Journal Issue

Do Fund-supported adjustment programs retard growth?: A study of available evidence

International Monetary Fund. External Relations Dept.
Published Date:
March 1986
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Mohsin S. Khan and Malcolm D. Knight

A recent study (see box below) reviewed available empirical evidence to see if such programs are intrinsically biased against economic growth. Selected passages from this study are reproduced below.

The Fund’s Articles of Agreement make it clear (Article I) that promoting the growth of output and trade is a primary objective of economic policy and that eliminating payments disequilibria should be sought in accordance with this objective. Fund-supported adjustment programs consequently have to be designed to achieve a viable balance of payments within the context of improved long-term growth performance and price stability. Nevertheless, Fund policies and programs have come under mounting criticism in recent years in the press, as well as in certain academic circles, for failing to encourage economic growth. Indeed, it has been frequently argued that rather than fostering the growth of output, Fund programs tend to cause a slowdown in economic activity, increased unemployment, and a general worsening of living standards… .

Fund-Supported Adjustment Programs and Economic Growth by Mohsin S. Khan and Malcolm D. Knight, Occasional Paper No. 41, International Monetary Fund, Washington, DC, 1985.

Price: US $7.50 (US $4.50 to university libraries, faculty members, and students). Available from: Publications Unit, Box A-861, International Monetary Fund, 700 19th Street, NW, Washington, DC 20431 USA.


In analyzing the effects of Fund-supported adjustment programs on the level or rate of growth of output, it is crucial first to consider the circumstances in which such programs are introduced. Typically the need for a stabilization program, whether supported by the Fund or otherwise, arises when a country experiences an imbalance between aggregate domestic demand (absorption) and aggregate supply, which is reflected in a worsening of its external payments position. While it is true that such external factors as an exogenous deterioration of the terms of trade or an increase in foreign interest rates can be responsible for the basic demand-supply imbalances, often these imbalances can be traced to inappropriate domestic policies that expand aggregate domestic demand too rapidly relative to the productive potential of the economy and seriously distort relative prices. If foreign financing is available, the relative expansion of domestic demand can persist for extended periods—albeit at the cost of a widening current account deficit, a loss of international competitiveness owing to rapid domestic inflation, an inefficient allocation of resources because of the distortions in relative prices, and a heavier foreign debt burden.

Clearly, this disequilibrium cannot continue indefinitely, as the country steadily loses international competitiveness and eventually creditworthiness. In the absence of appropriate policy action, a cessation of foreign financing would impose adjustment on the country, and this forced adjustment is likely to be very disruptive. The basic objective of the Fund in these circumstances is to provide for a more orderly adjustment of the imbalance between absorption and aggregate supply so as to achieve a viable balance of payments position within a reasonable period of time. A viable balance of payments has two aspects. First, it implies that the balance of payments problems will not merely be suppressed but eradicated, and second, that the improvement in the country’s external position will be durable.

The Fund’s task is, in the first instance, to ensure that foreign financing attains a level consistent with the country’s present and future debt-servicing capacity. This may involve setting limits on foreign borrowing or, as has been more evident in recent years, ensuring that the requisite inflow of foreign capital is in fact forthcoming to fill the financing gap. (For example, during 1983 lending by the Fund exceeded $12 billion and the Fund helped to secure over $21 billion in additional bank lending to countries with programs.) The permissible rate of foreign borrowing defines the necessary degree of adjustment of the imbalances in the economy. To achieve the required adjustment, the Fund designs a stabilization program that includes measures to restore a sustainable balance between aggregate demand and supply and simultaneously to expand the production of tradables, thereby easing the balance of payments constraint.

Policy content

Description of Fund programs. Although stand-by arrangements with the Fund are often viewed as synonymous with devaluation and domestic credit restraint, Fund programs are in fact complex packages of policy measures geared to the particular circumstances of the country. More important, the choice of policies and the nature of the policy mix in programs result from extensive negotiations between the country authorities and the Fund. Aside from monetary and exchange rate policies, a typical Fund program calls for fiscal measures, such as reductions in government expenditures and increases in taxation, increases in domestic interest rates and producer prices to realistic levels, policies to raise investment and improve its efficiency, trade liberalization, and wage restraint. Considerable overlap among these various policies does not preclude the convenience of grouping them into the following three categories: demand-side policies, supply-side policies, and policies to improve international competitiveness.

Demand-side policies are measures that influence the aggregate level or rate of growth of domestic demand and absorption. Such policies include the whole range of fiscal, monetary, and domestic credit measures associated with traditional macroeconomic policy. Although these policies also affect production and supply, it is useful at this level of abstraction to label policies that primarily affect aggregate absorption as “demand-oriented” policies.

Supply-side policies are intended to increase the volume of goods and services supplied by the domestic economy at any given level of domestic demand. Such supply-oriented policies can be divided broadly into two groups. First, there are policies designed to increase current output by improving the efficiency with which factors of production, such as capital and labor, are utilized and allocated among competing uses. This category includes measures to reduce distortions caused by price rigidities, monopolies, taxes, subsidies, and trade restrictions. The second group encompasses policies designed to raise the long-run rate of growth of capacity output. Under this heading are incentives for domestic saving and investment. Also important are policies designed to increase the inflow of foreign savings, whether in the form of private lending, foreign direct investment, or increased development assistance. These two groups of supply-side policies are obviously interrelated, since policies that increase current output may, by themselves, lead to a larger flow of saving and investment and a higher rate of growth of capacity output.

Policies to improve international competitiveness contain elements of both demand-side and supply-side policies, since they are based on combinations of measures (such as devaluation cum wage restraint) intended to affect the program country’s real exchange rate. Improving competitiveness is why considerable importance often attaches to the role of exchange rate policies in stabilization programs. In general, to the extent that a combination of policies alters the real exchange rate, it will affect both real domestic absorption and the incentive to produce tradable goods.

In summary, it would be misleading to suggest that Fund programs rely exclusively on one or two policy instruments directed solely at restraining domestic demand. As the above discussion has indicated, much more is involved in the design of Fund programs than a mechanical application of the simple monetary approach to the balance of payments, supplemented perhaps by an exchange rate change. From this standpoint, it may be noted that many alternative policies proposed by critics, particularly those relating to the supply side, already form an integral part of Fund programs…. The basic difference, if any, arises from some critics’ proposal to use controls as a policy to correct balance of payments problems. Fund policy leans heavily in the direction of eliminating controls and restrictions on trade and payments; nevertheless, the Fund has on occasion accepted the temporary use of import controls and export subsidies and, as an interim arrangement, the continuation of dual exchange markets. What the Fund has consistently opposed is the introduction of new restrictions, as well as the intensification on a permanent basis of existing restrictions and other distortions in the trade and payments system. (The use of controls on trade and payments also is inconsistent with the objectives of the Fund as set forth in the Articles of Agreement.) Although a theoretical case can be made for controls and restrictions in the short run, in practice it has proved difficult to manage such systems efficiently and effectively over time. Furthermore, such policies, by introducing rigidities in the economy and creating incentives for the inefficient use of resources and forms of production, can turn out to be counterproductive in the long run and damaging to the growth potential of the economy.

Choice of policy instruments. A crucial concern that arises in the design of adjustment programs is how much emphasis should be placed on supply-side policies relative to demand-side policies. As the need for a stabilization program typically reflects excess demand, all programs must involve some degree of restraint of aggregate domestic demand. This does not mean, however, that adjustment should be based exclusively on reducing absorption—the imbalance could in principle also be eliminated through expanding domestic supply. In fact, demand-side and supply-side policies are closely interrelated. Policies designed to achieve a higher growth rate in the medium term generally require an increase in the rate of productive investment, while demand-management policies require a reduction in the savings-investment gap. The policy package, therefore, must be designed to reduce the level of aggregate domestic demand and simultaneously to cause a shift in its composition away from current consumption and toward fixed capital formation.

Notwithstanding the difficulties of implementing supply-side policies as part of an adjustment program, the Fund has stressed their importance in improving efficiency and the long-term rate of growth. The first difficulty is that many types of supply-side measures improve output only after a significant delay….

A second constraint on the use of certain supply-side measures is the possibility that they may affect the political and social objectives of governments. Many government policies that create distortions (that is, deviations of prices from marginal costs) are designed to achieve objectives other than economic efficiency and may have been implemented with full knowledge of their likely adverse effect on resource allocation. Such policies may include food subsidies, employment programs, restrictions on imports of certain categories of goods and services, and capital controls. Changes in such policies often have a strong impact on equity as well as economic efficiency, and the Fund is enjoined to respect the views of sovereign governments in these matters, although it can, and frequently does, render advice on the budgetary costs of such policies.

Even if these difficulties with supply-side policies are somehow overcome, this does not imply that demand-side policies can be dispensed with. Supply-side policies by themselves do not guarantee an improvement in the balance of payments because, other things being equal, aggregate demand can rise beyond sustainable levels even with increasing aggregate supply, unless it is restrained from doing so. Consequently, stabilization programs have to use both sets of policies, and the decision on the relative emphasis that is to be placed on demand and supply measures in Fund programs is based on a number of criteria. These include:

(i) The nature, magnitude, and likely duration of the external payments imbalance. For example, if a deterioration in the country’s external terms of trade causes the balance of payments deficit, the appropriate response would include supply-side measures designed to change the basic structure of production in the economy. In other words, an adverse external development may alter the mix between demand and supply measures. By contrast, if the initial disequilibrium is the result of excess aggregate domestic demand, owing perhaps to excessively expansionary fiscal and domestic credit policies, then the response would normally rely more heavily on demand restraint than on supply-side measures.

(ii) The initial level of the country’s external indebtedness and the amount of additional financing that can be expected. These conditions determine the length of time over which the adjustment process can take place.

(iii) The nature and importance of the constraints facing the government in pursuing policies that have important social and political implications.

Issues relating to growth

…a distinction needs to be drawn between the short-term issues and the longer-term issues relating to the effects of Fund programs on growth.

Short-term issues. If the initial problem is excess aggregate domestic demand, then, in order to achieve the objectives of the adjustment program, absorption must be reduced in the short run. Although this reduction in absorption can be perceived as representing a decline in living standards, it should not be regarded as a “cost” of the program, since absorption is merely being brought back into line with availability of resources. The real issue is how the reduction in absorption—whether brought about by appropriate demand-side policies or by exchange rate action—will influence the level and rate of growth of output or real income…. In practice … the reduction in absorption necessary to achieve the objectives will generally be accompanied by some fall in the growth of output, particularly if inflation has become ingrained in the system. This decline in the growth rate is a necessary part of the adjustment to eliminate underlying imbalances in the economy. In other words, the adjustment aims at leading the economy onto a more stable and sustainable growth path from a higher but unsustainable path that generally accompanies the supply-demand imbalances. The critical question, of course, concerns the size and duration of the short-run effects of policies designed to reduce absorption.

…Fund programs are not intended to reduce a country’s absorption of goods and services below the level that can be financed (out of current savings and capital inflows) on a sustainable basis. Any reductions in absorption and growth that go beyond the levels necessary to achieve the objectives of the program can be fairly viewed as the true “costs” of a program. Since the “necessary” reduction in absorption and the consequent decline in growth, however, are not measurable precisely, such a notion of costs is difficult to quantify….

Long-term issues…. Even if it was determined that stabilization programs reduce output in the short run, this deficiency could be outweighed by the long-term benefits resulting from the adoption of suitable adjustment policies. Indeed, it is a basic premise of Fund programs that balance of payments recovery does not conflict with economic growth when the time-horizon of both objectives is properly specified to be the medium term.

This view is based on a number of considerations. First, even if a reduction in absorption impairs growth over the short run, to the extent that a Fund program succeeds in avoiding the drastic cut in absorption that accompanies a complete loss of creditor support, the program can be said to protect the growth of the economy currently and in the future. Second, the supply-side, or structural, policies in adjustment programs are intended to enhance the productive potential of the economy by improving the allocation of resources and stimulating domestic savings and investment. If such policies are successful, they diminish any inescapable impact upon growth of measures that focus on reducing absorption. Furthermore, by raising the capacity of the country to service debt in the future, these structural policies allow for a higher level of sustainable capital inflows, and thus a higher rate of economic growth in the long run. Lastly, financial stability resulting from a successful stabilization program can have a beneficial effect on the state of confidence in the economy. This confidence can encourage both domestically financed and foreign-financed investment, leading to gains in employment, productivity, and output.


…The main patterns to emerge from the present survey can be briefly summarized. First, the studies reviewed generally indicated that, while the size of the effect varied, tighter monetary and credit policies would result in a fall in the growth rate in the first year after they were implemented. Furthermore, if monetary and credit restraint took the form of a reduction in the flow of credit to the private sector, the empirical evidence showed that private capital formation and possibly the long-run rate of growth would be adversely affected. Second, no studies showed any clear empirical relation between growth and fiscal policy. There are close institutional links between monetary and fiscal policies in developing countries and thus, once monetary policy variables are taken into account, the various studies have found it difficult to measure the independent role of fiscal policy. Third, there is some evidence that supply-side policies, particularly policies to increase producer prices and the domestic interest rates, have favorable effects on production and savings. For example, price elasticities of supply of agricultural commodities tend to be higher than normally assumed, so that increases in prices encourage the production of primary goods. The effect of variations in real interest rates on savings is, however, quite small, implying that it would take fairly sizable increases in nominal interest rates to change the savings rate. Fourth, a number of studies find a close relationship between the growth rate and capital formation. Therefore, policies directed at increasing investment and improving its efficiency will tend to have a beneficial effect on long-run development. Finally, such empirical evidence as is currently available is consistent with the view that devaluation would, on balance, exert an expansionary rather than contractionary effect on domestic output, even in the short run. This result clearly has an important bearing on the use of exchange rate policy in developing countries.

One explanation of the view that Fund programs systematically reduce growth is perhaps the misconception that programs are designed solely to reduce aggregate demand through the use of contractionary monetary and fiscal policies. Since some empirical evidence indicates that such policies slow growth temporarily, it is concluded that Fund programs must therefore be deflationary. As discussed in this survey, this interpretation of the policy content of Fund programs is far too narrow, and account has to be taken of the other growth-inducing measures contained in Fund programs. This aspect is brought out clearly in the results of crosscountry studies measuring the effects of Fund packages that combined the whole range of demand-management and supply-side policies. These studies found that the rate of growth declined in a number of countries during the course of a program, but this result was matched by a number of cases where the growth rate in fact rose. Once the influence of all relevant policies on the growth rate is recognized, there is no clear presumption that Fund-supported adjustment programs adversely affect growth.

In conclusion, this paper has shown the serious limitations of existing empirical analysis of Fund-supported adjustment programs and economic growth. To evaluate the criticism that Fund programs are unnecessarily deflationary would require more systematic empirical studies. Such studies would have to be in the nature of a case-by-case approach, taking the whole range of Fund policies into consideration rather than focusing on individual elements of programs. They would also have to be supplemented by some type of modeling and simulation analysis so as to handle the issues that arise in comparing the set of policies included in a Fund program with a hypothetical alternative package of measures or in comparing the effects of a Fund program with the outcome that would occur in the absence of a program….

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