A persistent imbalance between aggregate domestic demand (absorption) and aggregate supply will be reflected in a worsening of the external payments position, an acceleration of domestic inflation, and a slower rate of growth. To address these problems, and in particular to regain a viable balance of payments position, measures will have to be taken (with or without Fund assistance) to bring about an orderly adjustment between absorption and aggregate supply. Either the level of absorption must be reduced or domestic output increased, or both.

1. Introduction

A persistent imbalance between aggregate domestic demand (absorption) and aggregate supply will be reflected in a worsening of the external payments position, an acceleration of domestic inflation, and a slower rate of growth. To address these problems, and in particular to regain a viable balance of payments position, measures will have to be taken (with or without Fund assistance) to bring about an orderly adjustment between absorption and aggregate supply. Either the level of absorption must be reduced or domestic output increased, or both.

Supply–side policies may be defined as measures that increase the incentive or ability of the domestic productive sector to supply real goods and services at a given level of aggregate nominal domestic demand. Such policies can be divided broadly into two categories.

  • Policies designed to increase current output by improving the efficiency with which factors of production (capital, labor, and land) are utilized and allocated among competing uses. Included in this category are all measures that reduce the distortions that drive a wedge between prices and marginal costs. Such distortions can arise, for example, from price controls, imperfect competition, taxes and subsidies, and trade restrictions.

  • Other measures designed to raise the long–run rate of growth of capacity output, for example, by providing incentives to stimulate domestic saving and investment and educational and technological innovation. Also important are policies that increase the inflow of foreign savings, whether in the form of private lending, foreign direct investment, or increased development assistance.

These two categories of supply–side policies are interrelated, since policies that increase current output may, themselves, lead to a larger flow of saving and a higher rate of growth of capacity output.

Following this distinction, Sections 2 and 3 of this chapter review issues related to sectoral resource allocation and measures to increase capacity output, respectively. Section 4 considers the use of supply–side measures in the design of Fund–supported adjustment programs. This chapter emphasizes the use of supply–oriented measures in developing countries. As illustrated in Box VII.1, however, structural measures have also been stressed in industrial countries in recent years.

The Role of Supply–dented Policies in Industrial Countries

The importance of supply–side policies as part of a strategy for long–term growth has been broadly recognized by industrial countries since the early 1980s. This recognition was motivated by a desire to shift from the existing environment of low growth, high and rising unemployment, high inflation, and large fiscal deficits to conditions of stronger and sustained non–inflationary growth. The reorientation of policies was also based on the recognition that, beyond the short run, macroeconomic performance was strongly influenced by the supply side of the economy.

Over the past decade, a number of industrial countries have taken important steps toward improving efficiency and removing distortions. Those have included financial market reforms, measures to deregulate domestic goods markets and stimulate competition through privatization, major tax reforms and steps to enhance the flexibility of labor markets. Efforts are also underway to consolidate the progress made so far in these areas and to extend structural reforms to other sectors where progress needs to be achieved.

Among the important measures that still need to be considered are to cut industrial and farm subsidies and to reduce the restrictions that distort agricultural production and trade; to reform land regulations and those aspects of the distribution system that add to domestic costs and restrict market access; to further reduce distortions and rigidities in labor markets; and to modify certain aspects of existing tax systems, including some tax preferences that affect the level and distort the allocation of private saving. Strong actions in these areas would contribute to raising productive capacity, lowering unemployment, and reducing price pressures. It would also enhance the ability of markets to react to changes in relative prices (including real exchange rates) and thereby facilitate the process of external adjustment.

2. Policies to improve resource allocation

Supply–oriented policies to improve the allocation of given productive resources consist of a wide range of actions to remove rigidities, including prices and distortions that hinder the mobility of resources. In this section, the focus is on broad aspects of structural reform in four key areas: the financial system, public sector enterprises, producer pricing and agricultural marketing, and labor markets. Box VII.2 provides illustrations of supply–oriented measures implemented by Turkey during 1980–85 in three of these key structural areas. Other areas, including the exchange and trade systems and taxes and public expenditures, are dealt with in other chapters.

Turkey: Supply–Oriented Measures, 1980–85

The government of Turkey, supported by large–scale external assistance, adopted an economic program beginning in 1980 aimed at achieving an export–oriented economy relying strongly on market forces. In light of this, structural reforms were implemented with a view to liberalizing prices and reducing the role of the government in the economy. Measures were also taken to manage domestic demand in a manner consistent with elimination of the external and internal imbalances.

The Turkish authorities implemented over the period 1980–85 a wide range of reforms in key structural areas including; the financial system; public sector enterprises; producer pricing and agricultural marketing; exchange rate and trade policies; and taxation. The following discussion focuses on measures taken in the first three areas of reform.

  • Financial system. Interest rates, which had been controlled at levels well below the inflation rate, were freed in 1980. Deposits rates became positive in real terms in 1981. The financial system underwent a number of reforms designed to end financial repression, free capital markets and enhance monetary control. Initially, this decontrol was not accompanied by appropriate safeguards against unsound financial practices, which contributed to a financial crisis in 1982. This strained the liquidity position of the entire banking system. Subsequent changes in monetary control and in banking and capital market regulations allowed the process of liberalization of the financial and capital markets to be continued.

  • Producer pricing and agricultural marketing. The prices of goods produced by the private sector were decontrolled in 1980. Prices of basic commodities produced by state economic enterprises (SEEs) were increased sharply, with future price changes to be made on the basis of cost developments. Pricing of agricultural products and inputs was also changed to reduce subsidization.

  • Public enterprises. Changes in the pricing policies of SEEs have been complemented by more fundamental reforms. Over time SEEs are increasingly expected to base their operations on principles of commercial viability, with greater managerial autonomy and accountability, and more exposure to competition.

a. Financial system

The financial system plays a central role in mobilizing saving and channeling it to the most efficient investment. Consequently, reform in this area is, in many cases, a primary element in the achievement of growth–oriented adjustment. A number of serious distortions in the financial sector, which have important macroeconomic consequences, can be identified. These include:

  • controls on deposit and lending interest rates;

  • the use of credit limits for individual banks to control monetary aggregates and the lack of alternative instruments for monetary control;

  • selective credit controls and subsidization of credit to favored sectors;

  • control over the direction of credit through the operation of publicly–owned financial institutions;

  • high reserve requirements and taxes on financial transactions and institutions;

  • restrictions on entry; and

  • underdeveloped supervision and regulation systems.

Interest rate controls can result in high negative real rates of interest (defined as the nominal interest rate on domestic financial assets adjusted for expected inflation) for prolonged periods. These rates tend to depress financial saving and discourage development of the financial system. In some cases, particularly in Latin America, the real interest rate was lower than –20 percent a year during the 1970s; it has been estimated that during this period financial saving in several countries was being eroded at an average rate of over 10 percent a year in real terms. Thus, while lower interest rates may increase the demand for investment, they tend to reduce actual investment, since at low interest rates insufficient financial savings will be generated to finance these investments.

Low or negative real interest rates imply credit rationing and control. This is likely to contribute to increased costs of intermediation, the growth of unofficial credit markets, and resource allocation problems. Subsidization of credit may also place a burden on the government budget and contribute further to an inefficient allocation of financial resources.

Reforms to reduce or eliminate distortions in the financial sector require achievement of positive real interest rates, as well as policies to improve the structure of rates. These may go beyond ad hoc adjustments to individual rates, and require systematic adjustment of interest rates at regular intervals in line with particular indicators. Rapid interest rate liberalization may, however, pose problems when there is limited competition in the financial sector and inadequate prudential and supervisory mechanisms. Any interest rate reform should be coordinated with exchange rate movements to avoid destabilizing capital flows.

Development of a more efficient financial system may involve a wide range of reforms in addition to measures directly affecting interest rates. These may include lowering reserve requirements that discriminate against the banking sector; strengthening of bank regulation and supervision systems; reduction in the scope of the authorities’ control over the direction of credit; and even liquidation, privatization, or rehabilitation of publicly controlled financial institutions.

Elimination of credit rationing will also require development of alternative, market–based instruments of monetary control. Experience has suggested that successful financial reform requires reasonable macroeconomic stability, and the elimination of excessive fiscal deficits.

b. Public sector enterprises

In many developing countries public sector enterprises have played a leading role in providing basic infrastructure, promoting industrial development, and in pursuing social objectives. Unfortunately, in many cases, public enterprises have proved highly inefficient and, particularly in recent years, experienced serious financial difficulties.

This poor performance can be attributed to a variety of reasons. For example:

  • a lack of managerial accountability and an implicit survival guarantee for the enterprise through government financial backing;

  • bureaucratic disincentives for efficient and innovative management;

  • rigid labor laws and practices;

  • a lack of clearly defined objectives for each enterprise, and the sector as a whole, often resulting in the overextension of the public sector into activities it does not have the resources to manage efficiently; and

  • the absence of competition in many areas of public enterprise operation.

Problems have often appeared in the form of wide–ranging subsidization. This has occurred because of inadequate pricing policies, overstaffing, poor investment decisions and arrears accumulation from other public agencies or the private sector. Implicit subsidies may arise from the preferential treatment of public entities in the allocation of credit or foreign exchange, and noncompetitive procurement and marketing policies. Moreover, inadequate accounting and financial reporting have rendered it difficult to assess the performance of these enterprises.

The financial performance of public enterprises has direct implications for government finance, credit and monetary aggregates, and the balance of payments. In many countries, large and growing deficits of public enterprises have contributed to a deterioration in the balance of payments, rising inflationary pressure, and a crowding out of the private sector. Further, when the public enterprise sector accounts for a significant proportion of the economy, efficient resource use by individual enterprises may have a direct bearing on economic growth.

Underpricing of inputs produced by public enterprises for the domestic private sector may artificially raise the profitability of certain sectors. This, in turn, will give false signals as to the areas of the economy that should receive emphasis in the overall development strategy. Inadequate pricing, especially of infrastructural services, also has a major impact on efficient resource use.

Recent adjustment programs have stressed measures relating to public enterprises. In some cases, the focus was on measures that could be taken quickly, such as price adjustments and hiring freezes. In other instances, more fundamental restructuring was undertaken. Progress, however, has generally been slower than anticipated, particularly when privatization was involved. This reflected the considerable logistical and operational problems that are connected with the task of privatization.

In sum, there are three broad approaches to the reform of the public sector enterprises: rehabilitation, privatization, and liquidation.

  • Rehabilitation involves measures at the level of individual enterprises, redefinition of the relations between public enterprises and the government, and policies that affect the competitive environment within which the public enterprises operate. Also considered are steps aimed at the restructuring of management and improvement in accounting procedures.

  • Privatization aims at taking advantage of productivity gains that might stem from the increased incentives for managerial performance imposed by responsibility to private shareholders. It also seeks the discipline of financial markets and limitations in political interference in decision making.

  • Liquidation might be considered when all options are exhausted.

c. Producer pricing and agricultural marketing

Intervention in agricultural pricing and marketing is a common practice in industrial and developing countries that takes various forms, including state control of domestic and international marketing, regulation of producer and consumer prices, and taxation of exports and imports. It is usually targeted at achieving a wide range of social and economic objectives, such as: stabilizing producer prices or income; influencing the distribution of income between the urban and rural populations; raising tax revenue; assuring food security; and exploiting monopoly power in world markets.

Intervention usually results in severe distortions in the level and structure of domestic producer and consumer prices with negative impacts on output and productive efficiency. In many countries marketing boards set prices for domestic producers well below world prices for their output, and food prices are directly subsidized. Uncompetitive prices often reduce the incentives for domestic agricultural production. Further, subsidization, especially of food, may both contribute to external imbalance and impose a direct drain on the fiscal budget. State–controlled marketing has also contributed, in some cases, to severe macroeconomic imbalance as a consequence of excessive credit expansion to the marketing agencies. Empirical research on food subsidy schemes has raised questions as to the effectiveness of many of these schemes in targeting those most needy. Subsidies on food can lead to overconsumption and waste, as well as the use of certain subsidized items in unintended ways, e.g., the use of subsidized bread as animal feed.

There are several approaches to reform of producer pricing and agricultural marketing. Producer prices may be adjusted on an ad hoc basis in line with international prices; in some cases, this may involve the reduction or elimination of export taxes. Alternatively, an adjustment formula can be adopted for producer prices, which would include international prices and strict margins for marketing agencies and limited government involvement. Pricing and marketing can also be liberalized by allowing prices to be determined by market forces and domestic marketing and exporting to be undertaken by the private sector. This system is likely to be more successful in maintaining appropriate price incentives.

d. Labor markets

The structure of the labor market and the price obtained in that market, the real wage, are important in determining the allocation of domestic factors of production and in maintaining international competitiveness. Distortion in this area arises from various factors.

  • Certain kinds of wage–setting arrangements, such as indexation, have the potential for reducing real wage flexibility.

  • Segmented labor markets and an environment where wage–setting is not subject to financial discipline (e.g., the existence of strong labor unions under accommodating credit policies, and wage–setting in the public sector motivated by political criteria) may cause widespread distortions and rigidity in the labor market.

  • A public sector that is acting as residual employer may push the wage bill too high while other expenditure categories are relatively underfunded. This is likely to cause an overemployment of labor compared to non–labor inputs, with adverse implications for public finance. High employment levels in the public sector may also coexist with low or declining real wages, particularly for skilled positions.

In many developing countries, real wages increased far beyond the rate of increase in productivity. Studies have suggested that capital/labor ratios are sensitive to relative costs of labor and capital. Distortion in labor markets have tended to hurt both growth and labor intensity, to impede growth of employment and, in particular, to contribute to urban unemployment.

Measures to improve the functioning of labor markets may be essential to ensure the successful implementation of macroeconomic policies. Examples of these measures are:

  • excluding the price effects of terms of trade shocks, or more generally, supply shocks, from indexation arrangements;

  • strengthening incomes policy by developing government wage guidelines and outright legal limits on normal increase in wages negotiated in collective bargaining agreements;

  • removing artificial barriers to labor mobility (including training, especially in cases involving a mismatch between demand and supply of given labor skills); and

  • controlling the size of employment, and reviewing wage differentials, in the public sector.

3. Policies to increase capacity output

The rate at which an economy’s capacity can be expanded depends among other things on the split between consumption and investment, as well as the nature and quality of the capital stock being added. Higher capacity growth rates therefore require policies that favor investment and saving. In particular, interest rate policy is prominent in influencing not only short–run changes in spending, inflation, and external finance but also in affecting longer–term accumulation of financial assets and the level and composition of investment.

a. Investment

A considerable increase in output can be achieved in the short run through more efficient and fuller utilization of existing resources. However, economic growth over the longer run requires an increase in productive capacity. This can be achieved through increasing the rate of investment and improving its quality.

(1) Increasing the rate of investment

Investment in developing countries is frequently constrained by the availability of saving, thereby giving policies that favor public and private saving special importance in adjustment programs.

For the public sector, this involves steps to improve the fiscal position. The focus for the private sector, is on interest rate policies and the elimination of distortions in the market for financial saving. Such measures are likely to yield gains in terms of increased rate of domestic private capital formation, and therefore higher rate of capacity output. Sound financial policies are also needed to create an atmosphere of confidence in the future of the economy and its management. Without such confidence, private capital will be transferred abroad and investors may postpone, or cancel, their domestic investment projects.

(2) Improving the quality of investment

The quality of investment is as important for growth as the quantity. Empirical studies generally find that less than half the growth in output is attributed to increases in labor and capital, with higher productivity, explaining the rest. Recent studies have shown that investment productivity as measured by the ratio of the change in GDP to investment (the inverse of the incremental capital to output ratio—ICOR), is significantly higher in faster growing countries.

Several measures may help improve the quality of investment.

  • Positive real rates of interest that adequately reflect real rates of return will help ensure that more productive private sector investments are selected; in turn, the average productivity of investment will be increased. The productivity of investment will also increase, with greater reliance on the price system for the allocation of capital, and less use of non–price rationing mechanisms. Moreover, maintaining a set of relative costs and prices that represent real underlying scarcities, including an exchange rate that reflects the true cost of foreign exchange, will encourage more efficient investment decisions.

  • Recent experience in developing countries has shown that public sector investment programs have sometimes not yielded returns commensurate with the cost of borrowing (especially from abroad). A more effective system of project evaluation is, therefore, an important part of the strategy to enhance the overall quality of investment.

  • Studies have also emphasized that public investment in human capital (e.g., health and education) may have a strong impact on growth in developing countries. Further, there is increasing evidence that investment in public infrastructure can complement the expansion of the most efficient sectors, especially those producing internationally traded goods. Examples of such investments are the development of irrigation facilities in agriculture, and improvements in transport infrastructure.

b. Saving

The objective of raising private saving and improving its allocation can be pursued through a variety of measures aimed at removing distortions in financial markets, eliminating tax disincentives, and fostering a climate of confidence and stability. In the latter respect, monetary and fiscal policies aimed at keeping inflation under control can play a key role in maintaining a stable environment. As previously discussed, interest rate and financial reforms are the principal policy measure for stimulating the mobilization of private domestic savings in developing countries. Although the effect of interest rates on the overall level of savings remains a debated issue, there is some recent evidence of a positive impact. There is more general agreement that positive real interest rates are likely to lead to financial deepening as savers switch some of their saving from real to financial, and from foreign to domestic, assets.

Recent discussion has argued that a switch from income to consumption taxes may encourage saving. The applicability of a general consumption tax in developing countries remains subject to debate, with concerns also expressed as to the equity implications of such a switch. Selective tax measures to promote saving may have more impact on the allocation than total amount of private saving.

4. Supply–side measures in adjustment programs

a. Role in Fund–supported programs

In recent years severe balance of payments problems in many developing countries have been accompanied by low, or even negative, growth rates. This has led to increasing importance being attached to designing programs that both address adjustment problems and contribute to an increase in sustainable growth over the medium term. In this context, considerable emphasis has been given to supply–side measures, such as those reviewed earlier, as these can enable a country to reduce its external imbalance with a smaller decline in absorption.

There are, however, important difficulties or constraints on the extent of reliance on supply–side measures. For example:

  • many types of supply–side measures increase output only after a significant delay (e.g., increases in producer prices for agricultural products, or infrastructure investment);

  • supply–side measures may affect the political and social objectives of the government, or be perceived as having important impacts on equity as well as efficiency (e.g., changes in food subsidy schemes, or public sector employment policy); and

  • elimination of excess demand remains an essential condition for the successful implementation of supply–side measures.

In general, stabilization programs have to use both demand and supply–side policies and the degree of emphasis on growth–oriented measures will vary according to the cause of external imbalance, the availability of financing to allow time for structural measures to have impact, and the constraints facing the government in pursuing policies that have important political and social implications.

b. Adjustment programs and growth

A distinction may be drawn between short– and long–term issues relating to the effects of Fund–supported programs on growth. In the short run, reduction in excess domestic demand will generally be accompanied by some fell in the growth of output, particularly if inflation has become ingrained in the system. The decline in the growth rate is a necessary part of adjustment to eliminate underlying imbalances in the economy. However, balance of payments recovery should not conflict with economic growth when the time horizon for both objectives is properly specified to be the medium term. This view is based on the following considerations:

  • to the extent that supply–side policies are successful in enhancing the production potential of the economy, they minimize any inescapable impact upon growth of measures that focus on reducing absorption;

  • by raising the capacity of the country to service debt in the future, supply–side policies permit a higher level of sustainable capital inflows and thus a higher rate of economic growth in the long run; and

  • financial stability resulting from a successful stabilization program can boost confidence in the economy.

Recent empirical analysis for 69 developing countries, during 1973–88, suggests that in the short run Fund–supported programs have led to an improvement in the current account of the balance of payments, a lowering of inflation, and a decline in growth. As the evaluation period is lengthened, the positive effects of programs on the external balance and inflation are strengthened and the adverse growth effects reduced. Evidence also supports a positive link between macroeconomic stability and economic growth. There is, however, no general agreement either about the methodologies employed in evaluating the macroeconomic effects of Fund–supported programs, or about the impact past programs have actually had on principal macroeconomic objectives. Further, existing studies do not take into account the degree of implementation of the policies agreed between the Fund and the country.

c. Bank–Fund collaboration

Adjustment with growth can best be promoted in an environment where demand–management and structural policies are mutually supportive. A comprehensive package of reform that enables an appropriate integration of macroeconomic and structural policies is facilitated by close Bank–Fund collaboration. In several areas, structural measures embodied in recent Fund–supported adjustment programs have been formulated with the assistance of the World Bank. These areas cover a wide range of structural policies, including trade reform, public sector, investment programs, public enterprise reform, agriculture and industrial policies. Similarly, the World Bank has relied on the Fund’s expertise in other areas, including reform of the exchange system, and certain elements of fiscal and financial sector reform.

For Structural Adjustment Facility (SAF) and Enhanced Structural Adjustment Facility (ESAF) eligible countries, Bank–Fund collaboration has been formalized in Policy Framework Papers (PFPs). These papers are prepared by the authorities (with the assistance of Bank–Fund staff) of recipient countries for arrangements under the SAF, ESAF and for the Bank’s Special Program of Assistance (SPA) in sub–Saharan Africa. A PFP document sets out macroeconomic and structural policies for a three–year period and reviews the country’s public investment program and financing requirements. The PFP also outlines the likely social impacts of policy changes, along with the steps that can be taken to cushion the poorest segments of the population.


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