The previous section has described Fund-supported adjustment programs as complex packages of policy measures designed to achieve a viable balance of payments, in the medium term if not in the short term. While programs differ considerably in their details, there is nevertheless a common thread running through them, namely, the need to restore balance of payments equilibrium while maintaining, indeed strengthening, the conditions for achieving a satisfactory rate of long-term output growth in a noninflationary manner. As a necessary condition for achieving this outcome, the basic structure of all programs is built on a financial analysis that aims at ensuring consistency between the impact of proposed policy measures and the desired balance of payments outcome. This consistency, which is incorporated into a set of balance sheet relationships that relate the assets and liabilities of the banking system to the balance of payments, has sometimes been termed the “monetary approach to the balance of payments”29 and has often been mistakenly identified as the “theory” underlying Fund-supported adjustment programs.30 While Fund staff certainly played a significant role in its development,31 and while it is utilized in some form in Fund-supported programs, this financial programming framework is only one element, albeit perhaps a central one, in the theoretical underpinnings of Fund-supported adjustment programs.
This section will outline the basic financial programming framework of an open economy with fixed exchange rates and discuss its principal advantages and shortcomings, leaving to Section IV policies specifically related to achieving medium-term growth objectives. The model serves as a convenient starting point for a more detailed study of the various alternative transmission mechanisms between the array of policies typically included in Fund-supported programs and the ultimate objectives of the balance of payments, price stability and economic growth. While one may base programs on different theoretical relationships, it is shown that monetary consistency, as incorporated in the financial programming approach, must always hold.
Derivation of the Basic Financial Programming Framework
The view of the balance of payments as a monetary phenomenon has a long history in economics.32 The monetary nature of the balance of payments, and the distinction drawn between money of external origin (international reserves) and money of domestic origin (domestic credit), also has a fairly long history in the operations of the Fund.33 The absorption approach, discussed in the previous section, played a key role in the design of Fund-supported programs, and at the same time changed the thinking on balance of payments issues by posing the problems of adjustment in a way that highlighted the policy aspects.34 The transformation of the absorption approach from a general theory into a policy device required, at the very least, some knowledge of the nature of the links between the monetary sector and the balance of payments. The papers by Polak (1957) and Robichek (1967, 1971) start from the proposition that in an open economy operating under a fixed exchange rate, the money supply is an endogenous variable influenced by surpluses and deficits in the balance of payments, and not an exogenous policy instrument as was customarily assumed in closed-economy models. The Polak and Robichek approaches can basically be interpreted as attempts to integrate monetary and credit factors into balance of payments analysis, and thus derive a formal relationship between the domestic component of the money stock (domestic credit) and changes in international reserves, which could then be fruitfully employed for policy. The earlier work by the two authors has influenced a large number of research papers written in the Fund on the subject of stabilization policies in developing countries,35 and the theoretical aspects of present Fund-supported adjustment programs can be shown to have their roots in these studies.
At the core of every Fund-related program is a basic financial programming framework based on the notions just reviewed. The actual design of a program is far more complex and pragmatic than would be indicated by this framework, but it does serve to highlight the essential theoretical features of any program designed for a small open economy operating under a fixed exchange rate.36
The financial programming approach starts with the accounting identity expressing the change in the money stock as the sum of the changes in its international and domestic components:
where M is the stock of money, R is the domestic-currency value of net foreign assets of the banking system (international reserves),37 D is net domestic assets of the banking system (domestic credit), and “Δ” preceding a variable indicates a one-period change. This identity is, of course, only a balance sheet relationship for the banking system, where liabilities (money) are equal to the sum of foreign and domestic assets.38
The second building block of this model is the demand for money, which can be specified in a variety of ways, ranging from a relation reflecting a constant income velocity of money to a general function relating the (nominal) demand for money to variables such as domestic income, prices, and the opportunity costs of holding money. Assume that the demand for money balances takes the form:
where the change in nominal money balances (ΔMd) is positively related to the change in real income (Δy), the change in the domestic price level (ΔP), and other unspecified variables. The latter would presumably include interest rates paid on deposits and other financial assets, wealth, and expected inflation, among others.
A more restrictive version of equation (5) would relate the change in nominal money (ΔMd) to changes in nominal income (ΔY):
where k is the inverse of the income velocity of money, and assumed to be constant over time.
The third and final building block is a condition defining flow equilibrium in the money market. This simply means that the change in the demand for money is equal to the change in the actual supply of money:
These three components, (4), (5), and (7), can be combined to yield an expression for the change in net foreign assets, in which the balance of payments is given by the difference between the change in the money stock (equal to the change in the nominal demand for money from the equilibrium condition) and the change in domestic credit:
This equation essentially says that the change in net foreign assets will be positive (the balance of payments will be in surplus) to the extent that the change in the total money stock exceeds the change in domestic credit. In this formulation, real income is treated as though it were exogenous. Indeed, in the special “small country” case, where the domestic price level is determined by foreign prices through purchasing power parity (or the “law of one price”), so that the demand for money is effectively independent of changes in domestic credit, any increases in domestic credit above the desired increase in money will be offset by decreases in net foreign assets on a one-for-one basis.39 It should be noted, however, that in the actual formulation of Fund-supported adjustment programs, the implications of policies for both output and the price level are carefully analyzed and, of course, output and inflation targets are major factors in deciding upon the policy package.
The simple model described by equation (8) can also be put in a more general framework, similar to that suggested in Section II, by explicitly considering income and expenditure relationships and the role of private capital movements in an open economy. The analysis here still retains the money demand function as the main behavioral relationship, although, as discussed later, this is only one of a number of relationships that need to be quantified in arriving at a framework for analysis. Equation (1) may be recalled, which states that the gap between income and absorption is equal to the current account (equal to the difference between imports and exports of goods and services):
The current account must be matched by changes in net foreign assets of the banking system (ΔR) and in the net foreign indebtedness of all nonbank residents (ΔFI),
Since the change in net foreign assets of the banking system is also equal to the difference between the change in the money supply and the change in domestic credit from the balance sheet of the banking system, it can be seen that combining equations (8) and (10) yields:
In terms of the difference between nominal income (Y) and domestic absorption (A), equation (11) can be rewritten as:
In other words, calls on resources by residents (absorption) will exceed the sum of the supply of domestic resources (income) and foreign savings (changes in net foreign indebtedness) when the change in domestic credit exceeds the change in the money stock.
If it is assumed that Md is a function of a few variables and that these variables are independent of ΔD, then the conclusion remains that a ceiling for ΔD will determine ΔR, that is, the balance of payments. It should be noted, however, that any current account balance matched by an appropriate nonbank capital flow is also consistent with equilibrium in this framework. Moreover, in each case one would still have to determine whether the domestic price level, the domestic interest rate, or domestic output (income) might be influenced by a change in net domestic assets.
With the overall outlines of the financial programming framework in mind, it is relatively straightforward to show how the basic relationship between the change in net foreign assets and changes in domestic credit—that is, equation (8) —can be used for the design of a financial program. In the simplest case, only three steps are required. First, it is necessary to set a target for changes in net foreign assets over some specified period, generally a year. Second, an estimate is made of the probable course of the demand for money over the same period. This involves projecting, or setting targets for, the principal determinants of money demand, such as real income and prices. If a simple velocity function is being utilized, then all that is needed is a projection for nominal income and an assumption of how the income velocity of money, if not assumed constant, is likely to behave over the period. For more general demand-for-money functions, such a projection would require estimates of the parameters that link the demand for money to the relevant explanatory variables. Finally, given a forecast of the demand for money during the period in question and the overall target for the balance of payments (i.e., for the change in net foreign assets), the corresponding figure for the change in net domestic assets of the banking system is deduced from the balance sheet identity of assets and liabilities.
It is obvious from the above description that within the context of the simple financial programming framework there is no conceptual difficulty in deriving the domestic credit ceiling consistent with a desired change in net foreign assets. The whole exercise involves mainly the manipulation of balance sheet relationships, with the demand for money being the only behavioral relationship to enter the picture. The demand for money, therefore, becomes a critical relationship in the analysis. For a change in domestic credit to have a predictable effect on the balance of payments, the demand for money must bear a predictable relationship to a limited set of variables. Given that this relationship is stable, an increase in domestic credit would cause a divergence between the demand for money and the supply of money, resulting in a decline in net foreign assets, because the public would not be willing to hold the additional money that was created. If there were no such divergence, then there would be no cumulative effect on the balance of payments. This would occur if the demand for money were passive in the sense that it simply adjusted to equilibrate the money market when there was any type of shock.
In the economic literature there is considerable support for the view that the demand for money is empirically related to a well-defined set of economic variables. While experience leads one to reject the extreme view that the income-velocity of money is constant, a view that was embedded in the earlier writings on the subject in the Fund,40 this does not affect the analysis. All that is needed is that the demand for money, or velocity, respond in a predictable way to variables such as real income, prices, interest rates, and so forth, and that it be independent of changes in domestic credit. On the first of these two conditions, studies both within the Fund and outside41 have shown that it is possible to identify empirically a demand function for money for a variety of developing countries. Typically, the preferred specification is one that relates the demand for real money balances to the level of real income and a variable representing the opportunity cost of holding money. It stands to reason, of course, that in situations of high and variable inflation—more generally, when future economic policies and developments are highly uncertain—it is difficult to predict both the opportunity cost of holding money and the demand for money. (See pages 20-22.)
The second condition is more problematic. While it is easy to accept the view that the demand for money is a useful empirical regularity, the assumption that changes in domestic credit result only in changes in reserves is much less likely to hold in practice. The conditions for making this assumption are quite stringent: in effect, an expansionary open market operation by the monetary authorities must have no effect on domestic interest rates, spending decisions, prices, or the exchange rate.42 Clearly such an assumption would not apply to a large country with a floating exchange rate, nor to most small developing countries, where international capital flows are restricted. The extent to which it might apply depends, inter alia, on the openness of goods and capital markets, the breadth of these markets, and the degree of exchange rate flexibility. The feedback among real income, prices, and the monetary sector will be further discussed below.
Some Extensions of the Financial Programming Framework
So far the presentation of the financial programming framework has focused exclusively on changes in net foreign assets, and has been completely neutral about the structure of the balance of payments. Specifically, this approach does not specify where the improvement in the balance of payments will occur, be it via the current account or the capital account, and within the current account, via reductions in imports or increases in exports. Yet such distinctions are important considerations in the design of Fund-supported adjustment programs. One standard extension of the basic financial programming framework is, therefore, to decompose the balance of payments into its individual components and explain these items separately. As will be shown, this is a straightforward extension of the monetary relationships developed earlier.
In the simplest case, to analyze the structure of the balance of payments requires the addition of a second behavioral relationship, namely, the demand for imports. The specification, as in the case of the money demand relationship, can be a very simple one that makes imports a constant function of domestic income, or a more complicated one that allows the effects of changes in relative prices, exchange rate changes, and perhaps other variables measuring import capacity. For the sake of simplicity, assume that the volume of imports is positively related only to real income:43
where IMV is the volume of imports, y is real income, and a is a constant. The value of imports can be derived from this equation by simply multiplying the volume by exogenously given import prices.
The balance of payments identity is:
where X and IM are the domestic-currency values of exports and imports of goods and services, respectively, and ΔFI is the change in net external indebtedness not held by the banking system.
With the addition of the equation for imports, the derivation of the domestic credit ceiling now becomes somewhat more involved. Step one is still to set a target for the overall balance of payments in the program period (ΔR*). Step two entails making projections or assumptions about the behavior of those components of the balance of payments that are considered to be exogenously determined, that is, exports of goods and services and net nonbank capital flows. Projections of export receipts can be made on the basis of forecasts of real income growth in the country’s export markets, and possibly the export prices of competing countries in the world market. For the case of net nonbank capital flows it is often necessary first to determine a “sustainable” level of foreign debt that is consistent with the country’s current and future debt-servicing capacity, and then to ensure that the increase in net external indebtedness is consistent with this sustainable level.44 The capital flows item will presumably include aid flows, direct investment, and commercial foreign borrowing. Having obtained the values for exports and capital flows, the target value of imports can be derived as a residual from the balance of payments identity (14) as:
where IM* is the target value of imports and
Step three is to project real income and set a target for domestic prices, and step four is to use these values to obtain the increase in the demand for money and the increase in imports from the two behavioral equations in the system. Step five is, as before, to solve for the change in domestic credit that would be consistent with the target change in net foreign assets and the desired increase in nominal money balances. Finally, step six is to compare the value of imports that emerges from the import equation (13) with that emerging as a residual from the balance of payments identity (15). If the two are equal, the exercise is completed. If, on the other hand, the two values of imports are different, as is frequently the case, some type of adjustment has to be made. Such an adjustment involves treating an additional variable as effectively endogenous by altering the target changes in net foreign assets, prices, and capital flows, or the projections for real income and exports. This iterative procedure would continue until the values of imports converge to a single one. In the end a domestic credit ceiling would be derived that would be simultaneously consistent with the target overall balance of payments (ΔR) and with the target or forecast values of its components.
A second extension that can be made to the financial programming approach is to link the monetary and fiscal accounts through expanding the underlying balance sheet relationships. This is done by discriminating between the expansion of credit to the private sector and that to the public sector,45 and taking into account the connections between the government budgetary position and official foreign borrowing on the one hand and the growth of domestic credit on the other. In practice, because of the central role of fiscal expenditure and revenues in a government’s economic policy, and because of the dependence of private sector economic activity on an adequate supply of credit, this stage of the financial programming process is often regarded as the one involving the most crucial decisions.
That inclusion of fiscal deficits is presented here as an extension to the basic financial programming approach should not obscure the frequent importance of fiscal deficits in creating initial imbalances and the fact that imbalances must often in large measure be tackled through fiscal adjustment, that fiscal policies are among those most directly amenable to strong and rapid government action, and that a more satisfactory growth performance may in some cases require a reallocation of resources from the public sector to more directly productive nonpublic sectors.46
Fiscal policy features can be grafted to the financial programming framework in a fairly straightforward manner. To do so requires the following three additional ex post identities: first, that the change in net foreign indebtedness of the country (ΔFI) is the sum of changes in the private sector’s (ΔFIp) and public sector’s (ΔFIg) net foreign debt position:
Second, a similar decomposition between the private and public sectors can be made with respect to changes in domestic credit:
where ΔDp is the change in credit channeled to the private sector, and ΔDg is correspondingly the change in credit going to the government. It should be noted, however, that Dg is conventionally defined as credit to the government minus the government’s deposits in the banking system; hence, D and M are also defined correspondingly for programming purposes.
Finally the government budget constraint is introduced, whereby the government must finance any deficit by either increasing its net borrowing from abroad, or by increasing its net borrowing from the banking system:
where G is total government expenditure and T is total government revenue; therefore (G — T) represents the fiscal deficit. This budget constraint contains an implicit assumption that there are no sales of government debt to the private (nonbank) sectors. For most developing countries this is not a particularly restrictive assumption to make; in these countries, markets for government securities are nonexistent or very thin, so that the government has no real alternatives but to finance its deficit by borrowing abroad or from the banking system. Nevertheless, in a number of developing countries financial programming needs to take into account the fact that certain controlled, or “captive,” nonbank financing sources—such as social security and pension funds, public enterprises, and local government—may provide a substantial portion of government resources.
The last three identities—(16), (17), and (18)—establish the relationship between monetary expansion and the fiscal position of the government and provide an important rationale for placing ceilings on both the amount of foreign borrowing (ΔFIg) and the amount of bank financing (ΔDg) undertaken by the public sector; for in such ceilings lie the means of monitoring the size of the public sector deficit.47 Nevertheless, while these may be the principal means of monitoring the public sector’s financial balance, the policies underlying that balance are, or course, chiefly concerned with expenditures and revenues (see pages 24—27). It should also be noted that the ceiling on foreign borrowing usually has other purposes besides monitoring public sector finances (see Section IV).48
Restricting the flow of credit to the public sector is frequently employed as a policy because the rate of credit expansion to the private sector (ΔDp) is generally an important secondary target in financial programs: allowing the private sector a sufficient amount of credit for working capital and investment purposes is an objective that must be taken into account in targeting the share of financial resources to be absorbed by the public sector. Basically, once the monetary model is used to solve for the overall rate of credit expansion (ΔD), the rate of credit expansion to the public sector (ΔDg) can be derived as the difference between the overall rate of credit expansion (ΔD) and the targeted rate of credit expansion to the private sector (ΔDp), or vice versa.49 By either technique, the calculated (or targeted) value of credit expansion to the public sector can then be added to the feasible level of official foreign borrowing (as in (18)) to obtain a first-round estimate of the government’s overall budget deficit. To the extent that this deficit is different from the budget plans of the authorities, there have to be changes in taxes or expenditures, or both, so as to close the fiscal resource gap; alternatively, credit to the private sector must be more restricted than originally planned.50
A third possible extension of the basic financial programming framework is to relate the basic monetary relationship to the balance sheet of the central bank as opposed to the banking system as a whole. The policy variable in such a case would be changes in net domestic assets of the central bank rather than total domestic credit expansion. In Fund-supported adjustment programs both forms of credit ceilings have been employed as criteria for measures taken to achieve a particular balance of payments outcome.
To apply the exercise solely to the central bank, it is first necessary to define the balance sheet equality between changes in the liabilities of the central bank (reserve money or high-powered money) and changes in its assets (net foreign assets and net domestic assets):
where H is reserve money, and equal to currency in the hands of the public and reserves of commercial banks; R is the stock of net foreign assets;51 and DCB is the stock of domestic assets (net of deposits) of the central bank. Again a “Δ” prefix defines a one-period change in the variable.
The total supply of money (M) is related to reserve money (H) through a multiplicative relationship:
where m is the money multiplier. This money multiplier is a function of the ratio of currency deposits and the ratio of commercial bank reserves to deposits; it is therefore partly determined by the public’s preferences and partly by government policies (changes in reserve requirements or the discount rate) that affect the reserve positions of banks.
If the money multiplier is stable and predictable, then with these two additional identities, (19) and (20), the financial programming exercise can be conducted as before. One simply has to replace the balance sheet relationship of the banking system, equation (4), with the following:52
and the analysis will carry through under fairly general assumptions.53
The choice between the alternative forms of credit as policy instruments is based on a number of factors. First, it depends crucially on the way the authorities operate monetary policy. To the extent that the monetary authorities implement credit policy through controls over total bank credit, and that other financial markets are poorly developed, the obvious credit variable would be the broader one covering the overall banking system. If, on the other hand, the monetary authorities take decisions related to credit policy in the context of their own credit operations, supplemented by variations in reserve requirements on the commercial banks that affect the money multiplier, then the appropriate credit variable would be one covering the domestic assets of the central bank alone. Second, how the money multiplier is likely to behave is an important factor in the decision. If the multiplier moves in an erratic or unpredictable fashion, it would clearly be more effective to work with overall domestic credit expansion than with credit extended by the central bank. Ultimately the question of whether to impose ceilings on net domestic assets of the central bank or the banking system is empirical and will depend on the structure of the financial system and the operating procedure for monetary policy in the particular country under consideration. At the theoretical level it is difficult, if not impossible, to argue for a particular definition of domestic credit.
Specification of Monetary Policy
The financial programming framework just described has proved a useful way of thinking about the balance of payments and macroeconomic policy. With some straightforward extensions, this framework can be used to handle issues relating to the determination of both the overall balance of payments as well as its components and can be easily linked to monetary policy and to the fiscal accounts of the government. At the same time, however, it must be stressed that this model is only a theoretical abstraction and for policy purposes must be specified more precisely. In particular, it must be supplemented by specific assumptions regarding the transmission mechanism relating the policy instruments to the ultimate objectives of balance of payments improvement and price stability; its validity in the short run can be questioned in some circumstances; and in its simplest form, it considers only one particular policy instrument, that is, the rate of domestic credit expansion, leaving open the issue of whether it is in all circumstances more practicable to target domestic credit rather than the money supply itself. These three issues are discussed in the remainder of this subsection.
Transmission Mechanism
The financial programming approach takes an eclectic view of the transmission mechanism underlying the adjustment of the balance of payments to any type of shock, such as a change in the rate of growth of domestic credit. In fact, this approach can be considered a relatively general theory of long-run behavior that encompasses a variety of models of short-term adjustment.54 The fundamental equation relating the balance of payments to the determinants of the demand for money and the rate of domestic credit expansion is thus an outcome of an adjustment process, and not a description of the channels through which the policy variables affect changes in net foreign assets.
A transmission process consistent with the basic financial programming framework was developed by Polak (1957), who introduced a structure that made imports a function of nominal income in a manner similar to equation (13), and then added a quantity theory of money equation to explain nominal income.55 In the context of this model, in which fixed exchange rates are assumed, an increase in the rate of credit expansion would increase the money supply and nominal income; this in turn would raise imports and cause an outflow of international reserves. This process would continue until the initial increase in domestic credit was exactly matched by the loss of international reserves. The Robichek (1967) model differed from the Polak model only with respect to the speed of adjustment of imports and not in any fundamental sense. If imports responded instantaneously to a change in domestic credit, then the basic monetary relationship would hold continuously. In a sense the Robichek model is, therefore, a particular case of the Polak model in which imports react passively to eliminate any disequilibrium in the money market.
More elaborate versions of the adjustment process permit expenditures to be affected directly by changes in real money balances and interest rates56 or, in a world of capital mobility, allow the purchase or sales of assets in response to changes in relative interest rates. For example, in a fixed exchange rate model developed by Khan and Knight (1981, 1982), the excess demand for money balances plays a direct role in the short-run behavior of prices, real income, and the balance of payments. In this model an increase in domestic credit will in the short run increase domestic inflation, raise domestic output, and worsen the balance of payments. Eventually, the decline in the money supply due to the outflow of international reserves will cause a reversal of the process, so that once again in the long run the monetary relationship will continue to hold.
In the fixed exchange rate models just described, the public disposes of surplus cash balances emanating from an expansion of domestic credit partly by purchasing foreign goods and securities and partly by increasing the prices of nontraded goods, thereby altering the composition of output as between the traded and nontraded goods sectors. Under flexible exchange rates, an expansion in credit results in an increase in the money supply, a depreciation of the exchange rate that is proportional to the increase in the stock of money, and a similar increase in the domestic price level. Most developing countries, however, possess neither the rich menu of financial assets nor the degree of integration with international markets for goods and financial assets required to render these descriptions of the effects of monetary policy directly relevant.
To approximate the situation in a typical developing country, it may be useful to analyze the effects of monetary policy on aggregate demand and the balance of payments. In a stylized setting in which the private sector can hold financial assets in the form of currency, deposits in commercial banks, and loans in the informal financial sector (or, for short, “curb market”), it can borrow in the curb market or from the commercial banking system.57 Lending and deposit rates at commercial banks are fixed by the government at below-market rates, but the rate in the curb market is free to settle at market-clearing levels. In addition to these financial assets, the private sector holds both reproducible and nonreproducible real assets. The authorities maintain an overvalued exchange rate parity and defend it with a system of foreign exchange controls that can initially be taken to be completely effective. While these assumptions may appear restrictive, in general such features would be present in some degree in many developing countries requiring Fund assistance.
Unlike the simple model outlined earlier, the monetary authorities can influence domestic base money in this setting via their control over credit extended by the central bank. They can affect the money supply and total bank credit to the nonfinancial private sector through their control over the monetary base and over required reserve ratios at commercial banks.58 In terms of the simple monetary model this implies that the authorities can change both net foreign assets (through direct controls) and domestic credit.59 Since equation (8) must continue to hold, the change in money supply (ΔM) will adjust to preserve the balance sheet relationship.
Monetary and fiscal policies would be closely linked in a country with the financial structure assumed here. To the extent that the gap between public sector purchases of domestically produced goods and services and net taxes (taxes net of transfers) collected from the private sector is financed either externally or through central bank credit, the monetary base will expand. However, scope still remains for an independent monetary policy. The monetary authorities can effect changes in the expansion of the domestic money supply, apart from the increased credit implied by the financing of the public sector deficit, by changing the rate at which foreign exchange is made available to the public, by altering the growth of credit to the banking system, or by changing reserve requirements.60
As in the standard closed-economy case, monetary policy affects real aggregate demand by causing divergences between the actual and desired composition of the private sector’s portfolio. The monetary authorities can change the supply of money without affecting the availability of bank credit to the nonfinancial private sector by combining a change in the monetary base with an offsetting change in reserve requirements. Alternatively, they can change the availability of bank credit without changing the total money supply by altering the base and required reserve ratios in opposite directions by appropriate amounts. Starting from a position of portfolio equilibrium,61 an increase in the supply of bank credit to the nonfinancial private sector will cause borrowers to shift away from the curb market to the lower-cost bank credit market. As a result, the curb market interest rate will fall. Since this rate represents the marginal cost of funds in the economy, interest-sensitive components of private demand will be stimulated. In particular, the implicit value of reproducible real assets will rise relative to their production costs and demand for such assets will increase. Similarly, an increase in the money supply leaves the private sector with too much money in its portfolio relative to loans and real assets. The resulting increase in the supply of curb market loans leads to a fall in the curb market interest rate and this, together with the initial portfolio imbalance, causes an increase in the implicit value of real assets relative to their production costs. Aggregate demand is again increased as a result of the increased demand for real assets. Conversely, a reduction in the availability of bank credit or in the supply of money would, of course, cause these mechanisms to work in reverse and thus reduce aggregate demand.
Monetary policy works somewhat differently if exchange controls are ineffective. Assuming such controls to be completely absent, the private sector can now add foreign exchange, or more generally claims on nonresidents, to its portfolio of financial assets either by retaining export receipts in the form of foreign exchange or by acquiring foreign exchange from the central bank at the official parity. This case now approximates more closely the simple monetary model, since the authorities no longer exercise direct control over the change in international reserves (ΔR). With the relaxation of the assumption of exchange controls the power of monetary policy to affect aggregate demand is diminished. Some of the effects of an increased supply of money are dissipated into an increased demand for foreign exchange. The private sector can satisfy this demand by acquiring foreign exchange from the central bank in exchange for domestic money. As a result, the initial increase in the money supply is partially reabsorbed by the central bank.62 Effects on the curb market interest rate and on the demand for real assets are therefore weakened. Similarly, if households consider the extension of loans in the curb market and holdings of foreign exchange to be close substitutes, the effects of changes in the availability of bank credit to the private sector are also weakened in this case. As borrowers move from the curb market to the bank credit market following an increase in the supply of bank credit, the more elastic supply of loans in the curb market in this case cushions the fall that would otherwise occur in the curb market loan rate.
The two preceding paragraphs have described the effects of monetary policy on real aggregate demand at a given domestic price level. The ultimate effects of such changes in aggregate demand on domestic output and the domestic price level will depend to a large extent on whether the policy measures were anticipated at the time that currently prevailing nominal wage contracts were negotiated. Broadly speaking, the greater the extent to which changes in monetary policy are anticipated by the private sector, the more such policies will affect the domestic price level rather than the level of real output. This result emerges from the “rational expectations” model associated with Lucas (1972), among others. Expectations would also be affected by government intervention in the process of wage and price formation. An incomes policy or price controls that the public perceives as effective could dampen inflationary expectations. Nevertheless, such effects would only be temporary unless accompanied by appropriate financial policies.
For policy purposes it is clearly necessary to have an understanding of the manner in which the balance of payments is likely to be affected by changes in the rate of credit expansion. The hitting of a short-run balance of payments target becomes complicated in a world where the variables that determine the demand for money are themselves influenced by policy, and it is essential for the authorities to know how these variables will respond. While the financial programming approach emphasizes monetary relationships, it does not imply that the transmission process has to be monetarist in character. Indeed, a Keynesian structure with rigid nominal wages in the short run, and with the domestic level of output, the domestic rate of inflation, and domestic interest rates all responding to monetary policy, is also quite compatible with the financial programming approach.63 What the discussion demonstrates is that this approach does not depend on any one particular model and can be consistent with a broad class of models that include fixed or flexible exchange rates, tradable and nontradable goods, flexible or rigid prices and wages, market-determined or fixed interest rates, and either full or variable employment.
Dynamics of Monetary Policy
Use of the financial programming model is generally straightforward when applied to the long run, when all adjustments have worked themselves out. On an empirical level, however, the demand for money is regarded as stable over periods of one year or more, rather than over the very short term. In the short run, for example, the demand for money may be more or less passive, operating as a buffer stock that serves to absorb the changes in other variables. Both theory and empirical evidence indicate that the stock of real money balances tends to rise initially, or that the income velocity of money falls, when there is an increase in the nominal supply of money. These excess cash balances are worked off slowly over time until the public is once again in equilibrium. Consequently, one might observe no particular relationship between increases in domestic credit and changes in net foreign assets if the period of observation were too short. In time, however, the expected adjustment process will begin to take hold.
In addition, it is not possible to assume that the variables that affect the demand for money, particularly real income, are independent of changes in domestic credit unless the period is taken to refer to the long run. Standard monetary theory argues that in the long run the rate of growth of output will be independent of the rate of monetary expansion.64 In the short run, as will be shown below, changes in domestic credit can influence output and thus cause shifts in the demand for money.
It is a standard property of models of the demand for money that in the long run the rate of growth of money will be equal to the rate of growth of real income plus the rate of price inflation adjusted for changes in velocity.65 Any variation in the exogenous variables will by definition lead to a new equilibrium through an instantaneous change in money balances. In the short run, however, there is no presumption that individuals will be continually on their demand schedules. In other words, if there is a change in any of the variables that influence money holdings, there may be a significant lapse of time before money balances actually adjust to the new level. If there are such lags in adjustment, then assuming continuous equilibrium when projecting the demand for money in the course of a financial program would lead to errors that could have a significant impact on the credit ceilings. Since projections are customarily made over a one-year period, all adjustments must occur within the year for the equilibrium model to be valid. (Moreover in Fund-supported programs quarterly projections of the demand for money are also required to fix quarterly performance criteria.) How long it takes for individuals to respond to changes in real income, prices, interest rates, and so forth is an empirical question that does not permit a general answer; it depends on the characteristics of the individual country. In some cases it may be legitimate to use an equilibrium model; in others the lags in response may be quite long.
All this does not imply that a monetary approach is completely irrelevant for short-run analysis of the balance of payments. Indeed, the long-run period over which the approach is applicable may well be only a year. This, however, is an empirical question. Furthermore, there is nothing in the methodology that precludes the introduction of dynamics and less restrictive adjustment assumptions. In the actual formulation of Fund-supported adjustment programs, these considerations suggest a number of specific problems. Two of these—the way that time lags are generally introduced into the formulation and accounting for the short-run movements in velocity, and the “liquidity overhang” problem—are discussed below.
Within the framework of money demand models there is a variety of ways to introduce dynamic behavior. The simplest procedure is to impose some arbitrary set of lags on each of the explanatory variables and perform empirical tests to determine the appropriate lag structure. A more common practice is to use some variants of the “error-learning” model. In such models, it is generally hypothesized that because of adjustment costs and the costs of being out of equilibrium, the stock of real (or nominal) money balances adjusts proportionally to the discrepancy between the demand for money and the actual supply. In other words, when there is a change in the demand for money, the public is assumed to adjust only part of the way in the same period. Complete adjustment, which is defined by the equality of demand for and supply of money, is thus achieved slowly over time. This partial-adjustment variant of the error-learning framework has become very popular, because it has a certain theoretical appeal and, perhaps more important from a practical point of view, is quite easy to apply. From the empirical estimates it is possible to ascertain directly how long adjustment takes, that is, the length of the lags. If the model indicates that all adjustment takes place within the year, then the equilibrium model can be utilized for the financial programming exercise. On the other hand, the presence of slow adjustment would require the use of the short-run money demand function.
While simple error-learning models do introduce dynamics into the picture, they are not able to capture the short-run phenomenon that an increased rate of monetary expansion results in a larger initial stock of real money balances, or, what amounts to the same thing, that the income velocity tends initially to move in the opposite direction of the change in monetary growth. This behavior of real money balances has been found in a number of studies, for example, by Harberger (1963) on Chile, Diz (1970) on Argentina, and Pastore (1975) on Brazil,66 and a theoretical rationale has been provided by, among others, Friedman (1970).67 Typically, one observes that the time path of real money balances after a monetary increase appears as shown in Chart 1. At time t0, there is a once-for-all increase in the rate of monetary growth, and initially the stock of real money balances rises, reaching a maximum at point
Time Path of Real Money Balances in Response to Monetary Shock
The type of behavior observed in Chart 1 has two important implications for financial programming. First, if the authorities set a credit ceiling that involves a reduction in monetary growth, then the observed demand for money may also fall in the short run. Therefore, in analyzing the short-run effects of monetary policy on the balance of payments, care must be exercised in using the short-run demand for money function and allowance made for shifts in the function.
The second problem has to do with the phenomenon of “liquidity overhang.” Fund support is generally sought in situations of fundamental disequilibrium when there has been excessive monetary expansion in the past. Clearly, in projecting the likely behavior of velocity over the next year, the staff has to recognize that there has probably been a large buildup of cash balances; it cannot therefore proceed as if the money market was in equilibrium and use the standard money demand model. In other words, it would be incorrect to start as if the situation was characterized by a position like t0 in Chart 1. More than likely the economy is somewhere between t0 and t*, if not at
Choice Between Money and Credit as Policy Variables
In the standard financial programming approach it may be assumed that the economy is closely integrated with the rest of the world and that it operates under a fixed exchange rate system. Under these assumptions, it follows that control of domestic credit—which in turn may largely depend on the fiscal deficit—is the only available instrument of financial policy for the authorities to determine the change in net foreign assets; they are unable to control the money supply.68 In this subsection the assumptions lying behind the simple model are relaxed, and with inflation treated as an endogenous variable and an objective of the program, some considerations are discussed pertinent to the issue of whether in some circumstances it would be more effective to target money or reserve money, as an intermediate variable, than domestic credit. The choice between credit and money depends primarily on the country’s exchange rate arrangements, which are closely related to the strength of the linkages between the domestic and external goods and financial markets. The importance of each of these is discussed below.
The strength of the linkages between domestic and international markets for goods is a key factor influencing the use of ceilings for monetary or credit aggregates in Fund-supported adjustment programs. If domestic and international markets for traded goods are closely integrated, for example, movements in the domestic prices of tradable goods would be tied to changes in the exchange rate and international prices. If international traded goods prices were stable, domestic goods prices would then change only in response to an exchange rate movement. Stable domestic prices of tradable goods would also help stabilize the prices of nontraded goods. In this situation, inflation would generally be associated only with the changes in prices produced by an exchange rate depreciation. As a result, it has been argued that the choice between a ceiling on a monetary or credit aggregate, as well as the specification of exchange rate policy, can be decided on the basis of the contribution of these instruments to the attainment of the other objectives of the program. For example, with closely integrated foreign and domestic goods markets, the combination of a ceiling on the domestic credit of the banking system and a fixed exchange rate has often been viewed as a means of achieving an improvement in the current account balance without generating a sustained inflation (apart from the response of prices to any initial exchange rate depreciation).69 In these circumstances, there would be no conflict between the external and inflation objectives of the Fund-supported program; and a ceiling on monetary growth would not generally be required to limit inflation.
For most Fund members, however, the linkages between domestic and international goods markets are far less direct, because of trade barriers, transactions costs, and shipping charges. These weaker linkages provide scope for extended periods of domestic inflation and create the possibility of a conflict between the attainment of the program’s external balance and inflation objectives. Domestic prices would respond not only to exchange rate adjustments but also to such factors as increases in reserve money generated by the conversion of foreign exchange or expansion of domestic credit by the central bank. In this situation, it might be argued that a ceiling on domestic monetary growth or the rate of growth of reserve money would be required to limit inflation.
The strength of the linkages between domestic and international financial markets is also a key factor influencing the use of ceilings for monetary and credit aggregates. Access to international financial markets affects the economy’s structure in at least two important ways: first, it gives residents an opportunity to acquire net credit (and goods and services) from abroad; and second, reserve money can expand as a result of the conversion of foreign exchange acquired through current account imbalances, external borrowing, or liquidation of foreign assets. Such capital flows may be temporary and reversible. In some instances, they may be a positive development, representing the repatriation of residents’ foreign capital holdings. In other instances, depending on their size and sustainability, such transactions can weaken the effectiveness of credit ceilings both by providing a source of credit from outside the banking system and also by creating an incentive for the development of unregulated domestic sources of credit. For example, central bank purchases of foreign exchange (possibly as part of a commitment to maintain a given exchange rate) increase the net foreign assets of the central bank as well as the stock of reserve money. Depending on the nature of the banking system, such an increase in reserve money could create an equal or substantially greater increase in total money, which would in turn affect domestic prices. Moreover, if there is an effective ceiling on bank credit, the existence of an unsatisfied demand for credit and an excess supply of reserve money will create substantial incentives for the development and more active use of unregulated non-bank financial intermediaries as an alternative source of credit.
Under the circumstances just described, in which the central bank is defending a fixed exchange rate, it can be argued that the inflationary effects of an overall balance of payments surplus (resulting from both current and capital account developments) could be mitigated by limiting the expansion of reserve money. Holding down the growth of reserve money would require the central bank to sterilize the impact of the capital inflows on reserve money by reducing the domestic credit of the central bank. The sustainability of such a policy depends on the cost of reducing central bank domestic credit and on the scope and persistence of net inflows of foreign exchange. The sterilization of an external surplus may involve a sharp redistribution of credit within the private sector, creating serious financing difficulties for those sectors of the economy especially dependent on domestic bank credit and not directly benefiting from higher foreign exchange receipts.70 The feasibility of continued sterilization is determined by the nature of the balance of payments surplus. For example, in some situations a capital inflow represents a once-for-all movement of capital between domestic and international markets, such as a reflow of funds to the domestic market following a currency realignment. In cases where it was judged necessary to offset any inflationary effect of this inflow, either targeted limits on credit expansion could be correspondingly adjusted or a targeted ceiling on reserve money could guide the authorities to undertake the required sterilization. In other instances, the capital inflow might reflect an unexpected increase in the demand for money. In such cases, the authorities would have to make a judgment with respect to how much of the inflow to sterilize and how much of an increase in reserve money to permit to satisfy the increased demand for money. In either case, it would be important to limit domestic credit expansion, since in the absence of a capital inflow it would still be important to ensure that the balance of payments target was met.
There is a far more serious problem when the capital flows represent the continuing arbitrage of financial market conditions between domestic and international markets. In economies with severe credit rationing, there are large incentives to obtain credit from international sources. In this case, a ceiling on reserve money would involve a sterilization of the capital inflow, leading not only to an ongoing redistribution of credit within the private sector financial markets but also to continuing increases in foreign exchange reserves of the central bank, without changing the conditions that originally created the capital inflow. Alternatively, the absence of such a ceiling on reserve money could result in a rapid increase in reserve money and thereby in inflationary pressure.
The policy dilemma just analyzed in the context of fixed exchange rates suggests a trade-off between price stability and exchange rate flexibility under circumstances in which the authorities must deal with larger capital inflows or a larger current account surplus than anticipated. For example, if the exchange rate has been substantially depreciated in an effort to secure a favorable trade balance, then substantial unexpected capital inflows could be generated by yield differentials that reflect, in part, the expectation that further large exchange rate depreciations are unlikely. If such flows occur, there could be substantial inflationary pressure in the economy. To limit this inflation, a greater degree of exchange rate flexibility may be required, since a fixed exchange rate, relatively unrestricted capital flows, and the establishment of effective ceilings on credit or reserve money may at times be mutually incompatible.
In general, with an exchange rate that is fixed or is adjusted only gradually (for example, to reflect inflation differentials), the ability of the authorities to control the growth of domestic monetary aggregates over any extended period is very limited. (This consideration should be borne in mind when a real exchange rate target is set as part of an adjustment program.) Even when the authorities limit the issuance of reserve money from domestic sources, portfolio and spending adjustments in the private sector would lead to external payments imbalances that could expand reserve money as the authorities intervene in the foreign exchange markets to maintain their exchange rate policy. In contrast, a flexible exchange rate allows the authorities to control the growth of reserve money, thereby making a ceiling on a monetary aggregate a potentially effective performance criterion.
In a number of respects, the effectiveness of ceilings on domestic credit is more closely related to the presence of unregulated domestic and foreign sources of credit than to the exchange rate regime. If sources of credit other than the domestic banking system are limited, then a ceiling on domestic credit of the banking system can be quite effective in influencing domestic spending and activity, regardless of the exchange regime. More generally, the authorities have great influence on domestic spending and activity and thereby the country’s external balance, through policies affecting the domestic credit of the banking system when most domestic financial institutions are part of that system, domestic tradable goods prices are closely tied to world prices, and linkages between domestic and international financial markets are relatively weak. Moreover, with a fixed exchange rate, a ceiling on domestic credit would generally be more readily attained than a ceiling on a monetary aggregate.
In contrast, a ceiling on a monetary aggregate would be the more useful type of monetary target when the economy has a flexible exchange rate, domestic goods prices are not closely tied to world prices, strong linkages exist between domestic and international financial markets, and there is a variety of unregulated domestic financial intermediaries that can provide credit not subject to the ceiling on credit from the banking system. Since credit ceilings in Fund-supported adjustment programs are often defined with regard to the lending of the banking system, the existence of significant financial intermediation outside the regulated banking system, through either domestic or foreign financial intermediaries, could weaken the relationship between the ceiling on credit from the banking system and economic activity or the current account balance.
The theoretical conclusions just summarized are subject, however, to serious qualifications arising from institutional and practical limitations. First of all, unless the exchange rate is allowed to float without official intervention, the feasibility of the authorities controlling a reserve money aggregate depends upon their ability to sterilize inflows of foreign exchange. As pointed out earlier, this may not only entail costs arising from the redistribution of credit but may also be limited by the lack of financial instruments, other than commercial bank reserves, available for sale by the central bank to mop up excess liquidity. This is a situation prevailing in many developing countries. Second, a “clean float” may in many circumstances be ruled out, either because a country is committed to membership in a currency union or another arrangement entailing long-term fixity of the exchange rate (see Section IV), or because some degree of official intervention seems justified—for instance, to avoid the inflationary effects of “overshooting.” Under these conditions, there are often severe limits to the ability of the monetary authorities to control monetary aggregates; ceilings on domestic credit rather than on such aggregates have therefore been chosen in most cases.
Specification of Fiscal Policy
Fiscal policy—that is, the use of the government’s budget to affect total domestic spending (absorption) and aggregate demand for domestically produced goods—was briefly discussed earlier in this section as an extension of the simple monetary model. In that context, a ceiling on the expansion of domestic credit to the public sector was derived in conjunction with the overall expansion of credit consistent with a balance of payments target and the targeted flow of credit to the private sector.71 Coupled with a limitation on external borrowing by the public sector, this yielded an effective limit on the size of the fiscal deficit. Thus in the simple financial programming framework fiscal policy played the role of constraining the government sector’s demand for credit within an overall ceiling on total domestic credit expansion, taking into account the private sector’s credit needs. In other words, fiscal policy was considered as an aspect of monetary policy and presumed to have no independent effects on aggregate demand and the balance of payments.
In reality, however, measures to reduce fiscal deficits are often of central importance in altering the level of aggregate demand and the current account balance, as well as influencing the current level and future growth of output. The supply-side effects are discussed in Section IV. With regard to demand-side effects, their interaction with the determinants of the demand for money, such as the price level and output, makes the setting of credit ceilings more complex. Although the net effects of fiscal policy on aggregate demand are currently much debated in the academic literature,72 there are many instances in which it is readily apparent that large fiscal deficits have been the chief cause of both internal and external imbalances. Moreover, changes in these deficits may be the chief available means for offsetting changes in other components of aggregate demand (for instance, “fiscal sterilization” of an export boom through temporary increases in export taxes). For these reasons, changes in fiscal policy are often the key feature of adjustment programs.
Since total spending by domestic residents consists of the sum of spending by the public and private sectors, fiscal policy will affect total spending directly through the public sector’s spending on goods and services and indirectly through the effects of both the expenditure and revenue sides of the public sector’s budget on private spending. The direct and indirect effects on total spending of the expenditure side of the public sector’s budget will be considered first, followed by the revenue side.73
Public Sector Spending
In broad terms, spending by the public sector can be classified into spending on goods and services, transfer payments, and interest payments. It is useful to consider the effects of each of these on aggregate spending separately.
Public sector spending on currently produced goods and services is itself a component of total domestic spending, and this, of course, represents its direct contribution to domestic absorption. If public sector purchases are devoted to domestically produced goods that are not internationally tradable, they also represent an addition to aggregate demand for domestic goods. However, public sector imports and purchases of domestic goods that could have been sold abroad at the prevailing world price do not directly affect the aggregate demand for domestic goods. Public sector spending on such traded goods contributes to a worsening of the trade balance while having no direct effect on real aggregate demand, or on such macroeconomic variables as real output and the domestic rate of inflation.
The indirect effects of public sector purchases have generated a considerable controversy, known as the “crowding out” debate. There are many channels through which an increase in public spending could have an indirect effect on private spending. At issue is the extent to which an increase in public spending reduces or increases private spending, thus resulting in an increase in total spending that differs from the original increase in public spending. Several levels of such crowding out or “crowding in” can be distinguished. First, if the public sector buys goods and services to supply public goods that are substitutes or complements for goods purchased by the private sector, total private spending may be affected.74 Second, to the extent that the increased public spending gives rise to an equal tax liability for the private sector, either in the present through tax financing or in the future owing to the need to retire public debt, current or future private disposable income would be reduced, and this would result in some reduction in private spending.75 Third, if the increased public spending results in a net increase in aggregate demand at original price and interest rate levels, domestic economic activity could increase, but this could lead to a reduction of private expenditures: for example, if domestic interest rates adjust upward immediately to maintain portfolio equilibrium with an increased demand for money, interest-sensitive components of aggregate demand would tend to fall, or, alternatively, if portfolio imbalances tend to persist, the excess demand for money may cause households to curtail current spending in order to accumulate cash balances.76 Even in the absence of the last-mentioned effect, the financing of the additional public expenditures could increase the cost or reduce the availability of financing for the private sector, depending on the financial structure of the economy and on the nature of the accompanying monetary policy.77 Finally, if nominal wages are flexible, or if the increase in public spending was foreseen at the time that currently prevailing nominal wage contracts were entered into, the domestic price level could rise sufficiently to reduce private spending by an amount equivalent to the increase in public spending, leaving no net change in total real aggregate demand.78 Clearly, the importance of each of these factors will be determined by the institutional characteristics and structural parameters of individual countries.
Transfer payments from the public to the domestic private sector do not represent a purchase of currently produced goods and services and thus have no direct effect on domestic absorption. They do, however, affect private disposable income and may thereby have an indirect effect on private spending. The amount of private spending induced by a transfer of a given size is likely to depend on the permanence of the transfer (temporary transfers are likely to be largely saved), the characteristics of the private sector recipient, which affect the marginal propensity to consume out of current income (including demographic factors such as age and household size), and the nature of the financial system (which will affect the extent to which recipients are likely to be liquidity constrained).79
Finally, like transfer payments, interest payments by the public sector to the private sector have no direct effect on domestic absorption and aggregate demand; they exercise their effects indirectly through their influence on private spending decisions. An increase in public sector interest payments on foreign debt with unchanged public spending on goods and nonfactor services would also have no direct effect on aggregate demand for domestically produced goods and services.80
In recent years a debate has arisen on whether the part of interest payments corresponding to the inflation rate has the same impact on aggregate demand as that part corresponding to real interest. This question is obviously of particular importance in high-inflation countries. It can be argued that the inflationary component of interest payments is equivalent to amortization of the public debt. Such amortization is usually not regarded as government expenditure, since it is assumed that under normal circumstances the public reinvests in government debt at the same terms as before, leaving aggregate demand thereby unaffected. It is nevertheless doubtful, especially in circumstances of high inflation, that the inflationary component of interest payments is entirely neutral in its effect on aggregate demand, because of changes in the terms and “moneyness” of government debt that are likely to occur in such a situation, especially if acquisition of foreign assets is a feasible alternative to holding government debt.81
Public Sector Revenues
For purposes of macroeconomic analysis in developing countries, it is useful to subdivide the revenue side into two broad analytical categories: taxes collected from the private sector and transfers received from abroad.
Taxes collected from the private sector have the opposite macroeconomic impact of transfers paid to the private sector. Although domestic absorption is not directly affected, a tax increase should reduce private absorption indirectly by reducing private disposable income. The specific impact of taxes on economic incentives and income distribution is, of course, an important topic, which is raised again in Section IV. It also bears mention that attempts to raise taxes beyond accustomed levels can lead to widespread evasion and shifting of various economic activities to black markets.
Transfers to the public sector from abroad also have no direct effect on domestic absorption, given public sector spending. To the extent that an expected future increase in such transfers causes the private sector to revise downward its estimate of its future tax liabilities, however, the perceived “permanent” disposable income of the private sector could rise and an indirect positive effect on domestic absorption would ensue.
The effects on real aggregate demand of changes in other items on the revenue side of the public sector budget can be derived by analogy to the cases of taxes and transfers from abroad. For example, an increase in the net income of public enterprises derived from an increase in their output prices acts like a tax on the private sector to the extent that output is sold domestically (e.g., public utilities and public transport) and like a transfer from abroad if that output is sold abroad (e.g., nationalized export industries).
Public Sector Deficit
The deficit of the public sector is frequently used as an indicator of changes in the fiscal stimulus to aggregate demand. The measure has considerable appeal, since increases in public spending on nontraded goods and services and on transfers to the private sector simultaneously increase the fiscal deficit and aggregate demand, whereas increases in taxes on the private sector reduce both aggregate demand and the fiscal deficit.
It has long been recognized, however, that the public sector deficit must be used with great caution as an indicator of the fiscal stimulus to aggregate demand and of the magnitude of the adjustment effort undertaken by a country in the course of a program of economic stabilization. In part this is because public sector purchases of goods and services have different impacts on aggregate demand from changes in taxes and transfers, so that the composition of the deficit matters, along with its size. In addition, of course, the endogeneity of tax receipts means that fiscal outcomes are only imperfectly controlled by the authorities. Perhaps just as important, though less familiar, is the observation that, in open economies, public sector spending on imports, payments of interest on foreign debt, and net transfers received from abroad may have a substantial impact on recorded fiscal deficits without having a direct effect on aggregate demand for domestic goods and services.
Furthermore, as indicated earlier, in an inflationary setting there are problems in analyzing the effect on aggregate demand of the inflationary component of interest payments on the public debt. For high inflation countries, the notion of an “operational deficit” that excludes this component has sometimes been proposed. While the conventional definition of the deficit, in this respect, also leads to inconsistencies—for instance, the size of the deficit may depend on the extent to which the public debt is held domestically or abroad—the operational deficit may seriously underestimate the monetary and aggregate-demand consequences of government financing operations. Regardless of the definition of the deficit, the total borrowing requirement, in nominal terms, does have to be financed and such financing does have to be monitored in a program to control the overall expansion of domestic credit.82
The inexact correspondence between changes in the size of the public sector deficit and changes in the magnitude of the public sector’s stimulus to aggregate demand explains why it may be insufficient, when aggregate demand is an intermediate policy target, to restrain public sector deficits from the “financing” side—that is, through the imposition of subceilings on the expansion of credit to the public sector and of limitations on external borrowing by the public sector. Since the effects on aggregate demand of a public sector deficit of a given size will vary depending on the composition of spending and revenues, decisions regarding the components of expenditures and revenues may also need to be geared to achieve the desired degree of restraint on aggregate demand.
Financial Programming and Growth-Oriented Adjustment
Although the promotion of sustained growth has always been a major concern of the Fund, growth aspects of adjustment programs have recently received increased attention. For example, the Fund, in collaboration with the World Bank, now supports, for certain low-income countries, financial programs formulated within the context of a long-term growth-oriented adjustment program. There is therefore increasing relevance to extending the basic financial programming model to incorporate the economic variables and relationships that are crucial for meeting growth objectives. To do so, however, is a formidable task, and studies aimed at doing so have only begun to suggest ways in which the financial programming framework might be extended. There is little precedent for combining the two models, in part because in that framework real output is treated as if determined by factors exogenous to the financial program—for example, climatic conditions and foreign demand for exports—even though, in the actual formulation of stabilization programs, output projections have often been adjusted to take the expected effects of policy actions into account. Another difficulty is that general discussions of economic growth in the context of adjustment programs often blur the distinction between three different types of growth of output: growth of output resulting from more efficient use of existing productive capacity; growth of aggregate demand (leading, in the short run, also to growth of output when excess capacity initially exists); and growth in productive capacity.
One approach83 to linking growth-related elements with the basic financial programming model is to incorporate into the latter a small number of additional variables and assumed relationships that characterize the “two-gap” model underlying the Bank’s long-term projections of economic growth in developing countries. These variables, which are related principally to the growth of productive capacity, are the volumes of public and private investment and the capital/output ratio for the economy as a whole; the investment variables depend on domestic and net foreign saving and on public and private consumption, and the capital/output ratio is given by existing labor skills and technology. Exports and the net inflow of foreign capital are assumed to be exogenous. The resulting model has formal characteristics that represent the basic analytical features of both the Fund and Bank frameworks, but it has yet to be elaborated so as to show the relationship between various policies and such variables as private saving, private investment, exports, the capital/output ratio, and indeed also the net inflow of foreign capital.84 A further step would be to incorporate variables for specific sectors of the economy to show, for example, the effects of policies designed to encourage the growth of particular activities. As such models grow in size, however, so do uncertainties about many of the parameter values, thereby limiting the usefulness of the models.
The blending of the Bank’s and Fund’s analytical approaches also does not spell out the relationship between the growth of aggregate demand and the growth of capacity. An approach to this question (see Chand (1987)) would be to expand the basic financial programming model to show how changes in domestic expenditure, and therefore in domestic output, are affected by domestic credit and exchange rate policies. Output is, of course, constrained in the short run by existing capacity, so that the policy changes being undertaken produce variations only within that constraint, and the target for output in an adjustment program would be geared to avoiding either excess demand or unemployed resources in relation to an exogenously determined growth of productive capacity. Relating policy variables to the growth in productive capacity would require further extension of such a model.
The preliminary nature of studies to date taking the approaches just cited suggests that it is not easy to find a clear relationship between financial policies and long-term economic growth. Experience does suggest certain basic propositions, although these are not easily expressed in formal models. First, financial stability over the long term tends to contribute to strong saving and investment performance. However, such a performance may not be assured by financial stability alone: for example, the volume and terms of external financing may play a crucial role. Second, efficiently functioning governmental and market institutions have much to do with the efficiency of both resource use and investment. Finally, a realistic set of incentives to producers and consumers—including exchange rates and interest rates that reflect the cost of foreign exchange and of foreign financing, respectively—makes a crucial contribution to growth performance. These considerations are further discussed in the next section.
