8 Fiscal Expansion and External Current Account Imbalances
- Mario Bléjer, and Ke-young Chu
- Published Date:
- June 1989
This paper analyzes, in a general equilibrium framework, how fiscal policy transmits its effects to the current account of the balance of payments. Some empirical evidence is also presented, based on data from ten Latin American countries.
The main findings of this paper are as follows. (1) The inflation tax—that is, the way in which the government deficit is financed—exerts a large negative effect on private savings and, hence, on the current account. (2) The equivalence of debt and tax financing of government expenditure (the so-called Barro neutrality hypothesis) cannot be sustained by the data. This implies a critical role for fiscal policy in the determination of external balances, since a change in the taxation-borrowing mix appears to have a major influence on the current account through its effect on saving. (3) Government capital expenditure “crowds in” private investment, possibly because it increases productivity (when it provides infrastructure and services) and/or because it provides financial resources to the private sector; government capital expenditure seems to exert a major influence on private investment that is largely independent of foreign and domestic interest rates.
There are various competing approaches to explaining the determination of the external balance, including the monetary, the absorption, and the fiscal, as well as the traditional elasticities, approach. Stabilization programs designed by the International Monetary Fund have been characterized as relying for their theoretical background on a mixture of the monetary and the absorption approaches.1 However, some aspects of the two approaches are difficult to reconcile, and neither approach can explain why the fiscal variables—and not only the financing of the deficit—are a crucial component of the Fund’s stabilization programs. The fiscal approach has also been identified as the theoretical support of the fiscal component of Fund programs,2 but, although it can be represented as the real counterpart of the monetary approach,3 its reduced form is, in fact, an identity between the fiscal balance and the current account of the balance of payments, and, hence, the approach fails to endogenize the current account.
In recent years, a more comprehensive general equilibrium approach based on intertemporal optimization has been developed. Several models based on this approach concentrate on the role played by private agents in saving and investment decisions and analyze whether present generations expand their budget constraint by taxing future generations via government budget deficits, which, in turn, create deficits in the current account.4 The model presented here is based on a similar theoretical framework, but it focuses on the behavior of private, as well as public, agents. The saving behavior of households is determined according to the intertemporal optimizing model of Yaari (1965) and Blanchard (1985), and investment by firms is determined by a stock-adjustment model. Government current revenue is determined by a “tax smoothing” approach, and government current expenditure is also explicitly modeled. Output is taken as given and can be formalized as supply-determined output with the quantity of factors given in the short to medium term. Only one good is considered; consequently, terms of trade changes are ruled out from the present model specification.
The intertemporal optimization models usually lack consistent empirical estimates; at the econometric level the general equilibrium approaches become very “partial” and/or the estimates are not well founded on the behavior of agents. This paper tries to fill the gap: its focus is on the empirical application of the model—namely, (1) an investigation of the forces that account for current account imbalances at a microeconomic level; (2) the direct and indirect roles played by different kinds of fiscal policies in determining current account imbalances; and (3) the application of this kind of model to Fund-supported stabilization programs.
The empirical model estimated here is a five-equation system of government current expenditure, government current revenue, total investment, private saving, and the current account. These equations form a recursive model that clearly spells out both the direct effect of private behavior and of fiscal policy on the current account and the indirect effect of fiscal policy through changes induced in private sector behavior.5
Section II contrasts the fiscal and monetary approaches to the balance of payments at the analytical level. It describes the assumptions upon which the two approaches rest and presents the structure of the two models. It concludes by showing how the two models can be reconciled in a more general framework. Section III presents the empirical estimates of the five-equation model based on the general framework and shows the effect of specific changes in the explanatory variables on the current account. Section IV draws some conclusions regarding the policy issues raised by the empirical estimates of the model. Appendix II presents an integrated system of financial, external, and government accounts. This accounting framework, which starts with the current account of the balance of payments identity that the fiscal approach is based on, is transformed in order to provide the basis for the absorption approach and, with further elaboration, for the monetary approach.
II. Comparison Between Monetary and Fiscal Approaches to the Balance of Payments
This section analyzes the basic characteristics of the monetary and fiscal approaches to the balance of payments in a context of a fixed and a flexible exchange rate system in the short and long runs. It also compares the two models to more recent portfolio balance models of exchange rate determination.
1. Monetary Approach
The monetary approach to the balance of payments, as developed by the Fund and the University of Chicago at the end of the 1950s, stresses the essentially monetary nature of balance of payment imbalances: “Its essence is to put at the forefront of analysis the monetary rather than the relative price aspects of international adjustment.”6
Accordingly, surpluses in the trade account and the capital account respectively represent excess flow supplies of goods and of securities, and a surplus in the money account reflects an excess domestic flow demand for money. Consequently, in analysing the money account, or more familiarly the rate of increase or decrease in the country’s international reserves, the monetary approach focuses on the determinants of the excess domestic flow demand for or supply of money.7
In the original formulation, the theory is framed in a long-run perspective with the crucial assumption that the monetary authorities cannot sterilize balance of payments surpluses or deficits,8 and that they will therefore be channeled into the money supply.9
The fundamental behavioral equation of the model is the money demand function:
where money demand, Md, is equal to the domestic price level, p, multiplied by a function of real income Y and nominal interest rate i. The money demand function is assumed to be stable, and the incremental demand for money is a function of the growth of nominal income. If the economy considered is a small, open economy, it would face prices and interest rates determined at the world level. Perfect international capital mobility and perfect substitutability between domestic and foreign bonds are also usually assumed. Perfect international capital mobility implies that the interest rate on domestic bonds is equal to the interest rate on foreign bonds plus the forward premium on the exchange rate—that is, covered interest parity; it should be noted that perfect capital mobility is based on the assumption that there is no differential risk of default or of possible changes in financial market rules and the exchange rate regimes.10 Perfect bond substitutability implies that the agents—behaving according to rational expectations—will allocate their portfolio shares indifferently between domestic and foreign bonds with the same expected rate of return.
Finally, it is assumed that purchasing power parity (PPP) holds. PPP relies, in turn, on the assumption that prices are perfectly flexible, and therefore any change in the nominal exchange rate will not be reflected in the real exchange rate. Perfect flexibility of prices and, in particular, of the price of labor ensures that output will be at its full-employment level.
In a system of a fixed exchange rate, the assumptions in the model can be summarized as follows:
where i (i*) refers to domestic (world) nominal interest rate, p (p*) to domestic (world) price level, and y (ȳ) to domestic (full-employment) output.
Given that the money supply equals the sum of international reserves (R) and domestic credit (DC),11 equilibrium in the money market requires that
An increase in the demand for money raises international reserves, whereas an increase in domestic credit by the central bank reduces international reserves.
Therefore, in a fixed exchange rate system, balance of payments disequilibria can be adjusted through a reduction of domestic credit to a level consistent with the evolution of money demand.
In a flexible exchange rate system, the uncovered interest parity, i - i*, is equal to the expected depreciation of domestic currency:
where e is the nominal exchange rate, defined as units of domestic currency in terms of foreign currency.
The depreciation expectation is formed rationally and corresponds to the expected inflation differential if PPP holds:
For the monetary approach to be able to explain the determination of the balance of payments or the exchange rate in its original formulation, all the above assumptions should hold, together with a stable demand for money function. However, available empirical evidence has shown that all these assumptions generally do not hold. Moreover, the relationship between the exchange rate and the various components of the balance of payments, in particular the current account, cannot be easily explained by the monetary approach. Within the narrow version of the monetary approach one can explain that relationship only through price shocks (such as the two oil shocks of 1973 and 1979, which raised the world demand for dollars) or through announcement effects of unexpected outturns in the trade balance.12
Therefore, a new generation of models has been originated—still in the tradition of asset-demand models of the balance of payments, but with some of the original assumptions of the monetary approach relaxed. These so-called portfolio-balance models are able to offer explanations of the current account/exchange rate relationship by taking into consideration the capital account and thus the real (wealth) effects of current account imbalances. The counterpart of current account surpluses consists of a shift of wealth from foreigners to residents. The increase in wealth for residents raises money demand and also the demand for domestic bonds if these are not perfect substitutes for foreign bonds. Preferences for domestic bonds can derive from special tax treatment of government bonds as well as from political risk attached to the foreign bonds.
The portfolio-balance models allow for a more complex view of the adjustment mechanism. First, they take into account the fact that the asset market reacts more quickly than the goods market, thus generating risks of overshooting and cumulative destabilizing effects. Second, they take into account the existence of nontraded goods and securities—that is, imperfect goods and financial markets.13 The latter implies, in turn, that any change in financial policy affects not only the balance of payments but also prices and the domestic interest rate. Under these circumstances, fiscal expansion, by affecting domestic interest rates, can lead to the financial crowding out of private firms. This mechanism was not an option in the original version of the monetary approach applied to small, open economies.
Because the monetary approach focuses on “the direct connection between the money market and the balance of payments, rather than working through the implied changes in the goods or financial assets markets,”14 it can provide simple and comprehensive indicators for the economic stance. However, it offers few instruments for devising and monitoring adjustment policies for intermediate targets, which in the short run often move in a direction that is opposite to the final result. Therefore, a so-called fiscal approach has been proposed to provide theoretical underpinning for the use of fiscal targets in Fund adjustment programs.15
2. Fiscal Approach
In contrast with the absorption approach, the fiscal approach, which was developed by the Cambridge Economic Policy Group (CEPG) in the mid-1970s, focuses on public sector saving as the only relevant determinant of the current account of the balance of payments. In common with the monetary approach, the fiscal approach extends the balance of payments theories of the 1960s to consider stock demand for assets as well as expenditure decisions. The fiscal approach lumps the private expenditure for consumption and investment together
where nominal private expenditure E, at time t, is a stable proportion of nominal disposable income at t and is lagged one year,
Since the wealth increase is equal to the period saving, this equation can also be written as
The demand for the net stock of financial assets is assumed to be a “small and stable” proportion of the disposable income of the private sector.17 Interest rates are fixed and investment demand is totally interest inelastic. Hence, the fiscal approach (which ignores net income and transfers from abroad) models the current account of the balance of payments, X–Z, as determined by the fiscal balance, T–G, and private balance, S–I, as follows:
Under certain conditions, the fiscal and monetary approaches can be considered mirror images of each other. In their simplest version—with only one financial asset and private expenditure depending solely on asset stock disequilibrium—the monetary approach concentrates on the official settlement accounts and lumps everything else into “items above the line.” The fiscal approach concentrates on the current account and lumps everything else into “items below the line.”18
The flow equilibrium conditions for the commodity and money markets can be written:
|Fiscal approach||(X − Z)||=||(T − G) +||(S − I)||(15)|
|Monetary approach||ΔR||=||ΔDC +||ΔMd||(16)|
With capital movements equal to zero, the sum of each column equals zero, showing the perfect similarity of the theoretical form of the fiscal and monetary approaches.
However, the fiscal and the monetary approaches are rooted in substantially different views about the working of the labor market and price and output flexibility. Whereas most versions of the monetary approach assume continuous full employment, the fiscal approach considers output and employment to be flexible. Therefore, a fiscal expansion raises output, which is not assumed to be at its full-employment level, and, thus, also raises tax revenue. The fiscal deficit will be less than the initial fiscal expansion. In addition, there will be no crowding out of the private sector because of the assumption of perfect, open financial markets, which implies i = i*, and also because of a marginal private propensity to spend that is assumed to be unity for both consumption and investment.
Accordingly, the policy recommendations of the two approaches for achieving equilibrium of the external balance are far apart. The key recommendation of the New Cambridge school for the U.K. economy was that import restrictions be introduced to offset the government expenditure that should continue to play a role in supporting domestic demand. According to the monetary approach, the burden of adjustment should fall on domestic credit creation and on the government deficit, which is considered the main cause of increases in domestic credit.
The differences in the policy recommendations depend on the sensitivity of exports to changes in domestic prices and of prices to changes in demand. In the monetary approach, the parameter that measures the price sensitivity of exports tends toward plus infinity because of the assumption of a small, open economy for which PPP holds and the demand for exports is infinite. In the fiscal approach, this parameter has a positive, but finite value. In the monetary approach, the parameter that measures the price effect of changes in demand in the price equation is equal to plus infinity because the labor supply curve is vertical; in the fiscal approach, the same parameter is equal to zero, because any change in demand will change the output—not at the full employment level—rather than the prices. The sensitivity of prices to changes in the exchange rate is assumed equal to unity by both approaches because money illusion is excluded. However, the fiscal approach allows for lags in real wage resistance (that is, the exchange rate elasticity of prices is less than unity in the short run). In its formulation of the fiscal approach, the CEPG proposed import quotas or an increase in import tariffs to offset the effects of government expenditure. The CEPG’s argument was that increasing tariffs would have the same result as an autonomous reduction in the import propensity of the U.K. economy.19
Despite these unorthodox policy recommendations, which depend on the assumption of a (stationary) quasi-steady state in which private saving equals zero and interest rates are fixed, Milne (1977) and Kelly (1982) extended the model from the industrial country framework so that it could be applied to analyses of Fund-supported stabilization programs in developing countries. The fiscal approach to the determination of the balance of payments is based upon the national accounts identity, which states that the current account of the balance of payments is equal to the government balance and the private sector balance between investment and saving (equation (14)). However, Milne’s estimates of equation (14), also quoted by Kelly,20 differ little from estimations of the national accounts identity; given the current account identity and treating the private balance as a constant, the parameter of the public balance is bound to be not significantly different from unity.
3. An Alternative Fiscal Approach Model
A model that can explain changes in the current account of the balance of payments can be built within the fiscal approach framework, once the behavioral content of private and public saving and investment is specified and once the criticisms of the rather simple behavioral relationship between income and private expenditure of the private sector that characterize the fiscal approach are taken into account. The direct effect of government spending and of different kinds of taxes on aggregate demand, and therefore on the current account, should not be overlooked, nor should the effect on private consumption of increases in debt, in the monetization of debt (inflation tax), and in taxes. The full exogeneity of the private sector in the determination of the current account stated by the fiscal approach can be relaxed without having to substitute the full exogeneity of the public sector, which is only necessary in a neutral framework à la Barro.
Barro’s neutrality hypothesis (Barro (1974)) states that government expenditure has the same impact on the intertemporal allocation of national consumption whether it is financed by taxes or by debt, because, in order to fulfill the intertemporal budget constraint, agents discount the value of the present government debt by the equivalent future tax liabilities necessary to service the debt.21 The assumptions necessary for this hypothesis to hold are the absence of distortionary taxes (that is, only lump-sum taxes are allowed), perfect capital markets, and agents with an infinite life span (or perfect intergenerational chains). The infinite horizons of the agents make the intertemporal budget constraint of individuals equal to that of the government; with perfect financial markets, this equality results in the same discount rate for the individual and the government. In this framework, expenditure-financing policy has no consequences on the current account of the balance of payments, because every fiscal expansion is offset by an equal response by the private sector. It has been demonstrated that once taxes other than lump-sum taxes are introduced in the Barro model (Barro (1978)), or allowances are made for borrowing constraints (Tobin and Buiter (1976)) or for myopia, or finite horizons for the agents are introduced (Blanchard (1985)), the neutrality hypothesis does not hold.
In order to obtain real effects from current and anticipated financing policy, one or more of the equivalence assumptions must be relaxed. The model considered here has three sectors: households, firms, and government.
The private saving function is based on the Blanchard-Yaari model22 which allows for finite horizons of the agents and thus maintains the distinction between individual and government discount rates. In this model, an agent faces a probability of death, ω, which is constant throughout the agent’s life. The existence of insurance companies allows a transfer of wealth from those who die; thus, total financial wealth, W, accumulates at the rate r, the interest rate, and individual—financial and human—wealth accumulates at the rate r + ω.
The aggregate consumption function is a linear function of aggregate financial and human wealth:
where ω is the constant probability of death and θ is the discount factor (pure time preference rate). Accumulation of human wealth is given by
where Y is non-interest income; financial wealth is given by
If the government and foreign sectors are introduced, and government spending is financed either by lump-sum taxes, T, or by debt, D, the consumption function becomes
where government debt and net foreign assets have been substituted for nonhuman wealth.23 The dynamic foreign budget constraint is
which amounts to net income from foreign assets and total saving of the economy. The government dynamic budget constraint is
Ḋ is equal to zero because D, G, and T are assumed to be constant. Only at time t0 do D and T increase permanently.
In the steady state, a change in foreign assets is a decreasing function of government debt as well as of consumption
When r = θ, the change in foreign assets will exactly offset the change in debt-thatis, F = -D.
When agents have infinite horizons (ω = 0), foreign assets are independent of changes in D; in other words, the debt-neutrality condition holds.
This result is quite different from that predicted by Barro’s neutrality hypothesis, according to which a zero increase in consumption is to be expected in the case of a debt increase, corresponding to an increase in private saving equal to − D, with no effect on foreign assets in an open economy framework. Indeed, with ω = 0—that is, an infinite life span—individuals have the same budget constraint—same horizon and same interest rate—as government, and they are thus indifferent to the timing of taxes.
In a two-period framework, households maximize a two-period utility function subject to an intertemporal budget constraint.24
As usual, the first-order condition for intertemporal utility maximization requires that the marginal rate of substitution between consumption in two consecutive periods equal the reciprocal of the market discount rate to the private sector
Whether consumption will rise over time depends on the ratio between the real interest rate, on the one hand, and the sum of the discount rate and the probability of death, on the other hand.
Human and nonhuman wealth must be equal to the discounted value of household consumption.
where human wealth, H, is equal to the discounted value of labor income minus taxes.
The hypothesis of utility maximization implies that, at any age, consumers allocate resources according to their life resources—that is, the present value of their labor income and the stock of wealth in their possession.25
Private savings are equal to private disposable income less private consumption:
Changes in the interest rate on financial assets will change the inter-temporal allocation of resources because of the intertemporal substitution effect as well as the wealth effect.
The investment function is a stock-adjustment function: firms make investments in order to achieve the optimal, desired capital stock, K*; net investment will then be used to partially adjust the actual to the desired capital stock:
where λ is the adjustment coefficient between zero and one.
Government expenditure is given and taxes are set in order to comply with the government budget constraint
where the implicit initial stock of bonds is assumed to be zero. Government saving is defined as
The macroeconomic equilibrium is achieved when private and public savings minus total domestic investment equal the current account.
In this framework, the role played by intertemporal substitution effects suggests that fiscal policy can modify the current account balance indirectly through its effects on investment and saving behavior. Therefore, a cut in the budget deficit through an increase in taxes can cause an improvement or a deterioration in the current account according to the substitution effect. A cut in public investment expenditure will have the same uncertain effect, once the assumption of fixed output is relaxed. The following section tries to estimate empirically the model discussed here, specifying the above equations in order to take into account historical and institutional characteristics of the countries examined. Moreover, the hypothesis of the direct effect of government expenditure, revenue, and deficits on the current account will be tested.
III. Empirical Model
1. Specification and Estimates
An empirical approximation of the equations described above is estimated for ten South American countries, using annual data for the period 1973-83.27 The period chosen includes the two oil shocks, the increase in world interest rates, and the emergence of the debt crisis in developing countries. Pooled time-series and cross-sectional data have been used to estimate the model, owing to the limited availability of data. In order to avoid the problem of heteroskedasticity often connected with pooled time series, all variables are deflated by a measure of size; most of the variables used in the regressions are scaled to gross domestic product (GDP) at market prices, and some variables are scaled to total population. In order to take into account the different institutional characteristics, ten country dummies replace the constant in the estimates. The sources of the data are the United Nations’ National Accounts, World Bank’s World Debt Tables, and the Funds International Financial Statistics yearbook and Government Finance Statistics Yearbook. In order to ensure that public revenue and expenditure, and private investment and saving, are consistent with the current account of the balance of payments, the United Nations’ National Accounts are also used as the source of fiscal data whenever possible. An attempt has been made to construct a coherent set of information and classification rules, which is especially important when working with cross-country data.28
The model estimated in this section is a five-equation system of government current expenditure, government current revenue, total investment, private saving, and the current account of the balance of payments. The equations have been estimated with ordinary least squares because the model is recursive. The notation used is listed below:
|CA||= current account balance of the balance of payments|
|CE||= government current expenditure|
|CR||= government current revenue|
|GCF||= government capital formation|
|GDPPC||= GDP per capita|
|I||= total investment|
|INF||= inflation rate|
|INFTAX||= inflation tax computed on the government’s outstanding domestic debt at the end of the year|
|RFIR||= real foreign interest rate|
|RGDPG||= real GDP growth|
|RIR||= real domestic interest rate|
|SG||= government saving = CR - CE|
|SP||= private saving|
|XZ||= exports plus imports (i.e., trade component of total output)|
A bar over a variable denotes its ratio to GDP, and the suffix t - 1 denotes a one-year lag. According to the definition of a recursive model, the structural equations can be ordered in the following way:
The first three equations consist only of exogenous variables on the right-hand side. The fourth equation includes two previously estimated endogenous variables, and all the previous equations enter into the fifth equation—the current account equation. In this recursive system the error terms are assumed to be independent. Thus, each equation has been estimated with ordinary least squares without incurring a simultaneous bias. (See Table 1.)
|Current Expenditure (||Equation (40)|
|Current Revenue (||Equation (41)|
|Total Investment (Ī)||Equation (42)|
|Private Saving(||Equation (43)|
a. Expenditure Equation
The structural equation of current government expenditure depends, on the one hand, on the population structure, the size of the outstanding government debt—domestic and foreign—the interest rate on government debt, and the inflation rate; and, on the other hand, on cyclical elements such as unemployment benefits. The higher the ratio of people over 65 years of age to the total population, the higher will be health expenditures and current transfers for pensions; the higher the proportion of the population aged 0-14 years—and a high proportion is typical of developing countries—the higher will be education expenditure.
From the estimates, the coefficient of the GDP per capita variable shows that current expenditure is not countercyclical, possibly because expenditures are very inelastic, as is evidenced by the positive and significant coefficient of the lagged dependent variable. Both the domestic and foreign interest rate coefficients are positive, but only the first one is significant at the 1 percent level of significance. Inflation increases current expenditure, even if with a very small impact and only at the 10 percent level of significance. Neither of the population variables—the percentage of the population over 65 years old and that below 14 years old—had coefficients significantly different from zero; therefore, equations including these variables are not shown.
b. Current-Revenue Equation
The current-revenue equation is based on previous studies of taxable capacity,29 which estimate the ratio of taxes to GDP by regressing it on economic variables that proxy the base to which the tax rates are applied (“tax handles”). A theoretical shortcoming of these tax-handle models (which were designed to overcome basic shortcomings of the simple “tax-ratio” approach that previously prevailed) is that they implicitly assume that revenue determination is the first step in determining the fiscal balance. In other words, the tax-revenue equation is estimated as the first equation of a recursive simultaneous-equation model30 on the basis of which expenditure, and then the deficit, are decided. If this implicit assumption is removed, expenditure and outstanding debt can enter as explanatory variables in the determination of tax revenue, and taxes are determined in order to comply with the government budget constraint. Moreover, the “tax-smoothing principle” proposed by Barro (1978) can be taken into account; according to this principle, smoothing tax revenues over time minimizes collection costs and any excess burden of taxation. To test this hypothesis, some approximation of the present value of future public expenditure should be introduced into the equation.
The results reported in Table 1 are more favorable to the tax-handle approach than to the tax-smoothing principle: the coefficients of GDP per capita and the trade component of total output are positive and significant at the 1 percent level; this trade component, XZ, was remarkably stable throughout different estimates, confirming the relevance for developing countries of taxes based on international trade.31 The coefficient of lagged tax revenue, a proxy for historical administrative capacity, is significant at the 2.5 percent level.
In equation (41b), the inflation coefficient showed a consistently negative sign that can be interpreted as a further confirmation of the “Tanzi effect” of high inflation on revenue collection.32 However, the coefficient was not significantly different from zero. The tax-smoothing principle was tested, adding public expenditure, domestic debt (lagged one year) and foreign debt (lagged one year) to the explanatory variables. None of these variables proved to be significant, and the lagged foreign debt appeared with the wrong (negative) sign.
c. Investment Equation
The investment equation (36) lies within the framework of stock-adjustment models. As has been shown by Blejer and Khan (1984), the market imperfections in the developing countries—such as the lack of developed financial markets, institutional constraints in the labor and foreign exchange markets, and the large share of public investment in total investment—make it difficult to apply other optimizing investment theories in the estimation of investment in these countries. These general problems, which are due to the necessary assumptions of the neoclassical models of investment, are compounded by scarcity of data; no data exist on capital stocks or the user cost of capital.
The behavior of agents aiming to achieve an optimal capital stock can be modeled with the accelerator hypothesis; according to this hypothesis, given a constant capital-output ratio and full utilization of capital equipment, a proportional change in capital stock corresponds to any change in output.
The actual capital stock becomes a function of past levels of desired capital, which depend on past levels of output 0:
Following the standard procedure in order to obtain gross investment as a function of past net investment and depreciation δ,33 the ratio of investment to GDP was estimated, giving the equation the following form:
In the framework of the flexible accelerator, the adjustment coefficient is assumed to vary systematically with underlying economic conditions, such as the various stages of the cycle and the cost and availability of financial resources. In the estimates, the cyclical component has been approximated by GDP growth, and several financial variables were taken into account, such as current and past levels of profits and the rate of return, which play a crucial role in determining the desired level of capital stock.
The availability of financial resources plays a larger role in determining investment than their cost, because of the seriously limited financial markets in developing countries. The three main sources of finance for private investment in developing countries are retained profits, the flow of domestic credit to the private sector, and foreign loans. Accordingly, private domestic credit and private long-term foreign loans, together with two series of real interest rates, were taken into account in the estimates as variables affecting λ.34
Finally, government investment is included as an explanatory variable in order to test the crowding-out hypothesis against the hypothesis of complementarity of public and private investment. The insertion of this variable is crucial, because it represents the only direct effect of fiscal policy on investments. (Taxes on profits are ruled out in this case.) Moreover, government investment in developing countries is largely financed by foreign loans and grants, which brings the availability of foreign capital into the picture.
The results of the equations estimated reject the crowding-out of private investment by government investment; the coefficient of government capital expenditure is larger than 1, at the 1 percent level of significance, and thus has a multiplicative effect on private investment. The stock-adjustment model confirms its explanatory power, with the coefficient of the one-year-lagged investment remaining consistently above 0.5 at the 1 percent level of significance. The real GDP growth coefficient is significant and shows the expected positive sign.
Domestic costs of borrowing are very difficult to measure because of administered interest rates and selective credit policies; two series of interest rates have been used in the estimates—a real rate on deposits, RIR, and an actual rate of interest on foreign debt, RFIR, to approximate the world interest rate (actual i + ė - ṗ). However, introducing RIR and RFIR will not substantially change the results, and both show insignificant t-tests (-1.61 and 1.17, respectively). It is worth noticing that whereas the real deposit rate has the expected negative sign, the real foreign interest rate has a positive sign. Even more disappointing are the effects of financial variables representing the quantity of financial resources made available for investment finance.35 This is due to the lack of data on short-term loans, which usually go to the private sector. Still, credit availability influences total investment through government investment, because public investment in developing countries largely corresponds to the sum of foreign grants and loans.
d. Saving Equation
The saving equations estimated here draw on equation (35). A number of additional variables have been included in an attempt to capture life-cycle aspects of the saving decisions. The specification also reflects elements of a partial adjustment process, so as to take into account the presence of habit formation in savings behavior.
If the probability of death, ω, is zero, the present value of future taxes should equal the market value of government debt. In this case, any increase in debt should be offset by an equivalent increase in wealth. A serious problem facing anyone trying to test the above propositions for developing countries is the absence of reliable series for household financial wealth. In fact, the only available proxy for household wealth is government debt. Thus, the proposition that government bonds are not net wealth cannot be tested, except through the indirect effect on private savings. However, the same relationship should hold—in the case of an infinite life span—between fiscal deficits and private savings: the coefficient of the deficit in the private-saving equation should be positive and equal to 1.
This hypothesis does not appear to be supported by the estimates, which yield 0.16 for the fiscal deficit coefficient; an increase in expenditure financed by taxes will, therefore, increase the propensity to save, compared with a debt-financed deficit. The latter effectively discourages saving because the government offers better terms of trade between current and future consumption than do the financial markets. Hence, the deficit coefficient should be positive, because agents still expect future taxes to increase, but less than 1, depending, among other things, on the age structure of the population.
The coefficient of the ratio of taxes to GDP, which measures the influence on private savings of disposable income, has the expected negative sign.36 Even more important, the coefficient of the tax variable in the saving equation shows that an increase of 1 percent in taxes will reduce savings by 0.67 percent: it is interesting to note that this coefficient, derived from actual data, lies between the parameters proposed by Barro (1974) and Blanchard (1985) of 1 and ½, respectively. Barro deduces his parameter directly from his theoretical model, whereas Blanchard’s is derived from a separate study by Hayashi (1982). This result rejects Barro’s neutrality hypothesis, leaving room for fiscal policy to affect the current account through its effects on private saving.
A test was also included for money illusion by agents. Using equation (43c) in Table 1, it was found that the coefficient of capital losses on debt caused by the inflation rate more than offset the coefficient of nominal interest payments; if agents have target levels of wealth, one would expect the two coefficients to have opposite signs and similar magnitudes. Moreover, nominal interest payments are already included in disposable income and current government savings, so that the coefficient should be close to zero. However, the uncertainty deriving from high inflation also justifies a negative effect on savings, partly explaining capital flight. The inflation tax calculated on the government debt therefore becomes an important explanatory variable. Additional testing was felt to be advisable, however, since half of the countries for which the domestic debt series was available suffered from hyperinflation, implying a considerable degree of indexation. Accordingly, an inflation tax measured on the stock of money was included as a variable; however, the resulting coefficient proved to be insignificant. This result may be explained by the phenomenon of currency substitution and reduction in money balances that occurs in high-inflation countries, where imperfect indexation of government bonds can give rise to substantial capital losses.
Equation (43a) was chosen for several reasons. The positive coefficient on government saving accorded well with the implications of the life-cycle hypothesis and the estimates showed it to be closer to zero than to 1, as recently suggested by Modigliani, Jappelli, and Pagano (1985). The t-test showed that the coefficient of government current spending, which was tried in order to test for the substitutability of private sector consumption and government spending, was not significant. Real GDP growth turns out to have a positive and highly significant coefficient that agrees well with the predictions of the life-cycle hypothesis, which states that the wealth-income ratio is a decreasing function of the growth rate and that “between countries with identical individual behavior, the aggregate saving rate will be higher the higher the long-run growth rate of the economy” (Modigliani (1986), p. 300). Finally, the lagged dependent variable shows the expected positive sign and carries some explanatory power, tending to confirm the presence of past habit formation in saving behavior.37
The unsatisfactory results of the population and financial variables should be noted. The ratio of population over 65 years old did not show a significant coefficient, nor did the real rate on deposits and total—domestic and foreign—government debt.
e. Current Account Equation
The current account balance is therefore determined by means of the national accounts identity, CA = (CR - CE) + (Sp - I). Substituting the estimated values of the equations discussed above38 yields
Two important determinants of the short-run movements of the current account turn out to be the inflation tax and government capital expenditure, with the former affecting private saving negatively, and the latter exerting a multiplicative effect on investment. Public saving, calculated as current revenue less current expenditure, shows an indirect positive effect of 0.16. These results support the view that capital expenditure and the way in which the deficit is financed, rather than the balance of current government spending, influence the current account of the balance of payments.
Among the financial variables determining the current account, any increase in real domestic and foreign interest rates appears to worsen the current account, through their effect on current government expenditure. In the short term also, the availability of financial resources from abroad worsens the current account, raising investment through government capital expenditure.
The estimates presented here confirm the role of imperfections in capital markets in the determination of investments in developing countries and the low elasticity of current revenue to GDP growth shown by previous studies.
Finally, the lagged variables for saving, current revenue, and current expenditure illustrate the important role played by history and the institutional and administrative framework (though the structure of the population did not influence the results as expected).
IV. Concluding Remarks
The empirical results show that fiscal choices relating to the composition of public expenditure and the structure of taxation have crucial consequences for the current account of the balance of payments. In particular, the inflation tax appears to have a large negative impact on private savings and, hence, on the current account. This effect could well explain the capital flight experienced in Latin American countries, which combine an unsustainable fiscal stance with large foreign and domestic official debt.39
One may note that the failure of debt neutrality, shown by the results of the empirical estimates, creates a critical role for fiscal policy, since a change in the taxation-borrowing mix (for given government expenditure) appears to have a major influence on the current account through its effect on savings. However, the absence of debt neutrality does not appear to imply any significant financial crowding out of private investment, since investment seems to be largely independent of foreign and domestic real interest rates, as is private saving. However, interest rates do contribute to the decrease of public saving through their effect on current government expenditure.
Government capital expenditure has a crowding-in effect on private investment (providing an additional increase of 1.26 in total investment for every unit increase of public capital formation), but, since it also increases absorption, it will tend to worsen the current account, other things being equal. However, this would tend to be offset by the rise in profits, which, by increasing private savings, would improve the current account. Therefore, if projects show adequate returns, the initial negative position of the current account will be sustainable.
It would be interesting to see whether the results presented here for Latin American countries were true for other geographical areas. In any case, further research might include a study of the effect of terms of trade changes by distinguishing between tradable and nontradable goods in the model.
|AD||= country dummy for Argentina|
|BD||= country dummy for Bolivia|
|BRD||= country dummy for Brazil|
|CD||= country dummy for Chile|
|CE||= government current expenditure|
|COD||= country dummy for Colombia|
|CR||= government current revenue|
|e||= nominal exchange rate|
|ED||= country dummy for Ecuador|
|FG||= government foreign grants|
|FIR||= interest rate on government foreign debt|
|GCF||= government capital expenditure|
|GDD||= government domestic debt|
|GDP||= gross domestic product|
|GDPPC||= GDP per capita|
|GFD||= government foreign debt|
|GFDX||= government foreign debt in domestic currency|
|H||= human wealth|
|i||= nominal interest rate|
|I||= total investment|
|INF||= inflation rate|
|INFTAX||= government domestic debt adjusted for inflation according to the inflation adjustment factor in noncontinuous time, ṗ/(1 + ṗ)|
|IP||= interest payment for government domestic debt|
|Ip (g)||= private (government) investment|
|IPTOT||= total interest payments for government foreign and domestic debt|
|K||= capital stock|
|Md(s)||= money demand (supply)|
|(N)DC||= (net) domestic credit|
|p||= price level|
|P14||= percent of population over 14 years of age|
|P65||= percent of population over 65 years of age|
|PD||= country dummy for Paraguay|
|PDC||= domestic credit to the private sector|
|PED||= country dummy for Peru|
|PLTD||= private long-term foreign debt in domestic currency|
|POR||= percent of population between zero and 14 years of age|
|RFIR||= real interest rate on foreign government debt|
|RGDPG||= real GDP growth|
|RIR||= real interest rate on deposits|
|SG||= government saving (current revenue less current expenditure)|
|Sp||= private saving|
|UD||= country dummy for Uruguay|
|W||= nonhuman wealth|
|XZ||= ratio of foreign trade to GDP–that is, (imports + exports)/GDP|
|Yd||= disposable income|
|ω||= probability of death|
It is worthwhile to express the national account and financial identities for the balance of payments in the more complex framework of the Fund’s accounts. The accounting framework used by the Fund mirrors a highly complex financial structure: the scope of the integrated system of financial, external, and government accounts is not limited to efficient monitoring of stabilization programs; it can also provide a framework that guarantees the internal consistency of any economic adjustment package.
Let us consider three sectors: the government, the monetary system (central bank, financial institutions, and banks), and the private sector. The following notation will be used:
|A||= government deposits|
|B||= government domestic debt|
|B*= B*H + B*m + B*f||= government foreign debt|
|Bf (B*f)||= government domestic (foreign) debt held by foreigners|
|BH (B*H)||= government domestic (foreign) debt held by nonbank residents|
|Bm (B*m)||= government domestic (foreign) debt held by the monetary sector|
|CN||= consumption of nontradables|
|CP||= private consumption|
|CT||= consumption of tradables|
|f*||= foreign assets|
|GN||= government expenditure on nontradables|
|GT||= government expenditure on tradables|
|i||= interest rate on government debt|
|i*||= interest rate on foreign government debt|
|î||= interest rate on foreign assets|
|iA||= interest rate on government deposits|
|IP||= private investment|
|L||= loans by the bank system|
|PT||= price of tradables|
|R||= international reserves|
|T= TH + Tm + eT*f||= transfers to government|
|Tf||= transfers from abroad (foreign aid)|
|TH||= taxes from nonbank residents|
|Tm||= taxes from the monetary sector|
|YN||= output on nontradables|
|YT||= output on tradables|
|π||= relative price of nontradables over the price of tradables—that is, the inverse of the real exchange rate|
|ρ(ρ*)||= interest rate on private domestic (foreign) loans|
The budget constraints can be written as follows:
Real government expenditure on tradable and nontradable goods and services, (GT, GN), and on interest payments on domestic and foreign bonds, (iB, i*B*) should be equal to the sum of domestic and foreign bonds issued; changes in government deposits, ΔA; and interest payments on them, i*A; and tax revenues from the household, monetary, and foreign sectors, (TH, Tm, and T*f)—all in real terms.
According to the budget constraint of the monetary sector, the domestic counterpart of changes in international reserves, eΔR, plus any changes in government domestic and foreign debt held by the monetary sector (ΔBm and eΔB*m, respectively), plus the increase in loans to the private sector, ΔL, minus changes in government deposits, ΔA, should be equal to the changes in money supply and operating income—interest payments on government domestic and foreign debt (iBm and ieB*m, respectively), on private loans ρL, and on international reserves (ρ*Re), minus the interest payments on government deposits, iAA, and taxes paid to government, Tm.
The right-hand side of the equation states that the resources available to households and firms consist of disposable income originating in the tradable and nontradable sectors, plus capital income from government bonds and foreign assets, plus the flow of credit net of interest payments. The left-hand side of the equation indicates the uses of these resources, which consist of consumption of tradables and nontradables, investment, and changes in money, government bonds, and foreign asset holdings.
Consolidating the three sectors gives
where the difference between income and total absorption of the economy equals the changes in international reserves, foreign assets, and government bonds. If bonds are not taken into account, what remains is the typical presentation of the absorption view of payments imbalances. For developing countries, the following additional assumptions should be made: no domestic government debt is held by foreigners (Bf ≡ 0); no foreign government debt is held by the monetary system (B*m ≡ 0); and there are rudimentary domestic financial markets (BH ≡0, B*H ≡ 0). Simplifying the notation yields
The monetary system is therefore reduced to
the government sector is equal to
and the private sector is equal to
Consolidating the three sectors now yields
where total domestic absorption and net income from abroad are equal to changes in international reserves. If, in addition, private agents cannot borrow or lend abroad (because of restrictions designed to avoid capital flight) (Δf* ≡ 0), and if the government is experiencing credit rationing from abroad (ΔB*f ≤ 0), then total absorption and property income from abroad will be equal to changes in international reserves in the monetary approach. Therefore, balance of payments changes can be explained with a single use of the demand-for-money function.
A sufficiently wide accounting framework, starting from the current account of the balance of payments identity, on which the fiscal approach developed in Cambridge in the 1970s was founded, can therefore provide the base for the absorption model and, with further elaboration, for the monetary approach to the balance of payments.
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The estimations are based on a sample of ten Latin American countries: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela.
Johnson (1975), p. 229.
Frenkel and Johnson (1976), p. 21.
However, the experience of the Federal Republic of Germany in the 1970s has shown that the authorities can sterilize balance of payments surpluses for long periods. (See Dornbusch (1976a) and Obstfeld (1982 and 1983).)
In the case of a devaluation, the central bank experiences an increase in the value of its foreign assets, which will be balanced by the creation of an equivalent government deposit; the government can sterilize this capital gain (for example, by redeeming government bonds held by the central bank). The same thing can happen in the case of an expected appreciation—following a surplus in the balance of payments—and foreign capital inflows. In the case of sterilization, the money supply does not increase because the central bank sells domestic assets for an amount equivalent to the increase in net foreign assets.
Nor is it assumed that the agents are risk-neutral.
It is assumed that there is no banking system.
The “sticky-price” version of the monetary approach (Dornbusch (1976b)) can also explain the current account/exchange rate relationship. When the one-good representation of international trade is relaxed, and the existence of imperfect information and contracts is taken into account, prices do not adjust instantaneously following a monetary expansion. Therefore, in the short run, sticky prices cause liquidity effects as a consequence of monetary expansion. The subsequent fall in the interest rate will cause an “overshooting” of the depreciation of the exchange rate.
See Dornbusch (1976b).
Blejer and Frenkel (1987), p. 497.
See International Monetary Fund (1987), Kelly (1982), and Milne (1977). The absorption approach has also been seen as the theoretical basis of Fund-supported programs. However, this approach only takes account of the role the public sector plays in policy implementation.
An objection that has been raised to the CEPG interpretation of this statistical evidence is that the equation is an approximation of the national accounts identity. Chrystal (1979), using the CEPG data, found that the coefficient of the current income was equal to 0.92, which is not significantly different from unity, and that the R2 of the estimated equation was equal to 0.999. The different results of the CEPG estimates depended on an a priori restriction of the current income parameter, which cannot be considered a genuine correction for the simultaneous-equation bias.
See Cripps and Godley (1976).
See McCallum and Vines (1981).
It was shown byBlinder (1978) that the CEPG comparative static experiment with an “import quota” was not really an “import quota” effect, but an autonomous down ward shift in the import function: “…By plugging up some of the linkage’ from the circular flow, this change naturally raises national income. Further, since prices are independent from demand, this demand stimulus does not move the price level.”
where DCp is domestic credit to the private sector, NDCg is net domestic credit to the government, Ms is the money supply, Lpg denotes the funds loaned to government by the private sector, Kp(g), is the capital flow to the private (government) sector, and R is foreign official reserves. For a more complete description of national account and financial identities, see Appendix II.
For an exhaustive treatment of the implication of relaxing some of these assumptions, see Leiderman and Blejer (1988).
The effect of an increase in taxes on consumption is an increase equal to half the initial stimulus; an equal increase in debt will bring about an increase in consumption equal to one tenth of the original impulse.
A discussion of the importance of the assumptions regarding the utility function for the current account can be found in Svensson and Razin (1983).
This proposition is common to the life-cycle hypothesis developed by Modigliani, as well as the permanent-income hypothesis developed by Friedman.
From the various constraints, one obtains CA2 = - CA1.
The countries in the sample are Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela.
For instance, a lagged relation between the government surplus/deficit and the cur rent account can be derived from a different classification of the accounts—that is, using accrual versus cash-basis recording.
See Tait, Grätz, and Eichengreen (1979).
See Tabellini (1985).
Substituting GDP per capita for domestic demand (GDP less exports) and adding the relevant exports separately, as suggested by Tait, Grätz, and Eichengreen (1979), worsens the regression fit; the same effect results from substituting the foreign trade component of GDP with imports, as suggested by Tabellini (1985).
See Wallis (1979), p. 83.
According to Blejer and Khan (1985), investment in developing countries is positively influenced by the availability of domestic credit. An interesting consequence of their model of financial repression is that a rise in the interest rate will stimulate investment.
Private foreign long-term debt, PLTD, and private domestic credit, PDC, exhibit coefficients not significantly different from zero and not statistically significant. Moreover, private domestic credit shows a negative sign.
From the definition of disposable income, Yd = GDP - CR. Taking the ratios to GDP, one obtains
For the reasons stated in the above discussion of the estimates, equations (40a) and (41b) have been chosen for current expenditure and current revenue, respectively; equation (42b) for investment; and equation (43a) for saving.
See Ize and Ortiz (1989).