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.
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.