Aaron Choi Brian Lim Jomer Lu Anton Santiago EC 112 Group Exercise 2

Part I: Essay Questions

1. Dr. Noel de Dios’ essay on Adam Smith

The Wealth of Nations, the third section of Noel De Dios’ “Smith’s Economic Morals: An
Introduction,” discusses how promoting one’s own autonomy and self-interest can lead to the success
and development of the economy as a whole. According to De Dios, these ideas can be summarized
into seven points (De Dios, 2009). First of all, reciprocal exchange wherein both parties’ benefit can
be considered to be inherent in humans. Do ut des, as they say. This exchange, according to Smith,
then encourages the division of labor within individuals who are incentivized to devote himself to a
certain task knowing that the market for which he produces is vast and large enough to accommodate
his goods. Thus, he considered the division of labor to be the main determinant of labor productivity
which consequently leads to the economic development and wealth of a country.

Aside from the division of labor, Smith saw that the efficient accumulation of capital with regards
to employment was another essential factor in development. The accumulation can be further
increased by savings and good investments while its growth may be hindered by poor financial
decisions resulting in bad investments and unnecessary consumption. In the last three points, Smith
explains why the direction of the two aforementioned factors should be left to private institutions
instead of leaving it to the government and the state. He argues that government intervention with
regards to specialization leads to more harm than good. Instead, he proposes that the state has a
paradoxical role, such that its only function is to provide national defense, justice, and public works.
Thus, its only role would be to protect the market and people and institutions would be free to make
decisions they deem best for themselves and unknowingly, for society as a whole. 

Adam Smith’s Theory of Value or the Labor Theory of Value tells us that the value or “natural
price of a good” can be found by adding the costs of its production (Taylor, 1996). The market then
fluctuates above and below this natural price depending on the demand and supply curve. An excess
in demand would make the market price higher than the natural price while an excess in supply would
place the market price below the natural price. Thus, it can be said that the market moves depending
on one’s self-interest (De Dios, 2009). This theory of Smith can be seen as a counterpoint to the
mercantilist belief that the wealth and power of a nation lie in its control and ownership of a stock of
precious metals. In contrast to free trade, Mercantilism restrained imports and encouraged exports in
order to accumulate gold and silver (The Library of Economics and Liberty). Because of restraining
imports, no two parties would benefit from an exchange of mutual benefit, the importance of which
Smith emphasized. Furthermore, the specialization of labor was ignored. Smith saw this and thus
arrived at the theory of value. 
 In the Philippines, the sources of wealth lie in the service sector, followed by agriculture. In the
fourth quarter of 2018, the Philippines posted a growth of 6.1%. 56.2% of the Philippine GDP was
contributed by the service sector. (Department of Trade and Industry). This can be related to Smith’s
aforementioned ideas. He mentioned that in order to achieve economic growth, it is important for the
division of labor to take place. This can be seen through the diversity of the service sector, which can
be divided into construction, transportation, trade, and finance among others. This diversity allows
individuals to maximize their potential in certain tasks which help in the betterment of the economy.
Aside from diversity, the service sector emphasizes mutual benefit and reciprocity. Every day,
Filipinos trade services with one another, the transportation sector deliver doctors to their respective
jobs while the same doctors may have those in charge of the transportation sector as patients.
Anyhow, this exchange helps each with their activities as the doctor gets to his job while the member
of the transportation sector is able to return to work following his treatment. This cycle of reciprocal
exchange helps each and every one achieves his individual specialization, contributing to further
economic development.

References:

Dios, E. S. de. (2009, July). (DP 2009-04) Smith's Economic Morals: An Introduction. Retrieved from
http://www.econ.upd.edu.ph/dp/index.php/dp/article/view/15/12?fbclid=IwAR3b6PQ0hxWJC.

LaHaye, L., Hooper, C. L., Kling, A., Horwitz, S., Moore, T. G., & Minarik, J. J. (n.d.). Mercantilism.
Retrieved from https://www.econlib.org/library/Enc/Mercantilism.html.

Raposon, J. (n.d.). Gross Domestic Product (GDP). Retrieved from

The approach of Banko Sentral ng Pilipinas, or BSP for brevity, towards monetary policy is
inflation targeting to keep the economy growing at a good and safe rate. They want to keep inflation
low and balanced while being conducive to economic growth (Bangko Sentral ng Pilipinas -
Monetary Policy, n.d.). This is done by promoting price stability that is instrumental in economic
growth. Other money policy instruments that BSP utilizes include “encouraging/discouraging deposits
under the term deposit auction facility (TDF), standing liquidity facilities, namely, the overnight
lending facility (OLF) and the overnight deposit facility (ODF), increasing/decreasing the reserve
requirement, adjusting the rediscount rate on loans extended to banking institutions on a short-term
basis against eligible collateral of banks' borrowers, [and] outright sales/purchases of the BSP's
holding of government securities.” Aside from this, in order to absorb liquidity, the BSP offers term
deposits as one of their monetary tools.

In 2016, the BSP formally adopted the interest rate corridor (IRC) system as a framework for
conducting its monetary operations. This system is utilized for guiding short-term market rates to the
BSP policy interest rate which is also the overnight reverse repurchase (RRP) rate. This included a
rate at which the central bank lends to banks and a rate at which it takes deposits from the central
bank. This system includes Open Market Operations (OMO), acceptance of term deposits, and
standing liquidity facilities (Monetary Operations, n.d.).

The inflation targeting approach is a solution system which includes reverse repurchase facility,
acceptance of term deposits, standing liquidity facilities, rediscounting, and reserve requirements
which, we’ll go into one by one. First, the reverse repurchase facility was changed into an overnight
facility and was offered with a fixed-rate and full allotment method, where individual bidders are
awarded a portion of the offer. In 1998, BSP offered Special Discount Accounts (SDA) to banks and
trust entities of bank and non-bank financial institutions. BSP also offered standing liquidity windows
which aim to help counterparties adjust their respective liquidity positions. With rediscounting, BSP
extends discounts, loans, and advances to banks in order to influence the volume of credit in the
financial system. Lastly, reserve requirements were imposed on bank and non-bank financial
institutions with quasi-banking functions.

References:

Bangko Sentral ng Pilipinas - Monetary Policy. (n.d.). Retrieved from Bangko Sentral ng Pilipinas:
http://www.bsp.gov.ph/monetary/targeting.asp
Chappelow, J. (2019, June 25). Money Supply Definition. Retrieved from Investopedia:
https://www.investopedia.com/terms/m/moneysupply.asp
Monetary Operations. (n.d.). Retrieved from Bangko Sentral ng Pilipinas:
http://www.bsp.gov.ph/moperations/moperations.asp
Part II: Analysis of Data

2. Investment. Examine Table 3.1 or 3.2 in a recent Philippine Statistical Yearbook and review the
expenditure item ‘changes in stock’.
a. Does the behavior of this expenditure item follow the behavior explained by the accelerator
model of investment?

Figure 2.1 Changes in Inventory Figure 2.2 Changes in Net Primary Income

The accelerator model of investment states that an increase in income or demand will lead firms
investing more. This, in turn, will lead to an accelerated increase in expenditure. A strategy that may
be used to verify this model will be to compare the changes in the country’s GDP to the cumulative
change in inventory that domestic firms experience. The change in inventory is obtained by adding
beginning inventory and purchases then subtracting the final inventory. This would mean that a
positive change in inventory is a result of too little demand for the good while a negative change in
inventory is a result of sudden unexpected demand. Furthermore, changes in inventory can also be
interpreted as an increase in a firm’s costs if positive and a decrease when negative.

The income measure used for the analysis will be net primary income. This was chosen because
capital gains are not liquid in nature and as such will not immediately affect a household’s
consumption. In the context of the Philippines, it can be seen that the two graphs show unrelated
movements. However, in extreme cases where consumers experience a sudden large drop in net
primary income such as in 2008. It can be seen that there is indeed a drop in the change in inventory.
Furthermore, when the domestic net primary income experienced a sudden increase in the year 2009.
The change in inventory showed a similar trend during the year after it. From this, it can be said that
in the local context the accelerator model of investment holds only during extreme cases where
consumers experience a drastic change in their income.
b. The neoclassical model presumes that the level of investment is affected by the rental price of
capital. Examine changes in fixed capital in Table 3.1 or 3.2 and the table in the PSY (in the
Banking and Finance chapter, Table 16.24) that shows selected domestic interest rates. Do you
think there is a relationship between interest rate and changes in fixed capital stock? In
examining the relationship between the two, you can use graphical analysis.

Figure 2.3 Changes in Fixed Capital Figure 2.4 Changes in Domestic Interest Rates

In analyzing the relationship between fixed capital stock and interest rates, the domestic bank
interest rates were used. This is because banks are the financial institute that firms lend money from
when investing more into PPE or the like. Ideally, an increase in interest rate will lower consumptions
and increase savings. On the other hand, a decrease in interest rates will encourage firms and
households to take out loans. In the short run, it can be seen from tables 2.3 and 2.4 that a year to year
analysis of the relationship between interest rates and fixed capital stock will lead to nothing as both
graphs seem to shift based on their own momentum. However, in the medium run, it can be seen that
the continuous decrease in bank loan interest rates are met with an equivalent increase in capital stock.
Moreover, in years where interest rates suddenly displayed a lower negative change it was met with
an equivalent drastic decrease in change in fixed capital.
Part III: Problem Solving / Computations

1. Assume an individual lives for two periods. LetC 1and C 2 denote the consumption in the two

periods of life. In the first period of life, the individual receives an income of Y 1, and in the

second period of life, income is given by Y 2. The interest rate for both savings and borrowing is r .

Assume that Y 1 <Y 2.

a. Write out the (intertemporal) budget constraint for this individual.

The intertemporal budget constraint is given by

C2 Y2
C 1+ =Y 1 +
1+r 1+ r

b. Draw the budget constraint from part (a) and draw an example utility curve (indifference curve)
tangent to the budget constraint that represents an individual that is borrowing. Be sure to label
your axes, the slope of the budget constraint, the (Y 1, Y 2) point and the utility curve.

Figure 3.1: Graph of the Budget Constraint from a Borrower’s Perspecitve

c. Will an increase in the interest rate, r , increase or decrease savings for this borrower? You must
discuss your answer by describing both the income and substitution effects.

An increase in r will lead to a steeper slope for the budget constraint since |1+r| increases as r

increases. However, the point where Y 1=C 1 remains the same since if all income earned on period
one is consumed immediately, then interest rate has no effect on the consumption of the following
period.
For borrowers in the substitution effect, A moves to B along U 1. Therefore, the consumption during
the first period decreased. In the income effect, B moves to C thereby decreasing consumption during
the first period. Therefore, both in the income effect and substitution effect, savings for borrowers will
increase when r increases.

Figure 3.2: Graph of Budget Constraint with an Increase in Interest Rate from a Borrower’s Perspective

Now assume that the government decides to implement a tax on financial operations such that
the real interest rate is given by (1−τ )r , where τ is the tax rate, and r is the real rate before
taxes; this rate applies both to savers and borrowers. Assume that the government simply
throws away the tax revenue it collects.

d. Write out the new budget constraint and draw a graph similar to part (b). What is the new slope of
the budget constraint?

If the real interest rate is given by ( 1−τ ) × r where τ is the tax rate, the effective interest rate will

decrease from the previous interest rate of r since ( 1−τ ) <1. Therefore, the slope of the budget
constraint will be less steep than the original one.

The new budget constraint will be given by

C2 Y2
C 1+ =Y 1+
1+r ( 1−τ ) 1+r (1−τ )

and its slope is m=−( 1+ r ( 1−τ ) ).

e. Again, assume that the individual is borrowing. How will an increase in the tax rate τ affect
savings? Explain your answer using both the income and substitution effects.

An increase in the tax rate will decrease (1−τ ); therefore, ( 1+r ( 1−τ ) ) will decrease as well. This
will make the slope of the budget constraint less steep. For a borrower, in the substitution effect, A
moves to B along U 1 which increases consumption in period one and therefore, decreases savings. In
the income effect, B moves to C which also increases consumption in period one and therefore,
decreases savings. Both income effect and substitution effect will lead to a decrease in savings when
the tax rate increases.

Figure 3.4: Graph of Budget Constraint with an Increase in Tax Rate from a Borrower’s Perspective
f. Now assume that the individual is a saver. How will an increase in the tax rate τ affect savings
now? Again, explain your answer using both the income and substitution effects.

Similarly, an increase in the tax rate will decrease (1−τ ); therefore, ( 1+r ( 1−τ ) ) will decrease as
well. This will make the slope of the budget constraint less steep. For a lender, in the substitution
effect, A moves to B along U 1 which increases consumption in period one and therefore, decreases
savings. In the income effect; however, B moves to C which decreases consumption in period one
and therefore, increases savings. In this case, the income effect and substitution effects have opposite
effects when the tax rate increases.

Figure 3.5: Graph of Budget Constraint with an Increase in Tax Rate from a Saver’s Perspective