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The paper does not deal with one relevant matter, namely the methodology of the IMF, especially financial programming methods and the use of the Polak model which focuses on monetary and credit aggregates in monitoring adjustment. This is a large subject of Its own and has been discussed extensively elsewhere, notably in Khan and Knight (1981) and International Monetary Fund (1987).
There is a diagrammatic exposition of the standard analysis in Chapter 1 of Corden (1985) which also contains references to the origins of these ideas. The basic theory originated with Meade (1951), the concept of “switching” with Johnson (1958), and the formal dependent economy model with Salter (1959). The concern in this paper with sectoral (distributional) effects of adjustment expands on the discussion in Chapter 2 of Corden (1985).
Edwards (1987) analyzes 18 Latin American devaluation episodes and shows in each case what happened to the real exchange rate in each of three years after the devaluation. He calculates for each episode an “effectiveness index” and shows that, when there was stepwise devaluation, in most cases the real exchange rate effect was quickly eroded, sometimes completely after three years. On the other hand, when there was a “crawling peg” the real exchange rate did stay down, this result being obtained by frequent nominal depreciations. See also Connolly and Taylor (1976) for earlier evidence.
It is a well-known proposition that a devaluation may be deflationary for the kinds of reasons (and others) discussed here. See Diaz Alejandro (1965) and Krugman and Taylor (1978). The concern has usually been that it may reduce real expenditures too much, rather than too little. In any case, explicit expenditure policy, whether fiscal or monetary, is always available to supplement, or alternatively compensate for the expenditure-reducing effects of devaluation.
The comparison of wage cuts and public employment reduction to attain a given decline in the public wage bill raises a number of issues not discussed here. For example, wage cuts may cause the better quality employees to leave first while employment reductions might give the government opportunities for selectivity, possibly retaining the better employees. But it is also an oppportunity that can be misused.
The choice between import restrictions and devaluation as a switching device when the current account has to be improved is an important issue discussed in detail in Corden (1987).
For developing countries with debt service problems and hence serious adjustment needs there was a big fall in the investment ratio after 1981. For the three years 1979-81 the ratio of gross capital formation to gross domestic product averaged over 25 percent for them, but for the period 1983-86 it was down to 19 percent. (These figures refer to a large group of countries defined by the International Monetary Fund as “countries with recent debt servicing problems” and are calculated from the World Economic Outlook, October 1987.)
This statement is based on casual impression and awareness of particular cases, and really needs empirical support. The issue was analyzed in Kelly (1982). Kelly’s empirical work based on analysis of IMF programs 1971-80 led to the conclusion that “…(i) external imbalances in years prior to program years tended to be associated with large fiscal imbalances, and (ii) that reductions and increases (relative to gross national product (GNP)) in the current account/overall balance of payments deficit in the year of Fund programs tended to be associated with reductions and increases (relative to GNP) in the overall government, deficit/domestically financed government deficit.” It must also be added that association of fiscal deficits with current account deficits cannot automatically be regarded as indicating causation.
It is well known from the theory of hyper-inflation that if inflationary expectations exceed the actual rate of inflation the latter will accelerate, essentially because the demand for real balances relative to GDP is falling. As the inflation tax rate rises the base of the tax actually falls. Hence the revenue from the inflation tax (expressed as a proportion of GDP) would fall if the monetized budget deficit increased beyond a certain point: sufficient private savings to finance the budget deficit at an initial rate of inflation could not be generated, thus leading to a dynamic monetary disequilibrium—i.e., hyper-inflation.
This was tried in Argentina, Chile and Uruguay in the 1970s. There is now a large literature analyzing these episodes. For a detailed description of the Chilean episode, see Edwards and Edwards (1987) and for overviews of all three “Southern Cone” experiences, see Corbo and de Melo (1985) and Corbo, de Melo and Tybout (1986).
See footnote on page 9.
The term “government” is used here to include the central bank. Hence domestic borrowing refers to borrowing by the government from the private sector or, conceivably, the sale of bonds by the central bank in the open market while at the same time it is buying bonds from the government. The main point is that when there is “domestic borrowing” as defined here, the budget deficit is financed domestically without the money supply being increased. When a fiscal deficit is money-financed it is actually financed by borrowing from the central bank, which then creates the extra money; this process is not defined as domestic borrowing here.
On the measurement of fiscal deficits in the presence of inflation, see Tanzi, Blejer, and Teijeiro (1987).
This part of the deficit could be divided into two parts. One part is attributable to inflationary expectations abroad (which raise the nominal interest rate) and the remaining part is the foreign-financed real deficit. The first part will simply restore the real value of the foreign debt or, at least, will be expected to do so on the basis of inflationary expectations.