This section examines the empirical evidence available from studies that use the time-series approach in determining the growth effects of individual policies typically found in Fund programs. The evidence is grouped according to types of policies, that is, policies to restrain aggregate demand, policies to stimulate aggregate supply, and exchange rate policies.
While all the studies considered here deal with developing countries, they do not focus specifically on the subset of program countries as such.15 In addition, the policies examined in the empirical literature are not always identical to those pursued in the context of Fund programs, although they are often quite similar. Finally, the time-series studies typically consider policies individually, even though, as mentioned previously, Fund programs involve the simultaneous implementation of a number of policy measures. It is quite likely that the measures included in a Fund program may have effects on the rate of growth that are quite different when policies are pursued jointly rather than independently.
The common methodology adopted in the time-series studies is first to outline a model that relates the level or rate of growth of output to certain policy instruments (and perhaps a few other variables). This relationship is then tested econometrically by using data for an individual country or group of countries. The effects of policy changes on growth are determined either directly from the values of the estimated coefficients or by performing simulation experiments with the estimated model. This model-oriented approach has the distinct advantage of being able to isolate the effects of a change in a particular policy, which, as will be discussed in Section IV, is not possible in cross-country studies. At the same time, however, it is difficult to account fully for all the complex linkages between the policy variables and ultimate objectives, such as economic growth. Thus, the specifications that are used are often quite simplistic and can serve only as approximations to the “true” empirical relationships.
Policies to Restrain Demand
The two main instruments for controlling aggregate demand are monetary (or domestic credit) policy and government tax and expenditure policies.16
Monetary Policy
Virtually all Fund programs involve restrictive monetary policies, specifically ceilings on the rate of domestic credit expansion, whether by the banking system as a whole or by the central bank.17 Consequently, the relationship between economic growth and monetary or domestic credit expansion is crucial in judging the effects of Fund programs.
Despite the attention it receives in both the theoretical and empirical literature, the size of the effect of changes in the rate of domestic credit expansion on economic growth is still a matter of considerable controversy. The simple version of the monetary approach to the balance of payments suggests, for example, that in the long run in a small open economy operating under a fixed exchange rate regime, a reduction in domestic credit will be completely offset by international reserve flows that restore the money stock to the level desired by the public. Consequently, this policy would have no long-run effect on the level of output relative to its trend or on the rate of growth of output. It is clear, however, that during the adjustment process a decline in the growth of domestic credit may be associated with a reduction in capacity utilization and a possible rise in unemployment, since prices are not completely flexible downward. The estimated size and duration of the deflationary effect created by a restrictive monetary policy depends on a number of factors, such as (1) the speed with which the initial credit restriction is offset by international reserve movements (an effect that depends on the responsiveness of the current account and the degree of capital mobility); (2) the response of domestic inflation to the excess demand for real money balances created by the credit restraint policy; (3) the extent to which the excess demand for money reduces aggregate demand (which depends partly on the degree of excess demand for output in the economy);18 and (4) the effect on private investment of a rise in the cost, or a reduction in the availability, of credit. As these factors can interact in complex ways, the net outcome is clearly an empirical question.
In order to judge the effect of a contractionary monetary policy (defined as a reduction in the growth of either domestic credit or the supply of money) on the growth of output in developing countries, some recent empirical evidence has been assembled. Although the group of studies surveyed here is selective, it is nevertheless reasonably representative of the empirical work undertaken on this subject during the last five years or so. The only major exclusion would be a number of large structural macroeconomic models for individual countries. Table 1 summarizes the first-year effects, derived from the studies surveyed, on the rate of growth of real output (gross domestic product or gross national product) of a once-for-all change of 10 percentage points in the rate of growth of either money or domestic credit, holding everything else constant.
Short-Run Effect on the Growth Rate of Output of a 10 Percent Change in the Growth of the Money Supply or Domestic Credit
Effect on real GDP or GNP (in percent) over one year.
Simple average of individual country effects.
Cumulated effect over four quarters.
Short-Run Effect on the Growth Rate of Output of a 10 Percent Change in the Growth of the Money Supply or Domestic Credit
| Study | Countries | Policy Variable (Rate of Growth) |
Effect on Growth of Output1 |
|---|---|---|---|
| Aghevli and Khan (1980) | 8 developing countries | Domestic credit | 0.82 |
| Barro (1979) | Brazil, Colombia, and Mexico | Money | 0.92 |
| Blejer and Fernandez (1980) | Mexico | Domestic credit | 0.4 |
| Blejer and Khan (1984) | 24 developing countries | Credit to the private sector | 0.5 |
| Edwards (1983a) | 5 Latin American countries | Money | 1.72 |
| Edwards (1983b) | 9 Latin American countries | Money | 0.82 |
| Edwards (1983b) | 4 Latin American countries | Domestic credit | 1.22 |
| Hanson (1980) | 5 Latin American countries | Money | 1.02 |
| Khan and Knight (1981) | 29 developing countries | Domestic credit | 0.5 |
| Leiderman (1984) | Colombia and Mexico | Money | 0.2 |
| Lipschitz (1984) | Korea | Money | 0.73 |
| van Wijnbergen (1982) | Korea | Money | 4.03 |
Effect on real GDP or GNP (in percent) over one year.
Simple average of individual country effects.
Cumulated effect over four quarters.
Short-Run Effect on the Growth Rate of Output of a 10 Percent Change in the Growth of the Money Supply or Domestic Credit
| Study | Countries | Policy Variable (Rate of Growth) |
Effect on Growth of Output1 |
|---|---|---|---|
| Aghevli and Khan (1980) | 8 developing countries | Domestic credit | 0.82 |
| Barro (1979) | Brazil, Colombia, and Mexico | Money | 0.92 |
| Blejer and Fernandez (1980) | Mexico | Domestic credit | 0.4 |
| Blejer and Khan (1984) | 24 developing countries | Credit to the private sector | 0.5 |
| Edwards (1983a) | 5 Latin American countries | Money | 1.72 |
| Edwards (1983b) | 9 Latin American countries | Money | 0.82 |
| Edwards (1983b) | 4 Latin American countries | Domestic credit | 1.22 |
| Hanson (1980) | 5 Latin American countries | Money | 1.02 |
| Khan and Knight (1981) | 29 developing countries | Domestic credit | 0.5 |
| Leiderman (1984) | Colombia and Mexico | Money | 0.2 |
| Lipschitz (1984) | Korea | Money | 0.73 |
| van Wijnbergen (1982) | Korea | Money | 4.03 |
Effect on real GDP or GNP (in percent) over one year.
Simple average of individual country effects.
Cumulated effect over four quarters.
Most empirical results reported in Table 1 suggest that a monetary contraction does indeed tend to exert a deflationary effect on domestic output in the short run, although in a number of cases the effect appears to be quite small.19 The studies listed in Table 1 indicate that on average a 10 percentage point reduction in the growth of money or domestic credit would reduce the rate of growth of output by less than 1 percentage point over one year.20 This result suggests that even the rule of thumb proposed by Hanson (1980)—that in developing countries a 10 percentage point change in the rate of growth of the money supply would alter output (relative to its longrun trend) in the same direction by about 1 percentage point—seems to be somewhat of an overestimate. By far the largest estimated deflationary effect is found by van Wijnbergen (1982) in a study on Korea.21 Van Wijnbergen’s results, however, are disputed by Lipschitz (1984), who, using a different type of model for the same economy, estimates that the reduction in the growth of output would amount to only 0.5 percentage point. Aside from van Wijnbergen (1982), the quantitative estimates across the various studies are remarkably similar.22 The uniformity and apparent robustness of the results are interesting, given that the studies use quite different models, methods of estimation, sample periods, and geographical coverage.
It is also important to point out that the effects of monetary restraint on growth occur only in the short run. In the studies examined, the largest estimated impact typically takes place in the first year, and growth starts to pick up fairly soon thereafter. Generally, the total effect lasts for about two to three years. Most of the empirical models listed in Table 1 either assume or find that a reduction in monetary growth or domestic credit expansion exerts no long-run effect on the rate of economic growth.23
Since monetary policy is likely to affect growth mainly through its impact on domestic investment, further indirect empirical evidence on the effect of changes in domestic credit on output can be deduced from studies of investment behavior. A consensus has emerged in recent years that, in contrast to the case in industrial countries, one of the principal constraints on investment in developing countries is the availability of financial resources, rather than their cost. Even when adjusted for risk, the rates of return on capital investment in these countries are typically higher than real interest rates on loanable funds, which are often kept artificially low by governments for a variety of reasons. In such cases it would be unusual to find investors undertaking capital formation up to the point where the anticipated marginal product of capital is just equal to its service cost, as is assumed in theoretical models of investment. Indeed, the administrative control of interest rates at low real levels likely results in a chronic excess demand for capital, with some investments with low rates of return perhaps receiving priority over other higher-yielding investments.
In circumstances in which the amount of financing is limited and the price mechanism does not operate smoothly as an allocative device, it is generally more realistic to assume that the flow of private investment in a developing country is constrained mainly by the availability of bank financing. If this is the case, domestic interest rates will influence private investment only indirectly through the effect of an increase in the real return on financial assets in stimulating a larger volume of financial savings by the domestic private sector. Thus, an increase in real credit to the private sector will generally encourage private investment. Although bank loans are relatively short term, borrowers can normally roll them over, thereby effectively lengthening the maturity of the debt sufficiently to correspond to the investment period. Since the control of total bank credit generally represents the main instrument of monetary policy in developing countries, the authorities can influence the rate at which private investors achieve their desired level of investment by varying the flow of domestic credit and its allocation between the public and private sectors.
The results obtained by three recent empirical studies for the estimated effects of variations in domestic credit on real private investment are shown in Table 2.
Effect of Changes in Domestic Credit on Real Private Investment
Change in real private investment (in dollar terms) with respect to a $1.00 change (in real terms) in the policy variable.
Since the dependent variable is defined as the ratio of total real investment to real GDP, this estimate is not strictly comparable to the other two in this table.
Effect of Changes in Domestic Credit on Real Private Investment
| Study | Countries | Policy Variable | Effect on Real Private Investment1 |
|---|---|---|---|
| Blejer and Khan (1984) | 24 developing countries | Credit to the private sector | 0.21 |
| Tun Wai and Wong (1982) | 5 developing countries | Credit to the private sector | 0.36 |
| Fry (1984) | 14 Asian countries | Total domestic credit | 0.072 |
Change in real private investment (in dollar terms) with respect to a $1.00 change (in real terms) in the policy variable.
Since the dependent variable is defined as the ratio of total real investment to real GDP, this estimate is not strictly comparable to the other two in this table.
Effect of Changes in Domestic Credit on Real Private Investment
| Study | Countries | Policy Variable | Effect on Real Private Investment1 |
|---|---|---|---|
| Blejer and Khan (1984) | 24 developing countries | Credit to the private sector | 0.21 |
| Tun Wai and Wong (1982) | 5 developing countries | Credit to the private sector | 0.36 |
| Fry (1984) | 14 Asian countries | Total domestic credit | 0.072 |
Change in real private investment (in dollar terms) with respect to a $1.00 change (in real terms) in the policy variable.
Since the dependent variable is defined as the ratio of total real investment to real GDP, this estimate is not strictly comparable to the other two in this table.
The results in Table 2 confirm the hypothesis that in developing countries credit extended by the banking system can have a sizable impact on real private capital formation. Since considerable evidence now exists on the relationship between growth and investment in developing countries, this result would imply a connection between domestic credit changes and growth through the effect on private investment. Two of the three studies in Table 2, however, that is, Blejer and Khan (1984) and Tun Wai and Wong (1982), use credit to the private sector (in real terms), rather than total domestic credit, as the policy variable. To the extent that Fund programs attempt to ensure an adequate flow of credit to the private sector, the results in Table 2 probably overstate the effects of changes in total domestic credit.
Fiscal Policy
Direct evidence on the relationship between changes in government spending or taxes and economic growth in developing countries is quite scarce, especially when compared with evidence on the links between output and domestic credit discussed above. In standard Keynesian models a reduction in government expenditure or an increase in taxation is expected to have a multiplier effect on the level of real income, at least in the short run. While this proposition is well known, remarkably few studies introduce fiscal variables directly into a growth model for developing countries, and those that have done so have not generally found the effect to be statistically significant.24 The lack of positive results is probably a reflection of the fact that the relation between fiscal variables and the level of output (or the rate of capacity utilization) in developing countries is more complicated than basic Keynesian macroeconomic theory would suggest. Consequently, a more intensive investigation of the relationship between government spending and taxation, savings, investment, and the growth rate seems to be needed.25
The effects of fiscal deficits on growth also turn out to be difficult to establish empirically because of the linkage between fiscal policy and monetary policy, which is generally much tighter in developing countries than in industrial countries. This link occurs because changes in the money supply are, by definition, equal to changes in credit to the government, changes in credit to the private sector, and variations in international reserves. If domestic financial markets are underdeveloped, so that the government has to rely on bank credit for its financing needs, there is a close correspondence between the fiscal deficit and changes in the supply of domestic credit, unless the authorities are prepared to allow the private sector to be crowded out of the credit markets. An awareness of this close linkage between fiscal deficits and money supply changes is crucial to understanding the limitations on the use of monetary and fiscal policies as independent policy instruments in developing countries.26 As such, in models that include the rate of domestic credit expansion or the growth of money, empirical tests tend to suggest that fiscal variables have only a relatively modest independent role.
Other than through the demand side, fiscal policy can influence output through the effects of public sector investment on private investment. In developing countries, in contrast perhaps to industrial countries, the relationship between public and private investment takes on a greater importance because of the larger role played by the government in the overall process of capital formation. There is, however, considerable uncertainty as to whether, on balance, public sector investment raises or lowers private investment. In broad terms, public sector investment can cause crowding out if it uses scarce physical and financial resources that would otherwise be available to the private sector or if it produces marketable output that competes with private output. Furthermore, the financing of public sector investment, whether through taxes, issuance of debt instruments, or inflation, can lower resources available to the private sector and thus depress private investment activity.27
Clearly, public investment to maintain or expand infrastructure and the provision of public goods can also be complementary to private investment. Public investment of this type can enhance the possibilities for private investment, raise the productivity of capital, stimulate private output by increasing the demand for inputs and ancillary services, and augment overall resource availability by expanding aggregate output and savings. Ultimately, the effect of public investment on private investment will depend on the relative strength of these various effects, and there is no a priori reason to believe that they are necessarily substitutes or complements.
Specific evidence on the relationship between public sector investment and private investment is not easy to obtain, owing to the many difficulties, both conceptual and data-related, involved in modeling private investment behavior in developing countries. Nevertheless, a few advances have recently been made in this direction. The studies by Sundararajan and Thakur (1980) and Tun Wai and Wong (1982) derive models of investment behavior in which public sector investment enters as an independent explanatory variable. The results for the effect of public investment on private investment are not conclusive, however, in either of these studies.28 Blejer and Khan obtain somewhat better results when a distinction is made between infrastructural and other types of public investment.29 Using various proxies to represent these two types of public investment, Blejer and Khan draw several conclusions for the countries in their sample. First, a $1.00 increase in real infrastructural public investment would increase real private investment by about $0.25. Second, an equivalent increase in other forms of public investment would reduce real private investment by nearly $0.30. These results are consistent with the hypothesis that infrastructural investment is complementary to private investment, while increases in other types of government investment tend to crowd out the private sector.
The issue of whether a contractionary fiscal policy taking the form of a cut in real public sector investment will reduce or expand private capital formation is certainly far from settled. Although the direction of the effect may be uncertain, it is apparent that, by varying the level and composition of public investment, the government can alter private investment and influence the growth rate of the economy over the longer term. As such, in the course of reducing the fiscal deficit, it would be necessary for the government to weigh carefully the short-term consequences of cuts in current spending against the longer-term effects that would occur if the reductions fell more heavily on investment expenditures.
Policies to Stimulate Supply
Supply-side policies may be described generally under two headings: policies to improve the efficiency of resource allocation and policies to increase the level or rate of growth of capacity output in the economy.30
Improving Resource Allocation
Unlike measures to stimulate savings and investment, policies focusing on improving the efficiency of resource allocation—principally through the elimination of distortions—are designed to increase the overall level of output that can be produced from an economy’s given stock of resources. Nevertheless, attempts to eliminate distortions present a number of practical difficulties. As discussed in Section II, the removal of distortions may initially cause unemployment and in some cases may even reduce welfare. Furthermore, standard second-best considerations suggest that, if a country has a number of distortions, the removal of only some of them will not necessarily result in the desired gain in efficiency.
Generally, the main sources of distortions in prices are monopolies and other forms of imperfect competition, public sector pricing policies and government price controls, various types of taxes and subsidies, and tariffs and quotas. By their nature, distortions tend to be both microeconomic and country specific. Nevertheless, two sources of inefficiency have macroeconomic significance and have gained importance in recent years. First, there are inefficiencies related to energy pricing policies. The increases in world energy prices during the past decade were often accompanied by attempts by country authorities to limit corresponding increases in domestic energy prices. By now, however, it is widely accepted that countries should systematically pass through higher prices of oil and petroleum products to final users; otherwise, the government would have to absorb in the budget the cost of any subsidies. Furthermore, a policy of subsidizing energy tends to slow down the shift to less energy-intensive production techniques and patterns of consumption. Thus, the experience of energy price movements illustrates the adverse effects on resource allocation that can result from failure to set domestic prices at their international opportunity cost.
A second source of inefficiency, particularly in primary producing countries, derives from distortions associated with agricultural pricing policies, which often cause the prices of agricultural commodities to deviate from prices in competitive markets. Such policies have a strong impact on the level and allocation of agricultural production, because they act as a tax on output and exports. It is possible to get an idea of the effect of raising prices on agricultural supply from estimated price elasticities of supply of selected primary commodities. Such estimates have been provided by UNCTAD (1974) and more recently for the sub-Saharan African countries by Bond (1983). These estimates, shown in Table 3, indicate that the price responsiveness of primary commodities is not as small as might have been thought. Indeed, there are some commodities, such as cocoa, coffee, and rubber, where the long-run price elasticity is surprisingly high. By and large, these results suggest that pricing policies to increase the return to producers would tend to stimulate the output of major agricultural commodities, particularly in the longer term.
Estimates of Long-Run Price Elasticities of Supply of Selected Primary Commodities
Median value of estimates reported in Table 2, page 710.
Estimates of Long-Run Price Elasticities of Supply of Selected Primary Commodities
| Commodity | UNCTAD (1974) | Bond (1983) 1 |
|---|---|---|
| Cocoa | 0.20 | 0.79 |
| Coffee | 0.20 | 1.33 |
| Cereals | 0.40 | — |
| Groundnuts | — | 0.52 |
| Palm kernels | 0.30 | 0.25 |
| Palm oil | 0.30 | 0.49 |
| Cotton | 0.40 | 0.50 |
| Sisal | 0.50 | 0.62 |
| Rubber | 0.30 | 0.99 |
| Tobacco | — | 0.65 |
| Timber | 0.50 | — |
Median value of estimates reported in Table 2, page 710.
Estimates of Long-Run Price Elasticities of Supply of Selected Primary Commodities
| Commodity | UNCTAD (1974) | Bond (1983) 1 |
|---|---|---|
| Cocoa | 0.20 | 0.79 |
| Coffee | 0.20 | 1.33 |
| Cereals | 0.40 | — |
| Groundnuts | — | 0.52 |
| Palm kernels | 0.30 | 0.25 |
| Palm oil | 0.30 | 0.49 |
| Cotton | 0.40 | 0.50 |
| Sisal | 0.50 | 0.62 |
| Rubber | 0.30 | 0.99 |
| Tobacco | — | 0.65 |
| Timber | 0.50 | — |
Median value of estimates reported in Table 2, page 710.
Increasing Capacity Output
The rate at which the aggregate potential supply of output can be expanded depends, among other things, on decisions about the proportion of current real output to be invested in productive capital rather than consumed, as well as on the nature and quality of the capital stock being added. Once the decision to increase the economy’s total potential output is taken, the appropriate supply-side policies are those that favor private saving and (if private sector investment is being emphasized) those that increase the attractiveness of private capital formation. Furthermore, when the authorities choose to expand productive capacity within the public sector, it is necessary to ensure that the policies they adopt do not in turn create disincentives that induce a fall in private sector fixed capital formation.
Policies to foster the expansion of savings in programs supported by the Fund focus primarily on increasing the return on savings. A large number of developing countries impose ceilings and other restrictions on the nominal interest rates offered on savings deposits by the banking system. Under inflationary conditions, these ceilings may imply low or negative real interest rates on financial savings. If financial savings are interest sensitive, adjusting interest rates to more realistic levels would clearly be called for; this adjustment would presumably stimulate flows of both domestic and foreign savings. The increase in savings would raise domestic investment and thereby capacity growth. As such, the effectiveness of Fund policies in raising capacity output would depend on (i) the degree of interest sensitivity of savings and (ii) the effect of increased investment on the growth rate.
(i) Effect of interest rate policies on savings
Despite the amount of research expended on the interest responsiveness of savings in general, and in developing countries in particular, it is still uncertain whether an increase in interest rates will, on balance, raise the savings rate.31 Empirical work on savings behavior in developing countries, and particularly on the relation between savings and interest rates, has been handicapped by severe limitations of data. For example, savings data as a rule are calculated as a residual item in developing countries, either by taking the difference between gross national product (GNP) and consumption expenditure, or by subtracting the current account deficit (less net factor income from abroad) from gross domestic investment. In either case, the data on aggregate savings can be subject to substantial measurement errors. Furthermore, as mentioned previously, since nominal interest rates in many developing countries are regulated, they often exhibit little or no variation for extended periods. Suffice it to say that these two factors have made it difficult to employ standard empirical methodology in analyzing this subject.
Recently, however, estimation of the effect of interest rate changes on savings behavior has improved modestly. Essentially this improvement has been the consequence of researchers focusing their attention on the response of real savings to variations in real rather than nominal interest rates. From a theoretical perspective, this is clearly a more sensible approach and has in addition the practical advantage that, while nominal interest rates may be relatively constant over time, real interest rates fluctuate widely as inflation rates vary. Fry (1980,1984), for example, finds that savings rates in a number of Asian countries are positively related to real interest rates. The most recent estimates (Fry (1984)) show that for a pooled sample of 14 Asian countries the coefficient measuring the effect of the real interest rate on savings deposits was between 0.05 and 0.08, depending on the specific model in question. This would imply that a 10 percent increase in the real interest rate would, other things being equal, raise the ratio of savings to gross national product by a little less than 1 percent. These results for Asian countries are supported by McDonald (1983), who found that real interest rates played a significant role in the determination of real savings in 12 Latin American countries. The average short-run elasticity of savings with respect to real interest rates was about 0.2, and the corresponding long-run elasticity was of the order of 0.3.32 While the dispute on the interest responsiveness of savings is far from being settled,33 these recent studies lend a certain amount of support to the hypothesis that savers in developing countries are likely to modify their behavior as the (real) rate of return on savings changes.
Aside from the issue of the responsiveness of domestic savings, some observers have expressed doubt that the flow of savings from the rest of the world will exhibit significant interest elasticity. Appropriate exchange rate and interest rate policies in the context of a comprehensive stabilization program can influence capital inflows by creating a climate of confidence in the economy. The resulting increase in foreign savings, whether through capital inflows or remittances, can be far in excess of what would be implied by estimated interest rate elasticities. Such evidence as is available suggests that a financial reform involving the removal of ceilings on domestic interest rates can indeed have a strong effect on the capital account of the balance of payments. For example, the relaxation of interest rate ceilings in Argentina, Chile, Korea, and Uruguay was followed by such large capital inflows that the authorities experienced considerable difficulty in maintaining stability in the growth of domestic liquidity.34 This phenomenon of excessive inflow of capital, however, represents more a case for exercising caution in undertaking a financial reform than an argument against the basic policy.
In summary, while it is evident from the empirical studies reviewed here that the direct response of domestic private savings to variations in real interest rates is weak, this does not imply that policies to raise interest rates to their market-clearing levels are irrelevant. Even if increases in real interest rates have no immediate large impact on private savings, they still represent an important aspect of adjustment policies for at least three reasons. First, such a policy discourages domestic investment projects that will not yield an adequate rate of return over the longer run. Second, other things being equal, raising domestic real interest rates tends to increase the supply of foreign savings, and thus total savings could in fact rise. Third, eliminating distortions imposed by interest rate ceilings tends to increase the flow of savings intermediated through the domestic financial system, and this improves the overall efficiency of the savings-investment process.
(ii) Investment and growth
Policies designed to raise the long-run rate of growth of per capita output in the economy must necessarily involve measures to increase the rate of capital formation.35 Assuming that such measures are implemented and are successful in raising investment, what would be their impact on growth? This question can be addressed by formulating a growth model in which the rate of growth of output is related to increases in the various factors of production—such as the capital stock (of both domestic and foreign origin) and the labor force, as well as technical progress and the use of imported inputs—and then estimating the resulting model with either time-series or cross-section data. The expected positive relation between economic growth and investment in developing countries has been documented in a number of studies. Some of the empirical evidence on the elasticity of output growth with respect to capital formation and growth of the labor force is shown in Table 4.
Estimates of the Effects of Increases in Factors of Production on the Growth of Real GDP
Defined as the ratio of investment to GDP.
Rate of growth.
Estimates of the Effects of Increases in Factors of Production on the Growth of Real GDP
| Elasticity of Growth with Respect to Changes in: |
||
|---|---|---|
| Study | Capital1 | Labor2 |
| Robinson (1971) | 0.17 | 0.54 |
| Michalopoulos and Jay (1973) | 0.24 (domestic) | 0.60 |
| 0.12 (foreign) | … | |
| Balassa (1978) | 0.16 (domestic) | 0.92 |
| 0.24 (foreign) | … | |
| Tyler (1981) | 0.25 | 0.98 |
| Blejer and Khan (1984) | 0.18 | 0.58 |
Defined as the ratio of investment to GDP.
Rate of growth.
Estimates of the Effects of Increases in Factors of Production on the Growth of Real GDP
| Elasticity of Growth with Respect to Changes in: |
||
|---|---|---|
| Study | Capital1 | Labor2 |
| Robinson (1971) | 0.17 | 0.54 |
| Michalopoulos and Jay (1973) | 0.24 (domestic) | 0.60 |
| 0.12 (foreign) | … | |
| Balassa (1978) | 0.16 (domestic) | 0.92 |
| 0.24 (foreign) | … | |
| Tyler (1981) | 0.25 | 0.98 |
| Blejer and Khan (1984) | 0.18 | 0.58 |
Defined as the ratio of investment to GDP.
Rate of growth.
The estimated effects of a change in the ratio of investment to GDP or GNP on the rate of growth of real output are quite similar across studies, despite differences in the samples and periods of estimation. On average, the estimates in Table 4 are consistent with the view that a 1 percent increase in the ratio of investment to income would, other things being equal, raise the overall growth rate by about 0.2 percentage point.36
Exchange Rate Policies
It is worthwhile for several reasons to devote separate consideration to the use of the exchange rate as a stabilization tool. First, as discussed in Section II, imbalances that require stabilization frequently result from the loss of international competitiveness caused by an overvalued exchange rate. Second, since it is simultaneously an expenditure-switching and expenditure-reducing policy, devaluation affects both domestic absorption and domestic supply, and thus contains elements of both demand-side and supply-side policies. Finally, it is probably fair to say that, of all policy measures recommended by the Fund, devaluation has provoked the most criticism. One extreme criticism is that devaluation not only fails to improve the current account of the balance of payments, but also induces stagflation in the process. Even if such a policy is effective in changing trade flows, it is still regarded as too costly in comparison with alternative policies to improve the balance of payments (Taylor 1981).
The discussion on exchange rate policies here concerns itself solely with whether devaluation has a contractionary effect on output in the short run. No attempt is made to assess either the effectiveness of devaluation in correcting external imbalances or the inflationary consequences of the policy. Although important, both these factors are not directly related to the growth issue addressed here.37 Furthermore, in the studies reviewed, the policy of devaluation is basically considered in isolation. Since devaluation is seldom, if ever, undertaken on its own, but is usually accompanied by a number of other policies, the measured effects obtained from various studies are at best only suggestive of orders of magnitude.
The basic demand- and supply-side aspects of devaluation have been extensively discussed in the literature.38 Consider, for example, a situation in which excess real domestic demand is reflected in a current account deficit. A devaluation increases the level of foreign prices measured in domestic currency and thus the price of tradable goods relative to nontraded goods in the domestic economy. On the demand side, the effect of a devaluation on domestic absorption is unambiguously negative: the main demand-side effects are a reduction in private sector real wealth and expenditure, owing to the impact of the rise in the overall price level on the real value of private sector financial assets, and on real wages and other factor incomes whose nominal values do not rise proportionately with the devaluation. For these reasons, devaluation decreases domestic demand and, looked at from the point of view of current absorption, appears to be contractionary.
On the supply side, however, the effects of the devaluation frequently tend to move the productive sector in the opposite direction. If the prices of domestic factors of production rise less than proportionately to the domestic-currency price of final output in the short run, devaluation will have a stimulative impact on aggregate supply.39 Thus both the aggregate demand and aggregate supply effects of a devaluation work toward reducing the excess demand in the economy and the current account deficit. Whether total output rises or falls during this process obviously depends on whether the contractionary effects on aggregate domestic demand are outweighed by the supply-stimulating aspects of this policy. This depends, among other things, on the relative sizes of the price elasticities of imports and exports and on the relative shares of tradable and nontradable goods in total production. In general, output will decline if the trade elasticities are small and the structure of production is weighted more toward tradables than toward non-tradables.40
The arguments put forward to support the view that devaluation exerts an overall adverse effect on growth tend to rely on special assumptions that may be important in particular developing countries but have been found not to be applicable in all cases. For example, Diaz-Alejandro (1965) assumes that devaluation redistributes income to groups with a relatively low marginal propensity to consume and that the consequent reduction in aggregate domestic demand has a depressing effect on domestic supply, which more than offsets the increase in the country’s exports. Other writers postulate that the aggregate supply function is backward bending in the short run, either because distortions in the domestic credit market cause a credit crunch or because there is overindexation and nominal wages rise more than proportionately to the change in the exchange rate. As argued by Krugman and Taylor (1978), devaluation can also increase the domestic-currency price of imported inputs, and if the demand for them is inelastic, total production would decline. Finally, Cooper (1971), Dornbusch (1981), and Hanson (1983) have shown that, as a general rule, devaluation will be contractionary if the elasticities of import demand and export supply are low or if the initial trade deficit is large.41
Keeping in mind these possibilities, however, it would normally be expected that, as long as devaluation succeeds in altering the real exchange rate by raising product prices in domestic currency relative to factor incomes, it should exert a stimulative effect to the extent that the short-run marginal cost curves of the relevant industries are upward sloping. Naturally, the longer a real exchange rate change persists, the larger are the gains to be achieved. In addition, if the wealth and distributional effects of devaluation stimulate savings and investment, a long-run gain of increased potential output will also be realized.
In general, whether a devaluation exerts a net expansionary or contractionary effect on domestic output and employment depends on the relative strengths of the effect on demand and supply described above and on the time period in question. In the short run the demand factors may outweigh the supply factors, but this may be reversed in the medium and long term. Clearly, these issues are relevant to the use of exchange rate policies in adjustment programs, and two types of empirical evidence can be brought to bear on the question. First, one can simply ascertain whether the price elasticities of imports and exports are in fact as low as some of the writers referred to above assume. The empirical estimates reported by Khan (1974, Tables 1 and 2), for example, indicate that the Marshall-Lerner conditions for devaluation to be successful in improving the trade balance were satisfied in 13 of the 15 developing countries included in his sample. This evidence at least contradicts the presumption that developing countries are necessarily characterized by low trade elasticities.
Second, certain studies look directly at this issue within the framework of models that explicitly take into account both the demand and supply effects of devaluation. In Table 5, a representative set of these models is used to show the results of a 10 percent devaluation on the rate of growth of output in the first year. The dispersion of the estimates depends primarily on the underlying values of the supply-price elasticities, and generally the results reported in Table 5 indicate that the relative-price, or supply, effects outweigh the negative demand-side effects. As a result, output growth would be higher after a devaluation rather than lower.
Effects of a 10 Percent Devaluation on the Growth of Real GDP1
Over a period of one year.
In percent.
Depending on the degree of wage indexation: the lower value corresponds to zero indexation and the higher value to full indexation.
Corresponding to assumed low and high export price elasticities, respectively.
Effects of a 10 Percent Devaluation on the Growth of Real GDP1
| Study | Country | Effects on Growth of Real GDP2 |
|---|---|---|
| Gylfason and Schmid (1982) | Brazil | –0.5 |
| India | 1.1 | |
| Pakistan | 4.2 | |
| Philippines | 4.5 | |
| Turkey | 3.4 | |
| Nugent and Glezakos (1982) | 16 Latin American countries | 0.4 |
| Khan and Knight (1982) | 29 developing countries | –0.5 |
| Branson (1985) | Kenya | –0.9 to –1.43 |
| Taylor and Rosensweig (1984) | Thailand | 1.0 to 3.34 |
Over a period of one year.
In percent.
Depending on the degree of wage indexation: the lower value corresponds to zero indexation and the higher value to full indexation.
Corresponding to assumed low and high export price elasticities, respectively.
Effects of a 10 Percent Devaluation on the Growth of Real GDP1
| Study | Country | Effects on Growth of Real GDP2 |
|---|---|---|
| Gylfason and Schmid (1982) | Brazil | –0.5 |
| India | 1.1 | |
| Pakistan | 4.2 | |
| Philippines | 4.5 | |
| Turkey | 3.4 | |
| Nugent and Glezakos (1982) | 16 Latin American countries | 0.4 |
| Khan and Knight (1982) | 29 developing countries | –0.5 |
| Branson (1985) | Kenya | –0.9 to –1.43 |
| Taylor and Rosensweig (1984) | Thailand | 1.0 to 3.34 |
Over a period of one year.
In percent.
Depending on the degree of wage indexation: the lower value corresponds to zero indexation and the higher value to full indexation.
Corresponding to assumed low and high export price elasticities, respectively.
The main conclusion that follows from this analysis is that the direction and magnitude of the growth effects of exchange rate changes depend crucially on such issues as the extent and duration of the real exchange rate change, the structure of production, and the responses of trade flows to relative price changes. To the extent that devaluation affects the sectoral distribution of income, it may not be completely costless to some sectors. On the other hand, no strong empirical evidence supported the proposition that devaluation necessarily reduces the growth of real output even in the short term.
If devaluation is precluded as a policy measure on the grounds of potential output costs, it is valid to ask what alternatives could be used to restore the international competitiveness of the economy and improve the external payments position. One obvious possibility is to compensate with other policies in the package, and if the period of adjustment is limited, this may involve tighter demand management than would be necessary if devaluation is a feasible option. A second possibility, proposed by certain critics of the policy of devaluation in developing countries, would be to impose some type of controls on imports and provide subsidies to exports. As mentioned previously, controls can be successful in the short run in certain circumstances, but there is substantial evidence now that countries that have adopted outward-looking development strategies have experienced more satisfactory economic growth, employment, and economic efficiency.42 These outward-oriented strategies have typically been characterized by the provision of incentives for export production, the encouragement of import competition for domestically produced goods, and the use of the exchange rate and related policies to maintain the real exchange rate at a level consistent with the objectives of external balance and export promotion. Therefore, the use of controls to achieve balance of payments objectives appears much less attractive once account is taken of the probable longer-term effects on growth and efficiency.