Accounting Framework and Use of Models

An integrated system of accounts covering national income and expenditure, as well as financial flows and associated stocks, lies at the heart of the macroeconomic appraisal and analysis of the economic performance of any economy. For countries that have sophisticated statistical systems, such accounts include timely and detailed data on national income and expenditure, the current and capital accounts of the balance of payments, and the accounts of the central bank, the banking system, and the government. For certain recorded flows, estimates of real flows and associated price indicators are available. For countries with less fully developed statistical coverage the record may have important gaps and become available with substantial delays.

The economic accounts serve several purposes in the process of designing an adjustment program. First, they give to the programmer raw material required for arriving at an assessment of the state of the economy and the need for an adjustment of policy. Second, they provide the framework for the model of macroeconomic performance that gives the logical structure to any macroeconomic program.⁹ Finally, the accounts provide consistency checks for forecasts and policy packages.

For purposes of financial programming it is useful to divide an economy into sectors and record the transactions taking place among them. The four sectors usually distinguished are the private nonfinancial sector, the government sector, the banking sector, and the foreign sector.¹⁰ The foreign sector embraces all transactions of nonresidents with residents, and the consolidated accounts of this sector thus become an abbreviated balance of payments account.

For each sector the transactions between its members and those of other sectors can be divided into two categories: transactions arising in the course of producing or acquiring goods and services, and financial transactions. Since the two sets of accounts contain all incoming and outgoing transactions, the balance of all transactions for each sector is necessarily equal to zero, and the balance of income/expenditure transactions—which can be thought of as the saving (or dissaving) of that sector—is thus equal and of opposite sign to the balance of financial transactions. Indeed, the complete framework of income and flow-of-funds accounts, which has been summarized elsewhere¹¹ and thus need not be articulated in this paper, shows numerous equivalence relationships, or “identities,” among the magnitudes recorded in the accounts. These accounting relationships highlight the facts that any sector’s spending beyond its income must be financed by the savings of other sectors, and that such excess spending by an entire economy is possible only when it is financed by net saving of residents of the rest of the world (recorded in the foreign sector account).

These and other identities can be useful in gauging tendencies in an economy and in assessing the effects of policy changes. For an adequate quantitative understanding of economic processes and the operation of policies they must, however, be complemented by relations that indicate the typical reaction or response of some of the variables included in the accounting framework to changes in other variables. These “behavioral relationships” can be combined with the identities derived from the accounting framework to form a schematic quantitative representation, or “model,” of economic processes involving the accounts, or “variables,” that form the accounting system in question. Economic models can provide the quantitative framework required for forecasting and policy analysis. They can be used in two distinct modes: first, by assessing the consequences of foreseen or assumed changes in “exogenous” variables, which are determined independently of the processes illustrated in the model, for the magnitudes of “endogenous variables,” which are determined within the model; and second, by determining the changes in policy variables (“instruments”) needed to achieve desired changes in some of the endogenous variables considered to be “objectives” of economic policy. Financial programming involves the use of models in this second mode. It determines the appropriate setting of policy instruments in the light of the underlying economic situation and the desired outcome.

General Macroeconomic Framework for Fund-Supported Programs

The type of macroeconomic analysis that characterizes the financial programming exercise underlying Fund-supported adjustment programs is motivated by the general approach to the use of Fund resources found in the relevant provisions of the Articles of Agreement. Under Article V, Section 3(a), the Fund is called upon to adopt policies on the use of its general resources that will assist members to deal with their balance of payments problems “in a manner consistent with the provisions” of the Articles and “will establish adequate safeguards for the temporary use” of those resources. The first of these provisions refers, inter alia, to the purposes of the Fund, which are laid down in Article I; these include facilitating the expansion of international trade, promoting exchange stability, eliminating exchange restrictions, and maintaining orderly exchange arrangements among members. Article I refers to the use of Fund resources as follows:

• (v) To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.

It further enjoins the Fund “to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members” (Article I(vi)). Finally, the “provisions of the Fund” referred to in Article V, Section 3(a) clearly include the obligations of members with regard to avoidance of restrictions on current payments and discriminatory currency practices, as provided for in Article VIII, Sections 2 and 3, and Article XIV, Section 2.

The Fund has a mandate to ensure that the use of its resources by a member is linked to a policy program that leads within a reasonable time to a viable payments position, permitting scheduled repayment of the resources advanced by the Fund. More broadly, the Fund must have regard to the prospects that a member’s policies, if sustained beyond the program period, lead to an orderly long-term evolution of the member’s external indebtedness. The objectives must be achieved, however, without either damaging the member’s national prosperity or increasing the restrictiveness of international trade and payments. This specification of institutional purposes and associated obligations was clearly motivated by the experience of the 1930s, when countries attempted to deal with unsustainable payments imbalances by “beggar-my-neighbor” policies—trade and exchange restrictions and competitive depreciation of their currencies—which contributed to the high unemployment rates of that period. The experience of that era also shows that equilibrium in the balance of payments maintained by means of low levels of output and expenditure is in fact a suppressed disequilibrium. Use of the Fund’s general resources is therefore justified to support not only programs designed to correct overt payments imbalances but also, even where no initial imbalances exist, programs of economic recovery or structural adjustment that in the first stages may generate temporary external disequilibria.

Based on this general mandate, the analytical framework underlying Fund-supported programs, while focused on the balance of payments and its various components, is also concerned with overall macroeconomic developments. Indeed, the justification for offering the use of the Fund’s resources is not to prolong an external deficit by helping to finance it but to avoid unduly harsh measures that might have to be used by the member in the absence of financial support and that could be destructive of the member’s prosperity as well as of that of its trading partners.

In considering the framework used in the Fund to analyze adjustment programs, it may be useful to distinguish between a balance of payments disequilibrium that is reversible within a period of one to two years and a disequilibrium involving such serious structural impediments to growth or such a large accumulated external debt that the strategy for returning to equilibrium can only be framed over a considerably longer period. The two cases differ principally in respect of the emphasis placed in a Fund-supported program on measures aimed at the growth or utilization of productive capacity. In a program for a country with the more serious type of disequilibrium, the growth of exports and output typically becomes a crucial element in the strategy for achieving balance of payments viability.

In the short term, the analysis underlying the formulation of Fund-supported programs assumes productive capacity to be fixed, although not necessarily fully utilized. Output (and thus income)¹² could, therefore, change within the limits set by the existing productive potential. Residents’ expenditure on domestic and foreign goods and services—the sum of private consumption, domestic investment, and government expenditure, which is often called “absorption”—could either exceed or fall short of domestic income. The difference between the value of domestic production (Y)—which is equal to income—and absorption (A) is the balance of trade in goods and services, which is sometimes loosely referred to as the current account balance (CA):¹³

The current account shows a surplus if income exceeds absorption and a deficit in the reverse case. This information illustrates the important principle that a current account deficit can be reduced by a decline in absorption (relative to income) or by an increase in income (relative to absorption). The analysis of macroeconomic policy in an open economy on the basis of this relationship is referred to as the “absorption approach.”¹⁴

The desired current account balance is, of course, not likely to be zero. Foreign residents (including foreign governments) may more or less regularly make investments in and transfers to the economy in question, and domestic residents may in turn make investments and transfers abroad. The net balance of these transfers and capital transactions is itself affected by changes in the domestic economy and in the rest of the world—in particular, by the policies of the member and those pursued abroad. Ordinarily, however, there is an underlying tendency toward a net balance on account of transfers and capital flows that differs significantly from zero and marks the country as either a net recipient or a net provider of investments, loans, donations, and other transfers. An important determinant of these flows is the judgments of creditors and debtors as to what constitutes a sustainable level of external indebtedness for the country. Balance of payments adjustment refers primarily to the process by which the current account balance is made to conform to sustainable long-term capital flows and unrequited transfers;¹⁵ it refers as well to the restoration of capital inflows, or the stemming of outflows, where a loss of confidence has reduced net inflows below a sustainable level.

Adjustment programs for which Fund support is requested typically involve the problem of reducing a current account deficit to fit a sustainable net inflow of capital and may also be aimed at restoring a sustainable net capital inflow. In directing economic policy to this adjustment objective, the authorities are faced not so much with a target outcome that ought to be precisely achieved if possible, but with a more or less binding constraint that it may not be easy to violate for long periods and by large margins. Additional financing (including Fund support) can often be obtained, at any rate in the short and medium term, to permit the temporary acquisition of additional foreign resources. In the long run, however, the resource use of an economy must be constrained to the sum of residents’ resources retained domestically and those willingly made available for indefinite periods by the collectivity of foreign residents. Any short-run excess use of resources must in general be eventually reversed, either by restoring reserves previously drawn down or by repaying short-term foreign indebtedness.

The way in which the balance of payments acts as a constraint to resource use in the economy can be illustrated by an extension of equation (1). First, note should be taken of the balance of payments identity

where ΔR is the change in net foreign assets of the banking system (including net international reserves of the monetary authorities) and ΔFI is the change in net foreign indebtedness of nonbank residents. Combining equations (1) and (2), one obtains

which shows that an excess of absorption over income not financed entirely by foreign borrowing leads to a running down of net foreign assets. Since the stock of such assets is limited, there is clearly a limit to the extent to which absorption can be financed in this manner. For some countries, this loss in net reserves may take the form of accumulating arrears. What equation (3) also shows is that a balance of payments deficit leads to a decline in the overall liquid balances of residents; this result plays an important role in the financial programming framework described in Section III.

It follows from the definition of the current account balance as the difference between income and absorption (equation (1)) that a desired reduction in a current account deficit can be achieved through some combination of increasing output and reducing absorption. To be sure, there may be induced secondary effects on absorption resulting from an increase in output and income, and on output resulting from a fall in absorption. It can be shown, however, that under reasonable assumptions these further effects are always less than the initial change that has induced them.

It is generally easier to reduce absorption than to increase production. For this reason, policies affecting absorption are often first put in place when a rapid decline in a current account deficit is mandatory. In many instances, the source of excessive domestic demand is the government sector, or more broadly the public sector,¹⁶ and a combination of a reduction in public sector outlays and an increase in revenues appears the most direct way of reducing domestic demand; similarly, private consumption and investment can be reduced by raising taxes. Alternatively, demand-management policies may be pursued by influencing the monetary aggregates underlying both domestic demand and the balance of payments—for example, by measures to change the volume of credit extended to the private sector. (Alterations in net financial flows between the government and the banking sector can, of course, only be accomplished through changes of government expenditure and revenues.) The financial programming model described in Section III analyzes changes in the relevant monetary aggregates associated with expenditure-reducing policies.

Demand-management policies directly affect absorption and thereby “internal balance,” which refers to the conformity between aggregate expenditure (equal to absorption plus exports minus imports) and potential output at stable prices. Since output of domestic goods and services is by definition equal to the aggregate expenditure by domestic and foreign residents on these goods and services, a change in the latter necessarily produces a corresponding change in the former. If aggregate expenditure exceeded the productive capacity of an economy at the existing price level, the result would be a rise in prices that would continue until the excess demand was eliminated (for instance, by a fall in the real value of financial assets). If aggregate expenditure fell short of productive capacity, prices could conceivably fall if they were flexible downward; the more likely immediate outcome would, however, be a fall in employment of labor and other resources without much of a decline in prices.

In general, external balance and internal balance cannot be simultaneously achieved without employing at least two separate policy instruments, one acting to reduce domestic expenditure and the other to change the composition of foreign and domestic expenditure between foreign and domestic goods.¹⁷ For example, if absorption exceeded output while aggregate expenditure on domestic goods and services exceeded potential output at existing prices, policies restraining aggregate demand could alleviate both the external deficit and the inflationary pressure resulting from the internal disequilibrium. But the demand restraint would only by coincidence lead to simultaneous achievement of external and internal balance. If internal balance were restored while an external deficit still existed, further restraint of demand to achieve external balance would bring about underutilization of productive resources. What is needed in such a situation is a policy that can increase the global demand for domestic goods and services without at the same time raising the domestic absorption of all (domestic and foreign) goods and services. This result can be achieved through “expenditure-switching” policies—for instance, exchange rate adjustments—designed to change the relative prices of foreign and domestic goods facing both residents and nonresidents.

Expenditure-switching policies, in conjunction with expenditure-reducing policies, can reduce a current account deficit not only by diverting residents’ and nonresidents’ expenditures from foreign to domestic goods, but also by causing a shift of resources between different types of domestic goods and services produced. Specifically, a devaluation of the exchange rate entails a rise in incentives to produce goods for export or competing with imports and a fall in incentives to produce goods that are not currently or potentially traded across borders. The dichotomy between “nontradable” and “tradable” goods has become a principal analytical tool for analyzing devaluation and other expenditure-switching policies;¹⁸ this analytical approach is further discussed in Section IV.

The basic structure of the framework just described suggests why Fund-supported programs have normally combined measures to reduce (or control the rise in) domestic aggregate demand with policies that improve incentives to export and discourage imports. Expenditure-switching policies cover a wide range of measures, including in the first instance exchange rate policies and other measures (such as liberalization of price controls and of quantitative trade restrictions) to correct price distortions that favor foreign over domestic goods. In many instances, however, governments will attempt to accomplish the same aims by intensifying import and foreign exchange restrictions, or by changes in the structure of government taxes and subsidies. (All the policies mentioned may also have effects on absorption itself.) In countries where output is below its potential because of inefficient resource allocation, policies designed to switch expenditures on the demand side can also have the effect of increasing output by improving its composition on the supply side. They may therefore have welcome growth-supporting effects. The unquestioned difficulty of devising and implementing successful growth-oriented adjustment programs derives, however, from the fact that expenditure-switching policies often involve greater structural changes, appear less certain in their effect (because of limited information and second-best considerations), and may take longer both to implement and to achieve desired results than expenditure-reducing policies. Furthermore, while expenditure-reducing policies are unlikely to be entirely neutral in their effect on income distribution, the distributive effects of expenditure-switching policies are more visible and tend to entail greater political difficulties,¹⁹ causing governments to hesitate in their implementation. When governments are slow to put such growth-oriented measures into effect, and when there are sizable lags between implementation and results,²⁰ all the more burden is placed on expenditure-reducing policies to eliminate an external deficit, especially in the initial stages of an adjustment program.

Among alternative measures to induce expenditure switching, exchange rate adjustments are preferable, because other means, such as import restrictions or tax or subsidy schemes, tend to be discriminatory in their impact on different types of imports and exports and hence result in inefficient patterns of resource use (see Section IV). While the emphasis on the efficient use of existing capacity has become more prominent in adjustment programs in recent years, with considerable attention being paid to supply-side policies (see Section IV), it has never been absent from the thinking underlying Fund-supported programs. The elimination of barriers to international trade and support for a multilateral payments system were explicitly included in the purposes of the Fund precisely because the authors of the Articles of Agreement believed that a trade-promoting institutional framework contributed to global prosperity.

A member may encounter a disequilibrium in its balance of payments that is so serious that its elimination cannot be carried out in the short run, along the lines just sketched, in a manner consistent with the maintenance of its national prosperity. Since the debt crisis of 1982, such cases have multiplied. In such instances, it may not be possible to provide adequate safeguards for the temporary use of Fund resources merely on the basis of a program spanning one or two years without incurring unacceptably large reductions in domestic expenditure, because the economy’s debt service burden has grown far out of proportion to its export earnings. Rather, it is necessary under these circumstances to pursue a medium-term strategy at whose core is the growth of the economy’s debt-servicing capacity, while at the same time keeping domestic expenditure and the balance of payments under strict control and attempting to restructure external obligations to private and public creditors so as to provide the “breathing space” required to carry out the necessary adjustments. The role of external debt management in adjustment programs is discussed in more detail in Section IV.

The analysis presented earlier in this section, which showed the need for output to increase more than absorption in order to reduce a balance of payments deficit, is applicable also in the context of medium-term growth. To sustain an improvement in a country’s external position, growth in expenditure cannot, in general, be allowed to exceed the growth in output. It is sometimes suggested that in heavily indebted countries, where growth has been slow in recent years because of contractions in domestic expenditure and unfavorable external conditions—or, for that matter, simply because of severe structural problems—economic recovery could be led by government expenditure. But as the earlier analysis has made clear, such a policy, unless accompanied by expenditure-switching measures, will lead to a renewed slide into large external payments deficits. It is true that this analysis abstracts from capital movements and that a sustainable amount of net external borrowing can make it possible for a while to maintain a higher rate of growth of absorption than output, and may indeed be necessary to achieve a desired rate of output growth. Nevertheless, if the rate of growth of output is not adequate, and growth not adequately outward oriented, it will in the long run not be possible to service the external debt without reducing absorption and, inevitably, the economic well-being of the population. Economic growth and external equilibrium are therefore complementary and mutually supporting objectives of economic policy.

As is explained in Section IV, the analysis of “supply-side” policies is complicated by the fact that they have two distinct types of effect. One is to increase output from existing productive capacity, for which there is substantial scope in a typical developing country. This end may be met by such measures as liberalizing previously controlled consumer prices or previously restricted imports and foreign exchange transactions, maintaining realistic exchange rates and interest rates, permitting the allocation of credit to be carried out through competition for funds rather than through bureaucratic processes, and raising artificially depressed agricultural producer prices.

The second is to increase the rate of growth of productive capacity itself. This is accomplished not only by policies to increase domestic saving and investment—such as maintaining realistic interest rates, reducing fiscal deficits, and reallocating fiscal expenditures toward activities with the strongest benefits for growth and economic development—but also by policies that tend to guide new resources to investments with the highest rates of return. In fact, these latter policies are closely related to those for inducing efficient utilization of existing capacity.

Finally, in formulating growth-oriented policies in a medium-term framework for heavily indebted countries, it is important to note that aiming at a more rapid growth rate of output does not imply indifference to the composition of that output. Unless the new productive capacity enables the country to increase exports at a rate not less than that at which output itself is growing, and also to avoid acceleration in the growth of imports, external payments difficulties are eventually bound to reappear.

Choice of Economic Objectives and Policy Instruments

It has already been suggested above that not all Fund-supported adjustment programs emphasize the same principal objectives. Some variation in this respect is not at all surprising in view of the diversity of member countries in their social, political, and institutional characteristics. All the same, it is possible to discern a set of “core objectives” of Fund-supported programs. Most notable among these core objectives are the achievement of external and internal balance and of adequate economic growth. The question arises of how these objectives relate to each other and to other policy objectives that may be pursued by the authorities.

Governments pursue a wide variety of policy objectives that may at times conflict. One well-known analysis classifies three functions of government from an economic standpoint: in addition to the stabilization function, which is discussed at length in this paper, there are the functions of allocation and distribution.²¹ Allocation includes, inter alia, many noneconomic functions of the government, such as defense and justice. Even these noneconomic functions, however, require budget expenditures and therefore play at least an indirect role in economic decision making (e.g., regarding the size of the budget), which impinges upon stabilization policy. There are, of course, many specific objectives that are clearly economic in nature. In a developing country, some of these objectives are often regarded as crucial for the process of economic development: among these are some typical government functions, such as provision of education, health facilities, sanitation, roads and bridges, and agricultural extension services, as well as special programs to assist particular sectors or groups in the economy that are deemed to be especially in need of government assistance to raise their income and productivity. Attempts to extend such assistance have often led to establishment of complicated systems of taxes, tax preferences, subsidies, licenses, price controls, selective credit and interest rate regulations, and other measures. While many of these measures may be justified on developmental grounds, some are principally of a distributive nature—for instance, the distribution of free or subsidized basic food products.

In balancing competing objectives, a government—and the Fund—may be faced with a variety of conflicts among them. Pursuit of allocational and distributional objectives may impede the adoption of measures required to correct a balance of payments disequilibrium and liberalize the system of trade and payments. For example, required cuts in fiscal expenditure may be omitted because the government is unwilling to cut back on budget items reflecting its priorities in the areas of allocation and distribution; or it may be unwilling to eliminate an import and exchange licensing system that is designed to channel foreign exchange to preferred activities.

The problem of conflicting objectives is not entirely caused by the inclusion of distributional and noneconomic goals. For instance, it is not always clear whether price stability—or, at any rate, a low rate of inflation—is implied by, or is a necessary condition for, the achievement of external balance and adequate economic growth. First, price stability would appear to be implicit in a financial program for bringing aggregate expenditure into line with aggregate output. Nevertheless, in some circumstances the inflationary process seems to take on a life of its own, even after an initial excess of aggregate expenditure has been eliminated. It is difficult, even with a policy package including monetary reform, to eliminate such “inertial inflation” without a protracted period of economic contraction. Second, there are strong reasons for supposing that a chronic environment of high inflation eventually discourages saving and productive investment, in part because of the high variability of relative prices associated with high rates of inflation.²² While in principle the negative impact of inflation on resource allocation can be reduced by a system of indexing prices (including wages, interest rates, and exchange rates), in practice such indexation can itself fuel an inflationary process. Third, a sharp improvement in the current account may in some circumstances lead to inflationary pressures that are difficult to counteract through other policies, in part because of wage rigidities in lagging sectors. Finally, achieving policy objectives may have an initial inflationary impact: for example, when elimination of price controls produces a once-forall increase in prices of the previously controlled items, or when a larger-than-targeted positive turnabout in the balance of payments produces an inflow of foreign exchange in an economy where tariffs and other import barriers place a substantial wedge between foreign and domestic prices.

Targets set for some objectives may be open-ended, that is, they are regarded as floors or ceilings rather than as point targets, since there is no apparent harm in overperformance.²³ Overperformance of a balance of payments target by a heavily indebted country, or of an inflation or output target by any country, should ordinarily be welcome developments. Nevertheless, such overperformance could have adverse effects. For example, a less-than-full utilization of the room for maneuver allowed within the balance of payments constraint may sacrifice output gains that could otherwise have been realized. Again, greater-than-targeted output growth, if not oriented toward exports or substitutes for imports, may impede achievement of an inflation target or result in violation of the balance of payments constraint. Once an achievable set of targets has been determined, it may be best to aim at avoiding overperformance of individual objectives, as there may be trade-offs among objectives. If, however, it becomes clear that several objectives could be overperformed, it might be best to redesign the program.

An important part of the overall program design—perhaps the most difficult part—lies in the derivation of intermediate targets from ultimate objectives, which may be difficult to relate directly to available policy instruments. In the underlying model or analytical framework, intermediate targets link the ultimate objectives and the policy instruments. In some instances, the policy instruments are themselves regarded as targets, and the ultimate objectives are not made explicit at all but are implied in the targeted values for the instruments. This procedure has the disadvantage of not specifying the policy problem for which the program seeks a solution and therefore of making more difficult an assessment of the success or failure of the program.²⁴

The choice of ultimate objectives, intermediate objectives, and policy instruments may be constrained by long-standing economic institutions that represent a past or prevailing political consensus. For example, some countries are members of a currency union or use a fixed exchange rate as the keystone to their economic policies. This sort of arrangement constrains the framework of policies and the available policy instruments in comparison with a country that has a floating, or at least partially flexible, exchange regime. This issue is addressed in Section IV.

A further factor influencing the availability of different policy instruments is the role of central government planning and direct controls over different facets of economic activity. The institutional setting in these respects may reflect political ideologies and may not be extensively adaptable to the requirements of program design. Nevertheless, experience in recent years has shown that such measures as the decentralization of economic decisions and the use of realistic prices to guide such decisions can improve the efficiency of production and investment in a variety of political and institutional settings.²⁵

More broadly, the choice of policy instruments is heavily influenced by the stage of development of economic institutions. In a country with sophisticated financial markets, for example, there are more means available for the government to influence the rate of monetary expansion (although there are also more ways to satisfy the demand for credit, in the face of restrictive official policies, through the layering of financial assets). In a country with a relatively undeveloped, sharply segmented financial market, the economy is likely to respond much less flexibly to changes in monetary policy. Moreover, where there are severe policy-related distortions—arising from price controls, exchange and trade restrictions, overvalued exchange rates, and official ceilings on interest rates—the efficacy of normal demand-management policies is greatly weakened, and the need for structural changes is all the more urgent. In some less-developed countries such structural changes may amount to nothing less than the new development of certain economic institutions, such as particular types of markets.

The choice of policy instruments is often dictated by the circumstances in which an adjustment program is being formulated. In situations in which the external financing constraint is severe and the need for a sharp adjustment in the current account is urgent, emphasis must be placed on rapid changes in fiscal and monetary policies rather than on the more slowly moving processes bringing about structural adjustments.

Dynamics and Lags

It is generally true that economic theory provides a guide only to basic equilibrium relationships and not to the length of time it takes for changes in exogenous variables, including policy instruments, to have an impact on the endogenous variables.²⁶ Indeed, simple policy models—such as the expenditure-reducing/expenditure-switching paradigm—are usually set in a world of instantaneous adjustments. In practice, however, policies operate with lags that can be substantial. For example, changes in monetary policy may take considerable time before affecting aggregate demand, prices, and the balance of payments; the reasons are explained in Section III. Another well-known lag is between exchange rate adjustments and the balance of trade (see Section IV).

The empirical investigation of such lags has led to many innovations in econometrics over the past thirty years. Nevertheless, the lags prevailing in many smaller developing countries remain largely a matter of guesswork and judgment and may in any event vary with prevailing circumstances. Estimates must be made of these lags, however, because the best timing of policy measures depends on them: in particular, the phasing of quantitative Fund-supported programs requires estimates of the speed with which policies affect the target variables. A broader question is posed by the fact that aggregate demand policies may take more rapid effect than certain supply-side measures. Where this is true, it may imply the desirability of obtaining additional external financing to avoid overshooting the targeted expenditure reduction until the supply-side part of the program shows the expected results.

Another problem of timing arises with respect to the two types of supply-side policies, those that are aimed at increasing current output and those designed to raise the growth rate of productive capacity. The results of the latter policies may not become evident for several years; yet there is often a need for an immediate increase in output to prevent serious hardships resulting from expenditure reductions and thereby to sustain the political viability of an adjustment program. Supply-side policies of the first type come into play in this context, even though uncertainties as to the extent and timing of their effects can cause serious difficulties. In a successful program, growth in productive capacity is being fostered while increases in output (and greater outward orientation of output) are being achieved with the use of existing resources, so that the fruits of growth policies become available when possibilities of expanding output on the basis of existing resources have been exhausted.

The interactions between supply-side policies and demand-management policies, as well as between the different supply-side measures themselves, pose further problems in designing an adjustment strategy. Specifically, the liberalization of import restrictions, of domestic financial markets, and of foreign exchange markets each alters the way in which the economy responds to changes in fiscal, monetary, and exchange rate policies. Moreover, the impact of a particular supply-side measure (e.g., freeing interest rate determination from official controls) will depend on whether other supply-side measures (e.g., liberalization of restrictions on capital inflows and outflows) have also been taken. The effect of different sequences of liberalization of various markets in the economy is a subject that has only recently begun to receive serious attention.²⁷

Perhaps the greatest problem in forecasting the dynamics of policy effects arises in connection with efforts to bring down high rates of inflation. This is especially true of a gradualistic approach, where the results depend crucially on the private sector’s expectations generated by government policies. The strategy of a shock approach—such as a currency reform and price freeze, accompanied by strong fiscal and monetary measures—has often met with initial success, but the long-run results, which depend on a variety of factors, are more uncertain. There is still much to be learned about the effects of monetary policy, exchange rate movements, price and wage controls, and interest rates on the inflationary process.

The choice between a shock treatment or a gradualistic approach to policy reform is often strongly influenced by political considerations: a gradualistic approach may appear to have greater political acceptability. Nevertheless, the gradual introduction of measures whose results are achieved only with a long time lag may result in an unacceptably long period of waiting for results. This is typically the case with structural reforms, which frequently encounter strong political resistance and are therefore introduced in stages. Delays in introducing such reforms, accompanied by implementation of urgently required demand-management policies, can lead to unnecessarily large declines in income and output over the short run.

Another important factor in deciding on the pace of policy implementation is the nature of the external payments imbalance and the adaptability of the domestic economy to changes in prices. For example, a low-income primary producing country with a narrow productive base may respond more slowly to expenditure-switching policies than a country with a broader range of production. In this example, the short-run response to a fall in export prices may be relatively more weighted toward financing in the former country than toward adjustment. Nevertheless, such judgments also depend on whether an external shock is judged to be temporary or permanent. If permanent, initiating adjustment may be an even more urgent priority in the country where such adjustment is slower.

A final—and often dominant—consideration in determining how quickly to carry out an adjustment program is the availability and terms of external financing. In recent years the scarcity of such financing has compelled many countries to adjust current account balances more quickly than they might otherwise have chosen to do, often using measures of import compression that have adversely affected absorption and output. Furthermore, the supply of finance must be considered in conjunction with the borrowing country’s debt situation; initially high levels of debt and scheduled debt service may induce governments to avoid heavy additional borrowing, even if the required financing is available.²⁸