Macroeconomic Models forAdjustment inDeveloping Countries

Edited by Mohsin S. Khan, Peter J. Montiel,

and Nadeem U. Haque

International Monetary Fund

© 1991 International Monetary Fund

Library of Congress Cataloging-in-Publication Data

Macroeconomic models for adjustment in developing countries / edited by Mohsin S. Khan, Peter J. Montiel, and Nadeem U. Haque.

• p. cm.

• Includes bibliographical references.

• ISBN 9781557752192

• 1. Developing countries—Economic policy—Econometric models.

2. Economic stabilization—Developing countries—Econometric models.

I. Khan, Mohsin S. II. Montiel, Peter J. III. Haque, Nadeem UI.

IV. International Monetary Fund.

HC59.7.M239 1991

339.5’09172’4—dc20

91-20951

CIP

Price: US$20.00

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Contents

• • Foreword

  • List of Authors

• 1. Introduction

  • Mohsin S. Khan, Peter J. Montiel, and Nadeem U. Haque

• 2. A Model of Adjustment and Growth: An Empirical Analysis

  • Carmen M. Reinhart

• 3. Stabilization Programs in Developing Countries: A Formal Framework

  • Mohsin S. Khan and Malcolm D. Knight

• 4. Prices, Output, and the Trade Balance in Iran

  • Bijan B. Aghevli and Cyrus Sassanpour

• 5. Oil Wealth and Economic Behavior: The Case of Venezuela, 1965-81

  • Reza Vaez-Zadeh

• 6. Financial, Exchange Rate, and Wage Policies in Singapore, 1979-86

  • Ichiro Otani and Cyrus Sassanpour

• 7. Domestic Credit and Exchange Rates in Developing Countries: Some Policy Experiments with Korean Data

  • Leslie Lipschitz

• 8. Stabilization Policies in Developing Countries with a Parallel Market for Foreign Exchange: A Formal Framework

  • Pierre-Richard Agénor

• 9. A Macroeconomic Model for Developing Countries

  • Nadeem U. Haque, Kajal Lahiri, and Peter J. Montiel

• 10. Dynamic Responses to Policy and Exogenous Shocks in an Empirical Developing Country Model with Rational Expectations

  • Nadeem U. Haque and Peter J. Montiel

• 11. A Forward-Looking Macroeconomic Simulation Model for a Developing Country

  • Nadeem U. Haque, Peter J. Montiel, and Steven Symansky

Foreword

The use of macroeconomic models for the design of adjustment programs has a long history in the IMF. The IMF’s approach to economic stabilization, generally referred to as “financial programming,” is based to a large extent on the models developed in the Fund during the 1950s and 1960s by, among others, J.J. Polak and E. Walter Robichek. The analytical foundation underpinning financial programming has come to be known in the literature as “the monetary approach to the balance of payments.” Financial programming essentially aims at ensuring consistency between the impact of proposed policy measures and a desired balance of payments outcome. This consistency reflects the interaction between a set of balance sheet and behavioral relationships linking the assets and liabilities of the banking system to the balance of payments.

The earlier IMF models are basically formalizations of the monetary approach to the balance of payments. They start from the proposition that in an open economy with a fixed exchange rate, the money supply is an endogenous variable reacting to surpluses and deficits in the balance of payments and not an exogenous policy instrument, as is customarily assumed in a closed economy. Though using somewhat different assumptions and structures, these models derive a formal relationship between changes in the domestic component of the money stock (domestic credit) and changes in international reserves, which can then be employed for setting policy. Specifically, the models allow one to obtain a value for the policy variable—domestic credit—that is consistent with a desired balance of payments position.

This volume contains a selection of the more recent models developed in the IMF dealing with adjustment and stabilization policies in developing countries. The macroeconomic models of the 1980s, while retaining the basic insights of the monetary approach to the balance of payments, have gone well beyond the simple structures outlined in the earlier formulations. For example, they now include objectives in addition to the balance of payments—principally output and inflation—as well as consideration of other policy instruments along with the rate of domestic credit expansion. Such developments were only to be expected, given the advancement of theoretical understanding of macroeconomic relationships, the refinement of econometric methods, and the dramatic improvement in computer technology which has greatly facilitated experimentation with alternative assumptions of macroeconomic behavior.

The newer generation of models included in this volume represents efforts by IMF staff to specify and estimate models that incorporate many of the key structural and institutional characteristics that make developing countries differ significantly from most developed economies. These features include the absence of well-developed equity and capital markets, the existence of credit and foreign exchange rationing that leads to the emergence of parallel markets and curb markets for credit, foreign financing constraints, and underdeveloped fiscal systems that result in frequent use of inflationary finance.

The new generation of models stresses the role, among others, of dynamics, expectations, relative prices, foreign debt issues, and exchange rate policy. The dynamic nature of economic relationships is an important consideration, since it permits an understanding of both the short- and the long-run costs and benefits of alternative policy measures, as well as the path of adjustment. To policymakers, the latter is often just as important as the initial and ultimate effects of a change in policy. By striving to capture expectations and lagged responses in one form or another, the models presented in this volume are capable of addressing dynamic issues. The role that relative prices play in affecting production and consumption decisions is now commonplace. Foreign debt issues, particularly those relating to optimal borrowing and to the effects of the debt stock and debt servicing on the level of economic activity and on the balance of payments, are routinely addressed in macroeconomic models. Since exchange rate policy has assumed much more importance in the adjustment process, it receives correspondingly greater attention than was given to it in the early formulations of the monetary approach to the balance of payments. The above examples are only a subset of the many advances that have been made. Basically, the overriding intention has been to bring a greater degree of realism into macroeconomic models, enabling better explanation of macroeconomic behavior and thereby an improvement in the quality of the input they can provide in the design and implementation of adjustment programs.

Nevertheless, the current macroeconomic models do not necessarily represent the last word. Model building is an evolutionary process that will continue to reflect new developments in economic theory, new econometric methods, and better understanding of the structure of developing economies. As such, the contributions contained in this volume may be viewed as a progress report of an ongoing research program aimed at improving economic policymaking in developing countries.

Jacob A. Frenkel

Economic Counsellor and Director of Research

International Monetary Fund

List of Authors

Pierre-Richard Agénor, Research Department, IMF

Bijan B. Aghevli, Research Department, IMF

Nadeem U. Haque, Research Department, IMF

Mohsin S. Khan, Research Department, IMF

Malcolm D. Knight, Middle Eastern Department, IMF

Kajal Lahiri, Professor of Economics, State University of New York

Leslie Lipschitz, European Department, IMF

Peter J. Montiel, Research Department, IMF

Ichiro Otani, IMF Institute

Carmen M. Reinhart, Research Department, IMF

Cyrus Sassanpour, Middle Eastern Department, IMF

Steven Symansky, Research Department, IMF

Reza Vaez-Zadeh, Central Banking Department, IMF

Edited for publication by

Elin Knotter, External Relations Department