Abstract
MOST OF THE LESS DEVELOPED ECONOMIES have been subject during the postwar period to inflationary pressures of various degrees of intensity. As a rule, these pressures emanate from attempts by one or more sectors of the economy to secure a larger share of the total product. The primary motivations for such attempts are the desire of either the public sector or the private sector, or both, to undertake additional investments and to put the burden of the required additional saving on the other sector. However, the attempt of any one sector, once made effective, tends in turn to induce defensive reactions of other sectors that want to maintain their share in the total product, not only for investment but also, especially on the part of the government and of wage and salary earners, for consumption. These defensive reactions usually intensify the inflationary pressures. Moreover, they tend to re-establish the prior distribution of the total product and thus defeat any one sector’s attempt to increase its share.
MOST OF THE LESS DEVELOPED ECONOMIES have been subject during the postwar period to inflationary pressures of various degrees of intensity. As a rule, these pressures emanate from attempts by one or more sectors of the economy to secure a larger share of the total product. The primary motivations for such attempts are the desire of either the public sector or the private sector, or both, to undertake additional investments and to put the burden of the required additional saving on the other sector. However, the attempt of any one sector, once made effective, tends in turn to induce defensive reactions of other sectors that want to maintain their share in the total product, not only for investment but also, especially on the part of the government and of wage and salary earners, for consumption. These defensive reactions usually intensify the inflationary pressures. Moreover, they tend to re-establish the prior distribution of the total product and thus defeat any one sector’s attempt to increase its share.
One facet of the development process in countries with such economies has been the emergence of monetary systems which facilitate monetary management, with the objective of maintaining stability and promoting economic development. Chronic inflation is evidently incompatible with the objective of stability. Moreover, as chronic inflation could not occur without continued excessive monetary expansion, it is an indication that central banks play an important role in the generation of inflationary pressures. Their role may be considered to be active even when they only respond to demands for money from other sectors, which attempt to increase or maintain their share in the total product.
This raises the question of the ability of central banks to determine what amount of money is compatible with stability, to maintain this amount of money, and to facilitate a transfer of real resources from one sector to another by distributing the total “safe” amount of credit among competing sectors.
In this context, the existence of a “safe” rate of monetary expansion will be assumed. Attention will be focused rather on the ability of central banks to control effectively the over-all volume of money and to distribute it. The objective of stability evidently requires that, when aggregate output is inelastic, an expansion of credit to one sector be compensated by a contraction of credit to another sector. If monetary authorities should be found to be unable for technical reasons to take such compensating action, changes in the legal and institutional framework would be necessary. The enforcement of an effective monetary policy may call for the invention of new tools adapted to the particular setting or for an appropriate change in the setting. If monetary authorities are equipped with a set of modern tools, their use may nevertheless prove ineffective because of structural and psychological factors characteristic of less developed countries. If monetary authorities have the technical capacity to compensate for excessive credit expansion, chronic inflation would be an indication of their unwillingness to use that capacity. Since “refraining from doing” is just as much a policy as “doing,” it may be useful to inquire into the reasons for not wishing to compensate when it is possible to do so.
In this paper, the experiences of four countries (Indonesia, Mexico, Nicaragua, and Paraguay) which were subject to chronic inflation during 1949–57 are reviewed. An attempt will be made to show how far central banks mitigated or contributed to inflationary pressures; the potential scope for a more effective monetary policy and the reasons for failure to implement such a policy will then be evaluated.
Since this paper is concerned with monetary rather than with general public policies in relation to inflation, it is assumed that changes in central bank assets in the form of claims on government and of foreign assets are autonomous. This assumption is made in order to limit the discussion to rediscount policy, variable legal reserve requirements, and selective credit controls as anti-inflationary instruments.1 To put it negatively, the assumption makes it possible to disregard the relationship between central banks and governments as well as the link between domestic monetary developments and changes in foreign balances.2
The limitation of the discussion to monetary policy in a narrow sense requires the elimination of one further complication. In most of the countries reviewed, the commercial banking system is composed of government-owned, privately owned, and jointly owned institutions. Moreover, borrowing enterprises are frequently owned jointly by governments and private persons, or even owned completely by governments, without, however, necessarily being called “official entities.” It is, therefore, conceptually and statistically difficult, if not impossible, to draw a clear line between credit to the public and credit to the private sector.3 In view of this problem and of the unavailability of detailed data, the analysis in this paper will employ (unless otherwise specified) the concept of “private sector” as used in the International Monetary Fund publication, International Financial Statistics. This means that partly or even completely government-owned enterprises which are not defined as official entities may, to some extent, be included as final private borrowers. This approach, which draws a line between central bank transactions with the government proper, on the one hand, and the indirect financing of activities of enterprises that are partly or completely government-owned, on the other hand, may appear arbitrary and unrealistic. With existing data it is, however, the only one feasible for analytical purposes if the scope for purely monetary measures is to be explicitly distinguished from general public policies in relation to inflation.
In Nicaragua and Paraguay, central bank credit furnished more cash to banks and the private sector than to the government. In Indonesia and Mexico, the primary expansion in money that was due to the autonomous factors (changes in claims on government and foreign assets) exceeded, on the average, that of central bank credit to banks and the private sector. The autonomous primary expansion also exceeded the estimated safe rate. In those two countries, monetary stability would have required a contraction of central bank credit to banks and the private sector; in Nicaragua and Paraguay, a lower rate of central bank credit expansion to banks and the private sector would have been necessary. On the average, secondary credit expansion by the banking system was relatively most significant in Nicaragua and Mexico; in Indonesia and Paraguay, it was insignificant or absent.
Reserve requirements were changed most frequently in Mexico. Central bank rediscount rates were changed only in Nicaragua. In general, the tools available for restraining secondary credit expansion were not employed to the extent that was technically possible. In Indonesia and Nicaragua, imposition and/or variations of reserve requirements were initially precluded by statutory limitations. Yet, after these limitations were gradually modified, the implementation and enforcement of restrictive measures followed only slowly. When such measures were made effective, they were frequently counteracted, if not overcompensated, by offsetting changes in the credit multiplier and in the income velocity. When changes in those factors were not of an offsetting type, a fairly determined implementation of restrictive measures, mostly a reduction in rediscounting combined with the raising and enforcing of reserve requirements, succeeded in reducing credit to the private sector. This appears to have happened in Nicaragua and in Paraguay in 1956–57.
In spite of institutional limitations, monetary measures could, in two of the four countries reviewed, Nicaragua and Paraguay, have succeeded in preventing continuous inflation. In Indonesia and Mexico, central bank action could have reduced the rate of inflation. The potentially most effective restrictive tool would have been greater restraint in central bank rediscounting for banks and the private sector. During some periods, the exercise of the required degree of restraint might have had adverse effects on output and the utilization of productive capacity, mainly because of the agricultural sector’s heavy reliance on credit.
The unwillingness of the monetary authorities to use restrictive tools more vigorously was due mostly to apprehensions regarding the output effects of a reduction in the rate of credit expansion and, a fortiori, of a reduction in the volume of credit.
To some extent, the reluctance of the monetary authorities to apply greater restraint may have been due to their feeling that a severe restrictive policy toward the private sector, including banks, was politically impossible and therefore would have tended to jeopardize their standing and power in the community.
There are indications that in most of the countries reviewed gradual changes in the legal and institutional framework were slowly followed by a more determined implementation and enforcement of restrictive monetary measures. In addition, further improvements in the efficacy of monetary policy in still predominantly agricultural economies may depend on the extent to which the present inflexibility of credit policy can be reduced. This may require the growth of capital markets and credit institutions outside the monetary system, i.e., nonbank financial intermediaries which derive their resources from genuine savings.
Degree and Sources of Inflation
Each of the countries reviewed in this paper is generally considered to be a less developed country. All have made efforts of various degrees of intensity to raise the rate of economic development. They have currency systems that are de facto managed, i.e., they have monetary institutions which have at their disposal devices that enable them to influence the cost and availability of money and credit. In most of them, the legal framework for monetary policy was extended and strengthened during the period under review, 1949–57.
In all four countries, both the cost of living and the money supply increased almost continuously. The average annual rate of increase in prices was highest in Paraguay (47 per cent) and in Indonesia (17 per cent); in Mexico the average rate of increase was 8 per cent and in Nicaragua, 7 per cent (Table 1). Except in Paraguay, where the income velocity rose almost continuously, the annual average percentage increase in the money supply exceeded the percentage increase in prices. The two countries with the highest rate of inflation showed the closest correspondence between the increase of money and the increase of prices. In both these countries, currency in circulation also expanded at a higher rate than the money supply, i.e., the ratio of currency to total money supply tended to rise, while in Mexico it declined.
Changes in Cost of Living and Money Supply, and Factors Affecting Changes in Money Supply, in Four Countries, 1949–571
(Annual averages in per cent)
Based on data from International Monetary Fund, International Financial Statistics (IFS).
Annual average data were used to compute changes from year to year.
End-of-year data were used to compute changes from year to year.
The increase in the monetary system’s claims on government less government deposits is taken as the cash deficit and is compared with the money supply at the beginning of the year. For Nicaragua and Paraguay, claims on official entities are included.
For Mexico, claims on related institutions (government and private mortgage banks) are included.
This is the change, as a percentage of the money supply at the beginning of the year, of the sum of the remaining items as given in the Monetary Survey in IFS: unclassified assets less quasi-money and unclassified liabilities. Prepayments for exchange are included for Indonesia, Nicaragua, and Paraguay, and counterpart funds for Indonesia.
Changes in Cost of Living and Money Supply, and Factors Affecting Changes in Money Supply, in Four Countries, 1949–571
(Annual averages in per cent)
| Change in Cost of Living2 | Change in Money Supply3 | Increase in Government Net Borrowing from Banking System4 | Bank Credit Expansion to Private Sector5 | Increase in Foreign Assets | Other6 | |
|---|---|---|---|---|---|---|
| (as percentage of money supply at beginning of year) | ||||||
| Indonesia | 17 | 25 | 24 | 8 | 5 | –10 |
| Mexico | 8 | 14 | 2 | 8 | 9 | –6 |
| Nicaragua | 7 | 13 | –5 | 22 | 6 | –9 |
| Paraguay | 47 | 41 | 10 | 38 | … | … |
Based on data from International Monetary Fund, International Financial Statistics (IFS).
Annual average data were used to compute changes from year to year.
End-of-year data were used to compute changes from year to year.
The increase in the monetary system’s claims on government less government deposits is taken as the cash deficit and is compared with the money supply at the beginning of the year. For Nicaragua and Paraguay, claims on official entities are included.
For Mexico, claims on related institutions (government and private mortgage banks) are included.
This is the change, as a percentage of the money supply at the beginning of the year, of the sum of the remaining items as given in the Monetary Survey in IFS: unclassified assets less quasi-money and unclassified liabilities. Prepayments for exchange are included for Indonesia, Nicaragua, and Paraguay, and counterpart funds for Indonesia.
Changes in Cost of Living and Money Supply, and Factors Affecting Changes in Money Supply, in Four Countries, 1949–571
(Annual averages in per cent)
| Change in Cost of Living2 | Change in Money Supply3 | Increase in Government Net Borrowing from Banking System4 | Bank Credit Expansion to Private Sector5 | Increase in Foreign Assets | Other6 | |
|---|---|---|---|---|---|---|
| (as percentage of money supply at beginning of year) | ||||||
| Indonesia | 17 | 25 | 24 | 8 | 5 | –10 |
| Mexico | 8 | 14 | 2 | 8 | 9 | –6 |
| Nicaragua | 7 | 13 | –5 | 22 | 6 | –9 |
| Paraguay | 47 | 41 | 10 | 38 | … | … |
Based on data from International Monetary Fund, International Financial Statistics (IFS).
Annual average data were used to compute changes from year to year.
End-of-year data were used to compute changes from year to year.
The increase in the monetary system’s claims on government less government deposits is taken as the cash deficit and is compared with the money supply at the beginning of the year. For Nicaragua and Paraguay, claims on official entities are included.
For Mexico, claims on related institutions (government and private mortgage banks) are included.
This is the change, as a percentage of the money supply at the beginning of the year, of the sum of the remaining items as given in the Monetary Survey in IFS: unclassified assets less quasi-money and unclassified liabilities. Prepayments for exchange are included for Indonesia, Nicaragua, and Paraguay, and counterpart funds for Indonesia.
Toward the end of the period, i.e., after 1955, the rate of increase in prices declined in Indonesia and Paraguay, and in Nicaragua prices actually fell. The highest increases in prices during any one year ranged between 123 per cent (Paraguay in 1952) and 16 per cent (Mexico in 1955). The lowest increases ranged from minus 4 per cent (Nicaragua in 1956) to plus 16 per cent (Paraguay in 1957).
Government cash deficits and credit expansion to the private sector were the major inflationary factors. In all countries except Nicaragua, the fiscal operations of the government had a net inflationary effect. In Indonesia, the expansionary effect of government cash deficits exceeded that of credit expansion to the private sector in all years during the period under review except in 1951, when government revenues rose substantially because of the boom related to the Korean war. For Mexico, the small average percentage of government cash deficits in the increased money supply shown in Table 1 tends to understate the credit obtained by the public sector, while the relatively large percentage for foreign assets tends to overstate increases in gold and foreign exchange resources.4 If this qualification is allowed for, credit to the public sector appears to have been on the average the most significant source of monetary expansion in Mexico as well. In Paraguay and Nicaragua, credit expansion to the private sector was the principal single cause of increases in the money supply.
Increases in foreign assets had, on the average, an expansionary effect in all four countries. The average annual contractionary effect of other absorption factors (representing the excess of changes in quasi-money, unclassified liabilities, prepayments in foreign exchange, and counterpart funds, over changes in unclassified assets) ranged from minus 6 per cent in Mexico to plus 10 per cent in Indonesia.
On the assumption that central banks cannot control the primary monetary effects of fiscal operations and of changes in foreign assets, the scope for monetary policy is limited to central bank credit extension to banks and directly to the private sector and to the control of secondary credit creation by the banking system. A review of the activities of central banks in these two respects will show to what extent they contributed to, or mitigated, inflationary pressures.
The by-and-large “safe” rate of money expansion may be considered as being related to the average rate of increase in output and the level of, and changes in, income velocity. The increase in monetary liabilities of the central bank that stays within the limits of this safe increase in the money supply is related to the credit multiplier, whose ex post order of magnitude is indicated by the ratio of the increase in the money supply to the increase in total monetary liabilities of the central bank.
This is a rather elementary hypothesis which is, of course, subject to many qualifications. When, for instance, unemployed productive resources of all types are available so that aggregate output is highly elastic, the safe expansion rate of money and effective demand will depend on the extent of unemployed capacity and the relative significance of various bottlenecks (including foreign exchange resources). This condition of a highly elastic output in the short run is not, as a rule, found in less developed countries. Or, to mention another qualification, it may be argued that a rise in world market prices may warrant a monetary expansion greater than would be justified by the domestic output/velocity criterion alone. Also, it has been reasoned that the real transfer of international long-term capital requires a monetary expansion and a rise in relative prices in the capital-importing country. These and other still more subtle considerations regarding the safe rate of monetary expansion, such as the enlargement of the monetized sector, cannot serve to explain chronic inflation; therefore, they may be disregarded in this study. The same holds for increases in velocity or in the credit multiplier. While changes in those coefficients are largely autonomous, there are definite institutional limitations to continuous increases.
The extent to which central bank credit to the private sector contributed to inflation and the relevant factors determining this extent are shown in Table 2. The average values for increases in real income, for income velocity, and for the credit multiplier are shown in columns 1,2, and 3. Average annual increases in the money supply, central bank monetary liabilities, and central bank credit to the private sector are shown in columns 4, 5, and 6. Increases in monetary liabilities (column 5) exceeded increases in central bank credit to the private sector (column 6) in Indonesia and Mexico. In Nicaragua and Paraguay, increases in central bank credit to the private sector were larger than the increases in monetary liabilities; in other words, decreases in other central bank assets and/or increases in nonmonetary central bank liabilities partially offset the effects of increases in central bank claims on the private sector.5 Column 7 shows the estimated “safe” increase in the money supply derived from the increases in real income and the income velocity. The “safe” increase in central bank monetary liabilities (column 8) is estimated by relating the “safe” increase in the money supply (column 7) to the credit multiplier. By comparing this safe increase in central bank monetary liabilities with the actual increase (column 5), one obtains the amount by which central bank credit to the private sector would have had to be adjusted in order to keep the increase in central bank monetary liabilities within the safe limit shown in column 8.
Factors Determining Significance of Central Bank Credit to Private Sector as Source of Inflation in Four Countries, 1949–571
(Annual averages)
Based on data from International Monetary Fund, International Financial Statistics; United Nations, Yearbook of National Accounts Statistics, 1957; International Bank for Reconstruction and Development, The Economic Development of Mexico (1953).
For Indonesia, net domestic product at factor cost, 1951–54; for Mexico, gross national product at market prices, 1948–56; for Nicaragua, annual increases of 7 per cent of gross national product in 1950 assumed, in accordance with estimates of IMF staff; for Paraguay, national income, 1950–56. Except for Nicaragua, all increases in aggregates are shown in terms of 1953 prices.
Average of national income (see footnote 2) at current prices divided by average money supply.
Total increase in money supply during 1949–57 divided by total increase in central bank monetary liabilities minus increase in government deposits during the same period. (Equals col. 4 divided by col. 5.)
For Mexico, central bank credit to banks, related institutions, and private sector; for Nicaragua and Paraguay, central bank credit to commercial banks.
Col. 1 divided by col. 2.
Col. 7 divided by col. 8.
Col. 6 minus (col. 5 minus col. 8).
Col. 6 minus col. 9.
Annual average, 1952–57.
Factors Determining Significance of Central Bank Credit to Private Sector as Source of Inflation in Four Countries, 1949–571
(Annual averages)
| Increase in Real Income (billions of national currency)2 (1) | Income Velocity3 (2) | Credit Multiplier4 (3) | Increase in Money Supply (4) | Increase in Central Bank Monetary Liabilities (5) | Increase in Central Bank Credit to Private Sector5 (6) | “Safe” Increase in Money Supply6 (7) | “Safe” Increase in Central Bank Monetary Liabilities7 (8) | “Safe” Change in Central Bank Credit to Private Sector8 (9) | Excess Increase in Central Bank Credit to Private Sector9 (10) | |||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (millions of national currency) | ||||||||||||||
| Indonesia | 5.0 | 11.0 | 1.0 | 1,800 | 1,800 | 470 | 455 | 455 | –875 | 1,345 | ||||
| Mexico | 3.5 | 7.7 | 1.7 | 971 | 571 | 42 | 455 | 268 | –261 | 303 | ||||
| Nicaragua | 0.07 | 8.2 | 1.7 | 19 | 11 | 20 | 9 | 5 | 14 | 6 | ||||
| Paraguay | 0.4 | 4.6 | 1.2 | 10 | 280 | 10 | 237 | 10 | 353 | 10 | 87 | 73 | 189 | 164 |
Based on data from International Monetary Fund, International Financial Statistics; United Nations, Yearbook of National Accounts Statistics, 1957; International Bank for Reconstruction and Development, The Economic Development of Mexico (1953).
For Indonesia, net domestic product at factor cost, 1951–54; for Mexico, gross national product at market prices, 1948–56; for Nicaragua, annual increases of 7 per cent of gross national product in 1950 assumed, in accordance with estimates of IMF staff; for Paraguay, national income, 1950–56. Except for Nicaragua, all increases in aggregates are shown in terms of 1953 prices.
Average of national income (see footnote 2) at current prices divided by average money supply.
Total increase in money supply during 1949–57 divided by total increase in central bank monetary liabilities minus increase in government deposits during the same period. (Equals col. 4 divided by col. 5.)
For Mexico, central bank credit to banks, related institutions, and private sector; for Nicaragua and Paraguay, central bank credit to commercial banks.
Col. 1 divided by col. 2.
Col. 7 divided by col. 8.
Col. 6 minus (col. 5 minus col. 8).
Col. 6 minus col. 9.
Annual average, 1952–57.
Factors Determining Significance of Central Bank Credit to Private Sector as Source of Inflation in Four Countries, 1949–571
(Annual averages)
| Increase in Real Income (billions of national currency)2 (1) | Income Velocity3 (2) | Credit Multiplier4 (3) | Increase in Money Supply (4) | Increase in Central Bank Monetary Liabilities (5) | Increase in Central Bank Credit to Private Sector5 (6) | “Safe” Increase in Money Supply6 (7) | “Safe” Increase in Central Bank Monetary Liabilities7 (8) | “Safe” Change in Central Bank Credit to Private Sector8 (9) | Excess Increase in Central Bank Credit to Private Sector9 (10) | |||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (millions of national currency) | ||||||||||||||
| Indonesia | 5.0 | 11.0 | 1.0 | 1,800 | 1,800 | 470 | 455 | 455 | –875 | 1,345 | ||||
| Mexico | 3.5 | 7.7 | 1.7 | 971 | 571 | 42 | 455 | 268 | –261 | 303 | ||||
| Nicaragua | 0.07 | 8.2 | 1.7 | 19 | 11 | 20 | 9 | 5 | 14 | 6 | ||||
| Paraguay | 0.4 | 4.6 | 1.2 | 10 | 280 | 10 | 237 | 10 | 353 | 10 | 87 | 73 | 189 | 164 |
Based on data from International Monetary Fund, International Financial Statistics; United Nations, Yearbook of National Accounts Statistics, 1957; International Bank for Reconstruction and Development, The Economic Development of Mexico (1953).
For Indonesia, net domestic product at factor cost, 1951–54; for Mexico, gross national product at market prices, 1948–56; for Nicaragua, annual increases of 7 per cent of gross national product in 1950 assumed, in accordance with estimates of IMF staff; for Paraguay, national income, 1950–56. Except for Nicaragua, all increases in aggregates are shown in terms of 1953 prices.
Average of national income (see footnote 2) at current prices divided by average money supply.
Total increase in money supply during 1949–57 divided by total increase in central bank monetary liabilities minus increase in government deposits during the same period. (Equals col. 4 divided by col. 5.)
For Mexico, central bank credit to banks, related institutions, and private sector; for Nicaragua and Paraguay, central bank credit to commercial banks.
Col. 1 divided by col. 2.
Col. 7 divided by col. 8.
Col. 6 minus (col. 5 minus col. 8).
Col. 6 minus col. 9.
Annual average, 1952–57.
Column 9 indicates the type and order of magnitude of central bank credit operations which would have been required to maintain a reasonable degree of monetary stability. In Indonesia and Mexico, an annual average contraction of central bank credit to the private sector of the amounts shown in Table 2 would have been necessary in order to compensate for the inflationary forces generated by the public sector. As central banks in fact expanded credit to the private sector, their rediscount policies were destabilizing.
In Nicaragua and Paraguay, the primary monetary expansion caused by the autonomous factors fell short of the permissible increase in central bank monetary liabilities. Some expansion of central bank credit to the private sector, of about the average annual amounts shown in column 9, was therefore permissible. But since the central banks increased their credit in excess of those safe amounts, their rediscount policies were in fact overcompensating. The excess expansion was largest in absolute terms in Paraguay and smallest in Nicaragua, as shown in column 10.6
In all four countries, the rediscounting operations of the central bank with respect to the private sector contributed to inflationary pressures. These operations were relatively least significant as an inflationary factor in Mexico and Indonesia, and most extensive in Paraguay and Nicaragua.
Restrictive Policies and Their Effects
In Indonesia, Nicaragua, and Paraguay, the central bank attempted to counteract increases in monetary liabilities by imposing or raising advance deposit requirements for importers. For the most part, these deposits were to be kept at the central bank. The restrictive effects of these requirements were, however, only temporary, as might be expected in view of the limitations of this device, which by its nature can scarcely be more than a stopgap.
The significance of advance deposit requirements as an instrument of credit policy lies in their effects on the composition rather than on the amount of central bank liabilities. Any increase in central bank assets that is accompanied by increases in advance deposits, that is, in central bank nonmonetary liabilities, will result in smaller increases in central bank monetary liabilities than would occur without the increase in advance deposits. If the expansion effect of continued increases in central bank assets is to be compensated by use of this device, continued increases in advance deposits are necessary. This, however, requires that either imports (in terms of domestic currency) continue to increase or the advance deposit percentages be continuously raised.7 The limitations of the former approach are obvious. Continued increases in advance deposit percentages, while perhaps technically possible, would soon affect adversely output and employment in industries using imported raw materials and equipment.
For reasons such as this, the central banks found it necessary to reduce advance payment ratios not long after they had been raised—in Nicaragua in 1954 and in Paraguay in 1956. When a rise in advance payment requirements in 1955 resulted in a rather substantial increase in advance payment deposits, the central bank of Indonesia felt compelled to liberalize its rediscounting and to grant special accommodation to importers, in order to prevent stagnation in the supply of goods and to secure a smooth-running procedure for imports. Thus, the restrictive effect of the increase in advance payments was partially offset by an increase in central bank credit to the private sector. When advance payment requirements were substantially reduced in 1957 in connection with an exchange reform, the expansion effect of the resulting decline in advance deposits exceeded the contraction effect of the decrease in the monetary system’s claims on the private sector.
In Nicaragua, advance payment deposits showed very moderate year-to-year changes and had no significant stabilizing or destabilizing effects. In Paraguay, the continued increase in the local currency value of imports during 1951–57, which was due largely to the depreciation of import rates, resulted in continued increases in advance payment deposits and thus a smaller rise in central bank monetary liabilities than, other things being equal, would have occurred otherwise.
If the primary monetary expansion is not kept within the permissible bounds, an anti-inflationary monetary policy should prevent, or at least restrain, secondary expansion by the banking system. The effect of any given primary expansion on the money supply will be determined by the credit multiplier, which is defined as being equal to the reciprocal of c + r(1 - c), where c stands for the ratio of currency in circulation to money and r for the legal or customary reserve ratio maintained by banks against deposits. This multiplier is usually considered as a fairly stable ex ante coefficient. An approximate ex post indication of its magnitude may be obtained by dividing the increase in money during a given period by the increase in the central bank’s monetary liabilities during the same period. This coefficient was, for the period 1949–57 as a whole, largest in Nicaragua and Mexico and smallest in Indonesia and Paraguay (Table 2).8 Accordingly, secondary expansion of credit by the banking system was more significant in the former than in the latter countries.
The credit multiplier, and consequently the scope for secondary credit expansion with given changes in monetary liabilities of the central bank, may increase or decrease with changes in c or r. Monetary authorities are unlikely to have any influence on changes in c—except for the possibility of reducing it indirectly in the long run by encouraging an expansion of the financial and banking system and changes in payments habits and asset preferences. They may, however, influence the multiplier by imposing or changing legal cash reserve requirements against deposits. The imposition of, or changes in, capital/asset ratios and portfolio ceilings may have similar effects, although these devices aim predominantly at the composition of earning assets in bank portfolios rather than at the proportion between earning and nonearning assets.
There are no indications that the central banks of the countries reviewed effectively checked secondary credit expansion. The annual ratios of increases in money to increases in monetary liabilities of central banks do not show any declining tendency, except in Paraguay since 1955 and possibly in Indonesia since 1954. This tendency in these two countries seems to have been due to a rising trend in the ratios of currency to money and of bank reserves to deposits. The latter probably occurred in Paraguay because of a gradually more vigorous enforcement of average and marginal reserve requirements, and in Indonesia because of the imposition of average reserve requirements in 1957.
The monetary authorities made more extensive use of variations in reserve requirements in Mexico than in any of the other countries, in respect not only to commercial and savings banks but also to other credit institutions. During the period 1949–57, reserve requirements were modified eight times. However, the changes in requirements were geared, to some extent, to influence the composition of earning assets of banks in favor of medium-term production loans and government securities.9 When, for instance, an inflow of short-term capital after the 1949 devaluation increased the liquidity of the banking system, the central bank imposed marginal legal reserve requirements of 100 per cent. But in view of the objective of maintaining medium-term credits to industry and agriculture, banks were permitted specified investments in medium-term production loans and securities of up to 70 per cent of increases in deposits.10 The rate of credit expansion to the private sector accordingly increased sharply, and, in spite of a government cash surplus, so did the money supply. In 1951, banks were required to keep 100 per cent of increases in deposits in the form of deposits with the central bank, except those banks whose deposit liabilities were less than ten times their capital and reserves. This requirement was offset by a substantial fall in bank reserves, both absolutely and relative to deposits, and a corresponding sharp rise in the credit multiplier and the rate of credit expansion to the private sector. Moreover, central bank purchases of securities in support of prices tended to increase bank liquidity. When the ratio of bank funds sterilized to deposits was increased, as in 1951 and 1955, the credit multiplier rose; and it also rose when the ratio was reduced, as in 1953 and 1957.
In Nicaragua, the first attempt to check secondary credit expansion was made in 1957 through monthly increases in legal reserve ratios for private commercial banks (but not for the banking department of the National Bank, which accounts for about three fourths of total loans and deposits). This measure led to a rise in the cash reserve ratios of banks and, combined with a reduction in central bank rediscounts, reduced credit to the private sector.
In Paraguay, the first reduction of legal reserve requirements for commercial banks in 1954 resulted in a higher rate of secondary credit expansion. Later in the same year, it was attempted to counteract this expansion, as well as a primary credit expansion due to increased rediscounting, by raising advance deposit requirements. In 1957, marginal reserve requirements were imposed for the first time. Indonesia established legal reserve requirements in mid-1957.
Scope for Anti-Inflationary Monetary Policies
How far might the central banks have been expected to succeed in maintaining monetary stability in the four countries here under review? In answering this question it is convenient to distinguish between Indonesia and Mexico, where credit to the public sector was the primary source of inflation, and Nicaragua and Paraguay, where credit to the private sector was the primary source.
Public sector as primary source of inflation
Suppose that in any given country the growth of productive capacity, as the result of a given investment pattern, is expected to permit annual increases in real output of, say, $50 million. Also assume that income velocity is 5 and is constant. Abstracting from the various qualifications stated earlier, monetary stability would call for an annual increase in effective demand of $50 million, or a monetary expansion of $10 million.
If the cash operations of the government and the monetary effects of international transactions are neutral, the monetary authorities could permit a net credit expansion to the private sector of $10 million. Assuming an elastic demand for credit, the central bank could induce this expansion by providing banks with a sufficient amount of excess reserves by, say, increased willingness to rediscount or by a reduction in legal reserve requirements. The necessary amount of additional rediscounts or of percentage decrease in reserve requirements would be indicated by the ratio of currency to money, the legal reserve ratio, and the working reserve ratio which banks customarily maintain.
Suppose the government insists on a cash deficit of $10 million. In that event, on the assumptions postulated above, no net expansion of credit to the private sector would be permissible. This means not only that there should be no addition to bank reserves by the central bank directly, but also that additions to bank reserves that are due to the cash deficit of the government should be sterilized. If the government spends the $10 million in the form of currency and the currency/money ratio is 50 per cent, $5 million will flow into banks and serve as a basis for a secondary expansion. In order to prevent this, it would be necessary to require 100 per cent reserves against increases in deposits.
If the government insists on a cash deficit in excess of the safe limit of $10 million, the central bank would have to bring about a net contraction of credit to the private sector.
Assume that the government finances a cash deficit of $20 million by borrowing from the central bank. In the absence of any compensating action, the inflationary gap would be $50 million (the increase in money times velocity minus the increase in real income) plus the secondary credit expansion made possible by increases in bank reserves. Marginal reserve requirements of 100 per cent would merely prevent a secondary expansion. For a complete offset, it would also be necessary to reduce the current expenditures of the private sector by $50 million. The only device available to a central bank to achieve this would be through a reduction of outstanding private credit by $10 million.
Such a contraction cannot take place, however, without some lag. If the central bank stops its rediscounting, contraction will become effective only gradually as the securities in its portfolio mature. The higher the average maturity, the more will the contraction lag behind the expansion of deficit-financed government expenditures. Also, the smaller the amount of rediscounts in the central bank’s portfolio, the smaller will be the scope for contracting credit by ceasing to rediscount and waiting for the paper held to mature. Similar limitations hold in respect to increases in average legal reserve requirements. The percentage by which average legal reserve requirements would have to be raised is equal to the ratio of the excessive government deficit to the amount of bank reserves. If, for instance, bank reserves are $25 million, the legal reserve ratio is 20 per cent, and the excess deficit is $10 million, the average reserve ratio would have to be raised to 28 per cent.11 If banks have excess reserves, the increase in the ratio would have to be correspondingly greater. When banks are loaned up, they will be able to reduce their loan portfolios in the absence of call loans only gradually as outstanding loans mature. De facto, it is therefore irrelevant whether average reserve ratios are raised at once, or gradually, to the necessary level. Moreover, the more important are medium- and long-term loans relative to commercial loans in commercial bank portfolios, the greater will be the lag in the technically possible contraction of credit to the private sector behind the increase in public expenditures.
The amount by which banks will have to reduce their loans in order to recover reserves will be inversely related to the ratio of currency to money. The higher this ratio, the less will banks have to reduce their loans in order to offset a given loss in reserves or an increase in reserve requirements.12
The same considerations hold in regard to the establishment of portfolio ceilings or capital/asset ratios below the existing levels. The scope for open market sales of securities is even more limited by the narrowness of the capital market and the frequent attempts to prevent security prices from falling in order to encourage investment in securities.
If, during the process of excess government deficit financing, the income velocity should decrease (rise) or the currency/money ratio increase (fall), the inflationary impact of any given cash deficit would be reduced (aggravated).
From these observations it follows that the extent to which central banks are technically able to compensate for cash deficits of governments depends on several conditions, even when it can be assumed that an adequate arsenal of modern weapons is available: (1) the average maturity of paper in their portfolios; (2) the amount of private credit instruments held (which will depend on the extent to which banks borrow from the central bank); (3) the average maturity of private credit instruments held by banks; and (4) the ratios of currency to money and of bank reserves to deposits, and changes in those ratios.
Suppose that the government is determined to increase its share in total resources through continued excessive deficit financing, and the monetary authorities are technically unable (or unwilling) not only to contract credit to the private sector, but also to prevent a secondary credit expansion. The share of the government in the total product will rise, but the rise will be smaller than the desired one. This is so because the rise in prices and money income will partially offset the initial rise in government expenditure. The share of the private sector will correspondingly fall, because the increase in private expenditure financed through the secondary credit expansion will necessarily lag behind the initial increase in government expenditure. In other words, the private sector will start spending more after prices have begun to rise, while the government started to spend more before prices began to move upward. If the government finds that the actual increase in its share is less than the desired increase and, accordingly, further increases its expenditures by the amount of the discrepancy with money borrowed from the central bank, the process will continue until the actual share has become equal to the desired share.
The intensity and duration of the resulting inflationary process will be determined by the magnitudes of the credit multiplier and the income velocity. Evidently, the increases in the money supply that are due to government deficits will be greater, the higher the credit multiplier; and the increases in effective demand and money incomes that are due to increases in money will be greater, the higher the income velocity. If compensating reactions of the private sector result not only in continued secondary credit expansion but also in increases in velocity and a deterioration in the pattern of investment, the inflationary process will be intensified and prolonged. A fall in output resulting from, say, crop failure will have a similar effect.
As shown above, the autonomous factors were the primary source of inflation in Indonesia and Mexico. In Indonesia, the principal source was government borrowing from the central bank; in Mexico, it was a combination of government cash deficits and increases in the local currency value of foreign assets.
In both these countries a stabilizing monetary policy would have required an average annual contraction of central bank credit to banks and the private sector, in Indonesia of 875 million rupiah, and in Mexico of 261 million pesos (column 9 of Table 2). The total contraction required during 1949–57 would have amounted to 7.9 billion rupiah in Indonesia and to 2.4 billion pesos in Mexico. Outstanding central bank credit to the private sector at the end of 1948 was only 100 million rupiah in Indonesia and 1.3 billion pesos in Mexico. Therefore, in both countries, not only a freezing of central bank credit to banks and the private sector, but even its complete liquidation, would have been insufficient to compensate for the expansion effects of the autonomous factors. In addition to complete liquidation, the central banks would have needed to borrow from the public.
It is, of course, arguable that the autonomous sources of expansion, especially the government deficits, might have been smaller if the rate of inflation had been lower. Thus, a freezing of rediscounts or, still more, some reduction in rediscounts outstanding would have reduced the rate of monetary expansion and might have resulted in lower cash government deficits.
In Indonesia, the scope for secondary credit contraction was limited, as the credit multiplier for the period as a whole was unity, though in most years it was greater than 1, and in 1951, as high as 2.8. In Mexico, the scope was greater, with a credit multiplier for the whole period of 1.7, and a maximum of 5.4 in 1951. Accordingly, in both countries it would have been technically possible to limit secondary credit expansion to a greater extent than was actually done.
Until 1953, Indonesia had no legal basis for the imposition of legal reserve requirements. When this basis was provided, the central bank, whose Banking Department is the largest commercial bank in the country, was reluctant to impose requirements because it felt that they would not have checked the lending capacity of the foreign banks which furnished most of the credit to the private sector. Marginal legal reserve requirements were objected to because they might have merely resulted in a further decline of the already low deposit/money ratio, unless the supply of currency was also restricted. This, however, was considered impossible as long as the government produced large cash deficits and made its expenditures mostly in currency. Also it was believed that a restriction of credit would not have affected importers financed by wholesalers, and that a reduction in private credit would have amounted to discrimination in favor of importers financed by nonbank sources. When in 1957 minimum legal reserve requirements were introduced for the first time (30 per cent of demand and time deposits of private banks, exclusive of state banks), the credit multiplier fell below unity for the first time since 1950.
In Mexico, as shown above, changes in legal reserve requirements were used, to some extent, to influence the composition of banks’ earning assets. Moreover, increases in reserve requirements were partially offset by autonomous increases in the credit multiplier, while the effect of reductions was reinforced by increases in the multiplier.13
Furthermore, in 1951 and 1955, the expansion effects of sharp increases in the credit multiplier were reinforced by increases in the income velocity. Yet, the effective increases in legal reserve requirements in 1951, while immediately offset by a reduction in bank reserves, almost wiped out excess reserves in 1952, and thus strengthened the central bank’s control over the lending operations of the banking system.
However, in view of a fall in output and employment in almost all sectors, except agriculture, during 1952 and 1953—which was due to a fall in private investment and a reduction in government investment expenditures and resulted in underutilization of capacity in some consumer goods industries—the monetary authorities felt compelled again to relax their credit restrictions.
In both Indonesia and Mexico, restrictions in central bank rediscounts and a more effective use of legal reserve requirements would have reduced the rate of monetary expansion. But in view of the magnitude of the autonomous expansion factors—government deficits and nominal increases in the local currency value of foreign assets—it appears unlikely that monetary measures alone would have succeeded in attaining and maintaining monetary stability.
The attempts of the Mexican authorities to redistribute deposit and savings bank credit through selective reserve requirements and other devices in favor of agriculture and industry appear to have been successful to some extent. The share of these two sectors in current loans of deposit and savings banks increased from 52 per cent in 1948 to 83 per cent in 1954, and then declined to 71 per cent in 1956. This development, however, tended to lengthen the average maturity of assets in the private and central banks’ portfolio, and thus reduced the potential speed with which outstanding credit could be contracted.
The persistent and large government cash deficits in Indonesia could be interpreted as an indication that the government attempted to secure a larger share of the total product by deficit spending. There is, however, no clear evidence that the government succeeded in this respect for any length of time. In 1952, when its cash deficit accounted for almost the whole of the monetary expansion, the ratio of government gross expenditure to net domestic product at factor cost rose from 17 per cent to 19 per cent but declined subsequently, to 17 per cent, in 1954. Government gross expenditures at constant prices increased sharply in 1950 (they almost doubled), financed mostly with increased revenues resulting from the Korean war boom. In the following years they tended to decline and in 1956 were less than in 1950 (but greater than in 1948 and 1949).
The reasons for this apparent inability of the government to secure a lasting increase in its share of the national product might be found in a high, although declining, velocity and a highly elastic supply of credit which enabled the private sector to make its defensive reaction effective. The decline in velocity and possibly in the credit multiplier, on the other hand, tended to mitigate somewhat the inflationary effects of the government deficits.
Private sector as primary source of inflation
In Paraguay and Nicaragua, central bank credit to banks and the private sector was the primary inflationary factor. With the permissible increase in central bank monetary liabilities determined by the average rate of increase in output, the income velocity and the credit multiplier, and the primary expansion effects of the autonomous factors having been less than required, the rate of central bank credit expansion to the private sector and banks exceeded the warranted rate. The excess of actual over required expansion of central bank credit to the private sector was larger in Paraguay than in Nicaragua (see Table 2, column 10).
In Nicaragua, the possibility of reducing the rate of credit expansion by restricting both rediscounts and secondary expansion appears to have been greatest, since on the average one half of bank credit to the private sector was financed by central bank rediscounts and the credit multiplier was relatively high. In Paraguay, in view of a relatively low credit multiplier and the fact that the average increases in central bank credit to banks exceeded increases in bank credit to the private sector, reduced central bank lending to banks was the most promising approach.
The central banks were unable to reduce the net increases in rediscounts—as was done in Paraguay in 1956 and 1957—for more than two consecutive years, or to reduce the amounts of rediscounts outstanding—as happened in Nicaragua in 1957—for more than one year. In principle, the required reduction of net increases in credit to banks and the private sector could have been achieved by either cost or quantitative restrictions.
As to cost restrictions, again in principle, there is no limit, i.e., at some high interest rate the demand for central bank credit will become highly elastic, and increases in the rate will therefore become effective in reducing demand. Neither country, however, permitted a rise in official interest rates to a level approaching the “natural” rate in the Wicksellian sense.
In Nicaragua, increases in the National Bank’s discount rate, from 4 per cent to 5 per cent in 1953, and from 5 per cent to 6 per cent in 1954, reduced neither bank borrowing from the Issue Department nor the rate of credit expansion to the private sector. One reason probably was that the effective interest rates (including charges) charged by banks ranged from 8 per cent to 17 per cent on mortgage loans and from 9 per cent to 10 per cent on commercial loans.
In Paraguay, interest rates ranged from 6 per cent to 10 per cent, according to the purpose of the loan. The central bank applied no cost restrictions because it was believed that an effective restriction of private credit would call for an unduly large rise in interest rates. On the contrary, it sometimes liberalized its rediscounting in order to reduce interest rates in private credit markets, as those rates were considered artificially high.
Sufficiently severe cost restrictions, possibly increases in official interest rates to a level approximating that prevailing in unofficial money markets, might have gone a long way toward restraining the demand for credit without interfering with the market mechanism. It is less certain to what extent the ensuing distribution of the “safe” amount of credit to the private sector would have coincided with, or deviated from, the one desired on the basis of social rather than private productivity criteria.
In view of the unwillingness to apply effective cost restrictions, ceilings on increases in total central bank credit to banks and the private sector would have been called for. As a rule, however, credit ceilings were imposed in a selective manner, with the major objective of controlling the composition of credit to the private sector rather than its volume, and with the view that private credit for “productive” purposes is not inflationary. Thus, the restrictive effects of ceilings on import, construction, and personal credits in Nicaragua were frequently offset by an expansion of loans for other purposes.
When a determined effort was made to reduce central bank credit to banks, as in Nicaragua and Paraguay in 1956–57, in combination with increases in, and enforcement of, legal reserve requirements, the rate of credit expansion to the private sector was effectively checked. The legal reserve policy succeeded in raising bank cash reserve ratios and in reducing the rate of secondary credit expansion in Paraguay; in Nicaragua it resulted in a substantial secondary credit contraction.
Again it would appear that, apart from legal limitations, which were gradually reduced in Nicaragua, the central banks in Nicaragua and Paraguay would have been able technically both to bring increases in their rediscounts closer in line with the required rate and to check the rate of secondary credit expansion. In the latter respect, abrupt increases in the credit multiplier, as in Nicaragua in 1954, provided a limitation.
In the absence of reductions in legal reserve requirements, the principal reasons for increases in the credit multiplier are reductions in the working reserve ratios of banks or a fall in the ratio of currency to money. The latter ratio shows not insignificant changes from year to year in all countries during the period under review. Such changes are hardly subject to control by monetary authorities. Yet, there is no evidence of a continued decline in the currency/money ratio at a rate which would have made impossible any control of secondary credit expansion. The ability of banks to reduce their working reserve ratios, and thus to raise the credit multiplier, is subject to definite limitations. To be sure, when banks are liquid they may respond to a more stringent credit policy by reducing their reserve ratios.14 When they are down to what they may regard as the minimum ratio, they cannot raise the credit multiplier further. At that stage, when central bank control over the credit operations of the banking system is greatly enhanced, central banks at times, as in Nicaragua in 1956, relax their quantitative restrictions, and thus forego the technically possible restrictions of credit to the private sector. Erratic changes in the credit multiplier, therefore, cannot explain continued technical inability to check secondary credit expansion.
Some Reasons for Insufficient Implementation of Restrictive Measures
From the foregoing analysis it follows that an effective application of rediscount policy and increases of reserve requirements could have succeeded in maintaining a fair degree of over-all monetary stability in Nicaragua and Paraguay; in Indonesia and Mexico, the rate of inflation could have been reduced. Accordingly, the question may be raised why the central banks did not adopt and carry out the necessary measures.
It has been shown that the potentially most effective single tool would have been greater restraint in central bank rediscounting activities on behalf of banks and related financial institutions. The failure to exercise a greater degree of restraint may have been due to the unwillingness of the monetary authorities. This unwillingness seems to be attributable primarily to their views on the purposes of, and the criteria for, monetary policy and to apprehension regarding the effects on output of a restrictive policy.
The monetary authorities in most, if not all, of the four countries were apparently guided predominantly in their activities with respect to the private sector by the needs of trade doctrine, safety of deposits, and soundness of individual loans (without being subject to the traditional built-in checks of the gold standard). They were not sufficiently concerned with control of the over-all volume of credit. This appears to hold the most in Indonesia and perhaps the least in Mexico. In view of the tendency to regard a central bank as an engine of growth rather than an instrument to enforce restraint, the traditional, as well as the Keynesian, doctrines appear to have been modified. The principal role of credit policy was deemed to consist in discouraging inflationary “unproductive” commercial credits and in encouraging supposedly noninflationary production credits for agriculture and certain “essential” industries in order to change the pattern of economic development. This reasoning appears to have prevailed in all the central banks concerned and explains the predominant reliance on selective credit controls.
There seems to be discernible, however, an increasing awareness of the limitations of this reasoning. This is indicated by the deliberate and at least initially successful attempts, notably in Paraguay and Nicaragua in 1956–57, to contract the volume of credit to the private sector or to reduce the rate of expansion substantially. The principal means employed to this end were restrictions on the availability of central bank credit to banks and the imposition or enforcement of legal reserve requirements.
However, not all aspects of concern with the output effects of a restrictive credit policy may be unjustified. Suppose that, in view of the anticipated rate of output, a cash deficit of the government prevents, for stability reasons, an expansion of an equal amount of credit to the private sector which otherwise would have been possible. If the increase in government expenditures (or the increase in private expenditures made possible by a fall in tax collections) is for current consumption, while an increase in credit to the private sector would have been used for investment, productive capacity and future output will grow at a lower rate. This decline in the rate of growth may be mitigated to the extent to which the unavailability of new credit for additional production induces additional saving and self-financing in the private sector. In other words, if additional credit had been available, it would have been used, say, to open up new areas for agricultural production. In view of its unavailability, however, the investments might yet be undertaken by a reduction in current consumption, i.e., an increase in current saving.
Suppose that the increase in government expenditures is devoted to public investment and that credit to the private sector is kept at the same level as before. Instead of an increase in credit-financed private investment, there is a rise in credit-financed public investment. The effect on productive capacity and future output will depend on the relative productivity and gestation period of the investment undertaken and the investment foregone. If, for instance, the public investment is undertaken in fields with high capital/output ratios, e.g., in social overhead capital, while private investments are in fields with low capital/output ratios, such as an expansion in acreage, the growth in productive capacity and output in the immediate future will be reduced.15
Considerations of this kind may be particularly prominent in the minds of monetary authorities in less developed countries. An easy money policy may not result in any significant rise in prices as long as increases in the money supply are largely offset by substantial increases in production owing to a high level of investments, favorable crops, import surpluses, and a decline in velocity. In this setting of relative price stability, savings and investment habits may tend to change in the “right” direction. When total output falls, however, as a result, for example, of a crop failure, the monetary authorities face a dilemma which may be characteristic for predominantly agricultural countries, since Paraguay, Nicaragua, and perhaps also Indonesia, experienced situations of this kind.
A fall in output and employment in a predominantly industrialized economy is probably due to a deficiency in effective demand for goods and services, precluding large-scale capital destruction as a cause. Accordingly, an expansionary monetary policy may be called for. In countries where agriculture accounts for the largest part of the total product, a fall, or a substantial decline in the rate of increase, in aggregate output is probably due to a crop failure. Fewer goods will be available with a given money flow. Even without any monetary expansion, prices will tend to rise. If money is expanded, the rise in prices is likely to exceed the increase in money, as in Paraguay in 1952 and 1953 and in Nicaragua in 1955. A stabilizing monetary policy would call for a net contraction of credit to banks and the private sector. However, the fall in agricultural incomes will, to some extent, lead to defaults on agricultural loans and inability to collect. The larger the share of agricultural loans in total private credit outstanding, the greater will be the difficulty of contracting credit. The less it is possible to contract, the greater will be the rise in prices on account of any given fall in output (unless foreign exchange resources permit increased imports).
Suppose that at least an expansion of credit is prevented. Agricultural producers will have to do without working capital for the next season’s planting. The more they rely on credit for their working capital needs—in Paraguay the ratio has been estimated at close to 100 per cent—the smaller is likely to be the area planted and the smaller will output and income be during the following period. If, however, new credit is granted, money during the current period is increased while currently fewer goods and services are available. To the extent to which the restrictive credit policy deprives manufacturing industries of working capital, underutilized capacity will emerge in those sectors too.
As there are indications, e.g., in Nicaragua, that agricultural producers tend to use their own resources for investments in real estate and commercial undertakings, a reduction in production loans may result in some redirection of producers’ own resources to the self-financing of their output rather than in a reduction in output. It is a problem for the monetary authorities under such conditions to determine to what extent a reduction of credit to producers would result in increased self-financing and to what extent in a reduction in output. If producers have become accustomed to rely on bank credit for their working capital, an abrupt restriction of credit would probably not result in immediate changes in deeply ingrained savings and investment habits. Slow changes could perhaps be expected if credit gradually is made scarcer and dearer.
As noted earlier, the monetary authorities in Mexico felt compelled to relax credit restrictions in 1952 because of a fall in output and employment in all sectors except agriculture, which followed a decline in private investment and reductions in public investment. The resulting fall in effective demand, reinforced by a decline in the share of wages and salaries in national income, led to underutilization of productive capacity in some consumer goods industries.
The views and attitudes of the monetary authorities may be seen in perspective, if they are related to the legal and institutional framework within which they operate. In Nicaragua, for instance, a law had been enacted during the depression which assured agricultural producers almost unlimited credit for production and marketing, subject only to certain minimum collateral requirements. Also, it committed banks to renew production loans practically on request. In this setting, the Issue Department of the National Bank apparently had become accustomed to extending rediscounting facilities to the Banking Department in a more or less automatic fashion. Also, the power of the Issue Department over the Banking Department was largely nominal because the managers of both departments were on the same administrative level and under the same superior. The Banking Department is the principal commercial bank, accounting for about 80 per cent of total loans and deposits. Accordingly, the effects of monetary measures could at best be marginal, unless they could be enforced also with respect to the Banking Department, as was done to some extent in 1957; by then, however, the growth of the three private banks had increased the practical importance of measures directed toward them.
Similarly, the Bank of Paraguay continued to provide about 80 per cent of total credit to the private sector after its Issue Department had been converted into a separate modern central bank. Not only did the Bank of Paraguay extend medium-term and long-term credit to agriculture and industry, but it also engaged in the purchase and distribution of seeds, fertilizers, and crops. Since it holds only about 40 per cent of private demand deposits, it derives most of its resources from the central bank. The three other commercial banks in the country are all branches of foreign banks. Here, too, effective restraint in rediscount activities hinged on enforcement of restrictions upon the quasi-monopoly government bank. It may take some time to impose upon state banks, which are perhaps more influential, the degree of control that is necessary.
Another, more subtle, restraining factor that explains the unwillingness of a central bank to exercise the restraint technically possible and feasible may be its standing in the community. Central banks cannot refuse credit to the government16 while, in principle, they can refuse it to the private sector. In practice, however, it will often be difficult to exercise this power. When the private sector’s demand for credit rises, as is likely under inflationary conditions, a denial of accommodation will antagonize the public, including banks, against the monetary authorities. Criticisms will, of course, be aired in terms of observations that the authorities stifle economic progress by preventing “productive” investments, or that restrictions will hurt mostly national but not foreign banks and businesses. Central banks, especially when they are new and have little tradition and prestige to start out with, may feel, perhaps not without justification, that continued criticism along these lines will jeopardize their limited status in the community still further and may ultimately eliminate whatever admittedly little influence and effective power they have.17
Some Conditions for Greater Efficacy of Monetary Policy
These observations suggest some avenues toward improving the efficacy of central banking in less developed countries. The experiences of the four countries reviewed suggest that governments are perhaps not as universally the principal single source of inflation as often seems to be supposed. Nor is the actual, and much less the potential, scope for an anti-inflationary monetary policy quite so limited as is frequently concluded. The more significant is central bank credit to the private sector as a primary expansion factor, the greater will be the possibility of preventing chronic inflation through monetary measures. It follows that the realization of a stabilizing, or, if the government is the primary expansion source, an at least partially compensating policy, requires the removal of obstacles. The most important obstacle seems to be the unwillingness of the monetary authorities to exercise greater restraint upon the private sector. Limitations to the control of secondary credit expansion and contraction seem to be less important. Such limitations appear in the structure of money and capital markets and in the payments habits and asset preferences of the public. The perhaps least significant and relatively easiest removable obstacles may be found in banking legislation.
If monetary authorities are reluctant to exercise a greater measure of restraint in their credit policy because they believe that a highly elastic supply of credit is conducive to an acceleration of economic development, the lessons of experience may gradually tend to induce changes in views.
So far as unwillingness to enforce sufficiently severe anti-inflationary measures is due to apprehensions regarding the short-run output effects of a restrictive credit policy, it may be more difficult to induce a greater degree of restraint. For a less developed country in which the foremost policy objective is not only absolute but also relative economic growth, underutilized productive capacity will be socially less tolerable than in an advanced industrial economy where the stability of full employment objectives tend to take priority over the growth objective. It may, therefore, be difficult to persuade monetary authorities to contract credit, or even to freeze it, when, for instance, output and income in the agricultural sector fall on account of exogenous factors, like a crop failure or depressed export markets, since such a policy may result in underutilized capacity. Similar considerations may hold in regard to credit restrictions for import-competing industries when income falls or imports increase. If, however, producers, especially in the agricultural sector, derive their working capital and, for that matter, long-term finance not from the monetary system but largely from their own resources and nonbank financial intermediaries (with nonmonetary liabilities), there will be less reliance on medium-term and long-term credit from the monetary system and monetary policy can become more flexible; that is, of course, provided that the nonbank financial intermediaries do not obtain their resources primarily from the central bank.
In their day-to-day decisions on credit policy, especially in respect to rediscounting, central banks are likely to be more concerned with the immediate effects of their decisions on output than with the long-run effects on propensities (to save, to invest, to hold money, securities, or real assets) and the structure of the financial system. In less developed countries, those long-run effects will, however, determine the scope for monetary policy in the future. Therefore, an important, although perhaps unorthodox, field of what may be called long-run monetary policy may lie in activities that aim at changing these propensities and the structure of the monetary and financial system. Such attempts may often conflict with short-run policies; for instance, open market sales of securities may clash with the endeavor to prevent fluctuations in security prices in order to induce the public to invest in securities and to create conditions for using open market operations as a stabilizing instrument in the future. Other related measures are the encouragement of specialized savings institutions and the extension of central bank control over the investment policies of nonbank financial intermediaries.18 If such long-run policies succeed in changing saving, investment, and asset-holding habits in the “right” direction, some reasons for the reluctance of central banks to apply restrictive measures to commercial banks and the private sector will gradually disappear.
Complementary measures of long-run monetary policy might aim at widening the banking system. The establishment of new banks under the—so to speak—sponsorship of central banks would, in suitable circumstances, tend to strengthen the prestige and power of moral suasion of the latter. Moreover, as the new banks are less likely than old banks to hold substantial excess reserves, or to have access to foreign funds, their lending policies will be more responsive to central bank rediscount policies.
One particular aspect of long-run monetary policy may warrant special attention. The extent to which credit can be expanded without inflation, other things being equal, will be greater when income velocity declines than when it remains constant or even increases. Long-run policy may, therefore, aim at reducing velocity by, say, lengthening payment periods and encouraging the holding of money. On the other hand, it has also been noted that the efficacy of short-run monetary policy will be raised when the public, including banks, can be induced to hold financial assets and to use means of payment less liquid than money. However, if this objective is pursued, velocity will tend to increase, other things being equal. This will reduce the scope for credit expansion without inflation; but it will also permit greater credit extension by financial institutions outside the monetary system, i.e., from sources other than the central bank and commercial banks.
Mr. Ahrensdorf, economist in the Finance Division, was educated at the Universities of Berlin, Heidelberg, and Michigan. Before joining the Fund staff he was professor of economics at the University of the East, Manila, and lecturer at the University of the Philippines. He has contributed several papers to economic journals.
Since open market sales of securities are usually not possible in less developed countries, changes in central bank claims on government in these countries reflect, as a rule, fiscal operations.
The primary monetary effects of increases in foreign assets are, of course, the same as those of increases in claims on government or the private sector. The former represent additional real resources, however, while the latter do not. Therefore, as a first approximation, increases in domestic assets will generate inflationary pressures through both primary and secondary monetary expansion, but increases in foreign assets only through the secondary expansion that they may make possible.
A series of operations is conceivable in which a central bank lends to a commercial bank, 51 per cent of whose capital is owned by the government, and the commercial bank in turn lends to an enterprise, 40 per cent of whose capital is owned by the government. In such circumstances, it is difficult to determine how much credit went to the private sector and how much to the public sector.
It appears that devaluation profits in general were credited to the government, which applied the proceeds to the cancellation of the indebtedness of state banks to the central bank. While this operation enabled state banks to write off bad loans, mostly to the agricultural sector, it did not reduce the monetary liabilities of the central bank.
In Nicaragua, the major offsetting factors were the decline in central bank claims on government on the asset side and increases in capital accounts on the liability side. In Paraguay, they were mostly increases in prepayments for exchange and in capital accounts.
This is also true in relative terms, as shown by the following ratios of column 6 to column 9: Nicaragua, 1.4; Paraguay, 1.9.
For a more extensive discussion, see Jorge Marshall, “Advance Deposits on Imports,” Staff Papers, Vol. VI (1957–58), pp. 239–57.
If the coefficient is calculated on the basis of the average ratios of currency to money, and of bank reserves to deposits, slightly different values are obtained without, however, any change in order of magnitude or pattern. The differences in values appear to be due mainly to changes in the nonmonetary liabilities of the monetary system.
See Banco de Mexico, Informe al Vigésimanovena Asamblea General Ordinaria de Accionistas (Mexico, D.F., 1951), p. 23.
See Banco de México, Informe al Vigésimaoctava Asamblea General Ordinariade Accionistas (Mexico, D.F., 1950), p. 21.
Let the excess increase in the money supply (M) be equal to the excess government deficit (G); and let r stand for the legal reserve ratio and R for initial bank reserves (assuming no excess reserves). Then ΔM = G; to offset this increase in M, the money supply would have to be reduced by
For algebraic proof, see Richard Goode and Richard S. Thorn, “Variable Reserve Requirements Against Commercial Bank Deposits,” Staff Papers, Vol. VII, No. 1, April 1959, pp. 43–44 (Appendix I).
A fall in the ratio of currency to money and/or in the ratio of bank working reserves to deposits which bankers feel is adequate has twofold effects on the money supply. De facto, such a fall amounts to an increase in excess reserves in the same manner as does an increase in central bank monetary liabilities. At the same time, it raises the credit multiplier.
To what extent banks will respond in this manner may depend partly on their expectations about the availability of central bank credit in the future. If they consider any tightening of central bank credit to be temporary, they will be more prone to respond by reducing their cash reserve ratios than if they expect a definite and lasting turn to more stringent rediscount policies.
The opposite may, of course, also be the case, when, for instance, private investments take largely forms such as residential construction, which hardly increase productive capacity.
To quote Mr. Montagu Norman: “I look upon the Bank [of England] as having the unique right to offer advice and to press such advice even to the point of nagging: but always of course subject to the supreme authority of the Government!” Cited by Sir Theodore Gregory in The Present Position of Central Banks (The Stamp Memorial Lecture delivered before the University of London on October 31, 1955, University of London, The Athlone Press, 1955), p. 10.
When perusing annual reports of central banks in underdeveloped countries, one is always struck by the frequently recurring statements that great pains were taken to satisfy the public’s demand for credit for “legitimate” purposes.
It is customary to discuss such efforts in terms of mobilization and channeling of idle savings. This manner of formulating the problem tends to perpetuate the frequent confusion between saving as a flow and savings as a stock. It creates the impression that there is no deficiency in the flow of saving and that the only problem is to get hold of the stock of idle savings and to direct it into productive investments. In fact, this stock of savings, in the form of currency hoards or savings and time deposits, has already been invested during the income period in which it was accumulated; that is, during those past income periods the deflationary effect of nonspending was offset by the inflationary effect of credit-financed spending. If those idle savings were literally mobilized and spent, the inflationary effect would be the same as a corresponding increase in expenditures financed with newly created money. It might be less ambiguous to formulate the problem in terms of increasing the flow of saving and of reducing the liquidity of the asset portfolio of the public. Monetary policy may not be able to accomplish much in regard to the flow of saving except perhaps by raising interest rates. The relationship between saving and interest rates is, however, uncertain. The measures discussed above in terms of long-run monetary policy all aim at reducing the liquidity of the public, in respect both to the use of means of payment and to asset holding.