTS’ CHECKS FROM NON-BANK ISSUERS, AND OTHER
CHECKABLE DEPOSITS. BASICALLY, THESE ARE FUNDS READILY AVAILABLE FOR SPENDING.
ADJUSTED M1 IS CALCULATED BY SUMMING ALL THE COMPONENTS MENTIONED ABOVE.

M2: BROAD MONEY

THIS IS TERMED BROAD MONEY BECAUSE M2 INCLUDES A BROADER SET OF FINANCIAL ASSETS
HELD PRINCIPALLY BY HOUSEHOLDS. THIS CONTAINS ALL OF M1 PLUS PESO SAVING DEPOSITS
(MONEY MARKET DEPOSIT ACCOUNTS), TIME DEPOSITS AND BALANCES IN RETAIL MONEY
MARKET MUTUAL FUNDS.

M3: BROAD MONEY LIABILITIES BROAD MONEY LIABILITIES INCLUDE M2 PLUS MONEY
SUBSTITUTES SUCH AS PROMISSORY NOTES AND COMMERCIAL PAPERS.

M4: LIQUIDITY MONEY

THESE INCLUDE M3 PLUS TRANSFERABLE DEPOSITS, TREASURY BILLS AND DEPOSITS HELD IN
FOREIGN CURRENCY DEPOSITS. ALMOST ALL SHORT-TERM, HIGHLY LIQUID ASSETS WILL BE
INCLUDED IN THIS MEASURE.

IMPLICATIONS
IF THE VELOCITY OF M1 AND M2 MONEY STOCK HAS BEEN LOW, THIS INDICATES THAT THERE
IS A LOT OF MONEY IN THE HANDS OF CONSUMERS AND MONEY IS NOT CHANGING HANDS
FREQUENTLY.

GENERALLY, WE WOULD EXPECT THAT WHEN MONEY SUPPLY INDICATORS ARE GROWING
FASTER THAN INTEREST RATES PLUS GROWTH RATE OR INFLATION, WHICHEVER IS HIGHER,
INTEREST RATES SHOULD POSSIBLY BE INCREASED. THIS SHOULD ONLY GENERALLY APPLY
WHEN BROAD MEASURES OF MONEY SUPPLY GROWTH ARE HIGHER THAN NARROW
MEASURES, TO RULE OUT SOME OF THE MEASUREMENT ERROR ISSUES THAT COULD EMERGE.

INFLATION
A GENERAL INCREASE IN PRICES AND FALL IN THE PURCHASING VALUE OF MONEY.
THIS REFERS TO THE RATE OF CHANGE IN THE CONSUMER PRICE INDEX (CPI) WHICH EXCLUDES
THE FOLLOWING ITEMS/COMMODITY GROUPS: RICE, CORN, FRUITS AND VEGETABLES, AND
FUEL ITEMS (GAS, LIQUEFIED PETROLEUM GAS (LPG), KEROSENE, GASOLINE AND DIESEL),
WHICH TOGETHER REPRESENT 18.4 PERCENT OF THE CPI BASKET.

³INFLATION RATE
THE RATE OF CHANGE IN THE WEIGHTED AVERAGE PRICES OF GOODS AND SERVICES TYPICALLY
PURCHASED BY CONSUMERS. THE WEIGHTS OF THE GOODS AND SERVICES ARE BASED ON
THEIR CORRESPONDING SHARE TO THE CONSUMER PRICE INDEX (CPI) BASKET, I.E. STANDARD
BASKET OF GOODS AND SERVICES PURCHASED BY A TYPICAL HOUSEHOLD. IN THE PHILIPPINES,
THE COMPOSITION OF THE CPI BASKET IS DETERMINED FROM THE FAMILY INCOME AND
EXPENDITURE SURVEY (FIES) PERIODICALLY CONDUCTED BY THE NATIONAL STATISTICS OFFICE
(NSO).

4INTEREST RATE
THE COST OF BORROWING MONEY OR THE AMOUNT PAID FOR LENDING MONEY EXPRESSED
AS A PERCENTAGE OF THE PRINCIPAL.
IMPACT OF THE INTEREST RATE
THE INTEREST RATE IS THE RATE AT WHICH INTEREST IS PAID BY A BORROWER (DEBTOR) FOR
THE USE OF MONEY THAT THEY BORROW FROM A LENDER (CREDITOR). IT IS VIEWED AS A
“COST” OF BORROWING MONEY. INTEREST-RATE TARGETS ARE A TOOL OF MONETARY POLICY.
THE QUANTITY OF MONEY DEMANDED VARIES INVERSELY WITH THE INTEREST RATE. CENTRAL
BANKS IN COUNTRIES TEND TO REDUCE THE INTEREST RATE WHEN THEY WANT TO INCREASE
INVESTMENT AND CONSUMPTION IN THE ECONOMY. HOWEVER, LOW INTEREST RATES CAN
CREATE AN ECONOMIC BUBBLE WHERE LARGE AMOUNTS OF INVESTMENTS ARE MADE, BUT
RESULT IN LARGE UNPAID DEBTS AND ECONOMIC CRISIS. THE INTEREST RATE IS ADJUSTED TO
KEEP INFLATION, THE DEMAND FOR MONEY, AND THE HEALTH OF THE ECONOMY IN A CERTAIN
RANGE. CAPPING OR ADJUSTING THE INTEREST RATE PARALLEL WITH ECONOMIC GROWTH
PROTECTS THE MOMENTUM OF THE ECONOMY.
5PRICE STABILITY
THE SITUATION WHEREBY THE PRICES OF GOODS AND SERVICES OFFERED IN THE
MARKETPLACE EITHER CHANGE VERY SLOWLY OR DO NOT CHANGE AT ALL. FACTORS
AFFECTING THIS INCLUDE EMPLOYMENT AND INFLATION.

MONETARY POLICY INSTRUMENTS/TOOLS

THE CENTRAL BANK INFLUENCES INTEREST RATES BY EXPANDING OR CONTRACTING THE
MONETARY BASE, WHICH CONSISTS OF CURRENCY IN CIRCULATION AND BANKS’ RESERVES ON
DEPOSIT AT THE CENTRAL BANK. CENTRAL BANKS HAVE THREE MAIN INSTRUMENTS OR TOOLS
OF MONETARY POLICY: OPEN MARKET OPERATIONS, THE DISCOUNT RATE AND THE RESERVE
REQUIREMENTS.

OPEN MARKET OPERATIONS

OPEN MARKET OPERATIONS (OMO) IS AN ECONOMIC MONETARY POLICY WHERE CENTRAL

BANKS PURCHASE OR SELL BONDS OR OTHER GOVERNMENT SECURITIES ON THE OPEN
MARKET IN AN EFFORT TO REGULATE THE MONEY SUPPLY. IN OTHER WORDS, THE FEDERAL
RESERVE BANK BUYS BONDS FROM INVESTORS OR SELLS ADDITIONAL BONDS TO INVESTORS IN
ORDER TO CHANGE THE NUMBER OF OUTSTANDING GOVERNMENT SECURITIES AND MONEY
AVAILABLE TO THE ECONOMY AS A WHOLE.
(HTTPS://WWW.MYACCOUNTINGCOURSE.COM/ACCOUNTING-DICTIONARY-OPEN-MARKET-
OPERATIONS)

OPEN MARKET OPERATIONS CONSIST OF REPURCHASE AND REVERSE REPURCHASE

TRANSACTIONS, OUTRIGHT TRANSACTIONS, AND FOREIGN EXCHANGE SWAPS.

REPURCHASE AND REVERSE REPURCHASE

THIS IS CARRIED OUT THROUGH THE REPURCHASE FACILITY AND REVERSE PURCHASE FACILITY
OF THE BANGKO SENTRAL NG PILIPINAS.

IN PURCHASE TRANSACTIONS, THE BANGKO SENTRAL BUYS GOVERNMENT SECURITIES WITH A

DEDICATION TO SELL IT BACK AT A SPECIFIED FUTURE DATE, AND AT A PREDETERMINED
INTEREST RATE. THE BSP'S PAYMENT INCREASES RESERVE BALANCES AND EXPANDS THE
MONETARY SUPPLY IN THE PHILIPPINES.

ON THE OTHER HAND, IN REVERSE REPURCHASE, THE GOVERNMENT ACTS AS THE SELLER, AND
WORKS TO DECREASE THE LIQUIDITY OF MONEY. THESE TRANSACTIONS USUALLY HAVE
MATURITIES RANGING FROM OVERNIGHT TO ONE MONTH.
OUTRIGHT TRANSACTIONS
UNLIKE THE REPURCHASE OR REVERSE REPURCHASE, THERE IS NO CLEAR INTENT BY THE
GOVERNMENT TO REVERSE THE ACTION OF THEIR SELLING/BUYING OF MONETARY SECURITIES.
THUS, THIS TRANSACTION CREATES A MORE PERMANENT EFFECT ON OUR MONETARY SUPPLY.
"WHEN THE BSP BUYS SECURITIES, IT PAYS FOR THEM BY DIRECTLY CREDITING ITS
COUNTERPARTY'S DEMAND DEPOSIT ACCOUNT WITH THE BSP.” THE REVERSE IS DONE UPON
THE SELLING OF SECURITIES.

FOREIGN EXCHANGE SWAPS

THIS REFERS TO THE ACTUAL EXCHANGE OF TWO CURRENCIES AT A SPECIFIC DATE, AT A RATE
AGREED UPON THE DEAL DATE AND THE REVERSE EXCHANGE OF THE CURRENCIES AT A
FARTHER ATE IN THE FUTURE, ALSO AT AN INTEREST RATE AGREED ON DEAL DATE.

ACCEPTANCE OF FIXED-TERM DEPOSITS

TO EXPAND ITS LIQUIDITY MANAGEMENT, THE BANGKO SENTRAL INTRODUCED THIS METHOD
IN 1998. IN THE SPECIAL DEPOSITS ACCOUNT, OR SDA, CONSISTS FIXED TERMS DEPOSITS BY
BANKS AND INSTITUTIONS AFFILIATED WITH THE BSP.

DISCOUNT RATE

TO INCREASE THE VOLUME OF CREDIT IN THE FINANCIAL SYSTEM, THE BANGKO SENTRAL NG
PILIPINAS EXTENDS LOANS, DISCOUNTS, AND ADVANCES TO BANKING INSTITUTIONS.
"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."
THERE ARE TWO TYPES OF REDISCOUNTING IN THE BSP: THE PESO REDISCOUNTING FACILITY
AND THE EXPORTER'S DOLLAR AND YEN REDISCOUNT FACILITY.

RESERVE REQUIREMENTS

THE RESERVE REQUIREMENT (OR CASH RESERVE RATIO) IS A CENTRAL BANK REGULATION THAT
SETS THE MINIMUM AMOUNT OF RESERVES THAT MUST BE HELD BY A COMMERCIAL BANK.
THE MINIMUM RESERVE IS GENERALLY DETERMINED BY THE CENTRAL BANK TO BE NO LESS
THAN A SPECIFIED PERCENTAGE OF THE AMOUNT OF DEPOSIT LIABILITIES THE COMMERCIAL
BANK OWES TO ITS CUSTOMERS. THE COMMERCIAL BANK'S RESERVES NORMALLY CONSIST
OF CASH OWNED BY THE BANK AND STORED PHYSICALLY IN THE BANK VAULT (VAULT CASH),
PLUS THE AMOUNT OF THE COMMERCIAL BANK'S BALANCE IN THAT BANK'S ACCOUNT WITH
THE CENTRAL BANK.

IN BANKING INSTITUTIONS, THERE ARE REQUIRED AMOUNTS THAT BANKS CANNOT LEND OUT
TO PEOPLE. THEY ALWAYS NEED TO MAINTAIN A CERTAIN BALANCE OF MONEY, WHICH ARE
CALLED "RESERVES". ONCE THESE RESERVE REQUIREMENTS ARE CHANGED AND ARE VARIED,
CHANGES IN THE MONETARY SUPPLY WILL BE OBSERVED GREATLY.

IN THE PHILIPPINES, THE RESERVE REQUIREMENT (OR CASH RESERVE RATIO)—THE AMOUNT
OF CASH A BANK MUST HOLD IN RESERVES AGAINST DEPOSITS MADE BY CUSTOMERS—IS
CURRENTLY AT 12% FOR UNIVERSAL AND COMMERCIAL BANKS, AND 3% AND 2% FOR THRIFT
AND RURAL BANKS, RESPECTIVELY.

HTTPS://CORPORATEFINANCEINSTITUTE.COM/RESOURCES/KNOWLEDGE/ECONOMICS
TYPES OF MONETARY POLICY
DEPENDING ON ITS OBJECTIVES, MONETARY POLICIES CAN BE EXPANSIONARY OR
CONTRACTIONARY.
EXPANSIONARY MONETARY POLICY
THIS IS A MONETARY POLICY THAT AIMS TO INCREASE THE MONEY SUPPLY IN THE ECONOMY
BY DECREASING INTEREST RATES, PURCHASING GOVERNMENT SECURITIES BY CENTRAL BANKS,
AND LOWERING THE RESERVE REQUIREMENTS FOR BANKS. AN EXPANSIONARY POLICY LOWERS
UNEMPLOYMENT AND STIMULATES BUSINESS ACTIVITIES AND CONSUMER SPENDING. THE
OVERALL GOAL OF THE EXPANSIONARY MONETARY POLICY IS TO FUEL ECONOMIC GROWTH.
HOWEVER, IT CAN ALSO POSSIBLY LEAD TO HIGHER INFLATION.
EXPANSIONARY MONETARY POLICY TENDS TO ENCOURAGE ECONOMIC ACTIVITY AS MORE
FUNDS ARE MADE AVAILABLE FOR LENDING BY THE BANKS. THIS, IN TURN, INCREASES
AGGREGATE DEMAND WHICH COULD EVENTUALLY FUEL INFLATION PRESSURES IN THE
DOMESTIC ECONOMY.
CONTRACTIONARY MONETARY POLICY
CONTRACTIONARY MONETARY POLICY TENDS TO DECREASE THE LEVEL OF LIQUIDITY/MONEY
SUPPLY IN THE ECONOMY.
CONTRACTIONARY MONETARY POLICY TENDS TO LIMIT ECONOMIC ACTIVITY AS LESS FUNDS
ARE MADE AVAILABLE FOR LENDING BY BANKS. THIS, IN TURN, LOWERS AGGREGATE DEMAND
WHICH COULD EVENTUALLY TEMPER INFLATION PRESSURES BY ECONOMIC ECONOMY.
THE GOAL OF A CONTRACTIONARY MONETARY POLICY IS TO DECREASE THE MONEY SUPPLY IN
THE ECONOMY. IT CAN BE ACHIEVED BY RAISING INTEREST RATES, SELLING GOVERNMENT
BONDS, AND INCREASING THE RESERVE REQUIREMENTS FOR BANKS. THE CONTRACTIONARY
POLICY IS UTILIZED WHEN THE GOVERNMENT WANTS TO CONTROL INFLATION LEVELS.

EXPANSIONARY MONETARY POLICY VERSUS CONTRACTIONARY MONETARY POLICY

EXPANSIONARY POLICY INCREASES THE TOTAL SUPPLY OF MONEY IN THE ECONOMY MORE
RAPIDLY THAN USUAL AND CONTRACTIONARY POLICY EXPANDS THE SUPPLY OF MONEY MORE
SLOWLY THAN NORMAL. EXPANSIONARY POLICY IS USED TO COMBAT UNEMPLOYMENT, WHILE
CONTRACTIONARY IS USED TO SLOW INFLATION.
SETTING BASE INTEREST RATES
(HTTPS://WWW.MINNEAPOLISFED.ORG/ARTICLE/2000/HOW-DO-LENDERS-SET-INTEREST-
RATES-ON-LOANS)( MATTHEW D. DIETTE)
FOR MANY BORROWERS, THE FACTORS THAT DETERMINE A BANK'S INTEREST RATE ARE A
MYSTERY. HOW DOES A BANK DECIDE WHAT RATE OF INTEREST TO CHARGE? WHY DOES IT
CHARGE DIFFERENT INTEREST RATES TO DIFFERENT CUSTOMERS? AND WHY DOES THE BANK
CHARGE HIGHER RATES FOR SOME TYPES OF LOANS, LIKE CREDIT CARD LOANS, THAN FOR CAR
LOANS OR HOME MORTGAGE LOANS?
FOLLOWING IS A DISCUSSION OF SOME CONCEPTS LENDERS USE TO DETERMINE INTEREST
RATES. IT IS IMPORTANT TO NOTE THAT MANY BANKS CHARGE FEES AS WELL AS INTEREST TO
RAISE REVENUE, BUT FOR THE PURPOSE OF OUR DISCUSSION, WE WILL FOCUS SOLELY ON
INTEREST AND ASSUME THAT THE PRINCIPLES OF PRICING REMAIN THE SAME IF THE BANK
ALSO CHARGES FEES.
COST-PLUS LOAN-PRICING MODEL
A VERY SIMPLE LOAN-PRICING MODEL ASSUMES THAT THE RATE OF INTEREST CHARGED ON
ANY LOAN INCLUDES FOUR COMPONENTS:
THE FUNDING COST INCURRED BY THE BANK TO RAISE FUNDS TO LEND, WHETHER SUCH
FUNDS ARE OBTAINED THROUGH CUSTOMER DEPOSITS OR THROUGH VARIOUS MONEY
MARKETS;
THE OPERATING COSTS OF SERVICING THE LOAN, WHICH INCLUDE APPLICATION AND PAYMENT
PROCESSING, AND THE BANK'S WAGES, SALARIES AND OCCUPANCY EXPENSE;
A RISK PREMIUM TO COMPENSATE THE BANK FOR THE DEGREE OF DEFAULT RISK INHERENT IN
THE LOAN REQUEST; AND
A PROFIT MARGIN ON EACH LOAN THAT PROVIDES THE BANK WITH AN ADEQUATE RETURN ON
ITS CAPITAL.
LET'S CONSIDER A PRACTICAL EXAMPLE: HOW THIS LOAN-PRICING MODEL ARRIVES AT AN
INTEREST RATE ON A LOAN REQUEST OF $10,000.
THE BANK MUST OBTAIN FUNDS TO LEND AT A COST OF 5 PERCENT.
OVERHEAD COSTS FOR SERVICING THE LOAN ARE ESTIMATED AT 2 PERCENT OF THE
REQUESTED LOAN AMOUNT AND
A PREMIUM OF 2 PERCENT IS ADDED TO COMPENSATE THE BANK FOR DEFAULT RISK, OR THE
RISK THAT THE LOAN WILL NOT BE PAID ON TIME OR IN FULL.
THE BANK HAS DETERMINED THAT ALL LOANS WILL BE ASSESSED A 1 PERCENT PROFIT MARGIN
OVER AND ABOVE THE FINANCIAL, OPERATING AND RISK-RELATED COSTS.
ADDING THESE FOUR COMPONENTS, THE LOAN REQUEST CAN BE EXTENDED AT A RATE OF 10
PERCENT (10% LOAN INTEREST RATE = 5% COST OF FUNDS + 2% OPERATING COSTS + 2%
PREMIUM FOR DEFAULT RISK + BANK'S TARGETED PROFIT MARGIN). AS LONG AS LOSSES DO
NOT EXCEED THE RISK PREMIUM, THE BANK CAN MAKE MORE MONEY SIMPLY BY INCREASING
THE AMOUNT OF LOANS ON ITS BOOKS.
PRICE-LEADERSHIP MODEL

MORE BANKS ARE USING A FORM OF PRICE LEADERSHIP IN ESTABLISHING THE COST OF CREDIT.
A PRIME OR BASE RATE IS ESTABLISHED BY MAJOR BANKS AND IS THE RATE OF INTEREST
CHARGED TO A BANK'S MOST CREDITWORTHY CUSTOMERS ON SHORT-TERM WORKING
CAPITAL LOANS.

THIS "PRICE LEADERSHIP" RATE IS IMPORTANT BECAUSE IT ESTABLISHES A BENCHMARK FOR

MANY OTHER TYPES OF LOANS. TO MAINTAIN AN ADEQUATE BUSINESS RETURN IN THE PRICE-
LEADERSHIP MODEL, A BANKER MUST KEEP THE FUNDING AND OPERATING COSTS AND THE
RISK PREMIUM AS COMPETITIVE AS POSSIBLE. BANKS HAVE DEVISED MANY WAYS TO
DECREASE FUNDING AND OPERATING COSTS, AND THOSE STRATEGIES ARE BEYOND THE SCOPE
OF THIS ARTICLE. BUT DETERMINING THE RISK PREMIUM, WHICH DEPENDS ON THE
CHARACTERISTICS OF THE INDIVIDUAL BORROWER AND THE LOAN, IS A DIFFERENT PROCESS.
CREDIT-SCORING SYSTEMS AND RISK-BASED PRICING

CREDIT-SCORING SYSTEMS, WHICH WERE FIRST DEVELOPED MORE THAN 50 YEARS AGO, ARE
SOPHISTICATED COMPUTER PROGRAMS USED TO EVALUATE POTENTIAL BORROWERS AND TO
UNDERWRITE ALL FORMS OF CONSUMER CREDIT, INCLUDING CREDIT CARDS, INSTALLMENT
LOANS, RESIDENTIAL MORTGAGES, HOME EQUITY LOANS AND EVEN SMALL BUSINESS LINES OF
CREDIT. THESE PROGRAMS CAN BE DEVELOPED IN-HOUSE OR PURCHASED FROM VENDORS.
CREDIT SCORING IS A USEFUL TOOL IN SETTING AN APPROPRIATE DEFAULT PREMIUM WHEN
DETERMINING THE RATE OF INTEREST CHARGED TO A POTENTIAL BORROWER. SETTING THIS
DEFAULT PREMIUM AND FINDING OPTIMAL RATES AND CUTOFF POINTS RESULTS IN WHAT IS
COMMONLY REFERRED TO AS RISK-BASED PRICING. BANKS THAT USE RISK-BASED PRICING CAN
OFFER COMPETITIVE PRICES ON THE BEST LOANS ACROSS ALL BORROWER GROUPS AND
REJECT OR PRICE AT A PREMIUM THOSE LOANS THAT REPRESENT THE HIGHEST RISKS.
SO, HOW DO CREDIT-SCORING MODELS AND RISK-BASED PRICING BENEFIT THE BORROWER
WHO ONLY WANTS A LOAN WITH REASONABLE REPAYMENT TERMS AND AN APPROPRIATE
INTEREST RATE CHARGE? SINCE A BANK IS DETERMINING A REASONABLE DEFAULT PREMIUM
BASED ON PAST CREDIT HISTORY, BORROWERS WITH GOOD CREDIT HISTORIES ARE REWARDED
FOR THEIR RESPONSIBLE FINANCIAL BEHAVIOR. USING RISK-BASED PRICING, THE BORROWER
WITH BETTER CREDIT WILL GET A REDUCED PRICE ON A LOAN AS A REFLECTION OF THE
EXPECTED LOWER LOSSES THE BANK WILL INCUR. AS A RESULT, LESS RISKY BORROWERS DO
NOT SUBSIDIZE THE COST OF CREDIT FOR MORE RISKY BORROWERS.

HTTPS://CORPORATEFINANCEINSTITUTE.COM/RESOURCES/KNOWLEDGE/ECONOMICS
QUANTITATIVE EASING
QUANTITATIVE EASING (QE) IS A MONETARY POLICY OF PRINTING MONEY, THAT IS
IMPLEMENTED BY THE CENTRAL BANK TO ENERGIZE THE ECONOMY. THE CENTRAL BANK
CREATES MONEY TO BUY GOVERNMENT SECURITIES FROM THE MARKET IN ORDER TO
LOWER INTEREST RATES AND INCREASE THE MONEY SUPPLY. THESE ECONOMIC CONDITIONS
WILL THEN TRIGGER FINANCIAL INSTITUTIONS TO PROMOTE INCREASED LENDING AND TO
MAKE THE MONEY SUPPLY MORE LIQUID.
HTTPS://WWW.INVESTOPEDIA.COM/ARTICLES/ECONOMICS/10/QUANTITATIVE-EASING.ASP#
QUANTITATIVE EASING EFFECTIVELY ALLOWS CENTRAL BANKS TO DRAMATICALLY INCREASE
THE SIZE OF THEIR BALANCE SHEETS, WHICH ALSO INCREASES THE AMOUNT OF CREDIT
AVAILABLE TO BORROWERS. TO MAKE THAT HAPPEN, A CENTRAL BANK ISSUES CREATES NEW
MONEY AND USES THAT TO PURCHASE ASSETS FROM COMMERCIAL BANKS. THESE THEN
BECOME NEW RESERVES HELD AT THESE BANKS. IDEALLY, THE FUNDS THE BANKS RECEIVE FOR
THE ASSETS WILL THEN BE LOANED TO BORROWERS AT ATTRACTIVE RATES. THE IDEA IS THAT
BY MAKING IT EASIER TO OBTAIN LOANS, INTEREST RATES WILL REMAIN LOW AND
CONSUMERS AND BUSINESSES WILL BORROW, SPEND, AND INVEST.

ACCORDING TO ECONOMIC THEORY, THE INCREASED SPENDING LEADS TO INCREASED

CONSUMPTION, WHICH INCREASES THE DEMAND FOR GOODS AND SERVICES, FOSTERS JOB
CREATION, AND, ULTIMATELY, CREATES ECONOMIC VITALITY. WHILE THIS CHAIN OF EVENTS
APPEARS TO BE A STRAIGHTFORWARD PROCESS, REMEMBER THAT THIS IS AN
OVERSIMPLIFICATION OF A MORE COMPLEX TOPIC.

PHILIPPINE MONETARY/CURRENCY POLICY

BANGKO SENTRAL NG PILIPINAS

IN ACCORDANCE WITH REPUBLIC ACT NO. 265, THE BANGKO SENTRAL NG PILIPINAS OR BSP IS
THE CENTRAL MONETARY AUTHORITY OF THE REPUBLIC OF THE PHILIPPINES. IT PROVIDES
POLICY DIRECTIONS IN THE AREAS OF MONEY, BANKING AND CREDIT AND EXISTS TO
SUPERVISE OPERATIONS OF BANKS AND EXERCISES REGULATORY POWERS OVER NON-BANK
FINANCIAL INSTITUTIONS. IT KEEPS DEMAND FROM GROWING RAPIDLY WITH RESULTING HIGH
INFLATION, OR FROM GROWING TOO SLOWLY, RESULTING IN HIGH UNEMPLOYMENT.

THE PRIMARY OBJECTIVE OF BSP'S MONETARY POLICY IS TO PROMOTE PRICE

STABILITY BECAUSE IT HAS THE SOLE ABILITY TO INFLUENCE THE AMOUNT OF MONEY
CIRCULATING IN THE ECONOMY. IN DOING SO, OTHER ECONOMIC GOALS, SUCH AS
PROMOTING FINANCIAL STABILITY AND ACHIEVING BROAD-BASED, SUSTAINABLE ECONOMIC
GROWTH, ARE GIVEN CONSIDERATION IN POLICY DECISION-MAKING.
PHILIPPINE MONETARY FRAMEWORK I: 1980S TO EARLY 1990S

IN THE PAST, THE BSP FOLLOWED THE MONETARY AGGREGATE TARGETING APPROACH TO
MONETARY POLICY. THIS APPROACH IS BASED ON THE ASSUMPTION THAT THERE IS A STABLE
AND PREDICTABLE RELATIONSHIP BETWEEN MONEY, OUTPUT AND INFLATION.

IN PARTICULAR, ALL MONEY AGGREGATES, WITH THE EXCEPTION OF RESERVE MONEY, ARE
INCORPORATED WITH OUTPUT AND INTEREST RATE. THIS MEANS THAT THERE IS A LONG-RUN
RELATIONSHIP BETWEEN MONEY ON ONE HAND AND OUTPUT AND INTEREST RATE ON THE
OTHER SO THAT EVEN IF THERE ARE SHOCKS IN THE ECONOMY, THE VARIABLES WILL RETURN
TO THEIR TREND EQUILIBRIUM LEVELS.

THIS MEANS THAT CHANGES IN MONEY SUPPLY (ON THE ASSUMPTION THAT VELOCITY IS
STABLE OVER TIME) ARE DIRECTLY RELATED TO PRICE CHANGES OR TO INFLATION. THUS, IT IS
ASSUMED THAT THE BSP IS ABLE TO DETERMINE THE LEVEL OF MONEY SUPPLY THAT IS
NEEDED GIVEN THE DESIRED LEVEL OF INFLATION THAT IS CONSISTENT WITH THE ECONOMY'S
GROWTH OBJECTIVE. IN EFFECT, UNDER THE MONETARY TARGETING FRAMEWORK, THE BSP
CONTROLS INFLATION INDIRECTLY BY TARGETING MONEY SUPPLY.

PHILIPPINE MONETARY FRAMEWORK II: JUNE 1995 TO PRESENT

THE BSP EMPLOYS A MODIFIED FRAMEWORK BEGINNING THE SECOND SEMESTER OF 1995 IN
ATTEMPT TO ENHANCE THE EFFECTIVENESS OF THE MONETARY POLICY BY COMPLEMENTING
MONETARY AGGREGATE TARGETING WITH SOME FORM OF INFLATION TARGETING, PLACING
GREATER EMPHASIS ON PRICE STABILITY.

CERTAIN KEY MODIFICATIONS INCLUDE:

ALLOWS BASE MONEY LEVELS TO GO BEYOND TARGET AS LONG AS THE INFLATION RATES ARE
MET
AN EXCESS OF ONE OR MORE PERCENTAGE POINTS OF INFLATION OVER THE PROGRAM
INDUCES MOPPING UP OPERATION BY THE BSP TO BRING DOWN BASE MONEY TO THE
PREVIOUS MONTH'S LEVEL
UNDER AN AGGREGATE TARGETING FRAMEWORK, THE BSP FIXES MONEY GROWTH SO AS TO
MINIMIZE EXPECTED INFLATION. ON THE OTHER HAND, UNDER THE NEW FRAMEWORK, BSP
SETS MONETARY POLICY SO THAT PRICE LEVEL IS NOT JUST ZERO IN EXPECTATION BUT IS ALSO
ZERO REGARDLESS OF LATTER SHOCKS. MOREOVER, THE FRAMEWORK WAS CHANGED
BECAUSE BSP WANTED TO ADDRESS THE FACT THAT AGGREGATE TARGETING DID NOT
ACCOUNT FOR THE LONG-RUN EFFECTS OF MONETARY POLICY ON THE ECONOMY.

WITH THIS APPROACH, THE BSP CAN EXCEED THE MONETARY TARGETS AS LONG AS THE
ACTUAL INFLATION RATE IS KEPT WITHIN PROGRAM LEVELS AND POLICYMAKERS MONITOR A
LARGER SET OF ECONOMIC VARIABLES IN MAKING DECISIONS REGARDING THE APPROPRIATE
STANCE OF MONETARY POLICY.

CURRENT APPROACH: INFLATION TARGETING

AS MENTIONED EARLIER, INFLATION TARGETING REQUIRES A PUBLIC ANNOUNCEMENT OF AN

INFLATION RATE THAT A COUNTRY WILL TARGET FOR THE COMING YEARS, OR IN A GIVEN
PERIOD OF TIME. IT FOCUSES ON MAINTAINING A LOW LEVEL OF INFLATION, THAT WHICH IS
CONSIDERED TO BE OPTIMAL, OR AT LEAST WOULD ALLOW THE COUNTRY TO HAVE AMPLE
ECONOMIC GROWTH. ITS MAIN DESIRE IS TO ACHIEVE PRICE STABILITY AS THE ULTIMATE END
GOAL OF THE MONETARY POLICY. THE PHILIPPINES FORMALLY ADOPTED INFLATION
TARGETING AS THE FRAMEWORK FOR MONETARY POLICY ON JANUARY 2002.

THE PHILIPPINES’ INFLATION TARGET IS MEASURED THROUGH THE CONSUMER PRICE INDEX
(CPI). FOR 2009, INFLATION TARGET HAS BEEN SET TO BE 3.5 PERCENT, HAVING A 1%
TOLERANCE LEVEL, AND 4.5 PERCENT FOR 2010, ALSO HAVING 1% TOLERANCE. ALSO, THE
MONETARY BOARD OF THE PHILIPPINES ANNOUNCED A TARGET OF AROUND 4±1 PERCENT
FROM 2012 TO 2014.

EXCHANGE RATE

EXCHANGE RATES PLAY A SIGNIFICANT ROLE IN MONETARY TRANSMISSION MECHANISM AND

AT THE SAME TIME, IT CAN HAVE A LARGE IMPACT ON INFLATION RATES. ALTHOUGH THE BSP
HAS ADOPTED THE INFLATION TARGETING APPROACH, IT MAY BE TEMPTED TO INEXPLICITLY
TARGET EXCHANGE RATE TO ACHIEVE ITS LOW INFLATION TARGET. THE ISSUE HERE IS THE
EXTENT OF THE EXCHANGE RATE PASS-THROUGH OR ERPT TO DOMESTIC PRICES SINCE HIGHER
ERPT WOULD REQUIRE THE BSP TO SHIFT ITS ATTENTION TO EXCHANGE RATE MOVEMENTS TO
STABILIZE PRICES

ROLE OF MONETARY AGGREGATES

SINCE THE SHIFT TO INFLATION TARGETING, BSP HAS ALREADY ABANDONED MONETARY
AGGREGATES BECAUSE ITS INFORMATION CONTENT HAS APPARENTLY DECLINED IN THE
RECENT YEARS. MOREOVER, IT IS ALSO ASSUMED THAT A SHIFT OF APPROACH WAS NECESSARY
BECAUSE MONEY AGGREGATES ARE NORMALLY NOT GOOD INDICATORS OF FUTURE
ECONOMIC POLICY REQUIREMENTS DUE TO UNRELIABILITY OF MEASUREMENT

MEASUREMENT OF INFLATION AND LIQUIDITY TRAP

SINCE INFLATION TARGETING LEADS TO LOWER AND STABLE INFLATION RATES, MORE
IMPROVEMENT SHOULD THEN BE GIVEN TO THE MEASUREMENT OF THE CONSUMER PRICE
INDEX SINCE FEW PERCENTAGE POINTS HAVE GREATER REPERCUSSIONS WHEN RATES ARE
LOW. ERRORS IN CPI MEASUREMENT COULD LEAD TO INEFFECTIVE AND UNSUITABLE
MONETARY POLICY RESPONSE BY THE BSP WHICH DEFINITELY RESULT TO DETRIMENTAL
EFFECTS TO THE ECONOMY

ANOTHER ISSUE ARISING FROM MONETARY POLICIES IS THE LIQUIDITY TRAP. THIS HAPPENS
WHEN INFLATION RATE DECLINES TOO MUCH LEADING TO A THREAT OF DEFLATION. LIQUIDITY
TRAP IS DEFINED AS A SITUATION IN WHICH THERE ARE ZERO NOMINAL INTEREST RATES,
PERSISTENT DEFLATION AND DEFLATION EXPECTATIONS. IN THE EVENT THIS OCCURS, BONDS
AND MONEY EARN THE SAME REAL RATE OF RETURN THUS MAKING PEOPLE INDIFFERENT TO
HOLDING BONDS OR EXCESS MONEY

BUDGET DEFICIT AND EXTERNAL DEBTS

GIVEN HIGH BUDGET DEFICITS, THE GOVERNMENT IS CONCERNED ABOUT TWO CLOSELY
RELATED ISSUES: IT DOES NOT WANT TO PAY VERY HIGH INTEREST ON ITS BORROWINGS AND
IT DOES NOT WANT TO CROWD OUT THE MARKET. IDEALLY, THE GOVERNMENT COULD RAISE
TAX REVENUES TO AVOID BORROWING HUGE SUMS FROM THE MARKET. HOWEVER, THE
GOVERNMENT OPTED TO BORROW FROM THE INTERNATIONAL CAPITAL MARKET AND
THOUGH RATES ARE LOW, THESE HAVE SHORTER MATURITY AND COUNTRY'S OUTSTANDING
EXTERNAL DEBT HAS CONTINUED TO MOVE TOWARDS A LESS IDEAL POSITION

FISCAL DOMINANCE

ACCORDING TO THE FISCAL THEORY OF THE PRICE LEVEL, IT IS NOT THE NON-INTEREST
BEARING MONEY BUT THE TOTAL NOMINAL LIABILITIES INCLUDING INTEREST BEARING NOTES
AND FUTURE FISCAL SURPLUSES THAT MATTER FOR PRICE-LEVEL DETERMINATION. IN THE
ABSENCE OF FISCAL DISCIPLINE, AN INDEPENDENT CENTRAL BANK SUCH AS THE BSP CANNOT
GUARANTEE A STABLE NOMINAL ANCHOR. IN OTHER WORDS, FOR THE BSP TO SUCCESSFULLY
FOCUS ON PRICE STABILITY, THERE MUST BE A CREDIBLE COMMITMENT ON THE PART OF THE
NATIONAL GOVERNMENT TO REDUCE TOTAL FISCAL DEFICITS BY A MEANINGFUL AMOUNT.

LESSON 4 FISCAL POLICY

DEFINITION
ECONOMICS, CONCEPTS, THEORIES, AND APPLICATIONS, NEBRES, ABRIEL, M, NATIONAL
BOOKSTORE, 2008
FISCAL POLICY IS THE CAREFULLY CONSIDERED CHANGE IN EITHER GOVERNMENT SPENDING OR
TAXES TO MAKE MORE ACTIVE OR SLOWDOWN THE ECONOMY.
IF THE AGGREGATE INCOME IS TOO LOW, THE APPROPRIATE FISCAL POLICY IS EXPANSIONARY
FISCAL POLICY: REDUCE TAXES OR RISE GOVERNMENT SPENDING. IF THE AGGREGATE INCOME
IS TOO HIGH, THE APPROPRIATE FISCAL POLICY IS CONTRACTIONARY FISCAL POLICY: INCREASE
TAXES OR REDUCE GOVERNMENT SPENDING.
HTTPS://EN.WIKIPEDIA.ORG/WIKI/FISCAL_POLICY_OF_THE_PHILIPPINES
FISCAL POLICY IS THE USE OF GOVERNMENT REVENUE COLLECTION (TAXES OR TAX CUTS)
AND EXPENDITURE TO INFLUENCE A COUNTRY'S ECONOMY.
FISCAL POLICY IS BASED ON THE THEORIES OF THE BRITISH ECONOMIST JOHN MAYNARD
KEYNES, WHOSE KEYNESIAN ECONOMICS THEORIZED THAT GOVERNMENT CHANGES IN THE
LEVELS OF TAXATION AND GOVERNMENT SPENDING INFLUENCES AGGREGATE DEMAND AND
THE LEVEL OF ECONOMIC ACTIVITY.
FISCAL POLICY CAN BE DISTINGUISHED FROM MONETARY POLICY, IN THAT FISCAL POLICY
DEALS WITH TAXATION AND GOVERNMENT SPENDING AND IS OFTEN ADMINISTERED BY A
GOVERNMENT DEPARTMENT; WHILE MONETARY POLICY DEALS WITH THE MONEY
SUPPLY, INTEREST RATES AND IS OFTEN ADMINISTERED BY A COUNTRY'S CENTRAL BANK. BOTH
FISCAL AND MONETARY POLICIES INFLUENCE A COUNTRY'S ECONOMIC PERFORMANCE.
TYPES OR STANCES OF FISCAL POLICY
DEPENDING ON THE STATE OF THE ECONOMY, FISCAL POLICY MAY REACH FOR DIFFERENT
OBJECTIVES: ITS FOCUS CAN BE TO RESTRICT ECONOMIC GROWTH BY MEDIATING INFLATION
OR, IN TURN, INCREASE ECONOMIC GROWTH BY DECREASING TAXES, ENCOURAGING
SPENDING ON DIFFERENT PROJECTS THAT ACT AS STIMULI TO ECONOMIC GROWTH AND
ENABLING BORROWING AND SPENDING. THE THREE TYPES OR STANCES OF FISCAL POLICY ARE
THE FOLLOWING:
NEUTRAL FISCAL POLICY IS USUALLY UNDERTAKEN WHEN AN ECONOMY IS IN NEITHER
A RECESSION NOR AN EXPANSION. THE AMOUNT OF GOVERNMENT DEFICIT SPENDING (THE
EXCESS NOT FINANCED BY TAX REVENUE) IS ROUGHLY THE SAME AS IT HAS BEEN ON AVERAGE
OVER TIME, SO NO CHANGES TO IT ARE OCCURRING THAT WOULD HAVE AN EFFECT ON THE
LEVEL OF ECONOMIC ACTIVITY.
EXPANSIONARY FISCAL POLICY
USED BY THE GOVERNMENT WHEN TRYING TO BALANCE THE CONTRACTION PHASE IN
THE BUSINESS CYCLE. IT INVOLVES GOVERNMENT SPENDING EXCEEDING TAX REVENUE BY
MORE THAN IT HAS TENDED TO, AND IS USUALLY UNDERTAKEN DURING RECESSIONS.
IN EXPANSIONARY FISCAL POLICY, THE GOVERNMENT SPENDS MORE MONEY THAN IT
COLLECTS THROUGH TAXES. THIS TYPE OF POLICY IS USED DURING RECESSIONS TO BUILD A
FOUNDATION FOR STRONG ECONOMIC GROWTH AND NUDGE THE ECONOMY TOWARD FULL
EMPLOYMENT.
EXPANSIONARY FISCAL POLICY INCREASES THE LEVEL OF AGGREGATE DEMAND¹, EITHER
THROUGH INCREASES IN GOVERNMENT SPENDING OR THROUGH REDUCTIONS IN TAXES.
EXPANSIONARY FISCAL POLICY IS MOST APPROPRIATE WHEN AN ECONOMY IS IN RECESSION
AND PRODUCING BELOW ITS POTENTIAL GDP.
EXAMPLES OF EXPANSIONARY FISCAL POLICY MEASURES INCLUDE INCREASED GOVERNMENT
SPENDING ON PUBLIC WORKS (E.G., BUILDING SCHOOLS) AND PROVIDING THE RESIDENTS OF
THE ECONOMY WITH TAX CUTS TO INCREASE THEIR PURCHASING POWER (IN ORDER TO FIX A
DECREASE IN THE DEMAND).
¹AGGREGATE DEMAND. AN ECONOMIC MEASUREMENT OF THE SUM OF ALL FINAL GOODS
AND SERVICES PRODUCED IN AN ECONOMY, EXPRESSED AS THE TOTAL AMOUNT OF MONEY
EXCHANGED FOR THOSE GOODS AND SERVICES.
CONTRACTIONARY FISCAL POLICY
IN CONTRACTIONARY FISCAL POLICY, THE GOVERNMENT COLLECTS MORE MONEY THROUGH
TAXES THAN IT SPENDS. THIS POLICY WORKS BEST IN TIMES OF ECONOMIC BOOMS. IT SLOWS
THE PACE OF STRONG ECONOMIC GROWTH AND PUTS A CHECK ON INFLATION.
CONTRACTIONARY FISCAL POLICY DECREASES THE LEVEL OF AGGREGATE DEMAND, EITHER
THROUGH CUTS IN GOVERNMENT SPENDING OR INCREASES IN TAXES. CONTRACTIONARY
FISCAL POLICY IS MOST APPROPRIATE WHEN AN ECONOMY IS PRODUCING ABOVE ITS
POTENTIAL GDP.
BY REDUCING THE ECONOMY'S AMOUNT OF AGGREGATE INCOME, THE AVAILABLE AMOUNT
FOR CONSUMERS TO SPEND IS ALSO REDUCED. SO, CONTRACTIONARY FISCAL POLICY
MEASURES ARE EMPLOYED WHEN UNSUSTAINABLE GROWTH TAKES PLACE, LEADING TO
INFLATION, HIGH PRICES OF INVESTMENT, RECESSION AND UNEMPLOYMENT ABOVE THE
"HEALTHY" LEVEL OF 3%–4%.

GOVERNMENT BUDGET VERSUS SPENDING

(HTTPS://OPENTEXTBC.CA/PRINCIPLESOFECONOMICS)

GOVERNMENT SPENDING COVERS A RANGE OF SERVICES PROVIDED BY THE FEDERAL, STATE,

AND LOCAL GOVERNMENTS. WHEN THE FEDERAL GOVERNMENT SPENDS MORE MONEY THAN
IT RECEIVES IN TAXES IN A GIVEN YEAR, IT RUNS A BUDGET DEFICIT. CONVERSELY, WHEN THE
GOVERNMENT RECEIVES MORE MONEY IN TAXES THAN IT SPENDS IN A YEAR, IT RUNS
A BUDGET SURPLUS. IF GOVERNMENT SPENDING AND TAXES ARE EQUAL, IT IS SAID TO HAVE
A BALANCED BUDGET.

IN CASES WHERE A BUDGET DEFICIT IS IDENTIFIED, CURRENT EXPENSES EXCEED THE AMOUNT
OF INCOME RECEIVED THROUGH STANDARD OPERATIONS. A NATION WISHING TO CORRECT
ITS BUDGET DEFICIT MAY NEED TO CUT BACK ON CERTAIN EXPENDITURES, INCREASE REVENUE-
GENERATING ACTIVITIES, OR EMPLOY A COMBINATION OF THE TWO.
THE OPPOSITE OF A BUDGET DEFICIT IS A BUDGET SURPLUS. WHEN A SURPLUS OCCURS,
REVENUE EXCEEDS CURRENT EXPENSES AND RESULTS IN EXCESS FUNDS THAT CAN BE
ALLOCATED AS DESIRED.
IN SITUATIONS IN WHICH THE INFLOWS EQUAL THE OUTFLOWS, THE BUDGET IS BALANCED.

DEFICIT VERSUS DEBT

WE NEED TO CLARIFY THE DIFFERENCE BETWEEN THE DEFICIT AND THE DEBT. THE DEFICIT IS
NOT THE DEBT. THE DIFFERENCE BETWEEN THE DEFICIT AND THE DEBT LIES IN THE TIME
FRAME. THE GOVERNMENT DEFICIT (OR SURPLUS) REFERS TO WHAT HAPPENS WITH THE
FEDERAL GOVERNMENT BUDGET EACH YEAR. THE GOVERNMENT DEBT IS ACCUMULATED OVER
TIME; IT IS THE SUM OF ALL PAST DEFICITS AND SURPLUSES.
ILLUSTRATION. IF YOU BORROW P10,000 PER YEAR FOR EACH OF THE FOUR YEARS OF COLLEGE,
YOU MIGHT SAY THAT YOUR ANNUAL DEFICIT WAS P10,000, BUT YOUR ACCUMULATED DEBT
OVER THE FOUR YEARS IS P40,000.

FISCAL POLICY OF THE PHILIPPINES

(FROM WIKIPEDIA, THE FREE ENCYCLOPEDIA)

FISCAL POLICY REFERS TO THE "MEASURES EMPLOYED BY GOVERNMENTS TO STABILIZE THE

ECONOMY, SPECIFICALLY BY MANIPULATING THE LEVELS AND ALLOCATIONS OF TAXES AND
GOVERNMENT EXPENDITURES. FISCAL MEASURES ARE FREQUENTLY USED IN TANDEM WITH
MONETARY POLICY TO ACHIEVE CERTAIN GOALS. IN THE PHILIPPINES, THIS IS CHARACTERIZED
BY CONTINUOUS AND INCREASING LEVELS OF DEBT AND BUDGET DEFICITS, THOUGH THERE
HAVE BEEN IMPROVEMENTS IN THE LAST FEW YEARS.

THE PHILIPPINE GOVERNMENT’S MAIN SOURCE OF REVENUE ARE TAXES, WITH SOME NON-TAX
REVENUE ALSO BEING COLLECTED. TO FINANCE FISCAL DEFICIT AND DEBT, THE PHILIPPINES
RELIES ON BOTH DOMESTIC AND EXTERNAL SOURCES.

FISCAL POLICY DURING THE MARCOS ADMINISTRATION WAS PRIMARILY FOCUSED ON

INDIRECT TAX COLLECTION AND ON GOVERNMENT SPENDING ON ECONOMIC SERVICES AND
INFRASTRUCTURE DEVELOPMENT. THE FIRST AQUINO ADMINISTRATION INHERITED A LARGE
FISCAL DEFICIT FROM THE PREVIOUS ADMINISTRATION, BUT MANAGED TO REDUCE FISCAL
IMBALANCE AND IMPROVE TAX COLLECTION THROUGH THE INTRODUCTION OF THE 1986 TAX
REFORM PROGRAM AND THE VALUE ADDED TAX. THE RAMOS ADMINISTRATION EXPERIENCED
BUDGET SURPLUSES DUE TO SUBSTANTIAL GAINS FROM THE MASSIVE SALE OF GOVERNMENT
ASSETS AND STRONG FOREIGN INVESTMENT YEARS AND ADMINISTRATIONS. THE ESTRADA
ADMINISTRATION FACED A LARGE FISCAL DEFICIT DUE TO THE DECREASE IN TAX EFFORT AND
THE REPAYMENT OF THE RAMOS ADMINISTRATION’S DEBT TO CONTRACTORS AND SUPPLIERS.
DURING THE ARROYO ADMINISTRATION, THE EXPANDED VALUE ADDED TAX LAW WAS
ENACTED, NATIONAL DEBT-TO-GDP RATIO PEAKED, AND UNDERSPENDING ON PUBLIC
INFRASTRUCTURE AND OTHER CAPITAL EXPENDITURES WAS OBSERVED.

REVENUES AND FUNDING

THE PHILIPPINE GOVERNMENT GENERATES REVENUES MAINLY THROUGH PERSONAL AND

INCOME TAX COLLECTION, BUT A SMALL PORTION OF NON-TAX REVENUE IS ALSO COLLECTED
THROUGH FEES AND LICENSES, PRIVATIZATION PROCEEDS AND INCOME FROM OTHER
GOVERNMENT OPERATIONS AND STATE-OWNED ENTERPRISES.

TAX REVENUE
TAX COLLECTIONS COMPRISE THE BIGGEST PERCENTAGE OF REVENUE COLLECTED. ITS BIGGEST
CONTRIBUTOR IS THE BUREAU OF INTERNAL REVENUE (BIR), FOLLOWED BY THE BUREAU OF
CUSTOMS (BOC). TAX EFFORT AS A PERCENTAGE OF GDP HAS AVERAGED AT ROUGHLY 13%
FOR THE YEARS 2001-2010.

INCOME TAXES
INCOME TAX IS A TAX ON A PERSON'S INCOME, WAGES, PROFITS ARISING FROM PROPERTY,
PRACTICE OF PROFESSION, CONDUCT OF TRADE OR BUSINESS OR ANY STIPULATED IN THE
NATIONAL INTERNAL REVENUE CODE OF 1997 (NIRC), LESS ANY DEDUCTIONS
GRANTED. INCOME TAX IN THE PHILIPPINES IS A PROGRESSIVE TAX, AS PEOPLE WITH HIGHER
INCOMES PAY MORE THAN PEOPLE WITH LOWER INCOMES.

E-VAT
THE EXPANDED VALUE ADDED TAX (E-VAT), IS A FORM OF SALES TAX THAT IS IMPOSED ON THE
SALE OF GOODS AND SERVICES AND ON THE IMPORT OF GOODS INTO THE PHILIPPINES. IT IS A
CONSUMPTION TAX (THOSE WHO CONSUME MORE ARE TAXED MORE) AND AN INDIRECT TAX,
WHICH CAN BE PASSED ON TO THE BUYER.

TARIFFS AND DUTIES

SECOND TO THE BIR IN TERMS OF REVENUE COLLECTION, THE BUREAU OF CUSTOMS (BOC)
IMPOSES TARIFFS AND DUTIES ON ALL ITEMS IMPORTED INTO THE PHILIPPINES. ACCORDING
TO EXECUTIVE ORDER 206, RETURNING RESIDENTS, OVERSEAS FILIPINO WORKERS (OFW’S)
AND FORMER FILIPINO CITIZENS ARE EXEMPTED FROM PAYING DUTIES AND TARIFFS.

NON-TAX REVENUE
NON-TAX REVENUE MAKES UP A SMALL PERCENTAGE OF TOTAL GOVERNMENT REVENUE
(ROUGHLY LESS THAN 20%), AND CONSISTS OF COLLECTIONS OF FEES AND LICENSES,
PRIVATIZATION PROCEEDS AND INCOME FROM OTHER STATE ENTERPRISES.

THE BUREAU OF TREASURY

THE BUREAU OF TREASURY (BTR) MANAGES THE FINANCES OF THE GOVERNMENT, BY
ATTEMPTING TO MAXIMIZE REVENUE COLLECTED AND MINIMIZE SPENDING. THE BULK OF
NON-TAX REVENUES COMES FROM THE BTR’S INCOME. UNDER EXECUTIVE ORDER NO.449, THE
BTR COLLECTS REVENUE BY ISSUING, SERVICING AND REDEEMING GOVERNMENT SECURITIES,
AND BY CONTROLLING THE SECURITIES STABILIZATION FUND (WHICH INCREASES THE
LIQUIDITY AND STABILIZES THE VALUE OF GOVERNMENT SECURITIES[14]) THROUGH THE
PURCHASE AND SALE OF GOVERNMENT BILLS AND BONDS.

PRIVATIZATION
PRIVATIZATION IN THE PHILIPPINES OCCURRED IN THREE WAVES: THE FIRST WAVE IN 1986-
1987, THE SECOND DURING 1990 AND THE THIRD STAGE, WHICH IS PRESENTLY TAKING
PLACE. THE GOVERNMENT’S PRIVATIZATION PROGRAM IS HANDLED BY THE INTER-AGENCY
PRIVATIZATION COUNCIL AND THE PRIVATIZATION AND MANAGEMENT OFFICE, A SUB-BRANCH
OF THE DEPARTMENT OF FINANCE.
PAGCOR
THE PHILIPPINE AMUSEMENT AND GAMING CORPORATION (PAGCOR) IS A GOVERNMENT-
OWNED CORPORATION ESTABLISHED IN 1977 TO STOP ILLEGAL CASINO OPERATIONS. PAGCOR
IS MANDATED TO REGULATE AND LICENSE GAMBLING (PARTICULARLY IN CASINOS), GENERATE
REVENUES FOR THE PHILIPPINE GOVERNMENT THROUGH ITS OWN CASINOS AND PROMOTE
TOURISM IN THE COUNTRY.

GOVERNMENT SPENDING AND FISCAL IMBALANCE

IN 2010, THE PHILIPPINE GOVERNMENT SPENT A TOTAL OF ₱1.5 TRILLION AND EARNED A
TOTAL OF ₱1.2 TRILLION FROM TAX AND NON-TAX REVENUES, THUS RESULTING TO A TOTAL
DEFICIT OF ₱314.5 BILLION.

DESPITE THE NATIONAL DEFICIT OF THE PHILIPPINES, THE DEPARTMENT OF

FINANCE REPORTED AN AVERAGE OF ₱29.6 BILLION IN LOCAL GOVERNMENT UNIT (LGU)
SURPLUS, WHICH IS MOSTLY DUE TO AN IMPROVED LGU FINANCIAL MONITORING SYSTEM
WHICH THE GOVERNMENT IMPLEMENTED IN THE RECENT YEARS. EFFORTS OF THE
MONITORING SYSTEM INCLUDE "DEBT MONITORING AND CREDITWORTHINESS MONITORING
SYSTEM, EFFECTIVE MOBILIZATION OF SECOND-GENERATION FUNDS (SGF) TO PROMOTE LGU
DEVELOPMENT, AND THE IMPLEMENTATION OF A LAND ADMINISTRATION AND MANAGEMENT
PROJECT (LAMP2) WHICH RECEIVED A 'VERY GOOD' RATING FROM THE WORLD BANK (WB)
AND AUSTRALIAN AGENCY FOR INTERNATIONAL DEVELOPMENT (AUSAID)."

MICROFINANCE MANAGEMENT IN THE PHILIPPINES IS IMPROVING SUBSTANTIALLY. IN 2009,

THE ECONOMIST INTELLIGENCE UNIT "RECOGNIZED THE PHILIPPINES AS THE BEST IN THE
WORLD IN TERMS OF ITS MICROFINANCE REGULATORY FRAMEWORK." THE DOF-NATIONAL
CREDIT COUNCIL (DOF-NCC) FOCUSED ON IMPROVING THE STATE OF LOCAL COOPERATIVES BY
DEVELOPING A SUPERVISION AND EXAMINATION MANUAL, LAUNCHING ADVOCACIES FOR
THESE COOPERATIVES, AND PUSHING FOR THE PHILIPPINE COOPERATIVE CODE OF 2008. A
STANDARDIZED NATIONAL STRATEGY FOR MICROINSURANCE AND THE PROVISIONS OF
GRANTS AND TECHNICAL ASSISTANCE WERE FORMULATED.

FINANCING AND DEBT

ASIDE FROM TAX AND NON-TAX REVENUES, THE GOVERNMENT MAKES USE OF OTHER
SOURCES OF FINANCING TO SUPPORT ITS EXPENSES. IN 2010, THE GOVERNMENT BORROWED
A TOTAL NET OF ₱351.646 BILLION FOR FINANCING:

EXTERNAL SOURCES OF FINANCING ARE:

PROGRAM AND PROJECT LOANS - THE GOVERNMENT OFFERS PROJECT LOANS TO EXTERNAL
BODIES AND USES THE PROCEEDS TO FUND DOMESTIC PROJECTS LIKE INFRASTRUCTURE,
AGRICULTURE, AND OTHER GOVERNMENT PROJECTS.
CREDIT FACILITY LOAN
ZERO-COUPON TREASURY BILLSGLOBAL BONDS
FOREIGN CURRENCIES

DOMESTIC SOURCES OF FINANCING ARE[21]

TREASURY BONDS
FACILITY LOANS
TREASURY BILLS
BOND EXCHANGES
PROMISSORY NOTES
TERM DEPOSITS
MONETARY POLICY VS. FISCAL POLICY: WHAT'S THE DIFFERENCE?
BY TROY SEGAL
UPDATED FEB 21, 2019
(HTTPS://INVESTOPEDIA.COM/ASK/ANSWER/100314/WHATS-DIFFERENCE-BETWEEN-
MONETARY-POLICY-AND-FISCAL-POLICY.ASP#)

MONETARY POLICY VS. FISCAL POLICY: AN OVERVIEW

MONETARY POLICY AND FISCAL POLICY REFER TO THE TWO MOST WIDELY RECOGNIZED TOOLS
USED TO INFLUENCE A NATION'S ECONOMIC ACTIVITY. MONETARY POLICY IS PRIMARILY
CONCERNED WITH THE MANAGEMENT OF INTEREST RATES AND THE TOTAL SUPPLY OF MONEY
IN CIRCULATION AND IS GENERALLY CARRIED OUT BY CENTRAL BANKS, SUCH AS THE
U.S. FEDERAL RESERVE. FISCAL POLICY IS A COLLECTIVE TERM FOR THE TAXING AND SPENDING
ACTIONS OF GOVERNMENTS. IN THE UNITED STATES, THE NATIONAL FISCAL POLICY IS
DETERMINED BY THE EXECUTIVE AND LEGISLATIVE BRANCHES OF THE GOVERNMENT.

MONETARY POLICY
CENTRAL BANKS TYPICALLY HAVE USED MONETARY POLICY TO EITHER STIMULATE
AN ECONOMY OR TO CHECK ITS GROWTH. BY INCENTIVIZING INDIVIDUALS AND BUSINESSES TO
BORROW AND SPEND, MONETARY POLICY AIMS TO SPUR ECONOMIC ACTIVITY. CONVERSELY,
BY RESTRICTING SPENDING AND INCENTIVIZING SAVINGS, MONETARY POLICY CAN ACT AS A
BRAKE ON INFLATION AND OTHER ISSUES ASSOCIATED WITH AN OVERHEATED ECONOMY.

THE FEDERAL RESERVE, ALSO KNOWN AS THE "FED," FREQUENTLY HAS USED THREE DIFFERENT
POLICY TOOLS TO INFLUENCE THE ECONOMY: OPENING MARKET OPERATIONS, CHANGING
RESERVE REQUIREMENTS FOR BANKS, AND SETTING THE DISCOUNT RATE. OPEN MARKET
OPERATIONS ARE CARRIED OUT ON A DAILY BASIS WHEN THE FED BUYS AND SELLS U.S.
GOVERNMENT BONDS TO EITHER INJECT MONEY INTO THE ECONOMY OR PULL MONEY OUT
OF CIRCULATION. BY SETTING THE RESERVE RATIO, OR THE PERCENTAGE OF DEPOSITS THAT
BANKS ARE REQUIRED TO KEEP IN RESERVE, THE FED DIRECTLY INFLUENCES THE AMOUNT OF
MONEY CREATED WHEN BANKS MAKE LOANS. THE FED ALSO CAN TARGET CHANGES IN THE
DISCOUNT RATE (THE INTEREST RATE IT CHARGES ON LOANS IT MAKES TO FINANCIAL
INSTITUTIONS), WHICH IS INTENDED TO IMPACT SHORT-TERM INTEREST RATES ACROSS THE
ENTIRE ECONOMY.
MONETARY POLICY IS MORE OF A BLUNT TOOL IN TERMS OF EXPANDING AND CONTRACTING
THE MONEY SUPPLY TO INFLUENCE INFLATION AND GROWTH AND IT HAS LESS IMPACT ON THE
REAL ECONOMY. FOR EXAMPLE, THE FED WAS AGGRESSIVE DURING THE GREAT DEPRESSION.
ITS ACTIONS PREVENTED DEFLATION AND ECONOMIC COLLAPSE BUT DID NOT GENERATE
SIGNIFICANT ECONOMIC GROWTH TO REVERSE THE LOST OUTPUT AND JOBS.
EXPANSIONARY MONETARY POLICY CAN HAVE LIMITED EFFECTS ON GROWTH BY INCREASING
ASSET PRICES AND LOWERING THE COSTS OF BORROWING, MAKING COMPANIES MORE
PROFITABLE.

FISCAL POLICY
GENERALLY SPEAKING, THE AIM OF MOST GOVERNMENT FISCAL POLICIES IS TO TARGET THE
TOTAL LEVEL OF SPENDING, THE TOTAL COMPOSITION OF SPENDING, OR BOTH IN AN
ECONOMY. THE TWO MOST WIDELY USED MEANS OF AFFECTING FISCAL POLICY ARE CHANGES
IN GOVERNMENT SPENDING POLICIES OR IN GOVERNMENT TAX POLICIES.

IF A GOVERNMENT BELIEVES THERE IS NOT ENOUGH BUSINESS ACTIVITY IN AN ECONOMY, IT

CAN INCREASE THE AMOUNT OF MONEY IT SPENDS, OFTEN REFERRED TO AS STIMULUS
SPENDING. IF THERE ARE NOT ENOUGH TAX RECEIPTS TO PAY FOR THE SPENDING INCREASES,
GOVERNMENTS BORROW MONEY BY ISSUING DEBT SECURITIES SUCH AS GOVERNMENT
BONDS AND, IN THE PROCESS, ACCUMULATE DEBT. THIS IS REFERRED TO AS DEFICIT SPENDING.

BY INCREASING TAXES, GOVERNMENTS PULL MONEY OUT OF THE ECONOMY AND SLOW
BUSINESS ACTIVITY. TYPICALLY, FISCAL POLICY IS USED WHEN THE GOVERNMENT SEEKS TO
STIMULATE THE ECONOMY. IT MIGHT LOWER TAXES OR OFFER TAX REBATES IN AN EFFORT TO
ENCOURAGE ECONOMIC GROWTH. INFLUENCING ECONOMIC OUTCOMES VIA FISCAL POLICY IS
ONE OF THE CORE TENETS OF KEYNESIAN ECONOMICS.

WHEN A GOVERNMENT SPENDS MONEY OR CHANGES TAX POLICY, IT MUST CHOOSE WHERE
TO SPEND OR WHAT TO TAX. IN DOING SO, GOVERNMENT FISCAL POLICY CAN TARGET SPECIFIC
COMMUNITIES, INDUSTRIES, INVESTMENTS, OR COMMODITIES TO EITHER FAVOR OR
DISCOURAGE PRODUCTION—SOMETIMES, ITS ACTIONS ARE BASED ON CONSIDERATIONS THAT
ARE NOT ENTIRELY ECONOMIC. FOR THIS REASON, FISCAL POLICY OFTEN IS HOTLY DEBATED
AMONG ECONOMISTS AND POLITICAL OBSERVERS.
[IMPORTANT: FISCAL POLICY GENERALLY HAS A GREATER IMPACT ON CONSUMERS. IT CAN
LEAD TO INCREASED EMPLOYMENT AND INCOME.]

PUBLIC FINANCE
(HTTPS://EFINANCEMANAGEMENT.COM/FINANCIAL-MANAGEMENT/PUBLIC-FINANCE#)

WHAT IS PUBLIC FINANCE?

IN SIMPLE LAYMAN TERMS, PUBLIC FINANCE IS THE STUDY OF FINANCE RELATED TO
GOVERNMENT ENTITIES. IT REVOLVES AROUND THE ROLE OF GOVERNMENT INCOME AND
EXPENDITURE IN THE ECONOMY.

PROF. DALTON IN HIS BOOK PRINCIPLES OF PUBLIC FINANCE STATES THAT “PUBLIC FINANCE IS
CONCERNED WITH INCOME AND EXPENDITURE OF PUBLIC AUTHORITIES AND WITH THE
ADJUSTMENT OF ONE TO THE OTHER”

BY THIS DEFINITION, WE CAN UNDERSTAND THAT PUBLIC FINANCE DEALS WITH INCOME AND
EXPENDITURE OF GOVERNMENT ENTITY AT ANY LEVEL BE IT CENTRAL, STATE OR LOCAL.
HOWEVER, IN THE MODERN-DAY CONTEXT, PUBLIC FINANCE HAS A WIDER SCOPE – IT STUDIES
THE IMPACT OF GOVERNMENT POLICIES ON THE ECONOMY.

LET’S UNDERSTAND THE SCOPE OF PUBLIC FINANCE TO UNDERSTAND HOW PUBLIC FINANCE
IMPACTS THE ECONOMY.
THE SCOPE OF PUBLIC FINANCE
PROF. DALTON CLASSIFIES THE SCOPE OF PUBLIC FINANCE INTO FOUR AREAS AS FOLLOWS –

PUBLIC INCOME
AS THE NAME SUGGESTS, PUBLIC INCOME REFERS TO THE INCOME OF THE GOVERNMENT. THE
GOVERNMENT EARNS INCOME IN TWO WAYS – TAX INCOME AND NON-TAX INCOME. TAX
INCOME IS EASY TO RECOGNIZE, IT’S THE TAX PAID BY PEOPLE OF THE COUNTRY IN THE FORM
OF INCOME TAX, SALES TAX, DUTIES, ETC. ON THE OTHER HAND NON-TAX INCOME INCLUDES
INTEREST INCOME FROM LENDING MONEY TO OTHER COUNTRIES, RENT & INCOME FROM
GOVERNMENT PROPERTIES, DONATIONS FROM WORLD ORGANIZATIONS, ETC.

THIS AREA STUDIES METHODS OF TAXATION, REVENUE CLASSIFICATION, METHODS OF

INCREASING GOVERNMENT REVENUE AND ITS IMPACT ON THE ECONOMY AS A WHOLE, ETC.

PUBLIC EXPENDITURE
PUBLIC EXPENDITURE IS THE MONEY SPENT BY GOVERNMENT ENTITIES. LOGICALLY, THE
GOVERNMENT IS GOING TO SPEND MONEY ON INFRASTRUCTURE, DEFENSE, EDUCATION,
HEALTHCARE, ETC. FOR THE GROWTH AND WELFARE OF THE COUNTRY.

THIS AREA STUDIES THE OBJECTIVES AND CLASSIFICATION OF PUBLIC EXPENDITURE, EFFECTS
OF EXPENDITURE IN DIFFERENT AREAS, EFFECTS OF PUBLIC EXPENDITURE ON VARIOUS
FACTORS SUCH AS EMPLOYMENT, PRODUCTION, GROWTH, ETC.

PUBLIC DEBT
WHEN PUBLIC EXPENDITURE EXCEEDS PUBLIC INCOME, THE GAP IS FILLED BY BORROWING
MONEY FROM THE PUBLIC, OR FROM OTHER COUNTRIES OR WORLD ORGANIZATIONS SUCH AS
THE WORLD BANK. THESE BORROWED FUNDS ARE PUBLIC DEBT.

THIS AREA OF PUBLIC FINANCE EXPLAINS THE BURDEN OF PUBLIC DEBT, WHY IT IS NECESSARY
AND ITS EFFECT ON THE ECONOMY. IT ALSO SUGGESTS METHODS TO MANAGE PUBLIC DEBT.
FINANCIAL ADMINISTRATION
AS THE NAME SUGGESTS THIS AREA OF PUBLIC FINANCE IS ALL ABOUT THE ADMINISTRATION
OF ALL PUBLIC FINANCE I.E. PUBLIC INCOME, PUBLIC EXPENDITURE, AND PUBLIC DEBT.
FINANCIAL ADMINISTRATION INCLUDES PREPARATION, PASSING, AND IMPLEMENTATION OF
GOVERNMENT BUDGET AND VARIOUS GOVERNMENT POLICIES. IT ALSO STUDIES THE POLICY
IMPACT ON THE SOCIAL-ECONOMIC ENVIRONMENT, INTER-GOVERNMENTAL RELATIONSHIPS,
FOREIGN RELATIONSHIPS, ETC.

FUNCTIONS OF PUBLIC FINANCE

THERE ARE THREE MAIN FUNCTIONS OF PUBLIC FINANCE AS FOLLOWS –

THE ALLOCATION FUNCTION

THERE ARE TWO TYPES OF GOODS IN AN ECONOMY – PRIVATE GOODS AND PUBLIC GOODS.
PRIVATE GOODS HAVE A KIND OF EXCLUSIVITY TO THEMSELVES. ONLY THOSE WHO PAY FOR
THESE GOODS CAN GET THE BENEFIT OF SUCH GOODS, FOR EXAMPLE – A CAR. IN CONTRAST,
PUBLIC GOODS ARE NON-EXCLUSIVE. EVERYONE, REGARDLESS OF PAYING OR NOT, CAN
BENEFIT FROM PUBLIC GOODS, FOR EXAMPLE – A ROAD.

THE ALLOCATION FUNCTION DEALS WITH THE ALLOCATION OF SUCH PUBLIC GOODS. THE
GOVERNMENT HAS TO PERFORM VARIOUS FUNCTIONS SUCH AS MAINTAINING LAW AND
ORDER, DEFENSE AGAINST FOREIGN ATTACKS, PROVIDING HEALTHCARE AND EDUCATION,
BUILDING INFRASTRUCTURE, ETC. THE LIST IS ENDLESS. THE PERFORMANCE OF THESE
FUNCTIONS REQUIRES LARGE SCALE EXPENDITURE, AND IT IS IMPORTANT TO ALLOCATE THE
EXPENDITURE EFFICIENTLY. THE ALLOCATION FUNCTION STUDIES HOW TO ALLOCATE PUBLIC
EXPENDITURE MOST EFFICIENTLY TO REAP MAXIMUM BENEFITS WITH THE AVAILABLE PUBLIC
WEALTH.

THE DISTRIBUTION FUNCTION

THERE ARE LARGE DISPARITIES OF INCOME AND WEALTH IN EVERY COUNTRY IN THE WORLD.
THESE INCOME INEQUALITIES PLAGUE SOCIETY AND INCREASE THE CRIME RATE OF THE
COUNTRY. THE DISTRIBUTION FUNCTION OF PUBLIC FINANCE IS TO LESSEN THESE
INEQUALITIES AS MUCH AS POSSIBLE THROUGH REDISTRIBUTION OF INCOME AND WEALTH.

IN PUBLIC FINANCE, PRIMARILY THREE MEASURES ARE OUTLINED TO ACHIEVE THIS TARGET –
A TAX-TRANSFER SCHEME OR USING PROGRESSIVE TAXING, I.E. IN SIMPLER WORDS CHARGING
HIGHER TAX FROM THE RICH AND GIVING SUBSIDIES TO THE LOW-INCOME
PROGRESSIVE TAXES CAN BE USED TO FINANCE PUBLIC SERVICES SUCH AS AFFORDABLE
HOUSING, HEALTH CARE, ETC.
A HIGHER TAX CAN BE APPLIED TO LUXURY GOODS OR GOODS THAT ARE PURCHASED BY THE
HIGH INCOME GROUP, FOR EXAMPLE, HIGHER TAXES ON LUXURY CARS.

THE STABILIZATION FUNCTION

EVERY ECONOMY GOES THROUGH PERIODS OF BOOMS AND DEPRESSION. IT’S THE MOST
NORMAL AND COMMON BUSINESS CYCLES THAT LEAD TO THIS SCENARIO. HOWEVER, THESE
PERIODS CAUSE INSTABILITY IN THE ECONOMY. THE OBJECTIVE OF THE STABILIZATION
FUNCTION IS TO ELIMINATE OR AT LEAST REDUCE THESE BUSINESS FLUCTUATIONS AND ITS
IMPACT ON THE ECONOMY. POLICIES SUCH AS DEFICIT BUDGETING DURING THE TIME OF
DEPRESSION AND SURPLUS BUDGETING DURING THE TIME OF BOOM HELPS ACHIEVE THE
REQUIRED ECONOMIC STABILITY.

THE BUDGET PROCESS AND THE PHILIPPINE CONGRESS

(HTTPS://HREPREFLIBRARIAN.WORDPRESS.COM/2013/03/07/THE-BUDGET-PROCESS-THE-
PHILIPPINE-CONGRESS/)

MANY PEOPLE, ESPECIALLY STUDENTS WHO TAKE HIGHER STUDIES IN PUBLIC

ADMINISTRATION ARE UNAWARE OF THE ROLE OF CONGRESS IN THE BUDGET PROCESS. IN
THIS ARTICLE, THREE MAIN TOPICS WILL BE COVERED UNDER THE BUDGET PROCESS NAMELY:
BUDGETARY OVERVIEW, THE CONSTITUTIONAL PROVISIONS AND RELATED LAWS IN THE
BUDGET PROCESS, AND THE BUDGET PROCESS.

I. BUDGETARY OVERVIEW
FIRST, WE SHALL DEFINE THE NATIONAL BUDGET WHICH IS THE GOVERNMENT’S ESTIMATE OF
ITS INCOME AND EXPENDITURES. IT IS WHAT THE GOVERNMENT PLANS TO SPEND FOR ITS
PROGRAMS AND PROJECTS, AS WELL AS THE SOURCES OF FUNDS. THE BUDGET PROCESS
INVOLVES BUDGETING AND THE BUDGET. BUDGETING REFERS TO METHODS AND PRACTICES
OF GOVERNMENT PLANNING, ADOPTING AND EXECUTING FINANCIAL POLICIES AND
PROGRAMS. THE BUDGET REFERS TO A PLAN OF EXPRESSING IN MONETARY TERMS THE
OPERATING PROGRAM AND MEANS OF FINANCING OF A GOVERNMENT FOR A DEFINITE
PERIOD OF TIME. THE NATIONAL BUDGET IS SPENT FOR THE IMPLEMENTATION OF VARIOUS
GOVERNMENT PROGRAMS AND PROJECTS, THE OPERATIONS OF GOVERNMENT OFFICES SUCH
AS THE PAYMENT OF SALARIES, CONSTRUCTION OF BUILDINGS.

II. DIMENSIONS OF THE BUDGET

THE BUDGET POSSESSES VARIOUS DIMENSIONS. IT CAN BE CLASSIFIED ACCORDING TO THE
FOLLOWING: BY SECTOR, BY COST STRUCTURE, BY EXPENSE CLASS AND BY OBJECT, BY REGION,
BY TYPE OF APPROPRIATION.

A. BY SECTOR
THE BUDGET CONTAINS VARIOUS TYPE OF EXPENDITURES. THEY ARE FOR:
1. SOCIAL SERVICES EXPENDITURE;
2. ECONOMIC SERVICES EXPENDITURE;
3. DEFENSE EXPENDITURE;
4. GENERAL PUBLIC SERVICES; AND
5. DEBT BURDEN

B. BY COST STRUCTURE
1. FOR GENERAL ADMINISTRATION & SUPPORT SERVICES OR OVERHEAD EXPENSES
2. AS SUPPORT TO OPERATIONS FOR THE FACILITATIVE FUNCTIONS AND SERVICES, STAFF AND
TECHNICAL SUPPORT
3. FOR OPERATIONS OF REGULAR ACTIVITIES ADDRESSING AGENCY MANDATE
EXAMPLE: PRODUCTION OF GOODS, DELIVERY OF PUBIC SERVICES, AND REGULATION, ETC.
4. FOR PROJECTS SUCH AS HOMOGENOUS GROUP OF ACTIVITIES THAT RESULT IN THE
ACCOMPLISHMENT OF IDENTIFIABLE OUTPUT WITHIN A DESIGNATED PERIOD, WHETHER
FOREIGN OR LOCALLY FUNDED

C. BY EXPENSE CLASS & BY OBJECT

1. CURRENT OPERATING EXPENDITURES FOR PERSONAL SERVICES, MAINTENANCE AND OTHER
OPERATIVE EXPENSES (MOOE)
2. CAPITAL OUTLAYS FOR INVESTMENTS, LOANS, LIVESTOCK AND CROPS, LAND/LAND
IMPROVEMENTS, BUILDINGS/STRUCTURES, FURNITURE/FIXTURES

D. BY MAJOR RECIPIENT OF GOVERNMENT

THE MAJOR RECIPIENTS OF THE BUDGET ARE:
1. THE NGAS (NATIONAL GOVERNMENT AGENCIES) – THEY INCLUDE ALL AGENCIES WITH THE
EXECUTIVE, LEGISLATIVE AND JUDICIAL BRANCHES OF GOVERNMENT
2. THE LGUS (LOCAL GOVERNMENT UNITS) – FUNDING IS RELEASED IN THE FORM OF IRAS
(INTERNAL REVENUE ALLOTMENTS), SPECIAL SHARES IN NATIONAL PROCEEDS, CREDIT THRU
THE MDF (MUNICIPAL DEVELOPMENT FUND), AND PREMIUM SUBSIDIES FOR LOCAL
INSURANCE
3. THE GOCCS (GOVERNMENT OWNED AND CONTROLLED CORPORATIONS) – FUNDING IS
THOUGH SUBSIDIES, EQUITY AND NET LENDING

E. BY REGIONAL ALLOCATION
THE BUDGET IS APPORTIONED FOR EACH OF THE VARIOUS REGIONS OF THE COUNTRY.

F. BY TYPE OF APPROPRIATION
THE BUDGET IS FURTHER CLASSIFIED INTO DIFFERENT TYPES, NAMELY:
1. GENERAL APPROPRIATIONS
2. SUPPLEMENTAL APPROPRIATIONS
3. CONTINUING APPROPRIATIONS
4. AUTOMATIC APPROPRIATIONS
THE BUDGET MAY INCREASE OR DECREASE DEPENDING ON THE GOVERNMENT’S POLICY OF
HOW MUCH IT WILL INFUSE INTO THE ECONOMY. MATURING OF A COUNTRY’S DEBT
DETERMINES THE SIZE OF THE BUDGET.

III. SOURCES OF FUNDS FOR THE NATIONAL BUDGET

A. REVENUES
1. TAX REVENUES
2. NON-TAX REVENUES SUCH AS FEES TO BE COLLECTED

B. BORROWINGS
THE GOVERNMENT BORROWS TO PROVIDE FOR THE REQUIREMENTS OF CAPITAL PROJECTS
AND TO SUPPORT PRIORITY PROGRAMS AND PROJECTS. RELYING SOLELY ON DOMESTIC
RESOURCES WILL LIMIT GOVERNMENT’S CAPABILITY TO PROVIDE THE NEEDED SUPPORT.
DOMESTIC RESOURCES IS INSUFFICIENT TO FINANCE PRIORITY PROGRAMS AND PROJECTS.

C. OBLIGATIONS BUDGET VS. CASH BUDGET

OBLIGATIONS BUDGET ARE FOR EXPENDITURES INCURRED FOR THE YEAR AND IS TO BE PAID IN
SAID YEAR. THIS CAN ALSO BE FOR EXPENDITURES INCURRED FOR THE YEAR TO BE PAID NEXT
YEAR. ASIDE FROM THIS, IT IS ALSO ALLOCATED FOR INTEREST PAYMENTS.
CASH BUDGETS ARE FOR EXPENDITURES INCURRED FOR NEXT YEAR. IT CAN ALSO BE
ALLOCATED FOR EXPENDITURES IN PREVIOUS YEARS, AND IS ALSO ALLOCATED FOR INTEREST
PAYMENTS.
D. NATIONAL GOVERNMENT DEFICIT VS. CONSOLIDATED PUBLIC SECTOR DEFICIT
THE NATIONAL GOVERNMENT DEFICIT IS THE SHORTFALL OR DEFICIENCY IN REVENUES OVER
EXPENDITURES DUE TO ITS OPERATIONS ON A GIVEN PERIOD, USUALLY ONE YEAR. A
CONSOLIDATED PUBLIC SECTOR DEFICIT COVERS THE COMBINED DEFICIT OF THE NATIONAL
GOVERNMENT, THE RESTRUCTURING ACCOUNTS OF THE COMMERCIAL BANK, THE MAJOR
NON-FINANCIAL GOVERNMENT OWNED AND CONTROLLED CORPORATIONS, THE
GOVERNMENT FINANCIAL INSTITUTIONS, THE LOCAL GOVERNMENT UNITS, THE SOCIAL
SECURITY INSTITUTIONS SUCH AS THE GOVERNMENT SERVICE INSURANCE SYSTEM & THE
SOCIAL SECURITY SYSTEM, THE OIL PRICE STABILIZATION FUND AND THE BANGKO SENTRAL NG
PILIPINAS (CENTRAL BANK OF THE PHILIPPINES).
E. CONSTITUTIONAL PROVISIONS & MAJOR LAWS AFFECTING THE BUDGET/BUDGET PROCESS:

1. PHILIPPINE CONSTITUTION
THE CONSTITUTIONAL PROVISIONS RELATIVE TO THE BUDGET TO WIT ARE:
A. SECTION 24, ARTICLE VI, WHICH STATES THAT ALL APPROPRIATIONS, REVENUE OR TARIFF
BILLS INCREASE OF THE PUBLIC DEBT, BILLS OF LOCAL APPLICATION AND PRIVATE BILLS SHALL
ORIGINATE IN THE HOUSE OF REPRESENTATIVES, BUT THE SENATE MAY PROPOSE OR CONCUR
WITH AMENDMENTS
B. SECTION 25 (1), ARTICLE VI, STATES THAT THE [PHILIPPINE]CONGRESS MAY NOT INCREASE
THE APPROPRIATIONS RECOMMENDED BY THE PRESIDENT FOR THE OPERATION OF THE
GOVERNMENT AS SPECIFIED IN THE BUDGET. THE FORM, CONTENT, AND MANNER OF
PREPARATION OF THE BUDGET SHALL BE PRESCRIBED BY LAW.
C. SECTION 25 (2), ARTICLE VI STATES THAT NO PROVISION OR ENACTMENT SHALL BE
EMBRACED IN THE GENERAL APPROPRIATIONS BILL UNLESS IT RELATES SPECIFICALLY TO SOME
PARTICULAR APPROPRIATION THEREIN. ANY SUCH PROVISION OR ENACTMENT SHALL BE
LIMITED IN ITS OPERATION TO THE APPROPRIATIONS TO WHICH IT RELATES.
D. SECTION 25 (4), ARTICLE VI: “A SPECIAL APPROPRIATIONS BILL SHALL SPECIFY THE PURPOSE
FOR WHICH IT IS INTENDED, AND SHALL BE SUPPORTED BY FUNDS ACTUALLY AVAILABLE AS
CERTIFIED BY THE NATIONAL TREASURER, OR TO BE RAISED BY A CORRESPONDING REVENUE
PROPOSAL THEREIN.”
E. SECTION 25 (5), ARTICLE VI: “NO LAW SHALL BE PASSED AUTHORIZING ANY TRANSFER OF
APPROPRIATIONS, HOWEVER, THE PRESIDENT [OF THE PHILIPPINES], THE PRESIDENT OF THE
[PHILIPPINE] SENATE, THE SPEAKER OF THE [PHILIPPINE] HOUSE OF REPRESENTATIVES, THE
CHIEF JUSTICE OF THE [PHILIPPINE] SUPREME COURT, AND THE HEADS OF CONSTITUTIONAL
COMMISSIONS MAY, BY LAW, BE AUTHORIZED TO AUGMENT ANY ITEM IN THE GENERAL
APPROPRIATIONS LAW FOR THEIR RESPECTIVE E OFFICES FROM SAVINGS IN OTHER ITEMS OF
THEIR RESPECTIVE APPROPRIATIONS.”
F. SECTION 25 (7), ARTICLE VI: “IF, BY THE END OF THE FISCAL YEAR, THE [PHILIPPINE]
CONGRESS SHALL HAVE FAILED TO PASS THE GENERAL APPROPRIATIONS BILL FOR THE
ENSUING FISCAL YEAR, THE GENERAL APPROPRIATIONS LAW FOR THE PRECEDING FISCAL YEAR
SHALL BE DEEMED RE-ENACTED AND SHALL REMAIN IN FORCE AND EFFECT UNTIL THE
GENERAL APPROPRIATIONS BILL IS PASSED BY [THE PHILIPPINE] CONGRESS.”
G. SECTION 22, ARTICLE VII: “THE PRESIDENT SHALL SUBMIT TO THE CONGRESS WITHIN THIRTY
(30) DAYS FROM THE OPENING OF EVERY REGULAR SESSION, AS THE BASIS OF THE GENERAL
APPROPRIATIONS BILL, A BUDGET OF RECEIPTS AND EXPENDITURES AND SOURCES OF
FINANCING, INCLUDING RECEIPTS FROM EXISTING AND PROPOSED REVENUE MEASURES.
2. BOOK VI OF EXECUTIVE ORDER NO. 292 SERIES 1987, OR THE ADMINISTRATIVE CODE OF
1987 ENTITLED NATIONAL GOVERNMENT BUDGETING
3. PRESIDENTIAL DECREE NO. 1177, AS AMENDED, OR THE BUDGET REFORM DECREE OF 1977,
INSOFAR AS NOT SUPERSEDED BY EXECUTIVE ORDER NO. 292 SERIES 1987 OR THE
ADMINISTRATIVE CODE OF 1987
4. OTHER APPLICABLE LAWS

F. THE BUDGET PROCESS

THIS INVOLVES FOUR MAJOR STEPS NAMELY:

1. BUDGET PREPARATION
BUDGET PREPARATION INVOLVES THE FORMULATION OF ESTIMATES OF REVENUES AND
EXPENDITURES BY THE EXECUTIVE DEPARTMENTS AND AGENCIES. IN PREPARING THE ANNUAL
BUDGET PROPOSAL, THE SAID DEPARTMENT MAKES AN ESTIMATION OF GOVERNMENT
REVENUES. IT THEN DETERMINES THE BUDGET PRIORITIES WITHIN AVAILABLE REVENUES AND
BORROWING LIMITS. FINALLY, IT TRANSLATES THESE APPROVED PRIORITIES INTO
EXPENDITURES.
THE MAIN AGENCY INVOLVED IS THE DEVELOPMENT BUDGET COORDINATION COMMITTEE
(DBCC) COMPOSED OF THE FOLLOWING AGENCIES:
A. THE DEPARTMENT OF BUDGET AND MANAGEMENT, THE AGENCY RESPONSIBLE FOR
RESOURCE ALLOCATION AND MANAGEMENT;
B. THE DEPARTMENT OF FINANCE, THE AGENCY RESPONSIBLE FOR RESOURCE GENERATION
AND DEBT MANAGEMENT;
C. THE NATIONAL ECONOMIC AND DEVELOPMENT AUTHORITY, THE AGENCY RESPONSIBLE FOR
OVERALL ECONOMIC ACTIVITY;
D. THE BANGKO SENTRAL NG PILIPINAS (CENTRAL BANK OF THE PHILIPPINES), THE AGENCY
RESPONSIBLE FOR MONETARY MEASURES AND POLICIES;
E. THE OFFICE OF THE PRESIDENT OF THE PHILIPPINES, THE AGENCY RESPONSIBLE FOR THE
APPROVAL AND OVERSIGHT OF THE BUDGET
IN THE PREPARATION OF THE BUDGET, THE DBCC APPROVES THE PARAMETERS, MAKES A
BUDGET CALL, CONDUCTS BUDGET HEARINGS, MAKES A BUDGET REVIEW THEN CONSOLIDATES
THE BUDGET. IT THEN VALIDATES AND CONFIRMS THE BUDGET, WHICH IS FINALLY APPROVED
BY THE PRESIDENT OF THE PHILIPPINES AND HIS CABINET. THE PRESIDENT THEREBY SUBMITS
THE BUDGET TO CONGRESS FOR APPROVAL.
2. BUDGET LEGISLATION/AUTHORIZATION
A. OVERVIEW
THIS PERTAINS TO THE WHOLE RANGE OF LEGISLATIVE ACTION ON THE BUDGET, LEADING TO
THE ENACTMENT OF A GENERAL APPROPRIATIONS LAW FOR THE YEAR. THE PHILIPPINE HOUSE
OF REPRESENTATIVES FIRST CONDUCTS HEARINGS/DEBATES ON THE BUDGET.
THE HOUSE THEN APPROVES THE BUDGET, FOR SUBMISSION TO THE SENATE OF THE
PHILIPPINES. SENATE HEARINGS AND DEBATES ARE CONDUCTED ON THE BUDGET, WHICH IS
FINALLY APPROVED. A BICAMERAL CONFERENCE COMMITTEE COMPOSED OF
REPRESENTATIVES OF THE PHILIPPINE HOUSE OF REPRESENTATIVES AND THE SENATE IS
CONVENED. AFTER APPROVAL BY THE BICAMERAL CONFERENCE COMMITTEE, THE PRESIDENT
ENACTS THE BUDGET WHICH IS KNOWN AS THE GENERAL APPROPRIATIONS ACT.
B. THE LEGISLATIVE BUDGET PROCESS
THE MAIN UNIT OF THE PHILIPPINE HOUSE OF REPRESENTATIVES INVOLVED IN THE BUDGET
PROCESS IS THE COMMITTEE AFFAIRS DEPARTMENT (CAD) COMPOSED OF THE STANDING
COMMITTEES AND SUB-COMMITTEES. THE CAD’S ACTIVITIES DURING BUDGET LEGISLATION
ARE:
I. COMMITTEE BUDGET HEARINGS
STANDING COMMITTEES (SOMETIMES REFERRED TO AS THE MOTHER
COMMITTEE/COMMITTEE PROPER) ARE RESPONSIBLE FOR CONDUCTING BUDGET HEARINGS.
DURING THESE HEARINGS, MACROECONOMIC ASSUMPTIONS/PLANS ARE PRESENTED DURING
THE COMMITTEE BUDGET HEARINGS ON A DEPARTMENT WIDE LEVEL. ALL THE HEADS OF THE
EXECUTIVE DEPARTMENTS ARE INVITED TO THESE HEARINGS.
SUB-COMMITTEES ARE ALSO RESPONSIBLE FOR CONDUCTING THESE BUDGET HEARINGS.
BUDGET HEARINGS ARE CONDUCTED BY THE SUB-COMMITTEES ON AN AGENCY BY AGENCY
LEVEL. BUREAUS AND OTHER OFFICES UNDER THE VARIOUS DEPARTMENTS OF THE NATIONAL
GOVERNMENT ARE INVITED TO THESE HEARINGS.
II. PRINTING OF GENERAL APPROPRIATIONS BILL (GAB) ON 1ST READING
A NATIONAL EXPENDITURE PROGRAM IS FORMULATED, AND A COPY OF THE GAB ON 1ST
READING IS PRINTED BY THE COMMITTEE TECHNICAL STAFF, BASED ON THE NATIONAL
EXPENDITURE PROGRAM. THE GAB IS FILED IN THE PLENARY SESSION FOR 1ST READING.
III. EXECUTIVE MEETING OF THE COMMITTEE
THE COMMITTEE MEETS IN EXECUTIVE SESSION TO DISCUSS AND APPROVE PROPOSED
COMMITTEE AMENDMENTS TO THE GAB. COMMITTEE REPORTS ARE PREPARED AND FILED TO
THE BILLS AND INDEX DIVISION.
IV. SPONSORSHIP AND PLENARY DELIBERATIONS
GENERAL PRINCIPLES AND MACROECONOMIC ASSUMPTIONS ARE SPONSORED AND DEBATED
IN THE PLENARY SESSION. DELIBERATIONS ON THE BUDGETS OF EACH DEPARTMENT, AGENCY,
OFFICE, INCLUDING GOVERNMENT OWNED AND CONTROLLED CORPORATIONS.
V. APPROVAL ON 2ND READING OF THE GAB
TURNO EN CONTRA SPEECHES ARE DELIVERED ON THE FLOOR. THE TURNO EN CONTRA IS A
LEGISLATIVE TRADITION ALLOWING OPPONENTS OF A BILL AN OPPORTUNITY TO EXPLAIN AT
LENGTH THEIR POSITION, IN THE SAME MANNER THAT A BILL’S SPONSOR DELIVERS A
SPONSORSHIP SPEECH. AFTER THE TURNO EN CONTRA, THE PHILIPPINE HOUSE MEMBERS
VOTE ON THE APPROVAL OF THE GAB ON 2ND READING.
VI. AMENDMENTS, FINALIZATION & PRINTING OF THE GAB FOR 3RD READING
INCLUSION OF POSSIBLE AMENDMENTS TO THE GAB FOR 3RD READING ARE SUBMITTED TO
THE FLOOR. AMENDMENTS ARE APPROVED FOR INCLUSION IN THE PROPOSED COPY OF THE
GAB ON 3RD READING, WHICH IS SUBSEQUENTLY PRINTED FOR DELIBERATION.
VII. APPROVAL OF THE GAB ON 3RD READING
THE GAB IS DISTRIBUTED TO THE PHILIPPINE HOUSE MEMBERS WHO VOTE ON THE APPROVAL
OF THE BILL ON 3RD READING. THE GAB IS THEN APPROVED ON 3RD READING.
VIII. TRANSMITTAL OF THE 3RD READING COPY OF THE GAB TO THE PHILIPPINE SENATE
THE GAB, AS APPROVED ON 3RD READING, IS TRANSMITTED TO THE SENATE FOR
CONSIDERATION IN A SIMILAR MANNER AS DELIBERATED UPON BY THE HOUSE.
IX. BICAMERAL (BICAM FOR SHORT) CONFERENCE COMMITTEE
THE CONFEREES OR REPRESENTATIVES FROM BOTH THE PHILIPPINE HOUSE AND SENATE
CONVENE AS A CONFERENCE COMMITTEE IN ORDER TO SETTLE AND RECONCILE DIFFERING
PROVISIONS OF EACH CHAMBER’S VERSION OF THE BILL.
X. APPROVAL OF THE BICAM REPORT
DURING THIS STAGE OF THE BUDGET PROCESS, THE CONFERENCE COMMITTEE REPORT IS
RATIFIED BY EACH CHAMBER.
XI. FINALIZATION AND PRINTING OF THE ENROLLED COPY OF THE GAB
ALL AMENDMENTS AS APPROVED IN THE COMMITTEE REPORT IS INCORPORATED INTO THE
ENROLLED COPY OF THE GAB. THE ENROLLED COPY IS FINALLY PRINTED.
XII. SIGNING OF THE ENROLLED COPY OF THE GAB
THE ENROLLED COPY OF THE GAB IS FORWARDED TO THE PRESIDENT FOR SIGNING. VETO
POWERS OF THE PRESIDENT ARE EXERCISED IN THE ENACTMENT OF THE GAB. THE SIGNED
APPROPRIATIONS BILL IS FINALLY ENACTED INTO A LAW WHICH IS TERMED AS THE GENERAL
APPROPRIATIONS ACT.
3. BUDGET EXECUTION/IMPLEMENTATION
BUDGET EXECUTION COVERS THE ALLOTMENT OF APPROPRIATIONS BY THE CENTRAL BUDGET
AUTHORITY TO, AND THE INCURRENCE OF OBLIGATIONS BY, THE SPENDING DEPARTMENTS
AND AGENCIES OF GOVERNMENT. THE STEPS IN THE EXECUTION OF THE BUDGET ARE:
A. RELEASE OF THE FUNDS BY THE DEPARTMENT OF BUDGET AND MANAGEMENT (DBM)
B. IMPLEMENTATION OF THE VARIOUS PROGRAMS AND ACTIVITIES BY THE DIFFERENT
GOVERNMENT AGENCIES
I. INVOLVES THE FORMULATION OF ALLOTMENT AND CASH PROGRAMS
II. AN AGENCY BUDGET MATRIX (ABM) IS PREPARED
III. THE ABM IS VALIDATED/CONFIRMED FOR CORRECTNESS AND ACCURACY
IV. THE GENERAL ALLOTMENT RELEASE ORDER (GARO)/SPECIAL ALLOTMENT RELEASE ORDER
(SARO)/NOTICE OF CASH ALLOTMENT IS RELEASED (NCA)
V. GOVERNMENT PROGRAMS/PROJECTS/ACTIVITIES CAN NOW BE IMPLEMENTED DUE TO
FUND RELEASE
4. BUDGET ACCOUNTABILITY & REVIEW
THIS INVOLVED THE REPORTING OF ACTUAL PERFORMANCE AGAINST PLANS OR TARGETS, AND
IT INVOLVES THE FOLLOWING PROCESS:
A. MONITORING OF AGENCY BUDGETARY PERFORMANCE
B. COMPARISON AND EVALUATION OF ACTUAL PERFORMANCE WITH THE INITIALLY-APPROVED
WORK TARGETS
C. A SUMMARY LIST OF CHECKS ISSUED IS SUBMITTED ON A MONTHLY BASIS
D. PHYSICAL & FINANCIAL REPORT OF OPERATIONS IS SUBMITTED ON A QUARTERLY BASIS IN
THE FORM OF A TRIAL BALANCE
LESSON 5 INTERNATIONAL TRADE AND BALANCE OF PAYMENT

INTRODUCTION

INTERNATIONAL TRADE

REFERS TO THE EXCHANGE OF GOODS AND SERVICES BETWEEN ONE COUNTRY TO THE
REST OF THE WORLD.

THE EXCHANGE OF CAPITAL, GOODS, AND SERVICES ACROSS INTERNATIONAL BORDERS OR

TERRITORIES.

COUNTRIES BENEFIT FROM PRODUCING GOODS IN WHICH THEY HAVE COMPARATIVE

ADVANTAGE AND TRADING THEM FOR GOODS IN WHICH OTHER COUNTRIES HAVE THE
COMPARATIVE ADVANTAGE. TRADING-PARTNERS REAP MUTUAL GAINS WHEN EACH NATION
SPECIALIZES IN GOODS FOR WHICH IT HOLDS A COMPARATIVE ADVANTAGE AND THEN
ENGAGES IN TRADE FOR OTHER PRODUCTS.

IN OTHER WORDS, EACH NATION SHOULD PRODUCE GOODS FOR WHICH ITS DOMESTIC
OPPORTUNITY COSTS ARE LOWER THAN THE DOMESTIC OPPORTUNITY COSTS OF OTHER
NATIONS AND EXCHANGE THOSE GOODS FOR PRODUCTS THAT HAVE HIGHER DOMESTIC
OPPORTUNITY COSTS COMPARED TO OTHER NATIONS.

IN ADDITION TO COMPARATIVE ADVANTAGE, OTHER REASONS FOR TRADE INCLUDE:

DIFFERENCES IN FACTOR ENDOWMENTS: COUNTRIES HAVE DIFFERENT AMOUNTS OF

LAND, LABOR, AND CAPITAL. SAUDI ARABIA MAY HAVE A LOT OF OIL, BUT PERHAPS NOT
ENOUGH LUMBER. IT WILL THUS HAVE TO TRADE FOR LUMBER. JAPAN MAY BE ABLE TO
PRODUCE TECHNOLOGICAL GOODS OF SUPERIOR QUALITY, BUT IT MAY LACK MANY
NATURAL RESOURCES. IT MAY TRADE WITH INDONESIA FOR INPUTS.
GAINS FROM SPECIALIZATION: COUNTRIES MAY GAIN ECONOMIES OF SCALE FROM
SPECIALIZATION, EXPERIENCING LONG RUN AVERAGE COST DECLINES AS OUTPUT
INCREASES.
POLITICAL BENEFITS: COUNTRIES CAN LEVERAGE TRADE TO FORGE CLOSER CULTURAL
AND POLITICAL BONDS. INTERNATIONAL CONNECTIONS ALSO HELP PROMOTE
DIPLOMATIC (RATHER THAN MILITARY) SOLUTIONS TO INTERNATIONAL PROBLEMS.
EFFICIENCY GAINS: DOMESTIC FIRMS WILL BE FORCED TO BECOME MORE EFFICIENT IN
ORDER TO BE COMPETITIVE IN THE GLOBAL MARKET.
 BENEFITS OF INCREASED COMPETITION: A GREATER DEGREE OF COMPETITION LEADS
TO LOWER PRICES FOR CONSUMERS, GREATER RESPONSIVENESS TO CONSUMER
WANTS AND NEEDS, AND A WIDER VARIETY OF PRODUCTS.

THREE COMPONENTS OF INTERNATIONAL TRADE

EXPORT TRADE. SELLING GOODS AND SERVICES OUT OF THE COUNTRY.

IMPORT TRADE. GOODS AND SERVICE FLOWING INTO THE COUNTRY.
ENTREPOT TRADE. (ALSO KNOWN AS RE-EXPORT TRADE). IMPORTING GOODS FROM
ONE COUNTRY AND EXPORTING IT TO ANOTHER COUNTRY AFTER ADDING SOME VALUE
TO IT.

REASON (NEED) FOR AN INTERNATIONAL TRADE

WHEN THERE ARE NOT ENOUGH RESOURCES OR CAPACITY TO MEET THE DOMESTIC DEMAND.
BY IMPORTING THE NEEDED GOODS, A COUNTRY CAN USE THEIR DOMESTIC RESOURCES TO
PRODUCE WHAT THEY ARE GOOD AT. THEN, THE COUNTRY CAN EXPORT THE SURPLUS IN THE
INTERNATIONAL MARKET.

REASONS WHY NATIONS IMPORT GOODS AND SERVICES

PRICE.
IF FOREIGN COMPANIES CAN PRODUCE OR OFFER GOODS AND SERVICES MORE CHIEFLY,
THEN IT MAY BE BENEFICIAL TO GO FOR FOREIGN TRADE.
QUALITY.
IF COMPANIES ABROAD CAN OFFER GOODS AND SERVICES AT SUPERIOR QUALITY (E.G.
SCOTLAND WHISKY/SCOTLAND/37 BOTTLES PER SECOND).

AVAILABILITY.
IF IT IS IMPOSSIBLE TO PRODUCE A PRODUCT DOMESTICALLY, LIKE SPECIAL VARIETY OF
FRUITS OR MINERAL). (JAPAN HAS NO NATURAL RESERVES OF OIL, AND THUS, IT IMPORTS
ALL ITS OIL).
DEMAND.
 IF A DEMAND FOR A PRODUCT OR SERVICES IS MORE IN A COUNTRY THAN IT CAN
DOMESTICALLY PRODUCE, THEN IT GOES TO IMPORTATION).

ADVANTAGES VERSUS DISADVANTAGES OF INTERNATIONAL TRADE

ADVANTAGES OF INTERNATIONAL TRADE

1. COMPARATIVE ADVANTAGE
IT ALLOWS COUNTRIES TO SPECIALIZE IN PRODUCING ONLY THOSE GOODS AND SERVICES
WHICH IT IS GOOD AT.
2. ECONOMIES OF SCALE
PRODUCING HIGHER VOLUME LEADS TO ECONOMIES OF SCALE, THE COST OF PRODUCING
EACH ITEM IS REDUCED.
3. COMPETITION
SELLING GOODS AND SERVICES IN THE FOREIGN MARKETS ALSO BOOST COMPLETION
(PRICES AND QUALITY IS COMPETITIVE ENOUGH TO MEET THE FOREIGN COMPETITION).
4. TRANSFER OF TECHNOLOGY
MORE JOBS CREATION

DISADVANTAGES OF INTERNATIONAL TRADE

1. OVER-DEPENDENCE
VULNERABLE TO GLOBAL EVENTS. (THE RECENT US-CHINA TRADE WAR IS ADVERSELY
AFFECTING THE CHINESE EXPORT INDUSTRY).
2. UNFAIR TO NEW COMPANIES.
NEW COMPANIES OR START-UPS DON’T HAVE MUCH RESOURCES AND EXPERIENCE AND
THUS FIND IT DIFFICULT TO COMPETE AGAINST THE BIG FOREIGN FIRMS).
3. A THREAT TO NATIONAL SECURITY
EXPORTERS MAY TAKE A DECISION THAT MAY NOT BE IN THE NATIONAL INTEREST IF A
COUNTRY IS OVER-DEPENDENT ON THE IMPORTS FOR STRATEGIC INDUSTRIES.

4. PRESSURE ON NATIONAL RESOURCES

A COUNTRY ONLY HAS LIMITED RESOURCES AND IF IT OPENS ITS DOORS TO FOREIGN
COMPANIES, IT COULD DRAIN THOSE NATURAL RESOURCES MUCH QUICKER.

NOTE: THE ADVANTAGES FAR OUTWEIGH THE DISADVANTAGE. NOWADAYS, INTERNATIONAL

TRADE HAS BECOME A NECESSITY, BUT A COUNTRY MUST MAINTAIN A PROPER BALANCE
BETWEEN IMPORTS AND EXPORTS TO ENSURE THAT ECONOMY STAYS ON THE GROWTH TRACK.

BALANCE OF PAYMENTS (BOP)

BALANCE OF PAYMENTS: DEFINITION

 RECORDS OF ALL MONETARY AND ECONOMIC TRANSACTIONS MADE BETWEEN A
COUNTRY AND THE REST OF THE WORLD.
KEEPING A RECORD OF THESE TRANSACTIONS HELPS THE COUNTRY TO MONITOR THE
FLOW OF MONEY AND DEVELOPS POLICIES THAT WOULD HELP IN BUILDING A STRONG
ECONOMY.

RELEVANCE: BOP

THE CONCEPT OF BOP IS VERY IMPORTANT FROM THE POINT OF VIEW OF A COUNTRY BECAUSE
IT HELPS TO DETERMINE WHETHER:

THE COUNTRY KEEPS ENOUGH FUNDS TO PAY FOR ITS IMPORT (DEFICIT)
THE COUNTRY HAS ENOUGH PRODUCTION CAPACITY SUCH THAT ITS ECONOMIC
OUTPUT CAN PAY FOR ITS GROWTH (SURPLUS)

DEFICIT (IMPORTS ARE MORE THAN EXPORTS)

IN THE SHORT RUN, MAY FUEL THE ECONOMIC GROWTH OF THE COUNTRY.
IN THE LONG RUN, A COUNTRY IS FORCED TO BORROW FUNDS FROM OTHER
COUNTRIES TO PAY OFF ITS IMPORTS. (THE COUNTRY WILL BE FORCED TO GO INTO
MORE DEBT TO PAY FOR ITS CONSUMPTION INSTEAD OF INVESTMENT IN ITS OWN
FUTURE GROWTH PROSPECTS).
IN CASE DEFICIT LASTS FOR LONG, THEN THE COUNTRY MIGHT HAVE TO START SELLING
OFF ITS ASSETS TO PAY FOR ITS DEBT (LAND, NATURAL RESOURCES, COMMODITIES,
ETC.)

SURPLUS (EXPORTS ARE MORE THAN IMPORTS)

COUNTRY AND RESIDENTS ARE GOOD SAVERS
CAN EVEN EXTEND LOANS TO OTHER COUNTRIES
INCREASE IN EXPORTS CAN BOOST THE PRODUCTION REQUIREMENTS, WHICH MEANS
HIRING PEOPLE.

USES: BOP

ENABLES ANALYSTS AND ECONOMISTS TO UNDERSTAND THE COUNTRY’S ECONOMIC

STRENGTHS OR WEAKNESSES IN COMPARISON TO OTHER COUNTRIES.
POLICY MAKERS ARE GUIDED BY THE ANALYSIS OF SOURCES OF IMBALANCES AS
PRESENTED IN THE BOP AND BECOME BETTER EQUIPPED IN DETERMINING AND
IMPLEMENTING ADJUSTMENT MEASURES,

BALANCE OF PAYMENTS: COMPONENTS

CURRENT ACCOUNT (CA)

CAPITAL ACCOUNT (CAPA)
FINANCIAL ACCOUNT (FA)
THE FORMULA FOR BOP IS: (CA + CAPA + FA)

THESE THREE ACCOUNTS TELL A STORY ABOUT THE STATE OF AN ECONOMY, ITS ECONOMIC
OUTLOOK, AND ITS STRATEGIES FOR ACHIEVING ITS DESIRED GOALS.

LARGE VOLUME OF IMPORTS AND EXPORTS MAY INDICATE AN OPEN ECONOMY THAT
SUPPORTS FREE TRADE.

A COUNTRY THAT SHOW LITTLE INTERNATIONAL ACTIVITY MAY MEAN THAT ITS CAPITAL OR
FINANCIAL ACCOUNT MAY HAVE AN UNDERDEVELOPED CAPITAL MARKET AND LITTLE FOREIGN
CURRENCY ENTERING THE COUNTRY IN THE FORM OF FOREIGN DIRECT INVESTMENTS.

CURRENT ACCOUNT

FORMULA: (X-M) + NY + NCT

WHERE:
X-M = EXPORTS MINUS IMPORTS
NY = NET INCOME FROM ABROAD
NCT = NET CURRENT TRANSFER

SUB-COMPONENTS
BALANCE OF TRADE
PRIMARY INCOME (FACTOR INCOME)
SECONDARY INCOME (UNILATERAL TRANSFERS, ONE-WAY TRANSFERS)

BALANCE OF TRADE
NET EARNINGS ON EXPORTS MINUS NET EARNINGS ON IMPORTS). CLASSIFIED INTO INVISIBLE
ITEMS (IMPORT AND EXPORT OF GOODS) AND INVISIBLE ITEMS (IMPORT AND EXPORT OF
SERVICES).

PRIMARY INCOME
EARNINGS RECEIVED FROM FOREIGN INVESTMENTS MINUS PAYMENTS MADE TO FOREIGN
INVESTORS.

SECONDARY INCOME
RECEIVING OR GIVING ECONOMIC VALUES (MONEY OR GOODS) WITHOUT RECEIVING ANY
ECONOMIC VALUES IN RETURN.

INTERPRETATION:

SURPLUS IN CURRENT ACCOUNT:

INDICATES THAT THE NATION IS A NET LENDER TO THE REST OF THE WORLD.
DEFICIT IN CAPITAL ACCOUNT:
INDICATES THAT THE NATION IS A NET BORROWER.

CAPITAL ACCOUNT

SORT OF MISCELLANEOUS ACCOUNT, MEASURING CAPITAL TRANSFERS AND NON-PRODUCED

AND NON-FINANCIAL ASSETS.

SUB-COMPONENTS

CAPITAL TRANSFERS
SALE AND PURCHASE OF FIXED ASSETS
FLOW OF TAXES, SALES AND PURCHASES OF FIXED ASSETS TO MIGRANTS MOVING IN
AND OUT OF THE COUNTRY.
ACQUISITIONS AND DISPOSALS OF NON-PRODUCED, NON-FINANCIAL ASSET
DRILLING RIGHTS, PATENTS, TRADEMARKS, COPYRIGHT, ROYALTIES GIFTS AND
INHERITANCE TAXES

INTERPRETATION:

SURPLUS IN CAPITAL ACCOUNT:

MONEY IS FLOWING INTO A COUNTRY AND IS SELLING (OR DISPOSING OFF) DOMESTIC ASSETS.

DEFICIT IN CAPITAL ACCOUNT:

MONEY IS FLOWING OUT OF THE COUNTRY AND THE COUNTRY IS ACCUMULATING FOREIGN
ASSETS.

FINANCIAL ACCOUNT
FLOW OF FUNDS TO AND FROM FOREIGN COUNTRIES AND MEASURES THE NET CHANGE IN
OWNERSHIP OF NATIONAL ASSETS. IT INCLUDES:
INVESTMENTS MADE IN PURCHASING EQUITY CAPITAL
GOVERNMENT RESERVES WITH IMF
TOTAL AMOUNT OF FOREIGN CURRENCIES HELD BY THE GOVERNMENT

SUB-COMPONENTS:
1. DIRECT INVESTMENT
2. PORTFOLIO INVESTMENT
OTHER INVESTMENTS
RESERVE ASSETS/ACCOUNT FLOWS

DIRECT INVESTMENT
 REFERS TO LONG-TERM INVESTMENT, I.E. BUYING EQUITY CAPITAL IN EXCHANGE OF
COMMON OR PREFERRED STOCKS, PURCHASE OR CONSTRUCTION OF MACHINERY,
BUILDING OR WHOLE MANUFACTURING PLANT
YOU CAN UNDERSTAND WHETHER A COUNTRY IS ACQUIRING OR SELLING

PORTFOLIO INVESTMENT
INVESTMENT IN THE FORM OF A GROUP (PORTFOLIO) OF FINANCIAL ASSETS (BONDS,
ETC)
REFERS TO SHORT-TERM INVESTMENT, I.E. BUYING EQUITY SECURITIES (FIXED INCOME
INVESTMENTS: BONDS, NOTES, MONEY MARKET INSTRUMENTS (TBILLS, CERTIFICATE
OF DEPOSITS) AND COMMERCIAL PAPERS (PNS, DRAFTS, CHECKS)

OTHER INVESTMENT
CAPITAL FLOWS INTO BANK ACCOUNTS OR PROVIDED AS LOANS

RESERVE ASSETS/ACCOUNT FLOWS

GENERATED BY A NATION’S CENTRAL BANK TO BUY AND SELL FOREIGN CURRENCIES
INTERPRETATION

DEFICIT IN FINANCIAL ACCOUNT:

DOMESTIC BUYERS ARE PURCHASING MORE FOREIGN ASSETS THAN FOREIGN BUYERS ARE
PURCHASING DOMESTIC ASSETS.

SURPLUS IN FINANCIAL ACCOUNT:

NET OWNERSHIP OF A COUNTRY’S ASSETS IS FLOWING OUT OF THE COUNTRY. FOREIGN
BUYERS ARE PURCHASING MORE DOMESTIC ASSETS THAN DOMESTIC BUYERS ARE
PURCHASING ASSETS FROM THE REST OF THE WORLD.

BOP: STANDARD OF COMPONENTS

CURRENT ACCOUNT
GOOD AND SERVICES
GOODS (VISIBLE ITEMS)
SERVICES (INVISIBLE ITEMS)
TRANSPORTATION
TRAVEL
COMMUNICATION
CONSTRUCTION
INSURANCE
FINANCIAL
COMPUTER AND INFORMATION
 ROYALTIES AND LICENSE FEES
PERSONAL, CULTURAL AND RECREATIONAL

PRIMARY INCOME
COMPENSATION OF EMPLOYEE
DIRECT INVESTMENT
INCOME ON EQUITY CAPITAL (DIVIDENDS AND PROFITS)
INCOME ON DEBT (INTEREST VS LOANS)
PORTFOLIO INVESTMENT
INCOME ON EQUITY SHARES
INCOME ON DEBTS
(BONDS AND NOTES/MONEY MARKET INSTRUMENTS/FINANCIAL DERIVATES)
OTHER INVESTMENT

SECONDARY INCOME
A. WORKERS’ REMITTANCES (OFWS)
B. ECONOMIC AID, MILITARY AID, DONATIONS

CAPITAL ACCOUNT
A. CAPITAL TRANSFER
B. ACQUISITION/DISPOSAL OF NON-PRODUCED, NON-FINANCIAL ASSETS

FINANCIAL ACCOUNT
A. DIRECT INVESTMENT
B. PORTFOLIO INVESTMENT
A. EQUITY SECURITIES
B. DEBT SECURITIES
C. OTHER INVESTMENT
A. TRADE CREDITS
B. LOANS
C. CURRENCY AND DEPOSITS
D. RESERVE ASSETS
A. MONETARY GOLD
B. SPECIAL DRAWING RIGHTS
C. RESERVE POSITION IN THE FUNDS
D. FOREIGN EXCHANGE

HOW TO CALCULATE BALANCE OF PAYMENT (BOP)

(HTTPS://WWW.WALLSTREETMOJO.COM/BALANCE-OF-PAYMENTS-FORMULA/)
BALANCE OF PAYMENTS FORMULA

FORMULA TO CALCULATE BALANCE OF PAYMENTS (BOP)

THE FORMULA FOR BALANCE OF PAYMENT IS A SUMMATION OF THE CURRENT ACCOUNT, THE
CAPITAL ACCOUNT, AND THE FINANCIAL ACCOUNT BALANCES. THE TERM BALANCE OF
PAYMENTS REFERS TO THE RECORDING OF ALL PAYMENTS AND OBLIGATIONS PERTAINING TO
IMPORTS FROM FOREIGN COUNTRIES VIS-À-VIS ALL PAYMENTS AND OBLIGATIONS PERTAINING
TO EXPORTS TO FOREIGN COUNTRIES. IT IS THE ACCOUNTING OF ALL THE FINANCIAL INFLOWS
AND OUTFLOWS OF A NATION.

BALANCE OF PAYMENTS = BALANCE OF CURRENT ACCOUNT + BALANCE OF CAPITAL

ACCOUNT + BALANCE OF FINANCIAL ACCOUNT

STEP BY STEP CALCULATION OF BALANCE OF PAYMENTS (BOP)

THE FORMULA FOR THE CALCULATION OF BALANCE OF PAYMENTS IS CALCULATED IN THE

FOLLOWING FOUR STEPS-

STEP 1: FIRSTLY, THE BALANCE OF THE CURRENT ACCOUNT IS DETERMINED WHICH IS THE
SUMMATION OF THE CREDITS AND DEBITS ON VARIOUS MERCHANDISE TRADE. THE CURRENT
ACCOUNT DEALS WITH GOODS, WHICH MAY INCLUDE MANUFACTURED GOODS OR RAW
MATERIALS THAT ARE PURCHASED OR SOLD.

STEP 2: NOW, THE BALANCE OF THE CAPITAL ACCOUNT IS DETERMINED WHICH PERTAINS TO
THE DISPOSAL OR ACQUISITION OF NON-FINANCIAL ASSETS, WHICH MAY INCLUDE LAND OR
OTHER PHYSICAL ASSETS. BASICALLY, THE PRODUCTS ARE REQUIRED FOR MANUFACTURING
BUT HAVE NOT BEEN MANUFACTURED PER SE, FOR INSTANCE, AN IRON MINE THAT IS USED
FOR IRON ORE EXTRACTION.

STEP 3: NOW, THE BALANCE OF THE FINANCIAL ACCOUNT IS DETERMINED WHICH PERTAINS TO
INTERNATIONAL MONETARY INFLOWS AND OUTFLOWS RELATED TO INVESTMENT.

STEP 4: FINALLY, THE FORMULA FOR THE CALCULATION OF BALANCE OF PAYMENTS IS BY

ADDING A BALANCE OF THE CURRENT ACCOUNT (STEP 1), A BALANCE OF THE CAPITAL
ACCOUNT (STEP 2)AND BALANCE OF THE FINANCIAL ACCOUNT (STEP 3)AS SHOWN ABOVE.
EXAMPLES OF BOP

THE FOLLOWING INFORMATION IS USED FOR THE CALCULATION OF THE BALANCE OF

PAYMENTS.

1 PARTICULARS AMOUNT
2 CURRENT ACCOUNT
3 EXPORTS OF GOODS 1,046,000
4 IMPORT OF GOODS 1,562,000
5 EXPORT OF SERVICES 509,000
6 IMPORT OF SERVICES 371,000
7 INCOME PAYMENTS 89,000
8 UNILATERAL TRANSFERS -130,000
9 CAPITAL ACCOUNT
8 NET CAPITAL ACCOUNT 45,000
BALANCE
9 FINANCIAL ACCOUNT
10 NET DIRECT INVESTMENT 75,000
11 NET PORTFOLIO INVESTMENT -55,000
12 OTHER PORTFOLIO 25,000
INVESTMENTS
13 RESERVE ASSETS 10,000
14 ERRORS AND OMISSIONS 15,000

NOW, WE WILL CALCULATE THE FOLLOWING VALUES FOR THE CALCULATION OF THE BALANCE
OF PAYMENTS FORMULA.

THE BALANCE OF CURRENT ACCOUNT

BALANCE OF CURRENT ACCOUNT = EXPORTS OF GOODS + IMPORTS OF GOODS + EXPORTS OF

SERVICES + IMPORTS OF SERVICES + INCOME PAYMENTS + UNILATERAL TRANSFERS

= $1,046,000 + (-$1,562,000) + $509,000 + (-$371,000) + $89,000 + (-$130,000)

= -$419,000 I.E. CURRENT ACCOUNT IS IN DEFICIT

BALANCE OF CAPITAL ACCOUNT

THE BALANCE OF CAPITAL ACCOUNT =NET CAPITAL ACCOUNT BALANCE

= $45,000 I.E. CAPITAL ACCOUNT IS IN SURPLUS

THE BALANCE OF FINANCIAL ACCOUNT

BALANCE OF FINANCIAL ACCOUNT =NET DIRECT INVESTMENT + NET PORTFOLIO INVESTMENT +

OTHER PORTFOLIO INVESTMENTS + RESERVE ASSETS + ERRORS AND OMISSIONS

= $75,000 + (-$55,000) + $25,000 + $10,000 + $15,000

= $70,000 I.E. FINANCIAL ACCOUNT IS IN SURPLUS

THEREFORE, BY USING THE ABOVE CALCULATED VALUE WE WILL NOW DO THE CALCULATION
OF BALANCE OF PAYMENTS.

BALANCE OF PAYMENTS FORMULA = (-$419,000) + $45,000 + $70,000

BOP WILL BE –

THE BALANCE OF PAYMENTS = -$304,000 I.E. OVERALL THE ECONOMY IS IN DEFICIT.

RELEVANCE AND USE BOP FORMULA

THE CONCEPT OF BALANCE OF PAYMENTS IS VERY IMPORTANT FROM THE POINT OF VIEW OF A
COUNTRY BECAUSE IT IS THE REFLECTION OF THE FACT THAT WHETHER THE COUNTRY KEEPS
ENOUGH FUNDS TO PAY FOR ITS IMPORTS. IT ALSO DEMONSTRATES WHETHER THE COUNTRY
HAS ENOUGH PRODUCTION CAPACITY SUCH THAT ITS ECONOMIC OUTPUT CAN PAY FOR ITS
GROWTH. USUALLY, IT IS REPORTED ON A QUARTERLY OR YEARLY BASIS.

IF THE BALANCE OF PAYMENTS OF A COUNTRY IS IN DEFICIT, THEN IT MEANS THAT THE

COUNTRY IMPORTS MORE SERVICES, GOODS, AND CAPITAL ITEMS THAN IT EXPORTS. IN SUCH
A SCENARIO THE COUNTRY IS FORCED TO BORROW FUNDS FROM OTHER COUNTRIES IN ORDER
TO PAY OFF ITS IMPORTS. IN THE SHORT TERM, SUCH MEASURES CAN FUEL THE ECONOMIC
GROWTH OF THE COUNTRY. HOWEVER, IN THE LONG TERM, THE COUNTRY ENDS UP
BECOMING A NET CONSUMER OF THE ECONOMIC OUTPUT OF THE WORLD. SUCH A COUNTRY
WILL BE FORCED TO GO INTO MORE DEBT TO PAY FOR ITS CONSUMPTION INSTEAD OF
INVESTMENT IN ITS OWN FUTURE GROWTH PROSPECTS. IF IN CASE THE DEFICIT LASTS FOR
TOO LONG, THEN THE COUNTRY MIGHT HAVE TO START SELLING OFF ITS ASSETS TO PAY FOR
ITS DEBT. EXAMPLES OF SUCH ASSETS ARE LAND, NATURAL RESOURCES, AND COMMODITIES.

IF THE BALANCE OF PAYMENTS OF A COUNTRY IS IN SURPLUS, THEN IT MEANS THAT THE

COUNTRY EXPORTS MORE SERVICES, GOODS, AND CAPITAL ITEMS THAN IT DOES AN IMPORT.
SUCH A COUNTRY AND ITS RESIDENTS ARE GOOD SAVERS. THEY HAVE THE POTENTIAL TO PAY
FOR ALL THEIR DOMESTIC CONSUMPTION. SUCH A COUNTRY CAN EVEN EXTEND LOANS TO
OTHER COUNTRIES. IN THE SHORT TERM, A SURPLUS BOP CAN BOOST ECONOMIC GROWTH.
THEY HAVE ENOUGH SAVINGS TO EXTEND LOANS TO THOSE COUNTRIES THAT BUY THEIR
PRODUCTS. CONSEQUENTLY, THE INCREASE IN EXPORTS CAN BOOST THE PRODUCTION
REQUIREMENT, WHICH MEANS HIRING MORE PEOPLE. HOWEVER, THE COUNTRY MIGHT END
UP BECOMING TOO DEPENDENT ON EXPORTS IN THE END. IN SUCH A COUNTRY, A LARGE
DOMESTIC MARKET CAN GUARD THE COUNTRY AGAINST THE IMPACTS OF EXCHANGE RATE
FLUCTUATIONS.

AS SUCH, THE BALANCE OF PAYMENTS ENABLES ANALYSTS AND ECONOMISTS TO

UNDERSTAND THE STRENGTH OF THE ECONOMY OF A COUNTRY IN COMPARISON TO THAT OF
THE OTHER COUNTRIES. IN ADDITION, THEORETICALLY, THE CAPITAL AND THE FINANCIAL
ACCOUNTS SHOULD BE BALANCED AGAINST THE CURRENT ACCOUNT I.E. BOPS SHOULD BE
ZERO; BUT THAT SELDOM HAPPENS.

BALANCE OF TRADE (TRADE BALANCE)

THE BALANCE OF TRADE (OR TRADE BALANCE) IS ANY GAP BETWEEN A NATION’S DOLLAR
VALUE OF ITS EXPORTS, OR WHAT ITS PRODUCERS SELL ABROAD, AND A NATION’S DOLLAR
WORTH OF IMPORTS, OR THE FOREIGN-MADE PRODUCTS AND SERVICES THAT HOUSEHOLDS
AND BUSINESSES PURCHASE.

RECALL FROM THE MACROECONOMIC PERSPECTIVE THAT IF EXPORTS EXCEED IMPORTS, THE
ECONOMY IS SAID TO HAVE A TRADE SURPLUS. IF IMPORTS EXCEED EXPORTS, THE ECONOMY
IS SAID TO HAVE A TRADE DEFICIT. IF EXPORTS AND IMPORTS ARE EQUAL, THEN TRADE IS
BALANCED (BALANCED TRADE).

BALANCE OF TRADE
(COMPUTED AS EXPORTS MINUS IMPORTS (E – M), WHERE E, IS EXPORT AND M, IS IMPORTS)

TRADE. BUYING AND SELLING OF GOODS AND SERVICES ON A MARKET.

EXPORTS

EXPORT IS DEFINED AS THE ACT OF A COUNTRY SHIPPING GOODS AND SERVICES OUT OF THE
PORT OF A COUNTRY. IN INTERNATIONAL TRADE, AN EXPORT REFERS TO THE SELLING OF
GOODS AND SERVICES PRODUCED IN THE HOME COUNTRY TO OTHER MARKETS (OTHER
COUNTRIES). THE SELLER OF THE GOODS AND SERVICES IS REFERRED TO AS THE “EXPORTER.”
IMPORTS

IMPORTS ARE DEFINED AS PURCHASES OF GOOD OR SERVICES BY A DOMESTIC ECONOMY

FROM A FOREIGN ECONOMY. THE DOMESTIC PURCHASER OF THE GOOD OR SERVICE IS CALLED
AN IMPORTER. IMPORTS AND EXPORTS ARE CRITICAL FOR MANY ECONOMIES AND THEY ARE
THE DEFINING FINANCIAL TRANSACTIONS OF INTERNATIONAL TRADE.

TRADE SURPLUS. OCCURS WHEN A VALUE OF A NATION’S EXPORTS IS GREATER THAN THE
VALUE OF ITS IMPORTS.

TRADE DEFICIT. OCCURS WHEN A VALUE OF A NATION’S EXPORTS IS LESS THAN THE VALUE OF
ITS IMPORTS.

CONSEQUENCES OF A TRADE DEFICIT

1. EMPLOYMENT. DOMESTIC JOBS MAY BE LOST.
2. CURRENCY VALUE. DECLINE IN CURRENCY VALUE (DEVALUATION).
3. INTEREST RATES. MAY GO UP.

THEORIES OF INTERNATIONAL TRADE

INTERNATIONAL TRADE THEORIES ARE SIMPLY DIFFERENT THEORIES TO EXPLAIN

INTERNATIONAL TRADE. TRADE IS THE CONCEPT OF EXCHANGING GOODS AND SERVICES
BETWEEN TWO PEOPLE OR ENTITIES. INTERNATIONAL TRADE IS THEN THEN THE CONCEPT OF
THIS EXCHANGE BETWEEN PEOPLE OR ENTITIES IN TWO DIFFERENT COUNTRIES.

PEOPLE OR ENTITIES TRADE BECAUSE THEY BELIEVE THAT THEY BENEFIT FROM THE EXCHANGE.
THEY MAY NEED OR WANT THE GOODS OR SERVICES. WHILE AT THE SURFACE, THIS MAY
SOUND SIMPLE, THERE IS A GREAT DEAL OF THEORY, POLICY, AND BUSINESS STRATEGY THAT
CONSTITUTES INTERNATIONAL TRADE.
BELOW ARE SOME OF THE DIFFERENT THEORIES THAT EVOLVED OVER THE PAST CENTURY AND
WHICH ARE MOST RELEVANT TODAY. (HTTPS://SAYLORDDOTORG.GITHUB.IO)

A. CLASSICAL (OR COUNTRY-BASED) TRADE THEORIES

1. MERCANTILISM THEORY
2. NEO-MERCANTILISM THEORY
3. ABSOLUTE ADVANTAGE THEORY
4. COMPARATIVE ADVANTAGE THEORY
5. HECKSCHER-OHLIN THEORY
6. LEONTIEF PARADOX THEORY

B. MODERN (OR FIRM-BASED) TRADE THEORIES

1. COUNTRY SIMILARITY THEORY
2. PRODUCT LIFE CYCLE THEORY
3. GLOBAL STRATEGIC RIVALRY THEORY
4. PORTER’S NATIONAL COMPETITIVE ADVANTAGE THEORY

CLASSICAL (OR COUNTRY-BASED) TRADE THEORIES

MERCANTILISM
DEVELOPED IN 16TH CENTURY
STATED THAT A COUNTRY’S WEALTH IS DETERMINED BY THE AMOUNT OF ITS
HOLDINGS IN GOLD AND SILVER
COUNTRY SHOULD INCREASE ITS HOLDING OF GOLD AND SILVER BY PROVIDING
EXPORTS AND DISCOURAGING IMPORTS. OBJECTIVE IS TO HAVE A TRADE SURPLUS.
ONE WAY OF PROTECTING EXPORTS WAS TO IMPOSE RESTRICTIONS ON IMPORTS, A
STRATEGY CALLED “PROTECTIONISM”.

NEO-MERCANTILISM
TODAY COUNTRIES SUCH AS JAPAN, CHINA, SINGAPORE, TAIWAN AND EVEN GERMANY
STILL FAVORS PROTECTIONISM THROUGH A FORM OF “NEO-MERCANTILISM” IN WHICH
COUNTRIES PROMOTES COMBINATION OF PROTECTIONISM POLICIES AND RESTRICTION
AND DOMESTIC-INDUSTRY SUBSIDIES.

TRADE PROTECTIONISM. A POLICY THAT PROTECTS DOMESTIC INDUSTRIES FROM UNFAIR

COMPETITION FROM FOREIGN ONES.
TYPES OF TRADE PROTECTIONISM
TARIFF (OR CUSTOM DUTIES). TAX LEVIED UPON GOODS AS THEY CROSS NATIONAL
BOUNDARIES (GOVERNMENT OF IMPORTING COUNTRY).
SUBSIDIES. A PRIVILEGE GRANTED BY A GOVERNMENT, SUCH AS GRANT OF MONEY.
IMPORT QUOTAS. GOVERNMENT-IMPOSED LIMIT ON THE QUANTITY OR VALUE OF
GOODS.

ABSOLUTE ADVANTAGE
DEVELOPED BY ADAM SMITH IN 1776
FOCUSED ON THE ABILITY OF A COUNTRY TO PRODUCE A GOOD MORE EFFICIENTLY
THAT ANOTHER NATION.
STATED THAT A NATION’S WEALTH SHOULDN’T BE JUDGED BY HOW MUCH GOLD AND
SILVER IT HAD RATHER THAN THE LIVING STANDARD OF ITS PEOPLE.

EXAMPLE:
COUNTRY A – COULD PRODUCE A GOOD CHEAPER OR FASTER (OR BOTH) THAT COUNTRY B,
THE COUNTRY A HAD THE ADVANTAGE AND COULD FOCUS ON SPECIALIZING ON PRODUCING
THAT GOOD (OR THE CONCEPT OF SPECIALIZATION).

COUNTRY B – BETTER AT PRODUCING ANOTHER GOOD, IT COULD FOCUS ON SPECIALIZATION

AS WELL.

COMPARATIVE ADVANTAGE
DEVELOPED BY DAVID RICARDO, AN ENGLISH ECONOMIST, IN 1817.
OCCURS WHEN A COUNTRY CANNOT PRODUCE A PRODUCT MORE EFFICIENTLY THAN
THE OTHER COUNTRY, HOWEVER, IT CAN PRODUCE THAT PRODUCT BETTER AND MORE
EFFICIENTLY THAT IT DOES OTHER GOODS.
COMPARATIVE ADVANTAGE IS AN ECONOMIC TERM THAT REFERS TO AN ECONOMY’S
ABILITY TO PRODUCE GOODS AND SERVICES AT A LOWER OPPORTUNITY COST* THAN
THAT OF TRADE PARTNERS.

*OPPORTUNITY COST – INCOME BENEFITS FROM CHOOSING ONE ALTERNATIVE OVER

OTHERS.

ABSOLUTE ADVANTAGE THEORY VERSUS COMPARATIVE ADVANTAGE THEORY

ABSOLUTE ADVANTAGE THEORY. LOOKS AT THE ABSOLUTE PRODUCTIVITY.

COMPARATIVE ADVANTAGE THEORY. FOCUSES ON THE RELATIVE PRODUCTIVITY
DIFFERENCES.

ABSOLUTE ADVANTAGE/COMPARATIVE ADVANTAGE/COMPETITIVE ADVANTAGE

ABSOLUTE ADVANTAGE. REFERS TO THE ABILITY TO PRODUCE MORE OR BETTER GOODS AND
SERVICES THAN SOMEBODY ELSE.

COMPARATIVE ADVANTAGE. REFERS TO THE ABILITY TO PRODUCE GOODS AND SERVICES AT A

LOWER OPPORTUNITY COST, NOT NECESSARILY AT A GREATER VOLUME OR QUALITY.

COMPETITIVE ADVANTAGE. OFFERS SUPERIOR GOODS AND SERVICES THAN ITS COMPETITORS
OR THE LOW-COST PROVIDER OF GOODS AND SERVICES.

HECKSCHER-OHLIN THEORY (FACTORS PROPORTION THEORY)

DEVELOPED BY ELI HECKSHER AND BERTIL OHLIN
COUNTRIES WOULD PRODUCE AND EXPORT GOODS THAT REQUIRED RESOURCES OR
FACTORS THAT WERE IN GREAT SUPPLY, AND THEREFORE, CHEAPER PRODUCTION
FACTORS. CONVERSELY, COUNTRIES WOULD IMPORT GOODS THAT REQUIRED
RESOURCES THAT WERE IN SHORT SUPPLY, BUT HIGHER DEMAND.
A COUNTRY THAT HAS MORE CAPITAL FOR WORKERS SHOULD EXPORT CAPITAL-
INTENSIVE PRODUCTS (REQUIRE LARGE AMOUNT OF INVESTMENT TO PRODUCE A
GOOD OR SERVICE) AND IMPORTS GOODS THAT WOULD REQUIRE AN EXHAUSTIVE
USER OF ITS SCANT RESOURCES.

LEONTIEF PARADOX THEORY

DEVELOPED BY WASSILY W, LEONTIEF IN 1950S
USA WAS ABUNDANT IF CAPITAL, AND THEREFORE, AS PROPOSED BY HECKSCHER-OLIN
THEORY, SHOULD EXPORT MORE CAPITAL-INTENSIVE GOODS.
CONTRARILY, HOWEVER, IT WAS FOUND OUT THAT USA WAS INSTEAD IMPORTING
CAPITAL-INTENSIVE GOODS AND EXPORTING LABOR-INTENSIVE GOODS (LEONTIEF
PARADOX THEORY)
MODERN (OR FIRM-BASED) TRADE THEORIES

COUNTRY SIMILARITY THEORY

DEVELOPED BY STEFFAN LINDER IN 1961
SUGGESTS THAT INTRA-INDUSTRY TRADE TAKES PLACE BETWEEN THE COUNTRIES WITH
SIMILAR LEVEL OF DEVELOPMENT.
ACCORDING TO THIS THEORY, THE COMPANIES THAT DEVELOP NEW PRODUCTS FOR
THE DOMESTIC MARKET EXPORT THE PRODUCTS TO THOSE COUNTRIES THAT ARE AT
SIMILAR LEVEL OF DEVELOPMENT AFTER MEETING THE NEEDS OF THE DOMESTIC
MARKET
BASIS OF TRADE AMONG COUNTRIES ARE: (1) SIMILARITY OF LOCATION (LESS
TRANSPORTATION COST-PHILIPPINES TO MALAYSIA), (2) CULTURAL SIMILARITY
(AMONG ISLAMIC COUNTRIES, FOR EXAMPLE), AND (3) SIMILARITY OF POLITICAL AND
ECONOMIC INTEREST (COUNTRIES PREFER TO TRADE WITH THEIR POLITICALLY
FRIENDLY COUNTRIES.

PRODUCT LIFE CYCLE THEORY

DEVELOPED BY RAYMOND VERNON (HARVARD BUSINESS SCHOOL PROFESSOR) IN
1960S
CONCEPT IS USED BY MANAGEMENT AND BY MARKETING PROFESSIONALS AS A FACTOR
IN DECIDING WHETHER APPROPRIATE TO: INCREASE ADVERTISING, REDUCE PRICE,
EXPANDS TO NEW MARKETS, OR REDESIGN PACKAGING
PRODUCT LIFE CYCLE: INTRODUCTION, GROWTH, MATURITY/STABILITY AND DECLINE
PRODUCT LIFE CYCLE MANAGEMENT REFERS TO THE HANDLING OF A GOOD AS IT
MOVES THROUGH THE TYPICAL STAGES OF ITS PRODUCT LIFE.

GLOBAL STRATEGIC RIVALRY THEORY

DEVELOPED BY PAUL KRUGMAN AND KELVIN LANCASTER
FOCUSED ON MULTI-NATIONAL COMPANIES (MNCS) AND THEIR EFFORTS TO GAIN OR
DEVELOP COMPETITIVE ADVANTAGE AGAINST OTHER GLOBAL FIRMS IN THEIR
INDUSTRY. COMPETITIVE ADVANTAGE IS THE ATTRIBUTE THAT ALLOWS AN
ORGANIZATION TO OUTPERFORM ITS COMPETITORS.
EXAMPLES OF COMPETITIVE ADVANTAGES:
1. RESEARCH AND DEVELOPMENT
2. THE OWNERSHIP OF INTELLECTUAL PROPERTY RIGHTS
3. ECONOMIES OF SCALE
4. UNIQUE BUSINESS PROCESSES OR METHOD
5. EXTENSIVE EXPERIENCE IN THE INDUSTRY
 6. THE CONTROL OF RESOURCES OR FAVORABLE ACCESS TO RAW MATERIALS

PORTER’S NATIONAL COMPETITIVE ADVANTAGE THEORY

DEVELOPED BY MICHAEL PORTER OF HARVARD BUSINESS SCHOOL IN 1990S
STATED THAT A NATION’S COMPETITIVENESS IN AN INDUSTRY DEPENDS ON THE
CAPACITY OF THE INDUSTRY TO INNOVATE AND UPGRADE. (THIS THEORY FOCUSED ON
EXPLAINING WHY SOME NATIONS ARE MORE COMPETITIVE IN CERTAIN INDUSTRIES).
THE FOUR DETERMINANTS ARE: (1) LOCAL MARKET RESOURCES AND CAPABILITIES, (2)
LOCAL MARKET DEMAND CONDITIONS, (3) LOCAL SUPPLIERS AND COMPLEMENTARY
INDUSTRIES, AND (4) LOCAL FIRM CHARACTERISTICS.

LOCAL MARKET RESOURCES AND CAPABILITIES (FACTORS OR RESOURCES

DETERMINED)
WHAT PRODUCTS A COUNTRY WILL IMPORT OR EXPORT

LOCAL MARKET DEMAND CONDITIONS

SOPHISTICATED HOME MARKET IS CRITICAL TO ENSURING INNOVATION, THEREBY
CREATING A SUSTAINABLE COMPETITIVE ADVANTAGE (SCA).

LOCAL SUPPLIERS AND COMPLEMENTARY INDUSTRIES

TO REMAIN COMPETITIVE, LARGE GLOBAL FIRMS BENEFIT FROM HAVING STRONG,
EFFICIENT, SUPPORTING AND RELATED INDUSTRIES TO PROVIDE THE INPUTS REQUIRED
BY THE INDUSTRIES.
CORRESPONDS TO THE SUPPLIERS AND CUSTOMERS WHO CAN REPRESENT EITHER
THREATS OR OPPORTUNITIES IN THE FIVE FORCES MODEL.

LOCAL FIRM CHARACTERISTICS

CHARACTERISTICS INCLUDE FIRM STRATEGY, INDUSTRY STRUCTURE AND INDUSTRY
RIVALRY.
THIS POINT IS RELATED TO THE FORCES OF COMPETITORS AND BARRIERS TO NEW
MARKET ENTRANTS IN THE FIVE FORCES MODEL.