Mr. Mohsin S. Khan, Mr. Saleh M. Nsouli, and Mr. Chorng-Huey Wong
Since its establishment in 1964, the IMF Institute has trained more than 13,000 officials from 183 member countries in Washington and over 8,000 officials overseas. The training focuses on such subjects as financial programming and policies, monetary and exchange operations, public finance, financial sector issues, and macroeconomic statistics. This book includes some of the background material that the IMF Institute uses in the training of country officials. Although IMF Institute courses also cover structural issues—such as banking system, public enterprises, and labor market reform (which are also critical to the achievement of economic policy objectives), this book deals only with macroeconomic issues. Specifically, it addresses some of the key questions policymakers face in managing national economies:
Traditional models of exchange rate determination have focused on three types of explanatory variables: national price levels, interest rates, and the balance of payments. Although the perception that exchange rates are related to national price levels had existed for a long time, it was with Cassel’s introduction of the term purchasing power parity (PPP) in 1918 that exchange rates became closely associated with the comparative purchasing powers of national currencies. Policymakers were also aware that the behavior of exchange rates could be influenced by adjustments in interest rates: when interest rates rise, the exchange rate—the price of foreign currency in terms of domestic currency—falls, indicating an appreciation, or strengthening, of the domestic currency. The relationship between the interest rate and the exchange rate—known as the interest rate parity hypothesis—was bolstered as forward exchange markets developed. The recognition that exchange rates adjust to international payments established a relationship between the exchange rate and the balance of payments. With the Keynesian revolution and the rapid expansion of international capital transactions related to international trade, however, the behavioral links between the balance of payments and the exchange rate were reexamined and embedded in models that took into account the interplay of external and internal pressures on exchange rates.
A central focus of the macroeconomic policy advice that developing and transition economies have received over the past decade has been the importance of “getting prices right.” For transition economies this advice has an important microeconomic dimension. The decentralization that characterizes market economies implies that decisions about what and how much to produce, as well as about what and how much to consume, are made by individual economic agents, and relative prices are the signals and incentives that guide the decisions of these agents. In doing so, relative prices play a key role in allocating economic resources among competing uses. For both types of economies, however, the need to get prices right also has a key macroeconomic dimension. The two central macroeconomic relative prices are the price of goods in the present relative to the price of goods in the future (the real interest rate) and the price of domestic goods relative to the price of foreign goods (the real exchange rate).
This chapter provides a framework for determining the appropriate mix of monetary, fiscal, and exchange rate policies for correcting macroeconomic imbalances. It discusses the design of macroeconomic adjustment programs and the appropriate actions required of policy agencies facing imperfect coordination.
The IMF plays a central role in the adjustment efforts of its member countries by assisting in the design of appropriate adjustment programs to achieve viability of the balance of payments, price stability, and sustained high growth, and by providing financing to support these programs.1 An IMF-supported adjustment program includes a mix of stabilization and structural reform measures aimed at restoring a sustainable balance between aggregate demand and supply, while simultaneously expanding the production of tradables. Such a program takes the form of a set of policy intentions outlined by the government in a “Letter of Intent” that the IMF judges to warrant financial support. This financial support is thus conditional on the policy measures being carried out (Williamson, 1983).2 The targets for the key macroeconomic variables (which in a typical program include the level of net international reserves, the current account balance, inflation, and the growth of real GDP),3 the choice of policies to achieve those targets, and the amount of financing provided by the IMF all result from extensive and detailed negotiations between the country authorities and the Fund. Thus, an IMF-supported adjustment program reflects both the individual economic situation of the country and the preferences of the government.
One of the most important questions that economists can ask is why do some countries grow over the long run whereas others do not. After all, a continuous growth rate over an extended period is what brings wealth to a nation. To give an example: in 1870, income per capita in the United States was equal to $2,244 in 1990 dollars. By 1990, income per capita had reached $18,258. Thus, real income grew at an annual rate of 1.75 percent over the course of those 120 years, and real income per capita multiplied by a factor of eight.
The current account of the balance of payments is an important variable for policymakers. Deficits in the external current account are the result of the accumulation of net claims of foreigners on residents. The empirical literature considers persistent deficits above 5 percent of GDP to be unsustainable in the long run. Although the recent experience of Mexico and Thailand supports this view, some countries—for example, Australia, Canada, and Japan—have in the past persistently run large current account deficits without facing external problems. Because current account balances are a function of the interaction between private agents’ intertemporal decisions and government policies, current account deficits are in themselves neither a curse nor a blessing.
This chapter describes a general framework for formulating monetary policy. The first part describes the objectives of monetary policy, the instruments available to attain those objectives, the basic elements of the relationship between exchange rate policy and monetary policy, and alternative views of the transmission process of monetary policy. The second part discusses issues that pertain to the role of the central bank in conducting monetary policy: the inflationary bias of monetary policy, rules versus discretion in monetary policy implementation, central bank independence, and inflation targeting. The final part describes how some countries have adapted the general monetary framework to their own circumstances; it concludes with an example of how monetary policy is conducted in Canada.
The inflation-targeting framework is an operational regime intended to enhance the performance of monetary policy. Price stability is the primary goal of monetary policy, and the central bank has discretion for determining how monetary goals are attained and is accountable for achieving those goals. The inflation-targeting framework was initially adopted to resolve conflicts among competing monetary policy objectives. Many countries adopted the framework to address problems experienced with previous monetary regimes, such as those that used exchange rate pegs or monetary aggregates as the intermediate target. In a few countries, inflation targeting was used where earlier inflation-stabilization efforts consisting of heterodox programs1 and crawling exchange rate bands had conflicted with efforts to maintain the official exchange rate regime and to control inflation. The inflation-targeting framework avoids these conflicts by serving as a clear statement that inflation fighting is the primary goal of monetary policy. The central bank is given the freedom to conduct monetary policy independently of the influence of political cycles, thus making it accountable for its success in achieving monetary goals.
Fiscal policy is defined as the government’s measures to guide and control spending and taxation. The traditional view is that fiscal policy performs three main functions: allocation, distribution, and stabilization. The allocation function is the process of dividing total resource use between private and social goods and choosing the mix of social goods. The distribution function is the process of adjusting the distribution of income or wealth to ensure conformance with what society considers fair. The stabilization function supports achieving the main macroeconomic objectives set by policymakers to ensure economic growth, price stability, and sustainable external accounts.