The Role of Economy-Wide Prices in the Adjustment Process

Joaquín Muns
Published Date:
September 1984
  • ShareShare
Show Summary Details


In recent years, the experience of many countries with respect to their macroeconomic management has brought the issues of exchange rates, interest rates, and other prices with economy-wide repercussions into the forefront of economic debate. In many instances, particularly in Latin America, exchange rate policies were significantly modified relative to past practices, while wide-ranging financial reforms resulted in substantial changes in interest rate levels and structure. Countries in other areas experienced similar reforms, for example, Israel, Portugal, and Sri Lanka. The modifications were intended to improve the internal balance of the economy and to restore the medium-term viability of the balance of payments. In the event, some countries failed to achieve these objectives, and because the failure was frequently attributed to the pursuit of specific exchange and interest rate policies, many of the previously established policies were reversed.

The issue of adequate pricing—including appropriate exchange rates, interest rates, and wages—has been a focal point of Fund attention, both in consultations and negotiations of arrangements for the use of its resources. Price adjustment policies have been viewed as an integral part of adjustment, and recent experience with Fund-supported programs indicates that they have been generally successfully implemented; however, programs have occasionally failed in their objectives even when major pricing corrections were implemented.

Section 2 describes the conceptual framework for analyzing the effect of key prices on the macroeconomic equilibrium of countries entering into an external adjustment process, and its possible shortcomings. The analysis, although general, is of particular relevance to those developing countries with at least moderately developed capital markets. Section 3 reviews recent experience with Fund programs, and Section 4 presents a brief discussion of developments with respect to exchange rates in selected Latin American countries in recent years. Finally, Section 5 provides some tentative conclusions.


It is now well accepted that balance of payments developments—either the emergence of imbalances or their elimination—are directly linked to monetary phenomena. The accounting framework for the monetary approach to the balance of payments is provided by the identity equating changes in the quantity of money (broadly defined) with the sum of changes in domestic credit and net international reserves. But the policy content is determined by the behavioral relation between demand for money and the sources of money creation (domestic and foreign). Financial programming as practiced by the Fund staff is based on these observed behavioral relations and adjustment policies tend to reflect this approach.1 The monetary approach to the adjustment process is based on the assumption of a stable demand for money and the observation that an excess supply of (demand for) money would be eliminated through changes in nominal income and through changes in net international reserves. From this standpoint, the balance of payments can be seen as a monetary variable, and its imbalances can be corrected through the control of other components of the money supply—namely, domestic credit, either to the private or public sector. More broadly, adjustment must be viewed as the achievement of a viable relationship between aggregate income and aggregate expenditure—reflected in the current account of the balance of payments.2 In most instances, the size of the current account deficit—and therefore the possible excess of expenditure over income-will be constrained by the availability of financing, namely foreign reserves and foreign credits and grants.3 Foreign financing will depend on the quality of domestic policies being pursued: in particular, if policies are viewed as adequate, the access to foreign financing will be certainly higher than if policies are viewed as inadequate to solve a country’s problems.

The use of domestic financial policies—including credit and fiscal measures—helps relax the financing constraint and also narrows the gap between income and expenditure. But these policies have not been the sole mechanism of adjustment. They have been supported almost always by the use of prices that have a generalized impact on the economy. Adjustments in relative prices, including exchange rates, interest rates, and administered prices, have a direct impact on aggregate demand while at the same time they help increase the availability of resources in the economy through an increased level of savings and investment and through a more efficient use of existing resources. If no appropriate measures are taken, price distortions will continue to affect negatively the appropriate functioning of the price mechanism, aggravate internal and external imbalances, and reduce potential income.

The effects of price changes on resource allocation and demand are traditionally the best understood channels of adjustment, but they are not the only ones. The increasing openness of financial markets in many developing countries has brought about an important change in the speed of reaction and magnitude of capital flows; and more frequently than not, these flows have dominated the outcome of the overall balance of payments, at least in the short run. It is important, therefore, that policymakers bear in mind the effect of domestic policies on the capital account. A shift of confidence caused by altering signals may significantly change the availability of foreign financing or induce capital movements that may result in a path that was not expected for the macroeconomic price variables, thereby rendering the policies pursued inappropriate. The implications of capital mobility for economic management will become clearer in the following sections.

Price adjustments affect not only resource allocations and the income-expenditure balance, but the entailing transfer of resources also results in changes in relative factor incomes and in income distribution, having a direct bearing on a particular policy course. It is frequently asserted that the issue of income distribution is overlooked by the Fund.4 The apparent shortcoming reflects the fact that programs supported by the Fund deal with emerging or already existing balance of payments crises that require immediate and assertive action. For example, the constraints imposed by deteriorating terms of trade or reduced availability of foreign financing often result in an adjustment effort that, of necessity, modifies relative prices between sectors or between factors of production. The consequences of these adjustments may be burdensome from a political or social point of view but frequently cannot be avoided because of existing constraints, although some flexibility may exist as to how the costs are distributed. In any event, income distribution effects are not always clear in terms of who benefits from these changes; thus the impact of pricing measures must be carefully appraised.5

Role of the Exchange Rate

Exchange rate action probably constitutes the most conspicuous pricing measure in the adjustment process. The widespread effects of exchange rate changes—or their absence—both on the real and monetary sectors of the economy are well known, and it is not the purpose of this paper to review them thoroughly.6 Nonetheless, it is important to summarize exchange rate issues relevant to the emergence of internal and external imbalances and their correction.

Exchange rate changes have a direct effect on resource allocation from a medium-term point of view; but as indicated previously, in the short term their overwhelming effects are financial. In the framework of an economy that has close economic connections with the rest of the world—both from the point of view of trade and financing—a pegged or controlled exchange rate policy precludes an independent monetary policy—if no restrictions are imposed on exchange transactions; a floating exchange rate, on the other hand, allows for a domestic monetary policy which can diverge significantly from the rest of the world. The foreign exchange intervention policy can be determined by the perception of national authorities about the minimum inflation rate that can be achieved at any time, without major disruptions to economic activity. If the real exchange rate is to be maintained,7 the inflation rate determines a minimum rate of depreciation, once appropriate account is taken of foreign inflation. In turn, when an exchange rate path is established, the authorities can program the rate of monetary expansion in the economy, consistent with the rate of depreciation and inflation. An expansion in excess of that indicated by the exchange rate policy, and reflected in a rapid increase in domestic credit, will generate balance of payments pressures that will eventually lead to a change in the level of the exchange rate so as to restore equilibrium, immediately or after some time. Otherwise, policymakers will have to have recourse to stringent credit policies or increasingly complex and restrictive exchange and trade controls.

Expansionary policies will be reflected not only in possible changes in the nominal exchange rate, but also in changes in the real exchange rate. As an example, budget deficits will have a direct impact on inflation and the exchange rate.8 In addition, a shift in expenditure to nontradable goods can result in an increase of the relative prices of nontradables, that is, a change in the real exchange rate. Similarly, the increased availability of foreign financing can affect—in conjunction with fiscal policies—the equilibrium level of the exchange rate and the sustainability of the balance of payments outcome. Increased access to foreign financing—because of changes either in domestic or in external conditions—will eventually result in a widening of the current account deficit, either directly through government spending or through a change in relative prices, that is, an appreciation of the domestic currency in real terms. Similarly, reduced access can lead to a real depreciation of the domestic currency. But the access to foreign financing cannot be considered fully exogenous. A widening current account deficit may be perceived as unsustainable by foreign lenders, when expenditure is seen to expand without a corresponding improvement in productive capacity and when accompanied by a deterioration of competitiveness. If policies are not corrected, the deterioration in the external account can result in a reversal of capital flows that will require sharp adjustments, including the use of the exchange rate, in order to reduce the expenditure-income gap.

In general terms, in the short run, capital flows determine the behavior of the foreign exchange markets when capital mobility is significant.9 Sharp movements in exchange rates can be explained by shifts between currencies, in the context of a portfolio approach. According to this approach, either foreign exchange flows or exchange rate fluctuations can be explained by the expected differential between domestic and foreign rates of return. A change in expected rates of return may overshadow any effects of exchange rates on real economic activity, in particular in circumstances where countries are confronted with an increasing degree of capital mobility in international financial markets. Certainly the effect of foreign exchange flows will be directly related to the particular features of individual countries, that is, the degree of integration with the world financial system and the importance of the private sector in the economy. Consequently, the dominance of developments in the current account or the capital account will vary for each individual country.

The effects of exchange rates on the production and consumption of tradable goods cannot be viewed as distinct from those described above. For example, a production shift toward tradable goods can only be envisaged to be permanent in the context of a set of policies compatible with a more depreciated real exchange rate, namely, those incomes and financial policies that do not passively reflect the effect of the exchange rate on prices.

The impact of exchange rates on production will depend on the ability to transfer resources among productive sectors, a possibility that is frequently questioned because of the possible existence of pervasive rigidities, particularly in developing countries. While the argument may be valid from a short-term perspective, if the adjustment policies are pursued over a longer period of time, their impact can be significant.10 Moreover, even in the short run and with highly specific resources engaged in certain activities, there may be considerable scope for an increase in output, when these resources are used more intensively. A typical case is that of mining and agriculture, where output can be increased rapidly once appropriate prices are provided to producers—for example, through the exchange rate.

Another perspective of the exchange rate in increasing output and improving resource allocation is provided by the possibility of substitution of an exchange rate adjustment for a system of exchange and trade restrictions. Typically exchange and trade restrictions are imposed as a means of controlling the external sector in a period when expansionary policies exert pressures on the balance of payments. These controls can be successful in closing the economy in the short run, although at a high cost in terms of increasingly complex control mechanisms and of higher rates of inflation. More important, the cost is high in terms of generating major distortions that reduce the level of output and eventually render the measures ineffective. In these circumstances, the exchange rate plays a somewhat different role. Even for given financial policies, an adjustment of the exchange rate in conjunction with measures to liberalize exchange and trade transactions will allow for an increase in output, in particular, in the areas of export and import substitutes with low levels of effective protection; in these cases, the exchange rate can help improve resource allocation and reduce inflationary pressures by increasing output and reducing existing demand pressures which may have prevailed previously, even without the need for major financial corrections.

Interest Rate Policies

The discussion on exchange rates is not complete without an equivalent analysis of interest rates. The literature has extensively covered the effect of interest rates on international economic equilibrium.11 In a world of increasing economic sophistication and growing financial interdependence, interest rate policies have an impact on aggregate demand and affect capital flows to an extent that overtakes any impact on the real sectors of the economy in the short run. In general, the supply of financial resources will be dependent crucially upon the structure of interest rates in the economy. Financial repression—the establishment of ceilings on interest rates and the allocation of financial resources through nonprice means—results in an ineffective allocation of scarce resources and, more important, in a reduced supply of funds channeled through the organized financial markets; this impairs the normal savings-investment process in the economy. Moreover, the persistence of interest rates below those prevailing abroad—when adequate account is taken of the effect of changes in the exchange rate—generates incentives to channel domestic savings abroad, thereby further reducing the availability of capital in the economy.

The exchange and interest rate policies cannot be dissociated. The two policies have to be pursued consistently for an adequate external equilibrium; but in addition they have to be credible, in light of other developments. A slowly depreciating currency can be supplemented by interest rates equivalent to the rate of depreciation plus the interest rate prevailing abroad and may provide for interest rate parity from an accounting point of view.12 But other financial variables—domestic credit or the budget deficit—may be expanding at rates that generate the expectation that the exchange rate and interest rate policies are inconsistent and that they are, therefore, unsustainable; active intervention by the authorities may help postpone the required adjustment, but eventually the correction will have to take place.

If the authorities want to preserve a given exchange rate or predetermined depreciation path, and pressures emerge in the foreign exchange market, they can make use either of increased restrictions on payments or of tighter financial policies. If the introduction of restrictions is dismissed because of the negative impact of these measures on resource allocation and confidence, the only available option is to allow for increases in interest rates, to reduce capital flight, and to slow down expenditure. In those circumstances, the costs with respect to output and employment may be considerably higher than if the exchange rate is modified. Most of the adjustment will be reflected in reduced demand; any previous loss in competitiveness will not be corrected, and adequate incentives will not be restored for exports or efficient import substituting sectors. In the very short term, some capital inflows may be observed; but if underlying trends indicate the need for corrective actions, tight credit policies will seldom modify expectations about the eventual adjustment of the exchange rate.

The link between exchange rates and interest rates may be affected by the speed of adjustment in the goods and in the capital markets,13 but eventually the two variables will have to be aligned, taking into account monetary and real developments in the economy.14 Nonetheless, there may be some degree of maneuver to sever the link in the short run. Capital controls can generate a partial break between domestic and external capital markets. The goods market may also be somewhat isolated from the capital market by the existence of dual rates, where a fluctuating rate absorbs the effect of changes in interest rates and other elements that may affect confidence. Nonetheless, these practices can be seen only as stopgap measures that will eventually require modification. Their persistence may result in distortions that may be costlier than those emerging from excessive fluctuations in the rates, if they are allowed to move freely. In sum, interest rate policies in a world of increasing financial interdependence cannot be seen as separate from exchange rate management; they will have to be compatible with other domestic financial policies.

Other Prices

Administered prices have a similarly pervasive impact as that of exchange rates and interest rates. Producer prices for many export products are frequently subject to the control of the authorities and therefore can have a marked impact on macroeconomic equilibrium. The adjustment of prices may be either the necessary reflection of exchange rate adjustments or of international price changes. A break between domestic and external prices could be justified on the basis of welfare considerations, particularly when price changes are viewed as a windfall to be distributed among all inhabitants of a particular country—a typical example is that of increased oil prices during the period 1974–80. In most cases, however, the lack of adjustment of prices is based on other short-term considerations. For example, producer prices frequently remain unrealistically low because of revenue purposes, although the intended effect is offset by an eroding tax base caused by reduced production and contraband. In turn, utility pricing by the public sector often lags behind inflation and results in a marked deterioration of public finances. In some instances, public utility prices have been used as indicators of future inflation; but more often than not, the use of these policies is a faulty mechanism of inflation control. Price adjustments may result in the short term in a quantum increase in the price level, but because they will eventually result in increased public sector savings and reduced excess demand pressures, they are a more effective anti-inflation device. Moreover, frequently administered price changes can constitute an effective form of taxation, with a distributional impact that can be viewed as fair, a case in point is that of gasoline prices.


The adjustment of prices, exchange rates, and interest rates will necessarily be reflected in a decline in real wages. If the gap between expenditure and income is to be narrowed to help achieve a sustainable balance of payments, competitiveness should be improved and expenditure reduced. To this end, payments to most domestic factors would have to be reduced in the short term. The implications for wages are clear. Real returns to labor would decline—a counterpart to a more depreciated real exchange rate—unless increases in productivity offset the decline. The declining real wages may lead to social and political pressures that can preclude the achievement of an adequate adjustment process; but a reduction in real factor costs may be inevitable because of a deterioration in the terms of trade or reduced availability of foreign financing. If the available resources to the economy have declined, the costs of adjustment have to be shared by all sectors of the economy, although some flexibility exists with regard to the impact on various groups. In any event, a lack of adequate real wage corrections, in the context of an adjustment process, will most likely result in a marked increase in unemployment, beyond the levels that would have prevailed in the presence of lower real wages.15


Recent Evidence

Over the last 25 years, adjustment efforts in many countries have been carried out in the context of economic programs supported by the use of Fund resources in the form of stand-by and extended arrangements. The cooperation between the Fund and member countries has been particularly important because economic adjustment frequently imposes a sharp turnaround in policies. In particular, the pervasive existence of distortions and unrealistic prices has required a widespread use of economy-wide price adjustments in stabilization efforts, either in the context of market or centrally planned economies.16

Outsiders have viewed adjustment programs supported by Fund resources as restraining aggregate demand and thereby providing for an improvement in the internal and external balance.17 While the importance of demand management cannot be sufficiently stressed in the context of adjustment efforts, price adjustments have been central to adjustment—with an impact both on supply and demand. Typically, a country entering into a program supported by Fund resources in recent years could have been characterized by the existence of widespread balance of payments problems, high inflation, and low growth, relative to past performance or that of its trading partners. This is shown in Table 1, which is based on the evidence of recent stand-by and extended arrangements.18,19 While the particular nature of the problems depended on the features of each individual country, in general, a combination of internal and external factors contributed to the difficulties. Adverse exogenous factors occurred in most of the period 1973–81—the period covered by the table. Table 1 also describes the factors associated with economic performance at the time of program inception and shows the importance of exogenous problems, including external and domestic elements beyond the control of the authorities. The effect of deteriorating terms of trade, in part caused by the sharp increase in energy prices, was compounded by a slowdown in world economic activity, creating serious balance of payments difficulties. But expansionary demand pressures, mostly associated with the performance of the public sector, were at the center of imbalances. Moreover, the growing imbalances generated not only pressures on the current account and the overall balance of payments, but also gave rise to market distortions that further aggravated the emerging crises. Frequently, the authorities did not change the exchange rate policy course; instead, they made use of exchange and trade restrictions in order to reduce emerging pressures on reserves and thereby created bottlenecks and shortages. The restrictions affected aggregate supply and reduced output because of the negative effect on competitiveness. Moreover, restrictive practices were introduced in conjunction with other controls on administered prices and interest rates, thereby aggravating the effect of unrealistic exchange rates. The pursuit of these policies sometimes provided a short-term respite but was insufficient to arrest the deteriorating economic performance. Moreover, the expansionary demand pressures frequently resulted in mounting debt problems and capital flight—reflected in increasing problems of accumulation of arrears—further deteriorating the creditworthiness of the country and reducing the availability of foreign financing. The general pattern was not too different among countries and reflected an inconsistent pursuit of monetary, fiscal, pricing, and exchange rate policies.

Table 1.Characteristics of Economic Problems Prior to Program in Recent Stand-By and Extended Arrangements1(Number of cases)
Stand-By ArrangementsExtended
Approved inApproved inArrangements
General characteristics of problems
Total number of programs245016
Balance of payments difficulties244816
Economic growth214913
Public sector performance224813
Factors associated with economic problems
Total number of arrangements245016
Expansionary demand policies224415
Cost and price distortions235016
Related to exchange rate18318
Other prices204815
Exogenous factors214511
External debt problems3714

Subtotals do not add to totals for each group owing to concurrence of different problems in individual cases. Problems that emerged prior to the program period may have continued during the program period.

Sources: Reichmann (1978), Johnson and Reichmann (1978), and Fund staff estimates.

Subtotals do not add to totals for each group owing to concurrence of different problems in individual cases. Problems that emerged prior to the program period may have continued during the program period.

Price Adjustments and Fund Policies

Faced with mounting imbalances in a variety of situations, Fund-supported programs have always stressed realistic pricing policies—particularly the need for a modification of exchange rates and prices. The conceptual reasons justifying the approach have been discussed in previous sections. It may be sufficient to indicate here that the exchange rate and other prices were central in the design of macroeconomic adjustment, as reflected in Table 2, which shows the number of cases where price-related actions were included in programs.

Table 2.Selected Pricing Policy Content of Economic Programs in Recent Stand-By and Extended Arrangements1(Number of cases)
Stand-By ArrangementsExtended
Approved inApproved inArrangements
Total number of programs245016
Policies with regard to exchange rate142512
Policies with regard to prices and wages10459
General wage restraint236
Wage guidelines in public sector245
Producer prices213
Retail prices185

Subtotals do not add to totals for each category owing to concurrence of different problems in individual cases.

Sources: Reichmann (1978), Johnson and Reichmann (1978), and Fund staff estimates.

Subtotals do not add to totals for each category owing to concurrence of different problems in individual cases.

This concern of the Fund about pricing adjustments has been reflected in recent decisions related to the use of general resources and stand-by arrangements20 and Fund policies in general. In concluding the discussions on Guidelines on Conditionality, the Executive Board agreed that: “Performance criteria will normally be confined to (i) macroeconomic variables, and (ii) those necessary to implement specific provisions of the Articles or policies adopted under them. Performance criteria may relate to other variables only in exceptional cases when they are essential for the effectiveness of the member’s program because of their macroeconomic impact” (Guideline 9).

Clearly, the Executive Board expected that the achievement of adjustment required not only the use of financial variables, but also the use of macroeconomic price variables, namely, exchange rates and interest rates. Nevertheless, the Fund was not expected to review every pricing policy action: the authorities were to decide the particular price corrections that would result in a given adjustment effort. The Guidelines also indicate that: “The Managing Director will recommend [approval] … when it is his judgment that the program is consistent with the Fund’s provisions and policies and that it will be carried out. A member may be expected to adopt some corrective measures before a stand-by arrangement is approved by the Fund, but only if necessary to enable the member to adopt and carry out a program consistent with the Fund’s provisions and policies” (Guideline 7).

Two main ideas can be interpreted to emerge from Guideline 7: (a) The Managing Director and the staff have to be convinced about the likelihood that the program will be carried out—implying the need to have an explicit understanding about specific policies, including price adjustments; and (b) early action is needed to establish a credible program. Price corrections typically introduced at program inception—including exchange rate and interest rate adjustments—are the clearest example of early action. In many recent programs, exchange rate and pricing actions were taken prior to Board approval, and were in general fully implemented; that is, among the policies that countries announced as part of programs, pricing adjustments were among the most consistently pursued.

These observations do not imply that the price adjustment policies have been always successful. Restraints on wages, increases in interest rates, and exchange rate adjustments have been introduced and frequently have had the expected impact. Nonetheless, the lack of adequate supportive financial policies often neutralized the corrective effect of these measures, resulting in a deviation from the original course of action. Many programs were interrupted or canceled and created serious doubt about the feasibility of adjustment through the use of the price mechanism. Moreover, the ensuing inflationary pressures observed in the context of many programs was viewed as the consequence of price adjustments and not of the underlying inflationary pressures that had not been corrected in the first place. Nonetheless, it is true that slippages were present in many instances; and in others, excessive reliance was placed on the adjustment of prices alone, when no assurances existed that the supplementary policies would or could be carried out.

Recent Experience on Exchange Rate Actions

The experience with recent arrangements tends to confirm the importance of pricing actions in adjustment programs. In particular, in a recent study, Donovan has reviewed the real responses associated with exchange rate action in selected upper credit tranche stabilization programs21 and concluded that exchange rates have been central to external adjustment in the period 1970–76. The paper focuses mostly on the effect of exchange rate adjustments on selected variables. In analyzing programs, the study distinguishes between import restraint programs, in which corrections are mostly related to aggregate demand, and import liberalization programs, in which the action is directed mostly to providing an increase in the availability of resources and increasing supply. Table 3 reproduces data from Donovan’s article, showing the impact of exchange rate actions on exports and imports during the first one-year and three-year periods after the measure has taken place. The table clearly shows the positive impact of exchange rates in increasing exports and improving the current account, except in those instances when imports increased because of liberalization efforts by the authorities. In general terms, the study concludes that (1) the major reason for undertaking exchange rate action was the emergence of balance of payments pressures, reflected in many cases in increasing levels of restrictions, and a real appreciation of the exchange rate; (2) the depreciation was intended to improve export performance and reduce imports in the cases of expenditure-reducing programs. By contrast, imports were expected to increase when depreciations were accompanied by major liberalization efforts; (3) export performance showed a marked improvement after the depreciations, except in certain cases when supplementary measures failed: (4) imports declined in the import restraint group after the depreciation and increased in the import liberalization group, but in most cases the current account improved after the depreciation: (5) inflation rates increased somewhat in the postdepreciation period, but there was no evidence that the programs were associated with any systematic bias in economic growth. Nonetheless, in the demand restraint group, growth declined sharply, a fact associated with the demand-reducing effect of the adjustment program.

Table 3.Twelve Stabilization Programs: Annual Average Change in Real Imports (M) and Exports (X), 1970–76(In percent)
Before AdjustmentAfter Adjustment
One-year comparison
All programs1––5.1
Of which:
Import liberalization programs2–2.7–0.91.815.317.32.0
Import restraint programs31.–2.8
Three-year comparison
All programs40.–2.5
Of which:
Import liberalization programs2–8.9–
Import restraint programs38.43.82.5–5.0
Source: Based on Donovan (1981).

Afghanistan, Bangladesh, Bolivia, Burma, Ecuador, Israel, Jamaica, Pakistan, South Africa, Sudan, Yugoslavia, and Zambia.

Bangladesh, Burma, Pakistan, and Sudan.

Bolivia, Ecuador, Israel, Jamaica, South Africa, and Yugoslavia.

Excludes Bangladesh and Pakistan, owing to unavailability of data.

Source: Based on Donovan (1981).

Afghanistan, Bangladesh, Bolivia, Burma, Ecuador, Israel, Jamaica, Pakistan, South Africa, Sudan, Yugoslavia, and Zambia.

Bangladesh, Burma, Pakistan, and Sudan.

Bolivia, Ecuador, Israel, Jamaica, South Africa, and Yugoslavia.

Excludes Bangladesh and Pakistan, owing to unavailability of data.

No systematic work comparable to that of Donovan’s has been carried out for more recent experience, but the evidence suggests similar behavior. In general terms, exchange rate policy was implemented during the program period expected and covered elimination of multiple rates, restrictions, and depreciations of overvalued currencies; moreover, these policies were introduced at an early stage of the program.

Recent Experience on Interest Rate Policies

In general, interest rate adjustments were carried out as originally envisaged and helped attain the required adjustment, although in some cases, the corrective measures failed to bring about the expected results. In many countries, prior to program inception, interest rates were perceived to be too low—mostly negative in real terms—to provide adequate incentives for savings and investment.22 Specific action on interest rates was frequently included in and carried out by most programs. Nonetheless, in many cases after interest rates were adjusted, velocity tended to increase. The result may appear to be surprising, but in fact velocity could have been expected to increase because of the impact of constraints on the supply of financial resources. Although the original intentions were to increase nominal rates so as to achieve positive real rates, this was not always the case. Sometimes, the changes were marginal and therefore did not result in a turnaround in Financial savings. Only in those instances where the changes were perceived to be significant, or a return of confidence was observed, did resources flow into the financial system, resulting in increased savings and reduced demand pressures.

Adjustment of interest rates became more difficult in recent years, because domestic corrections had to reflect the effect of movements in nominal and real interest rates in the rest of the world, in addition to domestic inflation and exchange rate movements. In particular, the rising interest rates in international capital markets through early 1982 brought about the need for restrictive financial policies in many countries and thereby affected the level of economic activity. The high interest rates further aggravated difficulties in debtor countries because of the need to cover interest payments at a time when the availability of foreign financing was declining, also reflecting tighter financial policies in the major financial centers.

Energy and Other Prices

While the most important pricing measures in the context of adjustment programs referred to exchange rate and interest rate policies, other prices were also central to the corrective process. In particular, energy pricing policies were part of most programs supported by stand-by and extended arrangements, after the first oil shock of 1973–74. Programs sought adjustments in domestic energy prices that were to reflect to the largest possible extent the equivalent international prices. These policies were pursued both in oil importing and oil exporting countries. The policies were aimed at inducing reduced demand, increased supply of substitutes—in importing countries—and an improved budgetary outcome. The budgetary outcome was particularly important; in most cases, energy production was either under direct control of the public sector or prices were controlled, and price-cost differentials gave rise to major subsidies. Generally, energy-pricing policies were successful in attaining their objectives. In a few instances prices were not fully adjusted, but the subsidies were made explicit in the budgetary process and strict guidelines were established to avoid or reduce existing price distortions.

Producer prices were also subject to major corrections in the context of adjustment programs. In many instances high taxes on export commodities precluded adequate incentives to domestic producers and frequently resulted in declining supplies. In others, the effects of a depreciation or of higher international prices had not been passed on and resulted in new distortions. In general, producer price actions tended to reduce the divergences between external and domestic prices, induced output increases, and helped achieve corrections in the external account with a lesser emphasis on reduced expenditure. Because of their immediate impact, these price adjustments tended to be implemented at an early stage and thereby helped contribute to a substantial initiation of adjustment programs.


The recent experience with regard to exchange rate management in several Latin American countries has been of great importance in the understanding of economy-wide prices. At different times over the last five years, several major Latin American countries—Argentina, Chile, and Uruguay in 1979, as the most outstanding examples—announced the pursuit of either fixed exchange rates or exchange rates subject to a preannounced schedule of depreciation against the U.S. dollar. In others, the exchange rate remained fixed after a major adjustment—notably Mexico starting in 1977. Policies were supported in Uruguay by successive first credit tranche stand-by arrangements and in Mexico by an extended arrangement through 1979.

In most cases the fixed rate or predetermined exchange rate path was envisaged as a powerful means of sharply reducing the rate of inflation and providing the countries with a more stable financial environment. The exchange rate regime was predicated on the basis of a set of measures that would result in a consistent inflation outcome; the new exchange rate policies were implemented after periods of high inflation in which exchange rates were allowed to depreciate rapidly. The changes in the exchange rate intervention policy were frequently accompanied by a major revamping of the financial system, through interest rate reforms that were projected to result in rapid increases in domestic financial savings. The exchange rate was conceived as the key price, on the understanding that the budget deficit would be under control and that wages and prices of nontraded goods could rapidly converge to the preannounced path. The convergence was to be aided by appropriate fiscal, monetary, and trade policies. During the expectedly short period of adjustment, financing requirements were to be adequately covered from abroad, mostly through private capital flows, while the liberalization of trade was to achieve a greater degree of efficiency through increased foreign competition.23

In the event, countries that experimented with the preannouncement fixed rate scheme abandoned the policy and returned to either floating rates, to policies of frequent unannounced depreciations, or to highly restrictive systems. Argentina abandoned its preannouncement policy in early 1981 and Uruguay in late 1982. Chile abandoned a fixed rate policy in mid-1982. Among countries with a tradition of fixed rates, for example, Mexico maintained a virtually fixed rate for four years but allowed the rate to depreciate slowly in 1980 and finally abandoned the peg in early 1982. In general, the exchange rate policies were abandoned in circumstances when the balance of payments was under considerable strain, reflecting both domestic and external developments. In all cases, the exchange rate had appreciated markedly in effective real terms over the previous years (Table 4), while capital flows, which had been significant, reversed and resulted in marked pressures on international reserves and mounting external debt problems.

Table 4.Effective Real Exchange Rates in Selected Latin American Countries1(1977–81 = 100)
Sources: International Financial Statistics, Direction of Trade Statistics; and Fund staff estimates.

Index of exchange rate against major trading partners adjusted by changes in cost of living index for the same group of countries, weighted by total trade between individual country and trading partner. Increases reflect depreciations of the domestic currency.

Commercial rate, for the periods of split rates—June–December 1981 and July–December 1982.

Sources: International Financial Statistics, Direction of Trade Statistics; and Fund staff estimates.

Index of exchange rate against major trading partners adjusted by changes in cost of living index for the same group of countries, weighted by total trade between individual country and trading partner. Increases reflect depreciations of the domestic currency.

Commercial rate, for the periods of split rates—June–December 1981 and July–December 1982.

In these circumstances, the failure of adjustment programs to achieve both internal and external adjustment was attributed by some critics to the pursuit of the exchange rate policies described and the ensuing real appreciation of the currency. While the real appreciation contributed to the economic difficulties, the failure to achieve the original goals can be traced to a combination of domestic and external developments. In particular, an inadequate coordination of policies and the existence of institutional and market constraints precluded the expected internal adjustment and led to the appreciation of the currency, notwithstanding the marked deceleration of inflation—a key objective sought in the pursuit of preannouncement policies (Table 4 and Charts 14).

Chart 1.Argentina: Rates of Change, Exchange Rate, and U.S. Inflation Effect Versus Domestic Inflation

(Percentage change over same quarter of previous year)

Sources: International Financial Statistics; and Fund staff estimates.

1Combined effect of percentage change in exchange rate against the U.S. dollar and U.S. CPI.

Chart 2.Chile: Rates of Change, Exchange Rate, and U.S. Inflation Effect Versus Domestic Inflation

(Percentage change over same quarter of previous year)

Sources: International Financial Statistics; and Fund staff estimates.

1Combined effect of percentage change in exchange rate against U.S. dollar and U.S. CPI.

Chart 3.Mexico: Rates of Change, Exchange Rate, and U.S. Inflation Effect Versus Domestic Inflation

(Percentage change over same quarter of previous year)

Sources: International Financial Statistics: and Fund staff estimates.

1Combined effect of percentage change in exchange rate against U.S. dollar and U.S. CPI.

Chart 4.Uruguay: Rates of Change, Exchange Rate, and U.S. Inflation Effect Versus Domestic Inflation

(Percentage change over same quarter of previous year)

Sources: International Financial Statistics; and Fund staff estimates.

1Combined effect of percentage change in exchange rate against U.S. dollar and U.S. CPI.

The reasons for the rigidity of inflation to decline in line with the rate of depreciation can be explained by the concurrent impact of continued indexing of wages to past inflation in a period of declining inflation, by high increases in the prices of nontradables, and by the slow progress achieved toward trade liberalization. These domestic elements were exacerbated by the pegging of local currencies to the U.S. dollar, which appreciated markedly against other major currencies in the period 1980–82.

This enumeration provides a somewhat mechanistic explanation of the slow decline in inflation. Actually, the reasons for the continued pressures on prices and the balance of payments are to be found to a large extent in the pursuit of expansionary domestic policies. The continuous increase in the public sector expenditures—with the clear exception of Chile and, to a lesser extent, of Uruguay—and the consequent financing requirements rendered inconsistent the exchange rate and the Fiscal policy. Public sector financing requirements generated pressures on domestic resources and resulted in increases in the relative prices of nontraded goods, higher interest rates, and the widening of the current account deficit. While the public sector policies could be identified as a major factor behind the failure of preannouncement policies, overexpansion of private sector expenditure was also an important source of pressures. Concurrently, the loss of competitiveness of export and some import substituting sectors resulted in lower levels of activity, affecting the growth prospects of the economy.

The initially increased access to foreign financing and its eventual reversal also exacerbated emerging imbalances. At the early stages of financial and exchange rate reforms, the financial integration of domestic and international capital markets frequently proceeded at a rapid pace, resulting in sharp increases in capital flows: but domestic interest rates did not fall in line with the rate of depreciation. To some extent, the slow adjustment in interest rates could have reflected imperfect capital markets: but eventually, the interest rate differential reflected both a perception of exchange rate risk—which was on average different from the announced exchange rate path—and public sector financing needs that continued to induce large capital inflows.24 The slow pace of trade liberalization was also conducive to the real appreciation observed. The increased capital flows allowed for additional spending, generating pressures on domestic prices but without the required restraint imposed by foreign competition.

Economic performance was further affected by the emergence of exogenous events. Deteriorating terms of trade and higher external interest rates contributed to the widening balance of payments deficits, already weakened by the pursuit of the financial and exchange rate policies described. The ensuing loss of confidence induced more frequent episodes of capital flight and increasing reticence in international capital markets to lend to these countries, further aggravating the problems of employment and balance of payments and eventually resulting in the abandonment of the exchange rate policies pursued.

In summary, the failure of exchange rate preannouncement or pegging mostly reflected a lack of adjustment of other domestic financial policies, compounded by the effect of changing external circumstances. The exchange rate path became the main objective of economic policy, and its pursuit implied high costs and disturbances for economic activity. Eventually, the exchange rate policies had to be abandoned in the midst of growing financial difficulties that reflected to a large extent a loss of confidence in the policies pursued and forced a major correction effort that may not have been required otherwise.


Two main conclusions can be drawn from the previous discussion. First, pricing policies are an essential component of adjustment programs, insofar as they affect both aggregate demand and supply; in their absence, corrective policies may be more detrimental to output and employment. Second, in order to attain adequate adjustment, pricing policies can only be pursued successfully if they are supported by adequate financial policies. These points cannot be considered original, but they summarize in a simple manner the essence of many adjustment programs.

No particular policy can help fully to deflect the consequences of reduced foreign financing or a decline in the terms of trade. Any of these circumstances will require an accommodation of aggregate demand to aggregate supply and will result, in most instances, in a reduction in real disposable incomes, in a slowdown in investment, and in transfers of resources to the external sector. The issue to be addressed is what policy mix is the most adequate to achieve a smooth process of adjustment. A combination of demand restraint policies, trade liberalization, and pricing policies—in particular exchange rate policies—provides conditions for the restoration of domestic and external confidence, thereby allowing for less stringent demand adjustments in the context of a Fund-supported program. But the reduction in expenditure is unavoidable, and the costs of adjustment have to be borne among the different sectors of the economy, with only a narrow scope for flexibility.

The existence of political and social pressures makes adjustment more difficult, in particular when sharp corrections are required in real wages, in these instances, exchange rate action will help provide the needed correction if supported by sufficiently strong financial and incomes policies. Otherwise, pricing policies will only provide a short-term respite and in the medium term will possibly result in higher rates of inflation with no balance of payments relief. Moreover, the credibility of both current and future policy actions can be jeopardized, and any new corrective attempt may require a more prolonged period in order to produce the desired change in expectations and the restoration of confidence.

Finally, price targets in themselves should not be made the objective of policies, unless supported by other adequate measures. In different instances, the maintenance of a fixed exchange rate, or the commitment to a given preannouncement path, became in itself the objective, usually in the context of an anti-inflationary policy. Exchange rate policies were maintained even when it became clear that developments in other financial magnitudes did not allow for the achievement of medium-term viability in the context of the external policies pursued. The appropriate policy course required the restraint of public sector deficits and reduced wage pressures, but previous policy slippages, noneconomic constraints, and the dynamics of adjustment made the abandonment of a predetermined exchange rate path unavoidable. In many instances the exchange rate modifications came too late and were too abrupt, therefore worsening emerging balance of payments difficulties. A more flexible approach or an earlier correction both of exchange rate and demand policies would have allowed for a less drastic adjustment. Moreover, it would have precluded the conclusions made by many critics that the failure of controlled exchange rates have rendered useless the use of appropriate pricing policies in the context of adjustment efforts.


    AllenMark“Adjustment in Planned Economies,”Staff PapersInternational Monetary Fund (Washington) Vol. 29 (September1982) pp. 398421.

    BlejerMario I. and Donald J.Mathieson“The Preannouncement of Exchange Rate Changes as a Stabilization Instrument,”Staff PapersInternational Monetary Fund (Washington) Vol. 28 (December1981) pp. 760792.

    BlejerMario I. and Donald J.Mathieson“Interest Rate Differentials and Exchange Risk: Recent Argentine Experience,”Staff PapersInternational Monetary Fund (Washington) Vol. 29 (June1982) pp. 270280.

    ClineWilliam R. and SidneyWeintraub eds.Economic Stabilization in Developing CountriesThe Brookings Institution (Washington1981).

    DonovanDonal J.“Real Responses Associated with Exchange Rate Action in Selected Upper Credit Tranche Stabilization Programs,”Staff PapersInternational Monetary Fund (Washington) Vol. 28 (December1981) pp. 698727.

    DonovanDonal J.“Macroeconomic Performance and Adjustment Under Fund-Supported Programs: The Experience of the Seventies,”Staff PapersInternational Monetary Fund (Washington) Vol. 29 (June1982) pp. 171203.

    DornbuschRudigerOpen Economy Macroeconomics (New York: Basic Books1980).

    FrenkelJacob A. and Harry G.Johnsoneds.The Monetary Approach to the Balance of Payments (LondonAllen and Unwin1976).

    FrenkelJacob A. and Harry G.JohnsonThe Economics of Exchange Rates (Reading, Massachusetts: Addison-Wesley1978.

    FrenkelJacob A. and Harry G.Johnson and Carlos A.Rodríguez“Exchange Rate Dynamics and the Overshooting Hypothesis,”Staff PapersInternational Monetary Fund (Washington) Vol. 29 (March1982) pp. 130.

    GalbisVicente“Inflation and Interest Rate Policies in Latin America, 1967–76,”Staff PapersInternational Monetary Fund (Washington) Vol. 26 (June1979) pp. 334366.

    GoldJosephConditionalityIMF Pamphlet Series, No. 31 (Washington1979).

    GuitiánManuel“Credit Versus Money as an Instrument of Control,”Staff PapersInternational Monetary Fund (Washington) Vol. 20 (November1973) pp. 785800; reproduced in International Monetary Fund (1977) pp. 22742.

    GuitiánManuelFund Conditionality: Evolution of Principles and PracticesIMF Pamphlet Series, No. 38 (Washington1981).

    HookeAugustus W.The International Monetary Fund: Its Evolution Organization and ActivitiesIMF Pamphlet Series No. 37 (Washington3rd ed.1983).

    JohnsonG. G. and Thomas M.Reichmann“Experience with Stabilization Programs Supported by Stand-By Arrangements in the Upper Credit Tranches, 1973–75” (UnpublishedFebruary281978).

    JohnsonHarry G.International Trade and Economic Growth: Studies in Pure Theory (London: Allen and Unwin1958).

    JohnsonHarry G.“The Monetary Approach to Balance of Payments Theory,”Journal of Financial and Quantitative AnalysisVol. 7 (March1972) pp. 155071.

    International Monetary FundThe Monetary Approach to the Balance of Payments: A Collection of Research Papers by the Staff of the IMF (Washington1977).

    International Monetary FundSelected Decisions of the International Monetary Fund and Selected Documents9th ed. (Washington1981).

    KellerPeter M.“Implications of Credit Policies to Output and the Balance of Payments,”Staff PapersInternational Monetary Fund (Washington) Vol. 27 (September1980) pp. 45177.

    KellyMargaret R.“Fiscal Adjustment and Fund-Supported Programs, 1971–80Staff PapersInternational Monetary Fund (Washington) Vol. 29 (December1982) pp. 561602.

    LoserClaudio M.“External Debt Management and Balance of Payments Policies,”Staff PapersInternational Monetary Fund (Washington) Vol. 24 (March1977) pp. 16892.

    McKinnonRonald I.“Portfolio Balance and International Payments Adjustment” in Monetary Problems of the International Economyed. by R.Mundell and A.Swoboda (Chicago: University of Chicago Press1969) pp. 199234.

    McKinnonRonald I.Money and Capital in Economic DevelopmentThe Brookings Institution (Washington1973).

    MundellRobert A.International Economics (New York: Macmillan1968).

    MundellRobert A.Monetary Theory Inflation Interest and Growth in the World Economy (Pacific Palisades, California: Goodyear1971).

    ReichmannThomas M.“The Fund’s Conditional Assistance and the Problems of Adjustment, 1973–75,”Finance and DevelopmentVol. 15 (December1978) pp. 3841.

    ReichmannThomas M. and Richard T.Stillson“Experience with Programs of Balance of Payments Adjustment: Stand-By Arrangements in the Higher Tranches, 1963–72,”Staff PapersInternational Monetary Fund (Washington) Vol. 25 (June1978) pp. 293309.

    RodríguezCarlos A.“A Stylized Model of the Devaluation-Inflation Spiral,”Staff PapersInternational Monetary Fund (Washington) Vol. 27 (March1978) pp. 7689.

    SalopJoanneand OmotundeJohnson“Distributional Aspects of Stabilization Programs in Developing Countries,”Staff PapersInternational Monetary Fund (Washington) Vol. 27 (March1980) pp. 123.

    StewardFrances and ArjunSenguptaInternational Financial Cooperation (Boulder, Colorado: Westview Press1982).



Mr. Loser’s paper is intriguing and has several strengths, including the coherency and correlation between the theoretical framework and the experiences of Latin American countries. However, it would benefit from a few additions and clarifications.

My first remark refers to a basic and crucial distinction made in Mr. Robichek’s paper. The adjustment process and the role of prices in it take on particular special characteristics when the following are involved:

(1) isolated cases of countries;

(2) a worldwide economic depression, affecting a large group of countries.

Loser’s article draws several general conclusions for the first case, which implicitly is the one he is dealing with. For the second case it would be necessary to analyze how, in the area of price adjustments, the policies of some countries cancel out or counteract the policies of others (e.g., competitive devaluations). There would also be a need for other instruments, such as joint renegotiations of the external debt and a reordering of the international monetary system, should there be a desire to avoid exaggerated price adjustments and demand management measures (not a viable course in our countries and one with little guarantee of success). Given the current circumstances and prospects for the immediate future, it is the second case which should be analyzed.

A second remark relates to the (clear and explicit) distinction drawn by the Fund between demand management measures and supply-oriented measures. The first of these are generally associated with credit and fiscal measures which narrow the gap between income and expenditure. Some look upon price adjustment policy as if it were supply oriented. This is partially true, as adjustments of prices (exchange rates, interest rates, and real wages) have a short-term effect on aggregate demand and a longer-term effect on aggregate supply.

Third, Loser perceives market forces to be correct, meaning that in one way or another there is competitiveness between markets, stability, and automaticity. But rigidities do exist and must not be discounted.

Fourth, and summarizing Loser’s paper to the point of caricature, adequate pricing measures must take the following into account:

(1) Exchange rate. The real exchange rate must be maintained; that is, the exchange rate must change in line with the domestic rate of inflation adjusted by international inflation. This should be accompanied by measures to liberalize exchange and trade transactions (with low levels of effective protection).

(2) Interest rate. The interest rate should be equivalent to the rate of depreciation plus the interest rate prevailing abroad plus a risk premium.

Exchange rate and interest rate policies have to be pursued consistently. It is less efficient to make use of the second rather than the first to bring the balance of payments into equilibrium and reduce expenditure. Financial liberalization measures must be pursued at the same time.

(3) Other prices. Controlled or administered prices should be shifted toward the level of external prices adjusted by changes in the exchange rate. Prices for public utilities must be indexed for inflation. This is done with a view to improving the public finances.

(4) Wages. Upward adjustment of the above prices will of necessity be reflected in a decline in real wages.

Loser’s prescriptions must be clarified in several respects:

(i) To what degree of trade liberalization is he referring? Which is to be preferred, uniform tariffs or tariffs with small variations of 10, 20, or 40 percent? The implications and results differ widely.

(ii) It is necessary to analyze the risk of competitive devaluations, the desire to overcome the exchange lag (depending on the base year considered), and the pressure of expectations (prompted by political factors) generated by an easing of the concept of a real exchange rate.

(iii) Should the real interest rate be zero or positive? In the second case, should it be 2, 10, or 30 percent? The economic implications vary widely in each case. In a situation where external financing is available, a high positive real interest rate may attract international reserves (if other conditions are stable), making it possible to maintain the fixed exchange rate with a moderate rate of inflation. This is the situation prevailing in Chile in recent years.

The temptation to maintain high positive real interest rates raises another problem: a significant proportion of the money supply is generated abroad and the central bank loses the ability to control it.

(iv) I agree with the approach toward other prices, apart from very rare exceptions.

(v) The decline in real wages is deduced by its residual effect. Nothing is said about the liberalization of the labor market, the conditions required for this, or the need to reduce other labor costs.

(vi) Real wages continue to fall and unemployment continues to increase.

(vii) The application of temporary export subsidies on manufactured goods is not a feasible alternative. This would imply a different exchange rate for this type of product, which detracts from the coherency of the recommendations. This policy, followed by some countries in Southeast Asia, has been discarded.

Fifth, the implementation of these measures has not been taken into account:

(i) Gradualism versus sudden (or total) adjustment.

(ii) On page 84, we are told that the programs have been implemented successfully, but then we see that they are not functioning adequately in Argentina, Chile, Uruguay, Peru, etc.

(iii) Something always turns out wrong: exchange rate, budget deficit, programs in which some problem occurs.

Does this mean that the technocrats are unable to implement the measures? Is there some shortcoming on the part of the economic team? Are there exogenous factors which alter the rules of the game completely? Is this wisdom the product of hindsight or foresight?

(iv) The suitability of, or “the right time for,” liberalizing when surrounded by protectionist tendencies, for example, or, as in the case of Peru, deregulating when the country is losing reserves.

(v) Is inflation caused by the budget deficit or excessive private sector expansion?

(vi) Exogenous factors always alter and distort these policies.

My sixth remark relates to the evaluation of adjustment programs, in which only imports are analyzed but not the good effects as regards supply. There are already enough cases to make it possible to evaluate such program recommendations in overall terms, studying the effects in the real sector. Which sectors benefit and which are changed (e.g., the manufacturing sector)? What is the size of the financial sector and its relationship with the real sector, and what distortions arise therefrom? And what is the impact on income distribution?



In his paper, Claudio Loser provides an excellent analysis of the main problems arising in the course of implementing stabilization policies in open economies. In accordance with the subject of this seminar, Loser confines his presentation largely to those economies experiencing balance of payments difficulties.

There is much literature exhaustively analyzing the role of various instruments that can be used to achieve external equilibrium. Loser offers an overall analysis of the problem in the very positive spirit required if the objective is to assist in the implementation of rules for action by an institution such as the International Monetary Fund.

Among the numerous instruments customarily used in connection with adjustment programs, Loser distinguishes two main categories:

(1) Aggregate quantitative instruments that directly affect the differential between income and expenditure of the community, such as the size of the budget deficit or the amount of domestic credit.

(2) A group of prices which, because of their significance, may exert a considerable macroeconomic effect on the allocation of resources and thereby on the resultant external equilibrium. Furthermore, the use of such price variables may have a significant effect on the cost of the adjustment process for a given use of the aggregate quantitative variables (AQV).

In Section 2 of the paper, Loser concentrates on analyzing the interaction of the price variables with the traditional AQVs. The price variables he examines are the exchange rate, the interest rate, wages, and a set of “other prices,” which includes prices of exports and imports and rates for public services. In all cases Loser shows the strong interdependence between the different price variables and between these and the AQVs. He stresses the inevitable relationship between exchange rate policy and interest rates, and the interdependence of wage policy and exchange rate policy. Similarly, aggregate credit policy cannot be adopted independently of exchange rate policy, nor can the rates of public sector services be arbitrarily set without affecting public sector finances and, as a result, the budget deficit. In this connection, I would like to mention a couple of additional examples which I believe are of some significance, at least as regards the situation of several countries in southern Latin America.

The first is the relation which exists between the so-called real exchange rate (relative price of tradable to nontradable goods) and real wages. In an economy that allocates its resources effectively, equilibrium must exist between the two variables and, unless there is proof to the contrary, such a relation should be respected within the framework of any stabilization program. Were this not done, it would necessarily imply rationing both markets. The relation between the two variables depends on the intensity with which factors are used in the trading and nontrading sectors. In the case of Argentina, which I know best and which I have examined empirically, the noncommercial sector is relatively labor intensive. The so-called Stolper-Samuelson ratio indicates that an increase in the relative price of the labor-intensive sector will lead to an increase in the demand for labor, and hence to an increase in real wages. In terms of our variables, this indicates that increases in real wages will be associated with falls in the level of the real exchange rate. In Argentina, the period during which the so-called Exchange Schedule (Tablita cambiaria) was in effect, that is, 1979–80, was marked by a continual deterioration in the real exchange rate and an increase in real wages. It is interesting to see that subsequent administrations have assigned themselves the task of improving both the real exchange rate and real wages, an objective that clearly is unattainable if the earlier results are true. It is also indicative that during the period of efforts to increase the relative price of labor and the real exchange rate, inflation increased to the point that it has averaged 14 percent a month during the last eight months. I find it surprising that the Argentine Minister of Economy should have announced at the time of the last stand-by arrangement with the International Monetary Fund that under their economic policy the real exchange rate would be indexed so as to maintain its present real level (high, in my view) and that wages would be indexed so as to increase them by a minimum of 5 percent in real terms during the first year the arrangement was in effect.

The second example is the relation that exists in the short term between the level of government spending and the real wage level. This is so true that in the case of Argentina many specialists refer to both variables without distinction. This is because surely in Argentina the greater portion of government spending is on goods not traded internationally: education, justice, defense, public services, etc. A reduction in public spending implies a reduction in the relative demand for labor and, as a result, in real wages. In the medium and long term, if the usual arguments on the inefficiency of the public sector are valid, the productivity of the economy and hence, perhaps, wages as well, should increase. However, the short-term effect is practically undeniable and, I believe, creates a very real political constraint when it comes to implementing stabilization programs based on a reduction of the size of the public sector which hold out promise of popularly satisfactory results in the short term.

In Section 3 of the paper, Loser presents data on the origin, contents, and results of stabilization programs recently undertaken with the support of the Fund. This section is mainly based on the recent work of Donal Donovan. Frankly, I find it very difficult to comment on this topic as I have no experience of the problems of these countries nor can I easily obtain the necessary statistical data. I shall, therefore, limit myself to one small suggestion in this regard, all the more so as I have not read Donovan’s article (1982). Loser presents tables analyzing recent stand-by arrangements taking into account the problems which led to them, the instruments used, and the results obtained with regard to exports and imports; he also mentions the effect of these stand-by arrangements on the rate of inflation. One of the most discussed aspects of stabilization policies guided by the Fund is whether its adjustment programs are based on a contraction of domestic demand (usually associated with “monetarist” policy) or on the expansion of aggregate demand (obviously a more popular method of adjustment). For example, the recent Fund stand-by arrangement with Argentina, though it was never officially published, was announced by the economic authorities as being an economic recovery program which should lead to an increase in the rate of growth and to the increase in real wages mentioned above. In the spirit of this section, which seeks to determine what has happened with plans already carried out with the agreement of the Fund, it would be of interest to provide a table showing the evolution of supply and aggregate demand both before and after implementation of the program. This would serve to show whether Fund programs are directed toward increasing supply or restricting demand in the economy. Whatever the results may be, however, what is done is done and should not be used as an argument to invalidate any of the conclusions given in the second part of the paper (commented on above), based on theoretical analysis and on common sense.

Section 4 of the paper discusses the recent experience with stabilization efforts in southern Latin America (Argentina, Chile, and Uruguay), the main instrument used being a pre-announced exchange rate. There is a common element in the cases of these countries: at the time these policies were adopted, none of them had external payments problems of significance. The exchange policies adopted were just additional instruments within an overall plan to reduce the inflation rate and liberalize the economy. Prior to the introduction of the Exchange Schedule, all these countries decontrolled their financial markets, though in varying degree. They also permitted capital outflows to differing extents (Uruguay at one extreme, the most liberal, Chile, at the opposite extreme). Similarly, all these countries implemented an opening of the economy to international trade in goods, either before (Chile, through a prior reduction of tariffs) or at the same time (Argentina and Uruguay, through a more timid approach). I do not intend here to go into a detailed analysis of the three stabilization programs, as this would go beyond my duty as commentator, and I believe Loser has produced an excellent synthesis. The author mentions a number of the problems that arose during implementation of the programs, such as the inconsistency between the guidelines of the Exchange Schedule and the development of the budget deficit, or the overvaluation of the currency resulting from the decrease in the devaluation rate and the demand pressure caused by government expenditure. I also agree with Loser that the timing of developments on international markets played an important role in the subsequent failure of the policies adopted; those policies were confronted with deteriorating terms of trade and unprecedentedly high interest rates at the very time all these countries had adopted a strategy of promoting external indebtedness with a view to reducing, or distributing over time, the initial costs of the policy of stabilization and opening of the economy.

I would, however, wish to mention two problems which Loser has not referred to but which are relevant, at least if one is to understand the case of Argentina. One is the political error of implementing simultaneously a tariff policy (to open the economy) and a policy of pre-set exchange rates (to reduce inflation). Both measures penalized heavily the import substitution sector (both the exchange lag and the reduction of tariffs) and, in my view, seriously affected confidence in continuation of the economic strategy. The other problem is that, simultaneously, with the loss of credibility, the maintenance of government guarantees on bank deposits enabled the enterprises affected by the joint impact of tariff reductions and exchange rates to launch “apparently” suicidal policies of seeking to survive by borrowing from the financial system while waiting for the system to change. The resulting high degree of indebtedness further damaged the credibility of the existing system and, contrary to the wishes of each successive minister, the winners were those who bet against. The result was that the exchange strategy and the opening of the economy were abandoned and were replaced by controlled rates of interest in the midst of a resurgence of inflation in order to permit settlement of the debts contracted during the previous stabilization program.


    DonovanDonal J.“Macroeconomic Performance and Adjustment Under Fund-Supported Programs: The Experience of the Seventies,”Staff PapersInternational Monetary Fund (Washington) Vol. 29 (June1982) pp. 171203.

The views expressed in this paper represent the opinions of the author and not necessarily those of the International Monetary Fund. The author received helpful comments on an earlier draft from many colleagues in the International Monetary Fund—among them Messrs. Robichek, Beza, Gerhard, and Guitián and Ms. Kelly. None of them, however, should be held responsible for any views expressed in this paper.

See Manuel Guitián (1981) for a description of the approach. Also, Frenkel and Johnson (1976), Johnson (1972), and Mundell (1960) and (1971), and the International Monetary Fund (1977).

See Guitián (1973) and Kelly (1982) for a description of the conceptual framework.

See Loser (1977) and Keller (1980) for a description of the impact of foreign debt in overall economic management.

The real exchange rate is defined as the relative price of tradable to nontradable goods. From a simple empirical point of view, the movement of the real exchange rate would be measured by the behavior of the exchange rate relative to internal price developments adjusted for price developments in major trading partners.

In this connection, Frenkel and Rodríguez (1982) provide a description of exchange rate dynamics and exchange rate “overshooting.”

See Section 3 for a description of recent experience with exchange rates in the context of Fund-supported programs. Also see Donovan (1981).

In addition to authors mentioned in earlier sections, see McKinnon (1969) and (1973).

Interest rate parity is envisaged as taking into account the risk premium that may be required for an individual country.

A discussion of the link between interest rate differentials and exchange rate risk is presented in Blejer (June 1982).

See Dornbusch (1980) for a discussion of real wages and the process of adjustment. Also Steward and Sengupta (1982) for a critical view of stabilization programs.

See Cline and Weintraub (1981) for a general collection of papers on economic stabilization.

The experience with Fund-supported programs in the early 1970s is discussed in Reichmann (1978), Reichmann and Stillson (1978), and Johnson and Reichmann (1978).

In general terms, stand-by arrangements have been oriented to correct imbalances in a period of not more than two years and have stressed to a large extent shorter term policies. Programs supported by extended arrangements cover three-year periods and are designed so as to help achieve internal and external balance by the use of financial and structural modifications that improve the structure of the economy and enhance growth prospects. Nonetheless, structural changes are also an integral part of stand-by arrangements.

Decision No, 6056-(79/38), March 2, 1979, Selected Decisions of the international Monetary Fund and Selected Documents (1981); also see Gold (1979), Guitián (1981), and A.W. Hooke (1983).

Donovan (1981). A second article (Donovan (1982)) explores the general impact of adjustment programs on economic performance.

See Galbis (1977) for a review of interest rate policies in Latin America in the period 1967–76.

A detailed description of the preannouncement model is discussed by Blejer and Mathieson (1981); this discussion reflects many of their views.

Blejer (1982) presents an analysis of interest rate differentials and exchange rate risk in the context of recent Argentine experience.

The original version of this paper was written in Spanish.

    Other Resources Citing This Publication