The Aggregate

Demand and Supply

Model: Fitting BH
Macroeconomic
Data



2014

Course: EC245, Intermediate Macroeconomics
Course Co-ordinator: Adisa Omerbegovi-Arapovi
Student: LEJLA HODI




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Table of Contents

1. INTRODUCTION ........................................................................................................ 2
2. BH MACROECONOMIC DATA...3
2.1.Main aggregates of national accounts for B&H ....................................................... 3
2.2.Principal population characteristics ......................................................................... 5
2.3.Average annual inflation rate7
3. FITTING THE BH MACROECONOMIC DATA ................................................... 8
3.1.The 2007-2009 Financial Crisis....8
3.2.B&H macroeconomy in the period 2010-2012 ...................................................... 11
3.3.Evaluation of the B&Hs macroeconomy .............................................................. 13
4. CONCLUSION....15















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1. INTRODUCTION

The aggregate demand and supply model is a macroeconomic model that explains
inflation and aggregate output through the relationship of aggregate demand and aggregate
supply. Aggregate demand and supply analysis is a powerful tool for studying short-run
fluctuations in the macroeconomy. Moreover, it is also strong device in analyzing how
aggregate output and inflation are determined.
The aggregate demand and supply analysis is of great importance for interpreting episodes
in the business cycle such as recent severe recession 2007-2009 and in analyzing how
economic policies were conducted. Therefore, the subject of this research is macroeconomy
of Bosnia and Herzegovina. Moreover, the purpose of this research project is gathering the
macroeconomic data for Bosnia and Herzegovina, fitting that data into the demand and supply
model and finally doing an analysis on how the data fits the model and does it actually fit as
suggested in the period from 2007 until now.







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2. BH Macroeconomic Data
2. 1. MAIN AGGREGATES OF NATIONAL ACCOUNTS FOR B&H
Main aggregates of national accounts include analysis of data on Gross domestic product by
different structural components, for example, by type of expenditure, kind of economic
activity, major area, region and entity as well as per capita and as growth rates. Other
statistical information covered includes gross national income, gross national disposable
income. For the purpose of this project, only the gross domestic product is component which
is of great importance and which will be considered in fitting the BH macroeconomic data.
However, the tables purpose below is to have a broader view of the Bosnia and
Herzegovinas macroeconomy.

Figure 1: Main aggregates of national accounts in the period 2005-2008
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Figure 2: Main aggregates of national accounts for period 2009-2012


Figure 3: Graphical representation of the B&H's GDP growth from 1994-2012
Note: the data on main aggregates of national accounts that include gross domestic product,
gross national product, gross national disposable income, gross domestic product per capita,
for the years 2013 and 2014 are not available for the public.
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2. 2. PRINCIPAL POPULATION CHARACTERISTICS

Principal population characteristics include qualities and characterization of various types of
populations within a social or geographic group. In this project, the emphasis is on geographic
group, namely on residents of Bosnia and Herzegovina. In the tables below it is shown the
number of total population, as well as differentiation by gender, working age population,
labor force, person in employment, unemployed people and those who are not active.
However, only the unemployment rate, as a relevant indicator, will help in analyzing how and
if the data corresponds to what aggregate demand and supply predicts. It is believed that a
decrease in inflation results in soaring the unemployment rates.

Figure 4: Main population characteristics for the period 2006-2008
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Figure 5: Main population characteristics for the period 2008-2010

Figure 6: Main population characteristics for the period 2011-2013


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2. 3. AVERAGE ANNUAL INFLATION RATE

2006 2007 2008 2009 2010 2011 2012 2013
Inflation
rate
6.12 7.72 7.4 2.3 2.1 3.7 1.8 -1.10

Table 1: Average annual inflation rate for the period 2006-2013 reported by Agency for Statistics B&H



Figure 7: Graphical representation of Bosnia and Herzegovinas inflation rates for the period 2011-2014

Based on the table and graph above, it can be stated that there is a decreasing trend in annual
inflation rates of Bosnia and Herzegovina. Furthermore, it is clearly shown that Bosnia and
Herzegovina is experiencing deflation, rather than inflation.




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3. Fitting the BH Macroeconomic
Data
To begin the process of fitting BH Macroeconomic data to aggregate demand and supply
model, it is important to have relevant factors for the analysis at one place. Therefore, the
table below is created to show trends (increasing or decreasing) in the unemployment and
inflation rate as well as in the aggregate output. Since the aggregate demand and supply
analysis is a powerful tool which can help in interpreting episodes in recent severe recession
in 2007-2009, the table is made before, during and after the recession in order to correctly
evaluate B&Hs performance.
Year Unemployment rate (%) Inflation rate (%) Aggregate Output (mil. $)
2006 31.1 6.12 12.548
2007 29.0 7.72 15.436
2008 23.4 7.40 18.691
2009 24.1 2.30 17.278
2010 27.2 2.10 16.845
2011 27.6 3.70 18.329
2012 28.0 1.80 16.900
2013 27.5 -1.10 unavailable
Table 2: Unemployment, Inflation and Aggregate Output, 2006-2013

The table, as stated previously, illustrates trends in unemployment rate, inflation rate and in
aggregate output. However, to begin with the analysis, it is valuable to refer to the situation
in B&H before the mentioned years. With the beginning of 1990s, Bosnia and Herzegovina
had a very turbulent socio-economic situation. In macroeconomic terms, there was global
economic instability, decrease in production and hyperinflation. To put the hyperinflation
under control and to lower inflationary expectations new framework of monetary policy was
defined and it is known as Currency Board Arrangement (CBA). By doing that the KM was
tied, and still is, to the EURO. At the first glance, the hyperinflation was stabilized. However,
inflation maintained to rise at a steady pace until 2007, when it reached its peak of 7.72%. To
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fight high inflation rate, the Central Bank of B&H raised reserve requirements to 18% hoping
that the credit growth will decrease. From that year there is apparent decreasing trend in
inflation rate which was slightly interrupted in 2010. This trend led to a deflation in 2013.
However, this kind of measurement against inflation led to high levels of unemployment,
which is indicated by the unemployment rates in the table. They somewhat remind on Milton
Friedmans recipe for the fight against inflation, who stated that in order to cure the inflation,
the growth rate of total spending should be lowered.( N., 2007) In addition, it is important to
point out that B&H by changing the monetary policy can do little, almost nothing, since it has
CBA.
3. 1. THE 2007-2009 FINANCIAL CRISIS
Year Unemployment rate (%) Inflation rate (%) GDP (000 $)
2007 29.0 7.72 15 436
2008 23.4 7.40 18 691
2009 24.1 2.30 17 278
Table 3: GDP, Unemployment and Inflation Rate during the financial crisis

As in the United States, United Kingdom and the most of the Europe, the sharp rise in the oil
price in 2007 led to, or at least should have lead, along with increases in other commodity
prices, a negative supply shock in Bosnia and Herzegovina. Negative supply shock results in
shifting the short-run aggregate supply curve upward, which means lower output and higher
inflation rate than in previous years. However, that was not the case with Bosnia and
Herzegovina. In B&H there was an increase in the inflation rate, but also increase in the
aggregate output in 2007, which does not correspond to the predictions of aggregate demand
and supply model. It means that the aggregate demand curve shifts rightward, from AD1 to
AD2. Furthermore, the negative supply shock that occurred in the most of the world should
cause a contraction in both household and business spending which is known as the negative
demand shock. The negative demand shock shifts the aggregate demand curve to the left.
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However, at the beginning, the financial crisis did not have a strong impact on spending in
Bosnia and Herzegovina, so the aggregate demand curve did not shift because of that
reasoning. In 2008 B&H had decreased inflation and increased aggregate output, which
corresponds to what the aggregate demand and supply model predicts. These numbers
illustrate that the short-run aggregate supply curve shifted downward from AS1 to AS2 and
this is because in the year 2008 oil prices fell sharply. However, later that year the bankruptcy
of Lehman Brothers, which affected not only USA but also the whole world, caused a
decrease in aggregate demand. As a result, in 2009 the economy suffered from increased
unemployment and a low inflation rate, which corresponds to aggregate supply and demand
predictions, which can also be seen in the graph below. It is important to emphasize that, for
the purpose of the project it is assumed that Bosnia and Herzegovina was below its long-run
potential.










Figure 8: Aggregate Demand and Supply Analysis for B&H during the Financial Crisis
AD3
Inflation Rate
(percent)
Aggregate Output Y
(millions of dollars)
LRAS
AS1
AD1
$15.436
AD2
7.72 %
$18.691
AS2
7.40 %
2.30 %
$17.278
Initial equilibrium
Equilibrium after
the crisis
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In conclusion, Bosnia and Herzegovina partially fits the model of aggregate demand and
supply and its predictions in the period of severe recession in years 2007, 2008 and 2009.
Bosnia and Herzegovinas macroeconomic data show that in the year 2008, because of the
excess slack in the market labor, the aggregate supply curve shifted downward thereby
decreasing inflation and trying to return the economy to the potential level of output.
However, year 2009 caused a shift in the aggregate demand curve which again led B&H to be
below its potential level of output. Therefore, it can be concluded that even after the recession
Bosnia and Herzegovina is not at its long-run equilibrium. The non-correspondence of BH
macroeconomic data to the demand and supply analysis may be due to the currency board
arrangement.

3. 2. B&H MACROECONOMY IN THE PERIOD 2010-2012
Year Unemployment rate (%) Inflation rate (%) Aggregate output (mil. $)
2010 27.2 2.10 16.845
2011 27.6 3.70 18.329
2012 28.0 1.80 16.900
Figure 9: Inflation Rate, Unemployment Rate and Aggregate Output of B&H in the period 2010-2012

It is clear that the increasing trend in the unemployment rate in Bosnia and Herzegovina still
persists in the years after the recession. However, the inflation rate is not consistent with the
increase in unemployment. In 2010, there was a decrease in the aggregate output of the
country, as well as in the inflation rate, meaning that the aggregate demand curve shifts
leftward, from AD1 to AD2. However, in the next year, both inflation rate and the output rose,
indicating that the aggregate demand shifts to the right to AD3. In the 2012, output again fell
at almost the same level as it was in 2010, with a difference of $65, but causing inflation to go
down even further than in the mentioned year. This is shown by a leftward shift of aggregate
demand curve, from AD3 to AD4 and by a downward shift of aggregate supply curve, from
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AS1 to AS2. Although this shift corresponds to the predictions of aggregate demand and
supply model, the resulting equilibrium is even below the initial equilibrium, meaning it is
further away from its potential output. In the graph below it is shown how Bosnia and
Herzegovinas aggregate output and inflation rate fluctuate after the recession and it can be
concluded that in these years BH macroeconomic data fit the aggregate demand and supply
analysis, in a sense that they experience self-correcting mechanism. However, it was assumed
that B&H is below its long-run potential, and it can be concluded that B&H remained there.












Figure 10: Aggregate Demand and Supply Analysis for B&H in the period 2010-2012


LRAS
AS2
AD3
Inflation Rate
(percent)
Aggregate Output Y
(millions of dollars)
AS1
AD1
AD2
3.70%
2.10%
$16.845 $18.329
AD4
$16.900
1.80%
Initial equilibrium
Equilibrium in year 2012
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Overall, it is shown that B&H was affected by another recession in 2012. Consequence of
lowering the inflation rate was high unemployment. This type of fight against the inflation
reminds of Milton Friedmans principals. At the end of 2012, Bosnia and Herzegovina was
even further from its potential level of output, which means that the actions that were
conducted in order to stabilize inflation led to even larger deviation of aggregate output from
potential.

3. 3. EVALUATION OF THE B&Hs MACROECONOMY

The macroeconomic indicators: unemployment rate, income per capita, economic growth rate
and inflation rate indicate that B&H is not in the perfect situation. From Table 2 and Figure 8
it can be concluded that the macroeconomic equilibrium (the aggregate demand and aggregate
supply equilibrium, i.e. price level stability) with high unemployment is not perfect scenario
for the economy of B&H. The latest equilibrium that could be obtained is from year 2012.
This is because the data about the aggregate output for year 2013 are not yet available for
public. The obtained equilibrium shows that Bosnia and Herzegovina is below its potential
level of output, and the situation illustrates even worse scenario than it was at the beginning of
2012, or at the end of 2007-2009 financial crisis. The (in)stability of nominal macroeconomic
indicators (inflation rate, public debt, budget deficit, exchange rate) in Bosnia and
Herzegovina is not a consequence of economic development but very restrictive
macroeconomic policy (currency board system, hard budget policy) and impossibility of
domestic producers to increase prices because of high foreign competition. Bosnia and
Herzegovina in such situation should apply theory of expansive Keynesian economics
(combination of budget deficit because of investing into infrastructure that is a base for
industrialization, moderate inflation which can be under control of monetary policy and
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national currency depreciation which is a complementary to inflation and instrument for
export encouragement), as well as effective custom protection to protect domestic economy.
The effective custom protection is also instrument for direction with a domestic
unemployment resources and FDI as additional source of economic growth into certain
sectors where Bosnia and Herzegovina has potential comparative advantages. But, the
neoclassical concept of economic development (Washington Consensus) which is applied
in Bosnia and Herzegovina with a total liberalization of foreign trade and macroeconomic
stability is not logical in economic sense according to existing economic situation. Both the
economic theory and historical experiences show that Bosnia and Herzegovina should
implement different kind of economic development. However, according to the report of the
World Bank, Bosnia and Herzegovina, along with Albania, Former Yugoslav Republic of
Macedonia, Kosovo and Serbia, is slowly recovering from the 2012 recession. Even though
the recovery has brought growth to the country, it is still unable to create jobs and lower the
unemployment. In order to this, Bosnia and Herzegovina needs to take action in financial and
fiscal sectors. It needs to reduce public debt in order to stimulate the economic activity.
However, the most important issue that needs to be considered is strengthening domestic
macroeconomic fundamentals and policies that boost productivity, which means that
macroeconomic and fiscal position of the country should be stabilized for creation of jobs,
working on improving the competitiveness and connectivity and strengthen governance and
anti-corruption. Moreover, B&H should choose policy that would change current public
expenditure structure. Its aim should be reducing high administrative costs, thereby reducing
significant part of public expenditure and increasing productive investments.


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4. CONCLUSION
The main purpose of this project was to investigate does the macroeconomic data of
Bosnia and Herzegovina and increases and decreases in the data correspond to what is
predicted by the aggregate demand and supply model.
To sum up, Bosnia and Herzegovina partially fits the aggregate demand and supply
model. Bosnia did experience certain self-correcting mechanism action; however, it did not
succeed in moving closer to potential level of aggregate output. The actions conducted created
even larger deviation of aggregate output from potential, leading to B&H to be in even worse
situation at the end of 2012 than it was during the financial crisis. This is possibly because
B&H is very limited in autonomous macroeconomic policies conducting (custom policy,
monetary policy, fiscal policy and exchange rate policy) and it is a consequence of the
strictest macroeconomic policy implementation, which is implementation of the Currency
Board Arrangement (CBA), hard budget policy and foreign trade liberalization. Bosnia and
Herzegovina cannot as quickly adjust to certain shocks as it could have without currency
board arrangement. With CBA, monetary authority in B&H does not determine the money
supply and thereby cannot encourage economic growth by proposing certain monetary policy.
Bosnia and Herzegovina was, and still is, below its long-run potential. However, after the
crisis B&H achieved its one of many goals, which was to push down the inflation rate. The
consequence of accomplishing this goal was and remained high level of unemployment.
Possible solutions for the B&Hs macroeconomy is changing its macroeconomic program
from neoclassical to expansive Keynesian economics that represents a combination of budget
deficit, moderate inflation and national currency depreciation as well as effective custom
protection of domestic economy.
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List of Figures and Tables
Figures
Figure 1: Main aggregates of national accounts in the period 2005-2008 ............................................. 3
Figure 2: Main aggregates of national accounts for period 2009-2012 .................................................. 4
Figure 3: Graphical representation of the B&H's GDP growth from 1994-2012 ..................................... 4
Figure 4: Main population characteristics for the period 2006-2008 ..................................................... 5
Figure 5: Main population characteristics for the period 2008-2010 ..................................................... 6
Figure 6: Main population characteristics for the period 2011-2013 ..................................................... 6
Figure 7: Graphical representation of Bosnia and Herzegovinas inflation rates for the period 2011-
2014 ......................................................................................................................................................... 7
Figure 8: Aggregate Demand and Supply Analysis for B&H during the Financial Crisis ........................ 10
Figure 9: Inflation Rate, Unemployment Rate and Aggregate Output of B&H in the period 2010-2012
............................................................................................................................................................... 11
Figure 10: Aggregate Demand and Supply Analysis for B&H in the period 2010-2012 ........................ 12

Tables
Table 1: Average annual inflation rate for the period 2006-2013 reported by Agency for Statistics
B&H ......................................................................................................................................................... 7
Table 2: Unemployment, Inflation and Aggregate Output, 2006-2013 .................................................. 8
Table 3: GDP, Unemployment and Inflation Rate during the financial crisis .......................................... 9














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References

Agency for Statistics of B&H, (2014), Bosnia and Herzegovina, Agency for Statistics, date
accessed: 06.06.2014, http://www.bhas.ba/index.php?lang=en
Ingram, K. Joseph, n.d. The World Bank Role in the Development of a Financial Market in
Bosnia and Herzegovina; date accessed: 05.06.2014, http://www.worldbank.org/
Mishkin, S. Frederic, (2012), Macroeconomics: Policy and Practice, Courier, Kendallville
USA, Pearson Education