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The following are some common questions
about macroeconomics and agriculture:
What implications does a change in world
income growth have for agriculture?
Income growth outside of the United States is the single most important factor driving U.S. agricultural exports. As income grows, consumers will devote a share of that increased income to extra food expenditures. Changes in consumer income from either accelerating growth or the movement into recession lead to changes in the demand for agricultural goods and consequently affect the demand for agricultural imports. When incomes drop during a global recession, this causes greater unemployment and a general erosion of demand, including demand for agricultural products. Since trade makes up the difference between production and consumption, this often translates into reductions in import demand that are proportionately greater than the decrease in domestic demand.
The degree to which changes in income growth affect agricultural import demand depends a lot on which countries are affected. Japan and high-income countries in Europe have very low income
elasticities of demand for agricultural products (on the order of 0.1 or less), and respond weakly to changes in income. On the other hand, middle- and low-income countries such as China and India have relatively high income elasticities of demand (on the order of 0.25 to 0.5), which implies much larger impacts on agricultural trade associated with changing incomes. Given the higher income elasticities, high economic growth rates in middle- and low-income countries can have a larger impact on U.S. agricultural exports than a corresponding economic growth in high-income countries. For instance, changes in Japanese economic growth will have very little impact on U.S. exports to Japan. Beginning in the 1990s, when Japan experienced very slow growth and recession, the real (adjusted for inflation) value of U.S. agricultural exports to Japan remained relatively constant.
Falling incomes and wealth reduce consumer demand for foodstuffs, but the effect may be more severe on demand for other traded goods because consumers will reduce their expenditures for nonfood items more readily than those for food. The degree to which demand drops for specific foodstuffs depends on income elasticities of demand. Demand for high-value foodstuffs such as livestock products and fruit is relatively income elastic, while demand for staple foods such as bread and potatoes is income inelastic. In poorer countries, the income drop might increase the demand for (inferior good) staples. The general fall in domestic demand usually results in a strengthening of a country's agricultural trade balance by either reducing imports or increasing exports.
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Why are exchange rates important for agriculture?
The exchange rate is the price at which one currency converts to another.
Currency depreciations and appreciations change the value of currencies
against the U.S. dollar. If a U.S. market country depreciates against
the dollar, that makes U.S. exports to that country more expensive
in local currency terms. The reduced exchange rate raises consumer
and producer prices for imported foodstuffs, as well as prices for
tradable agricultural inputs, expressed in the country's currency.
An exchange rate change also changes prices of domestic foodstuffs.
The degree to which domestic prices change from an exchange rate
shock depends on the transmission
elasticity (or exchange rate pass-through). Transmission
elasticities vary by country, and also within countries among
commodities.
The increase in domestic consumer prices in a country that depreciates
against the U.S. dollar reduces food import demand from the United
States. When the Malaysian ringgit depreciated approximately 50
percent during the Asian financial crisis in 1997, for example,
the cost of U.S. soybeans in Malaysia doubled overnight. This reduced
the demand for imported soybeans and increased the demand for domestic
animal-feed substitutes. The net effect was that Malaysia imported
fewer U.S. soybeans and increased production of domestic feeds.
This reduction in demand also had the effect of reducing the price
of soybeans in U.S. dollar terms.
A currency depreciation changes agricultural producers' terms
of trade. If the terms of trade improve (output prices rising
more than input prices), producers are motivated to increase output.
If terms of trade worsen, production falls. The depreciation of
the Argentine peso in the first few months of 2002 provides a good
example of what happens after a major exchange-rate change. Argentina
is a significant agricultural exporter, so the more than 50 percent
depreciation in early 2002 resulted in higher domestic prices
for export crops such as wheat, soybeans, and corn.
However, a significant component of Argentina's agricultural
inputs, such as fertilizer, are imported, resulting in higher
costs to farmers.
At the same time, the government instituted export taxes, which
reduced the benefit of increased domestic prices for agricultural
commodities. Furthermore, the disruption of the economy from the
economic crisis is likely to preclude significant increases in
agricultural
production and exports. The net effect—as presented in USDA's
2003 Baseline Projections—was a decline in
Argentinean wheat and corn production
in 2002/03 because of high input costs and record high production
of soybeans, which lowered input costs.
In most cases of currency devaluation, the domestic agricultural
terms of trade improve for the devaluing country. The primary inputs
of labor and land are essentially nontradable, and farmers in some
countries rely largely on domestic inputs, so prices to producers
do not necessarily increase as a result of currency depreciation.
Rising production from an upswing in producers' terms of trade and
falling demand for imported agricultural goods improves a country's
balance of agricultural trade. (For specific goods, either imports
fall or exports rise, depending on whether the country is a net
importer or exporter).
However, for some agricultural producers in some countries, currency
depreciation can worsen terms of trade, causing a decline in output.
This occurs if a large share of inputs (in value terms) is imported
and prices for such inputs rise more than prices for outputs.
These conditions tend to hold more for producers of high-value and processed
goods, such as poultry farmers who import their feed, rather than
producers of bulk commodities. For such high-value commodities,
the effect of currency devaluation on the trade balance is uncertain.
If the drop in consumption from higher domestic consumer prices
is greater (smaller) than the fall in production, the trade balance
improves (worsens).
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How important is the farm economy for the
rural economy and the rural economy for the farm economy? How important
is the macroeconomy for both of these sectors?
During the Depression of the 1930s, the rural and farm economies
in the United States were largely synonymous, as those rural
residents not working on a farm either provided direct support
services to those on the farm or ranch or worked for businesses
that provided services to the farm sector. The current rural
economy
is far more complicated. Farming now ranks behind manufacturing,
construction, retail trade, health services, and Government as
source of rural jobs (based on data from the U.S. Department
of Commerce, Bureau of Economic Analysis).
In terms of economic dependence, farming is second only to manufacturing
as the dominant activity in industry-dependent counties.
Farming now accounts for less than 1 percent of the U.S. gross
domestic product, but has economic significance beyond the farm gate. While the
manufacturing of farm machinery and fertilizer is mostly done in metro counties, farm
services and food processing are disproportionately located in non-metro counties.
Even in many counties that are dependent on manufacturing or services, farming can be an
important component of local communities.
Many farm households depend on off-farm income to survive.
The rural economy is the source of many off-farm jobs, from manufacturing
to services. Even the largest farms have
significant off-farm income. Without the large number of manufacturing
and service jobs available in rural areas, many households would
be much less likely to farm.
The farming and rural manufacturing industries are tightly tied
to the world economy. Any sustained period of slow world growth
or a very strong U.S. dollar hurts both farm and manufactured goods
exports. The world oil and capital markets have large impacts
on both of these raw material and capital-intensive industries.
So, when world conditions are prosperous, farm households have
both relatively high commodity prices and good off-farm job prospects.
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How does the Federal Reserve Board influence
interest rates through monetary policy?
Interest rates are a major target of monetary
policy. When the
Federal Reserve Board wants to constrain growth under situations
when actual
gross domestic product (GDP) exceeds
potential GDP and thus lower the risk of inflation, it raises
the federal funds rate on overnight bank borrowing.
The increase in the federal funds rate will generally be followed by
increases in a broad range of interest rates in the economy.
The general implication of increased interest rates is to lower overall
borrowing, which reduces the overall demand for goods and services.
This lowers the pressures for increasing inflation. When the Federal
Reserve wants to stimulate economic activity during times
of slowdown and recession, it cuts the federal funds rate. A reduction
in the federal funds rate puts downward pressure on the interest rate
for actively traded money market securities, such as Treasury bills,
large denomination certificates of deposit, and commercial paper.
Depository institutions (commercial banks, savings and loan associations,
credit unions, and savings banks) then reduce loan rates. Long-term
interest rates will decline as well, but by a smaller amount. The
increase in the supply of funds entering credit markets from depository
institutions, following a lowering of the federal funds rate, also
tends to lower real (adjusted for inflation) interest rates. Since
real interest rates represent
the cost of borrowing in terms of foregone future consumption of
goods and services, a lower rate makes borrowing less costly.
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How does U.S. monetary policy affect
agriculture?
Easier monetary policy, accomplished by the Federal Reserve's reduction
in the federal funds rate on overnight bank deposits, promotes a
healthier financial environment for agriculture by reducing credit
costs (through the resulting reduction in interest rates) and by
increasing credit availability. An easing of monetary policy leads
to greater bank liquidity over time, which leads to greater willingness
on the part of commercial banks to make agricultural loans. An easing
of monetary policy also reduces interest rates charged by noncommercial
bank lenders, such as the Farm Credit System, equipment suppliers,
and life insurance companies.
Farmers benefit because lower real (adjusted for inflation) interest
rates make it easier for farmers to qualify for loans, as well
as reducing farm borrowing
costs. Lower real interest rates also tend to raise U.S. and world
economic growth, thus raising demand for agricultural commodities.
A fall in expected short-term real returns on U.S. assets relative
to those available outside the United States tends to place downward
pressure on the dollar. Thus, farmers will tend to benefit by increasing
international demand for their products.
The effect of this loosening of credit is an improvement in the
terms of trade for U.S. farmers and an incentive to expand production.
Lower interest rates also result in higher farm incomes as the decrease
in interest rates lowers production costs for farmers without necessarily
compensating with a decrease in the price of their output. Lower
interest rates further increase the incentive to invest in agriculture
directly as well as in research and development, which affects productivity
growth in subsequent years.
The Federal Reserve, however, must be concerned about the impacts
of monetary policy on short- and long-term inflationary expectations.
An overly expansionary monetary policy, for example, will harm businesses
by raising inflationary expectations. Higher inflationary expectations
raise nominal interest rates and lending risk premiums, and will
ultimately slow real credit expansion and economic growth. Higher
inflation also increases the cost of noncredit inputs to farms and
other businesses.
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How does a fiscal stimulus affect agriculture?
A fiscal stimulus refers to an increase in the level of government
spending or a reduction in tax rates. Fiscal policy affects agriculture
by altering real (adjusted for inflation) income, inflation,
real (adjusted for inflation) interest rates, exchange
rates, and long-term economic growth. The impact of a stimulative
fiscal policy on the macroeconomy and agriculture depends on the
magnitude of the stimulus package, the current stage of the business
cycle, and how long the stimulus package is expected to be in place.
A stimulative fiscal policy typically leads to larger government
deficits and greater government borrowing. In the case of higher
government spending, gross domestic
product is boosted directly in the intermediate
term by the increase in governmental spending, and indirectly through
the increased spending by those private individuals who receive
higher income as a result of the government spending. A reduction
in taxes boosts real output by increasing private disposable personal
income, raising corporate profits after taxes, and/or by lowering
corporate capital costs (through raising depreciation allowances
or by increasing the investment tax credit). The greater the increase
in government spending or the cut in taxes, the larger the expected
boost to total real output in the intermediate term.
The stage of the business cycle is an additional important variable
in determining the magnitude of the impact of a fiscal-policy
stimulus.
If an expansionary fiscal policy is pursued at a time when economic
output is below its potential, the impact will be larger due to
excess supply in the economy. If an expansionary fiscal policy
is pursued in times when output exceeds long-term potential, the
increase in overall output will be smaller and the inflationary pressures
generated will be greater.
A stimulative fiscal policy will benefit agriculture more when
actual national output is below potential. During these times,
the impact of an expansionary fiscal policy on U.S. and world growth
will be larger while the negative impacts on inflationary expectations,
real interest rates, and the U.S. dollar are likely to be small.
Fiscal-policy initiatives directed specifically toward agriculture,
such as more rapid depreciation and higher investment tax credits
for agricultural capital goods, are likely to be especially beneficial
for agriculture.
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Why are energy prices important for agriculture?
There are four primary reasons:
- Energy-related inputs—such as gasoline, diesel fuel, electricity, and fertilizer—are over 30 percent of farm expenses. Gasoline, diesel fuel, and natural gas prices paid by farmers are directly influenced by crude oil prices. Electricity prices, while not as directly and immediately responsive to crude oil prices, move up with oil prices over the long term. Natural gas—the price of which is influenced by crude oil, as industrial and commercial users substitute among energy sources—is key to the production of nitrogen-based fertilizer. For example, fertilizer prices rose sharply in the winter of 2000-01 when natural gas prices soared, the largest increase in nitrogen-based fertilizer prices since 1974. By the winter of 2007, prices for nitrogen-based fertilizers had risen almost 60 percent above the 1974 peak—driven by sharp increases in natural gas prices.
- Energy prices influence U.S. economic growth, driving domestic
demand for food and fiber. U.S. economic growth, while only
half as dependent on energy as in the 1970s, is still constrained
by restrictions on available energy. There is widespread agreement
that low energy prices contributed to the strong growth and low
inflation experienced in the 1990s. This growth in turn spurred
continually increasing demand for food and fiber products, supporting
farm cash receipts.
- Energy prices affect the growth of non-oil producing
countries, particularly developing economies, which are
increasingly important customers of U.S. food exports.
Developing countries, which tend to focus on manufacturing, are
far more dependent on oil
for growth than are developed countries, which rely relatively
more on services. China, for example, requires three times
more energy to produce one more dollar of gross
domestic product than the United
States. A large increase in energy prices has a significantly
negative impact on Chinese growth. (The quick turnaround from
the 1997-98 financial crisis was in part due to low crude oil
prices.) Slower Asian economic growth from higher energy prices
means smaller increases in U.S. farm exports.
- Agriculture has increasingly become a supplier of energy as biofuel production from corn has expanded. For further information, see ERS Bioenergy briefing room.
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