During the last few years, most Latin American countries have been confronted with increasingly serious balance of payments and economic difficulties. For 1982, practically every country in the region—whether an oil exporter or not—will show a significant current account deficit, accompanied by higher inflation rates and economic sluggishness that will be reflected in very low growth rates or—frequently—absolute declines in economic activity. As a matter of fact, 1981 and 1982 could be best described as the worst economic years the region has experienced in decades.


During the last few years, most Latin American countries have been confronted with increasingly serious balance of payments and economic difficulties. For 1982, practically every country in the region—whether an oil exporter or not—will show a significant current account deficit, accompanied by higher inflation rates and economic sluggishness that will be reflected in very low growth rates or—frequently—absolute declines in economic activity. As a matter of fact, 1981 and 1982 could be best described as the worst economic years the region has experienced in decades.

During the last few years, most Latin American countries have been confronted with increasingly serious balance of payments and economic difficulties. For 1982, practically every country in the region—whether an oil exporter or not—will show a significant current account deficit, accompanied by higher inflation rates and economic sluggishness that will be reflected in very low growth rates or—frequently—absolute declines in economic activity. As a matter of fact, 1981 and 1982 could be best described as the worst economic years the region has experienced in decades.

Numerous attempts have been made to identify and to explain the causes of such a poor economic performance. These have generally been based on evaluations of individual country cases, and the explanations have centered around the misuse of important domestic economic policy instruments: excessive levels of public expenditures, as have allegedly been seen in oil exporters like Mexico and Venezuela, or “unrealistic” exchange rate policies, as have allegedly been seen in Argentina, Chile, and Uruguay. In a few countries, particularly in Brazil, blame has also been placed on some specific external factor, such as oil price increases, or on the external debt burden.

Confronted with these situations, many Latin American countries have implemented, in the recent past, severe external adjustment policies centered basically around massive exchange rate depreciations; included among the adjusting countries are Ecuador and Paraguay, which depreciated their currencies after years of absolute stability.

It is worth mentioning that the majority of adjusting countries have achieved some degree of improvement in the current account (basically through recession-induced reductions in imports) immediately after the devaluations, but the overall balance of payments has, in most countries, tended to deteriorate shortly after, forcing much larger devaluations than were originally envisaged. The cycle of devaluation, inflation, recession, capital outflows, wage increases, fiscal deficit, and further devaluations is well under way in many of the adjusting countries, and it is very difficult to envisage what the end results of these competitive adjustment policies will be. To a certain extent, “beggar my neighbor” policies seem to be in evidence.

In analyzing these facts, the researcher is immediately struck by the strange “coincidence” that most countries in the region have simultaneously applied apparently “erroneous” economic policies (even though their “errors” originated in diverse economic policies); the possibility that one or more external disturbances have simultaneously affected most of the region appears, in these circumstances, to be an additional explanatory variable worth exploring. In fact, some individual countries (i.e., Brazil and Chile) and some international organizations have been claiming that at least part of these difficulties have originated in external factors (world recession, high nominal and real interest rates, low primary product prices), but little systematic work has been done on this subject. In particular, there has been little research on the differential effects of these external economic disturbances on the different sectors of the economy and on how alternative domestic economic policies may strengthen or weaken the internal effects of these external disturbances.

A final answer to these questions would require the complete specification of the type of external economic disturbance to be transmitted and the study of the transmission mechanism of such disturbances, the specification of the economic structures of the countries subject to such disturbances, etc.—tasks that lie completely outside the scope of the present paper. It is possible, however, if one uses some simplifying assumptions, to obtain some general answers to questions about the ways in which economic cycles are transmitted, the differential effects of such disturbances, and the possibilities of successfully applying countercyclical domestic measures.

In particular, it is the purpose of this paper to study the effects of a stereotyped cycle—to be described in the section entitled “The Model”—on a small (price taker), semi-open economy under alternative domestic policy scenarios.

I. Outline of Evaluation

After describing the most recent evolution of international transmission mechanisms for economic disturbances (the understanding of which is crucial to the understanding of how these disturbances affect small countries), the paper defines these disturbances in terms of a stereotyped cycle that is designed to resemble real-world business cycles.

In order to evaluate the global and sectoral effects of such stereotyped cycles on small, semi-open economies, the paper defines a model for such economies that is simple but contains enough elements to allow for such sectoral evaluation. This model includes some typical operational characteristics of Latin American countries, and these are described in detail. In addition, the paper emphasizes the analysis of stocks and flows, concentrating on equilibrium conditions rather than on behavioral assumptions. These behavioral assumptions and equilibrium conditions are implicit in the balance sheets in the Appendix.

In order to isolate effects of external shocks from effects of internal disequilibrium, this paper assumes that the external shocks are transmitted into small economies operating in what could be described as steady states—that is, economies operating in global and sectoral equilibrium and subject to no internal or external shocks. The characteristics of the steady state are clearly described.

Two kinds of effects of the stereotyped cycle upon the domestic economy are evaluated: global macroeconomic effects on variables such as prices, nominal and real interest rates, real exchange rates, output, and employment; and sectoral effects in the rent-ability and competitiveness of each productive sector, as well as the effects of the cycle upon the public sector budget, the accounts of the central bank, and individuals. The effects of the cycle upon the balance of payments are evaluated separately. This analysis is based upon two different assumptions about the operation of the exchange rate system and allows for varying degrees of the economy’s openness to capital movements.

Finally, to improve understanding of some of the distortions and real effects introduced by inflation, the paper also deals briefly with the effects of inflation on nominal and real transfers and with the effects of indexation and distorted cost of living measurements on these transfers.

II. Recent Evolution of International Transmission Mechanisms of Economic Disturbances

Economic interdependence is a very old constraint on economic policy; no country, however large or small, can consider itself economically isolated from the rest of the world. International economic cycles are recurrent phenomena in economic history and have been the subject of intense research by specialists.

Recent developments in the world economy, however, have drastically changed the speed and forms of international transmission of economic disturbances. Among the factors contributing to the transformation are the following:

(i) The fast expansion of world trade during the last 30 years that, in fact, implies the expansion of tradable goods in comparison with nontradable goods, as evidenced by the increasing interdependence in commodities markets.

(ii) The internationalization of capital markets, reflected in the phenomenal growth of Eurocurrency markets and offshore financial centers, which has limited national monetary independence significantly.

(iii) The abandonment of the system of fixed parities and the substitution of a hybrid system that could be best described as a system of floating currency blocs, with major currencies floating against each other and secondary currencies pegging in practice (even when a floating rate has been announced1) to their major intervention currency. This system of blocs implies a drastic transformation in the transmission mechanism of cycles, since price fluctuations, in terms of intervention currencies, tend to be wider than before.

(iv) Interest rate flexibility and, in particular, floating interest rates have drastically altered the functioning of international capital markets. Fluctuations in nominal interest rates not only influence capital flows but also have decisive macroeconomic effects via outstanding debt and reserve positions.

(v) The highly inflationary environment underlying the economic disturbances has significantly altered the operations of most markets, particularly capital markets. Higher inflation is always accompanied by larger fluctuations in relative prices, and, in addition, nominal accounting introduces serious distortions into the operations of most markets; financial flows, or transfers, tend to differ from real economic flows. These points need further clarification, but this task will be undertaken in other sections of this paper.

(vi) Easier facilities to finance fiscal and balance of payments disequilibria tend to be reflected in unprecedented levels of floating rate public external debts, a factor that seriously distorts the functioning of the public sector when it is confronted with external disturbances.

(vii) The growing importance of private sector transactions in international capital markets, which is reflected in much larger private holdings of international liquid assets and private external debt. As a matter of fact, in many countries, total private holdings of foreign exchange greatly surpass total private holdings of domestic financial assets, and aggregate private external debt surpasses the aggregate private sector domestic debt. As will become clear later on, the larger the ratio of private foreign assets and liabilities to domestic currency denominated assets and liabilities the larger will be the influence of external disturbances.

(viii) Inter-area trade growth has partly compensated for some of the previously mentioned factors. However, since most countries in the area have become more integrated into world capital markets, external shocks originating there tend normally to reinforce each other.

III. A Stereotyped Economic Cycle

In the last decade, the international economy has experienced shocks more severe than any seen since the Great Depression of the 1930s. Besides the great shocks resulting from the repeated increases in oil prices, the international economy has suffered a series of additional shocks resulting from uncoordinated domestic policies and competitive adjustment policies that exaggerated the cyclical behavior of the international economy.

The most recent cycle seems to have started toward the end of 1978: downward trends in inflation and interest rates came to an end during late 1977 and early 1978, and the dollar started to depreciate faster in relation to other major currencies at the same time that industrial production continued to expand at relatively high rates. Toward the middle of 1978, after a short period of relative stability, nominal oil prices increased sharply, spurring an acceleration in inflation rates and further devaluation of the dollar; the price of commodities other than oil rose during 1979 at a much faster rate (24 percent) than prices of other goods and services (Table 1). Nominal interest rates also rose following the acceleration in inflation, but not by quite as much, so that real rates became slightly negative.

Table 1:

Latin American Export and Import Prices, First Quarter 1979–First Quarter 1982

(First quarter 1979 = 100)

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Sources: Organization of American States, index of export prices; United Nations, import prices (manufactured commodities exported by industrial countries).

Figures in this column are the quotients of the figure in column (2) of the same row divided by the figure in column (3) of the same row.

Figures in this column are the quotients of the figure in column (2) of the same row divided by the figure in column (4) of the same row.

Starting in the first quarter of 1980, the growth rate of commodity prices slowed down. Prices remained stable during the latter part of the year and began to decline sharply beginning in the first quarter of 1981; other prices continued to increase throughout the period, accelerating at the beginning of the year and decelerating later on. Nominal interest rates remained very high during the period, and real interest rates reached unprecedented levels; furthermore, for commodity exporting countries, “real” interest rates (i.e., nominal rates deflated by commodity prices) reached even higher levels (Table 2).

Table 2.

Nominal and Real Rates of Interest, 1978–First Quarter 1982

(In percent)

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Source: International Monetary Fund, International Financial Statistics.

The preceding analysis suggests a possible definition of a stereotyped economic cycle, which can be divided into stages. This characterization of the cycle may facilitate the evaluation of mechanisms for the international transmission of disturbances. No attempt will be made to explain the underlying causes of such an international cycle.

Starting from a situation of equilibrium, the cycle is characterized by the following stages:

1. First stage: International prices start to rise as a result of an autonomous shock. Commodity prices rise much faster than the prices of other goods and services; industrial product prices rise faster than nontradable goods. Nominal interest rates also rise following the increase in inflation; real interest rates become slightly negative when deflated by the overall price level, being highly negative when deflated by commodity prices and positive when deflated by prices of nontradable goods.

2. Second stage: International prices rise, on average, at a faster rate than in the first stage; most prices rise at similar rates, which implies that the rate of increase of commodity prices slows while other price increases accelerate. Nominal interest rates tend to rise further, with real rates becoming neutral; sectoral real rates do not show large dispersion.

3. Third stage: Commodity prices tend to decelerate, and even to decline, in nominal terms; other price increases also tend to moderate, with the prices of nontradable goods tending to increase the most. Nominal interest rates remain high, and consequently there are very high real interest rates—a turn of events that has a major impact on producers of commodities.

4. Fourth stage: The economy tends to return to equilibrium, in terms of both prices and interest rates. Overall prices, however, remain higher than at the beginning of the cycle, partly as a consequence of nominal wage inflexibility.

Obviously, in the international economy, these cycles will be accompanied by large fluctuations in variables such as output and employment, as well as by other sectoral exchange rate and balance of payments effects. However, as this paper covers only the evaluation of the cycle in small, semi-open economies, the principal external repercussions of the cycles will be derived from the preceding description.

IV. The Model

In order to evaluate the global effects of such stereotyped cycles on small, semi-open economies, it seems better to work with a model of a small economy that is as simple as possible while containing enough elements to allow for the evaluation of differential effects on the economy’s various sectors and also for the isolation and evaluation of the effects of nominal interest rate variations on financial flows.

The model used in this paper puts emphasis on the analysis of stocks and flows, concentrating on equilibrium conditions rather than on behavioral assumptions. The model assumes the existence of three productive sectors: (1) a sector that produces an exportable commodity that is also sold, in part, in the domestic market; (2) a sector producing commodities that are import substitutes; and (3) a sector producing nontradable goods and services. Imports tend to be those products whose domestic production is either insufficient to meet demand or is nonexistent.

Prices of exportables and import substitutes are basically determined by external prices and the domestic exchange rate, since most small countries are price takers, while nontradable prices are determined by domestic forces of supply and demand. All products are assumed to be, simultaneously, intermediate goods and final goods. Besides these sectors, it is assumed that the economy possesses a well-developed financial system made up of a central bank and one or more financial institutions operating under a fractional minimum reserve requirement system, offering the usual kinds of deposits, and lending to both the private and public sectors.

Finally, the model assumes that the public sector performs exclusively administrative functions and engages in no productive activity whatsoever; it pays for its expenditures by collecting taxes from the productive sectors or direct from the public. If there is a budget deficit, it is assumed that it is financed by borrowing from the financial system, from the central bank, or direct from the public (by selling government bonds). In economies open to capital flows, external financing of the deficit is also allowed.

In addition, in order to focus the analysis on the problems of interdependence, it is convenient, and perhaps essential, to make some additional simplifying assumptions.

(a) All products are assumed to be consumption goods. The capital stock is assumed to be fixed, with no depreciation or additions through investment. Domestic production must be totally sold, either in the domestic market or foreign markets, during the period of analysis.

(b) Domestic production of exportables and import substitutes is assumed to be fixed, with variations in domestic aggregate demand being absorbed by variations in imports and exports and through the nontradable sector.

(c) Changes in relative prices mainly affect consumption while affecting production only marginally.2

(d) Changes in aggregate demand affect output and employment in the nontradable goods sectors.

V. Structural Operational Characteristics of Latin American Countries

In addition to the above-mentioned assumptions, some additional operational characteristics common to many Latin American countries are included in the model; some of these characteristics may also be shared by countries in other regions. The most relevant of these assumptions are as follows:

(1) There is a general practice of nominal wage indexation, with frequency of adjustment varying from monthly to yearly according to the country’s experience with inflation. In general, indexation is based upon ex post compensation for inflation as measured by cost of living indices. Ex post wage indexation implies that real wages will tend to fluctuate throughout the cycle; furthermore, nominal wages tend to be inflexible downward.

(2) Tax systems take only partial account of the distortions introduced by inflation in such a way that taxes, measured in real terms, tend to decrease when inflation increases and tend to increase when inflation decreases.

(3) Public sector expenditures on goods and services tend to be maintained in real terms when inflation rises (independently of nominal budgets) but tend to increase when reductions in inflation rates generate fiscal surpluses. In general, public expenditures tend to follow the rule of using “real” budgeting when prices rise and “nominal” budgeting when prices fall.

(4) Most exportable goods tend to be commodities; frequently, these are wage goods.

(5) International reserves tend, normally, to be included in the central bank’s accounts rather than in the fiscal accounts. Interest on such reserves does not accrue to the government, so it is not considered income of the public sector. As a consequence, such flows do not generate compensatory domestic currency flows.

(6) Variations in exchange rates generate important changes in real net wealth and alter the domestic currency values of external assets and liabilities. These changes are not, in general, registered in the nominal public sector accounting, and even though they have important macroeconomic consequences, they are difficult to identify and interpret by examining the official figures.

VI. Interest Rates, Capital Flows, Cost of Living Baskets, and Indexation

In an economy that does not permit capital movements, domestic interest rates are determined exclusively by internal factors; in addition, under such an assumption, neither the public sector nor the private sector holds any external assets or liabilities with the sole exception of international reserves held by the central bank. The total lack of equilibrating capital movements, however, does not imply that international cycles will not be reflected in domestic interest rates; since these economies are semi-open to the movements of goods, international price fluctuations will tend to be reflected in domestic prices and—through their effects on the domestic supply of, and demand for, credit and money—they will also be reflected in domestic interest rates.

The fact that many Latin American countries that have had long experience with inflation have introduced indexed instruments (basically, indexed bonds, deposits, and loans) implies that the above-mentioned tendency to interest rate approximation has also been substantially reinforced.

There are, however, some limits to this tendency toward covered interest rate equalization through indexation. In the first place, implicit nominal interest rates on indexed financial instruments are determined ex post by the actual behavior of inflation, while nominal interest rates are determined ex ante, taking into account expected inflation rates. In the second place, the selection of baskets for “measurement” of inflation plays an even more important role in interest rate discrepancies, since “international inflation” measured by domestic baskets may differ substantially from that measured by international baskets.

International inflation is transmitted to other countries in the form of price increases in tradable goods prices. Domestically, it is reflected in the prices of nontradable goods through its direct effect on costs, its impact on wages and interest rates, and through substitution in demand. Price indices play very important roles through their effects on wages and financial instruments that are indexed and in the formation of expectations. The measurement of the effects of the international inflation using totally different domestic baskets may, therefore, give results that are totally different for different countries.

With partial opening to capital movements, the effects of international cycles on small, semi-open economies are much stronger than in the previous case, but most of the analysis in the preceding paragraphs remains valid. In these circumstances, interest rate changes abroad will be immediately reflected in domestic interest rates because of arbitrage. At the same time, the problems derived from divergences in cost of living indices tend to be augmented; tendencies toward covered interest rate equalization may be distorted by arbitrage between indexed and floating-interest-rate financial instruments or between commodity stocks and financial instruments that generates much larger capital flows than are normally needed for interest rate arbitrage. The main reason for these distortions is that interest rates are transmitted as rates, while inflation is transmitted as price increases that are transformed into inflation rates according to each country’s cost of living basket.

VII. Nominal Interest Rates, Real Interest Rates, and Financial Flows

In a system of flexible interest rates and floating-rate financial instruments, nominal interest rates, like inflation rates, tend to adjust in such a way that real rates fluctuate significantly less than nominal rates. As is well known, nominal interest rates can be seen as having two elements—a real interest rate and an adjustment factor addressed to the maintenance of the real value of principal; this distinction is fundamental in the analysis of the real transfer effects of interest rate payments. However, when analyzing financial flows, nominal interest rates are as important as real interest rates, since, besides the real transfers involved in real rates, nominal interest rates payments involve an externally imposed advance prepayment of real capital—a phenomenon that has far-reaching macroeconomic consequences.

In an economy that is semi-open to capital movements, both the private and public sectors may, at any moment of time, hold important amounts of external assets and liabilities; in the last few years, most of these assets and liabilities have been covered by interest rate adjustment clauses. When international nominal interest rates rise, the advance payment of real capital implicit in nominal interest payments generates, ceteris paribus, a reduction in the aggregate demand of net debtor countries coupled with a deterioration in the current account of the balance of payments (and vice versa for net creditor countries). In substance, what is taking place is an improvement in the real wealth of net debtor countries that is derived from a reduction in consumption and is reflected in a reduction of the real net debt.

Recent developments in the world economy have greatly enhanced the importance of these factors. Enlarged private and public external debts, substantially larger private holdings of international liquid assets, wider fluctuations of nominal and real interest rates, and the practically unanimous use of floating-rate instruments in international capital markets have created a set of circumstances in which financial flows frequently play a much more important role than trade flows in the international transmission of economic disturbances. Interdependence seems to have reached unprecedented levels.

VIII. External Shocks and Domestic Economic Policies

As has already been stated, the main purpose of this paper is to evaluate the economic consequences for the economy of a small country of external disturbances exemplified by the stereotyped cycle described in preceding sections, isolating these external effects from the effects of domestic economic policies.

To achieve this objective, a very simple procedure was used—simulation of an external shock in an economy that could, up to then, be characterized as a “steady-state” economy. Specifically, this steady state can be defined as a situation in which domestic and external forces are in permanent equilibrium—that is to say, an economy characterized by

—absolute price stability

—full employment of all productive resources

—balance of payments equilibrium, in terms of domestic currency

—balanced public sector budget

—zero growth rate

—portfolio equilibrium in both assets and liabilities

—similar rate of return on investment in each productive sector

—in economies open to capital movements, equilibrium requires that net interest payments (or receipts) on external positions be compensated for by internal adjustments of consumption (lower imports and/or larger exports).

The Appendix includes an example of such a steady-state situation for an economy open to capital movements. For economies closed to such movements the situation would be similar, but with no external assets and liabilities (except reserves) and with no interest payments or receipts derived from these instruments. Obviously, the numbers used in the example are totally arbitrary, and the modification of any of them requires substantial modification of others in order to return to a steady-state situation. Although the numbers are arbitrary, they have been chosen in an effort to reproduce the situation of a commodity exporting developing country. However, external debt figures—relative to other figures—are extremely small compared with real-world figures. These relatively low figures were purposely selected to emphasize the extreme importance of external debt levels in the analysis of the repercussions of external shocks upon small economies.

Starting from this equilibrium situation, it is easy to reproduce most of the sequences of events that follow an external shock of the type defined by the stereotyped cycle; the advantage of this procedure is that it allows us to observe, step by step, how external shocks affect the economy’s different sectors and how these sectoral effects may introduce secondary shocks that either strengthen or weaken the initial external shock. Throughout the analysis, it will be assumed that there is no countercyclical domestic policy and that the only additional exogenous shocks will be those arising from the structural characteristics described in preceding sections.

The evaluation was carried on under two different exchange rate regimes (fixed rates and freely floating rates) and under varying assumptions about capital movements (from partial opening to total exclusion). Such an evaluation poses a variety of methodological questions, and the description of the cycle’s first stage will be much more detailed than the descriptions of the others, since it will attempt to clarify some of these methodological questions.

IX. Analysis of Results Under Fixed Exchange Rates

first stage

Macroeconomic effects

Effects on prices and interest rates. In this first stage of the cycle, the world economy is subject to inflation pressures that raise the prices of all products as well as nominal interest rates; increases in commodity prices (exportables in our example) tend to be larger than those of other goods and services. Nominal interest rates also rise, but become negative in real terms for all productive sectors. Prices of exportables and importables—expressed in domestic currency—increase following similar increases in international markets. Nontradable goods are also subject to several shocks: increased cost of inputs, increased interest payment flows (derived from the increase in nominal interest rates), and increased aggregate demands (derived principally from the improvement in the terms of trade, the inflow of foreign capital, and substitutions in demand in response to relative price changes). In addition, wage costs also tend to increase as indexation practices are applied. All the above-mentioned factors bring about an increase in the prices of nontradables.

Increases in the prices of nontradables will be higher, the greater the improvements in the terms of trade, the larger the capital flows, the shorter the period between wage adjustments (following indexation procedures), the smaller the interest payments on the net external debt, and the smaller the accumulation of domestic or external financial assets by residents. Global inflation will be the result, therefore, of the strength of those factors and of the proportion of tradables in total goods and services.

Increases in nominal interest rates are spurred by two factors—increases in international interest rates and increases in domestic inflation rates. The relationship between domestic and international rates depends upon the relative force of these two factors, which, in turn, depends upon the degree of the economy’s openness to capital movements (arbitrage efficiency). With less than perfect arbitrage, inflation rate differentials tend to determine interest rate differentials. These inflation differentials are basically the result of the different compositions of cost of living baskets and of divergent behavior of the prices of nontradables.

In the first stage of the cycle, inflation rates in commodity exporting countries tend to be higher than those in the rest of the world, and domestic interest rates tend to be higher in the former than in the latter. Nevertheless, “real” interest rates tend to be lower, on average, in commodity exporting countries than in the rest of the world. Capital tends to flow into the country expanding aggregate demand. The growth in demand will exceed the growth that can be accounted for by the expansionary forces derived from improvement in the terms of trade. The strength of these flows and their impact on inflation, interest rates, and output are naturally dependent on the economy’s openness to capital movements.

Deficiencies in the selection of cost of living baskets may introduce some distortions of their own. In defining the basic index for purposes of indexation, countries have several options, the main ones being indices whose weights are based on the composition of production or those based on the composition of consumption. In some countries in the region, the measurement of cost of living indices is based upon a special basket of consumption by a portion of consumers—basically, blue collar workers. Consumption indices tend to be weighted in favor of commodities (particularly in partial samples) in such a way that external fluctuations tend to be amplified in the domestic economy and external distortions in interest rates and wages tend to be amplified as well.

Real exchange rates, output, and employment. It should be clear by now that there are deficiencies in the traditional method of measuring real exchange rates. Real exchange rate indices attempt to measure the evolution of the competitiveness of domestic producers of tradables in relation to producers in other countries. Too many factors are involved in the determination of such competitiveness to permit one to determine it using only simple indices; the only sure way to evaluate it is by looking at the tradable producer’s complete balance sheet and by observing the evolution of both costs and prices.

Some form of index may, nevertheless, be useful when one is trying to obtain a first approximation of such competitiveness. The traditional procedure of comparing exchange rate variations plus international inflation with domestic inflation would show, in the case under analysis, a deterioration in the real exchange rate, which is absurd in view of the behavior of the terms of trade and of nontradables prices. This is another instance of distortion introduced by baskets. A more adequate procedure is to compare the evolution of the relative price between tradable and nontradable goods, measured in domestic currency. In the case under review, this procedure will show an improvement in the real exchange rate, since the increase in the price of tradables—especially exportables—greatly surpasses the increase in the price of nontradables.

With regard to output, it is clear that under the assumptions of the model, the increase in aggregate demand should be eliminated through increases in the prices of nontradables, the expansion of imports, the reduction of export volume, and the accumulation of nominal financial assets. Marginal fluctuations in the production of nontradables have been allowed as a mechanism for absorbing these changes in demand.

Once again, it is possible to conclude that the larger the improvement in the terms of trade, the larger the inflows of capital; and the smaller the interest payments on the net external debt, the larger will be the increases in output and employment and the increase in the price of nontradables. All the above-mentioned conclusions can be easily verified by examining the example included in the Appendix. This example can also be used to examine other sectoral effects of the cycle.

Sectoral effects

Public sector budget. Starting with the public sector budget, when the reader observes the figures in the example, he will be struck by the fact that in a situation where real expenditures are not increasing, real wages are declining, and the terms of trade, output, and employment are all improving, the budget turns from global equilibrium into deficit. Only a very detailed evaluation of the situation can help to solve this puzzle. Global inflation normally implies that practically every expenditure and receipt item tends to increase in nominal terms. What would happen to the nominal budget if all prices increased in the same proportion, real expenditures, wages, and taxes remained constant, and real interest rates remained the same as in the steady state? It would show a deficit as a consequence of the prepayment of debt implicit in the nominal interest rate increase (based on the assumptions that the government is a net financial debtor and that interest on reserves is not included in the budget). In addition, it should be noted that some of the results in the example are partly derived from the inclusion in the model of elements that tend to describe special characteristics of Latin American countries, such as the lags in wage indexation and in tax receipts.

In general, it may be asserted that as a consequence of the external shock, the nominal fiscal deficit will be larger the shorter the period between wage adjustments, the larger the lags in tax receipts, and the larger the amount of net financial indebtedness. Clearly, conditions may be described under which the budget will move into surplus, but these conditions rarely occur in Latin American economies.

Should this nominal deficit be considered a “real” deficit, in the sense of a net transfer of real resources that the public sector financed by increasing its outstanding “real” debt? The answer to this very important question depends on many factors, the main one being the contribution of net nominal interest payments to this deficit. “Inflation adjustment” of budget figures is helpful in evaluation of these real transfers.

Central bank. It is possible to verify that, as a consequence of the cycle, the central bank has, in this first stage, a surplus in both its domestic currency budget and its foreign currency budget; both surpluses originate in increases in foreign and domestic interest rates. Once again, this surplus corresponds to advance repayments on debt instruments held by the central bank. The surplus of foreign currency exists because the central bank’s reserves exceed its external debts.

In addition to this operative surplus, the central bank faces a very important flow demand for base money (derived from the increase in prices) that greatly surpasses (given the assumptions) the potential flow net supply (fiscal deficit minus the surplus of the central bank). Under a fixed exchange rate regime, this excess demand will be satisfied through the central bank’s acquisition of reserve assets, basically through a trade account surplus in those economies practically closed to capital movements and also through external capital flows or dishoarding of foreign assets in more open economies.

The above-mentioned results are normally valid almost regardless of the assumptions made about assets and liabilities. There is a very important case, however, in which the results of the analysis might be quite different; this occurs when the government confronts a very large external debt (in proportion to gross domestic product (GDP)) and in which the demand for base money is extremely weak (also in proportion to GDP), perhaps as a consequence of hyperinflationary circumstances. The increase in international interest rates tends to generate a fiscal “deficit” (and a corresponding need for foreign assets) greatly exceeding the flow demand for base money; as a consequence, the first stage of the cycle might, in these circumstances, generate a large balance of payments deficit notwithstanding the large improvements in the terms of trade.

Financial institutions. Nominal profits (gross or net) of financial institutions will also tend to improve in the first stage of the cycle, basically as a consequence of the increase in nominal interest rates and the maintenance of nominal spreads that occur at the same time as a decline in real expenditures. At the same time, deposits—particularly time deposits—tend to increase in nominal terms (and perhaps also in real terms) in response to a higher price level, relatively neutral real rates, and capital inflows; this increase in deposits is matched by a corresponding increase in credit.

Obviously, the larger the inflow of capital the smaller should be the discrepancy between domestic and foreign interest rates, and the smaller the spread between rates on loans and rates on deposits. Such shrinkage of spreads reduces the profits from outstanding credits, but this reduction is compensated for by the increased volume of credit generated by the capital inflows. However, the most important explanation of the increase in profits of financial institutions is derived from the relationship between the ratio of sight deposits to minimum reserve requirements, on the one hand, and the nominal rates of interest, on the other. In most countries in the region, financial institutions accept sight deposits and pay no interest to depositors on their outstanding balances. These institutions also maintain idle balances in order to comply with mandatory reserve requirements and receive no compensation whatsoever on such balances. Sight deposits, net of minimum reserve requirements, are lent at normal interest rates. Clearly, the larger the differences are between sight deposits and bank reserves, and the higher nominal interest rates are, the larger the nominal profits of financial institutions will be.

In the example, sight deposits substantially exceed bank reserves, and the surplus of funds enables banks to earn large profits as interest rates rise. In substance, financial institutions retain part of the inflationary tax being paid by the public.

Productive sectors. In the three basic productive sectors, it seems clear that the evolution of nominal gross profits depends upon too many factors to permit one to draw a priori conclusions on the subject; in substance, these profits depend on the evolution of the ratio between the prices of finished products and the prices of inputs, the lags in wage and tax adjustments, the outstanding net indebtedness of these sectors in domestic and external markets, and their respective interest rates.

Leaving aside indebtedness problems, it may be concluded that the main beneficiaries in this first stage of the cycle should be the producers of exportables; the results for producers of import substitutes depend on wage and tax lags. With no lags, this sector would suffer a deterioration in its rate of return; while with long lags, it would certainly lose relative position in comparison with other producers but would, nevertheless, increase its profits at the expense of workers and the public sector. Profits of the nontradable sector will tend to be extremely sensitive to the volume of capital flows. The larger these flows, the larger will be the profits of nontradable producers.

However, if elements derived from net indebtedness of producers are added, the main conclusions drawn in the preceding paragraph may be modified. Nevertheless, in considering inflation-adjusted profits, these conclusions are confirmed, and even reinforced, since real interest rates have been assumed to be negative in this first stage of the cycle. Interest payments, therefore, should generate large financial flow problems but no real flow problems. These real flows tend, in fact, to be negative.

Effects on individuals. Among individuals practically all forms of nominal income will tend to increase during the first stage of the cycle. Nominal disposable incomes (after taxes) of savers and investors should increase substantially, while those of wage earners depend upon the lags between wage and tax adjustments and upon employment growth. The larger the flows of foreign capital, the shorter are the lags in wage adjustments, and the longer the lags in tax adjustments, the greater will be the chances of both workers and investors having larger nominal disposable incomes.

Real disposable incomes, however, tend to increase only for savers and investors, and to decrease for workers. The definition of real income itself poses some difficulties. For savers, for example, the situation is complex, since interest flows, deflated by cost of living indices, tend to show large increases; at the same time, though, the real values of assets tend to deteriorate to such an extent that they may bring about a decrease in real wealth (negative real rates of interest) and an increase in real financial flows (prepayments of debt).

Individual expenditure levels are dependent not only on the above-mentioned factors but also on portfolio changes. In the first stage of the cycle, real rates of return on foreign and domestic assets tend to be negative, which leads to a dishoarding of assets (in real terms) and an increase in outstanding debt (also in real terms); real expenditures should therefore increase. The larger the inflow of capital, the larger should be the expansion of aggregate demand.

Balance of payments

The traditional definitions of the balance of payments and its components pose a series of problems when there is widespread inflation and generalized private holdings of international liquid assets. The main difficulties lie in the distinctions between (1) the current account and the capital account, and (2) the central bank’s official balance of payments and the national balance of payments, which, in addition to official reserves, includes variations in the external assets of other residents. Examples of the difficulties are the following: Should interest flows on private holdings of international liquid assets be treated as interest income in the current account or as capital flows? Should the “inflation adjustment” component of nominal interest rates be considered interest payments—and, as such, included in the current account—or as advance repayments of “real” debt? Should changes in the private sector’s portfolio—matched by corresponding changes in official portfolios (with opposite signs)—be considered capital outflows from a macroeconomic point of view?

Leaving aside these important questions, it seems clear that the most convenient way to evaluate the overall effects of the first stage of the cycle upon the balance of payments is to examine the behavior of the individual components of the balance of payments.

Exports tend to increase, both in value and in volume, owing to three factors: (1) improvement in the terms of trade; (2) a minimum expansion of output; and (3) substitutions in demand that originated in relative price changes. However, income effects originating in increases in national income tend to have the opposite influence on both exports and imports.

Imports also tend to increase, probably by less than exports in nominal terms but by more than exports in volume; as a matter of fact, if capital inflows are large enough, nominal imports will increase even more than nominal exports, and the trade account could move into deficit, notwithstanding the improvement in the terms of trade.3

Obviously, as was seen when the central bank figures were examined, the overall balance of payments normally tends to be in surplus in this first stage of the cycle, since the larger nominal interest payments tend to be more than compensated for by a (probable) trade surplus, capital inflows, and dishoarding. The larger the flow of foreign capital, the larger the balance of payments surplus and the smaller the trade account surplus. Only when there are large external debts and weak demand for base money might the balance of payments move into deficit, in this first stage of the cycle, as a consequence of the external shocks.

second stage

As the paper has already gone into detail in its analysis of the first stage’s repercussions on a small, semi-open economy, it should now be possible to proceed with the analysis of the other stages of the stereotyped cycle without delving further into such details.

During the cycle’s second stage, domestic prices of exportables and import substitutes should rise pari passu with international prices, and those of nontradables are subject to even more violent shocks than those received during the first stage: practically the same, or larger, input costs; even higher interest payments; and substantially larger adjustments in nominal wages and taxes. All these factors necessitate additional adjustments (and larger ones than were required during the first stage) in prices for the sector as a whole. With full indexation, domestic nontradables prices should tend to rise faster than the corresponding prices in the rest of the world.

Nominal interest rates should also rise in response to higher international interest rates, and higher domestic inflation rates are forced upward by the increases in prices of import substitutes and nontradables, but the rate of increase in exportables prices should be lower than in the first stage; the selection of baskets is, again, crucial, since the larger the distortions in favor of exportables, the larger will be the distortions in global inflation indices during the first and second stages. Normally, global inflation rises during this second stage, contributing to the elevation of domestic nominal interest rates. Interest rate differentials with the rest of the world tend to be reduced; and capital flows, although they remain positive, tend to be smaller than they were during the first stage.

Real exchange rates should tend to show a small deterioration when measured by the ratios of the respective prices of exportables and import substitutes, on the one hand, and the price of nontradables, on the other, but the exchange rate should continue to be much higher than it was in the steady state. Traditional measurements may show either an improvement or a further deterioration, depending upon the distortions introduced by the weighting of exportables.

Output and employment may continue expanding marginally, but this result depends basically upon which has a greater effect—nominal interest payments, on the one hand, or capital inflows and dishoarding, on the other. In economies closed to capital movements, output and employment tend to be reduced during this stage.

Turning to the sectoral effects and starting with the evaluation of the public sector budget, it is clear that the budget should show further nominal deficits. The size of these deficits, however, will be larger or smaller than those seen in the first stage, depending upon the following factors: the relative speed of adjustment of wages and taxes in accordance with indexation systems; the increased cost of real expenditures; and, especially, the amount of net nominal interest payments both domestically and abroad. In the example, the size of the nominal deficit remains relatively stable; but in real life, with larger public (domestic and external) debts, further enlargement of the nominal deficit would be likely.

The central bank, though, tends to show a larger operational surplus and larger receipts in its reserves. At the same time, nominal demand for base money should continue to expand owing to higher inflation rates and slightly less negative real domestic interest rates. Total flow demand for base money, however, depends as much on domestic factors as on foreigners’ demands for domestic deposits. If capital flows are smaller than during the first stage, global flow demand for base money may also be smaller. Obviously, the counterpart of such a disequilibrium in the domestic money market is the accumulation of international reserves.

Nominal profits of financial institutions should continue expanding, notwithstanding increased costs in the form of wages and taxes and the maintenance of nominal spreads. Basically, these increased profits come from larger credit operations and, in particular, from the increment in the implicit subsidies on sight deposits, which generally increase as nominal interest rates increase.

Net nominal profits of all productive sectors should decrease in the second stage, responding basically to the increase in nominal interest rates. Wage input and tax adjustments are approximately compensated for by increases in finished product prices, but increased interest rate payments involve an additional transfer to savers and to foreign creditors. Obviously, the larger the net indebtedness of any sector and the larger the increase in the nominal interest rate, the smaller will be nominal profits. As explained before, most of these interest payments should be considered advance payments of real debt and, as such, should not modify real profits; nominal accounting tends, therefore, to introduce strong distortions.

Real wages, with nominal adjustments based on past inflation rates, should, in this second stage, maintain levels similar to those reached at the end of the first stage. Deficiencies in cost of living indices may alter this general statement, since nominal wage adjustments will be larger the larger the weight of exportables in such an index. If nominal wages, dividends, and taxes all tend to increase at approximately the same rate, global real consumption will tend to depend exclusively on nominal interest payments, nominal variations in the value of assets and liabilities, and the magnitude of capital flows. In this second stage, capital flows and dishoarding should be smaller, and interest rate payments greater than during the first stage, with the result that consumption should also decrease. This decrease in consumption, in real terms, is reflected in the balance of payments in the form of a larger trade account surplus. The overall balance of payments result depends more on the magnitude of the government’s net indebtedness and on the tendency to hoard than on the evolution of real exchange rates.

third stage

This is the stage of the cycle when most of the externally generated problems of commodity exporting countries tend to show up. During the third stage, the rate of increase of commodity prices slows down, and prices may even decline in nominal terms. Prices of other goods and services continue increasing at rates slightly lower than those registered during the second stage. Nominal interest rates also remain very high and even tend to increase, while real interest rates tend to reach unprecedented levels.

Domestic prices of exportables and import substitutes tend to rise as a consequence of developments in international markets, and nontradables prices are subject to two opposite forces—on the one hand, increases in wages, taxes, and the costs of some inputs, and on the other hand, a decrease in the cost of commodity inputs and a decline in aggregate demand.

The implicit deterioration of the terms of trade during the stage may also create uncertainties and generate capital outflows. This is particularly so if, during the first two stages, capital inflows took the form of external indebtedness rather than dishoarding (nobody knows the amount of private international asset holdings, while data on total indebtedness are readily available). In these circumstances, domestic interest rates should rise above international interest rates, and real interest rates should become extremely high. Furthermore, the scarcity of domestic credit caused by capital outflows should certainly be reflected in larger spreads and additional external borrowing—that is, net capital outflows might not be reflected in reductions in external indebtedness but, on the contrary, would be reflected in larger private hoardings and smaller foreign holdings of domestic assets.

Global inflation, as measured by indices, should—ceteris paribus—decelerate during this stage, particularly in those countries with commodity-based indices. In these circumstances, real exchange rates, measured by traditional methods, may show an improvement, while those measurements based on the ratio of prices between tradables and nontradables, or based on direct evaluation of producers’ balance sheets, should show marked deterioration. During this third stage, output and employment should decline following the reversal of the terms of trade and the outflow of capital.

Debtors should be most severely affected during this stage, and since the public sector is the principal debtor in the economy, it should not be surprising if during the third stage budget deficits tend to become much larger in nominal terms, forcing increases in public indebtedness. If one examines the public sector accounts, it is possible to see why this is so, since while wages, taxes, and nominal expenditures all tend to rise at approximately the same rate (a phenomenon leading to an increase in the fiscal deficit), interest rate payments tend to rise significantly faster, which adds to the nominal deficit. During this stage, there is a tendency to finance part of this deficit by borrowing abroad.

In the central bank accounts, however, an increase in nominal interest rates implies a larger operative surplus; but, at the same time, the larger financial requirements of the government, coupled with a decrease in the growth rate of the flow demand for base money (basically, as a consequence of capital outflows), should lead to a significant loss of international reserves. These increases in the external indebtedness of the public sector and in the registered external debt of the private sector, in combination with reserves losses and a deterioration of the terms of trade, should normally reinforce speculation against the domestic currency.

The financial sector should, in principle, be the sole domestic sector to benefit during this third stage. Larger spreads and higher nominal interest rates should significantly increase the nominal profits of financial institutions, particularly as a consequence of the implicit subsidy on sight deposits. However, credit risks should also be increasing during this stage, especially those on credits to producers of exportables.

With commodity prices falling and production costs rising, the rate of return on investments in the export sector should decline and even become negative. Nominal financial costs should constitute one of the most important elements in this deterioration of profits. Adjustment of the sector’s balance sheets for inflation, made on the basis of general indices, might improve this negative result somewhat, but this adjustment would be erroneous, since real interest rates for the sector should be even higher than nominal rates.

Nominal profits of producers of import substitutes and nontradables should also decline, but by less than those of exportables producers, since the prices of the former goods tend to rise faster than those of the latter. “Inflation adjusted” profits should increase, since for the import substitutes and nontradables sectors real interest rates tend to be lower than nominal interest rates. The reduction in aggregate demand for nontradables plays an important role in the profitability loss on these goods.

Real wages should rise marginally during this stage as a result of adjustments based on past inflation rates and the deceleration of inflation during the current stage. However, the decline in employment in the nontradables sector should compensate for part of this increase in wages. With real profits declining, total wages stable, and capital outflows, total aggregate demand and, in particular, consumption should decline compared with the previous period. The more severe the lack of confidence in the domestic currency, the larger should be the outflow of capital and the larger the reduction in consumption. In fact, if capital outflows are large enough, consumption might be even lower than in the steady state.

The balance of payments must reflect all these contradictory forces. Exports should decline, both in value and in volume, following the decline in world prices and substitutability in demand. The behavior of imports during this period depends crucially upon the behavior of capital outflows: the larger the capital outflow, the smaller should be aggregate demand and, therefore, imports. In the absence of commodity speculation4 and compensatory expansionary policies by the government, imports should decline, both in value and in volume. Finally, with larger interest payments and massive capital outflows, the overall balance of payments should be in deficit—a result that would be consistent with money market equilibrium requirements.

These developments at the third stage seem to be totally coherent with developments in the world economy during 1981 and 1982 and, in particular, with the problems faced by Latin American countries.

fourth stage

During the fourth, and last, stage of the stereotyped cycle, international prices should tend to remain stable. After their decline during the third stage, commodity prices should either remain stable or rise slightly if the decline during the third stage was too large. Nominal interest rates should fall, while real interest rates should decline significantly while remaining positive, especially for commodity producers.

Domestically, with a smaller dispersion of international prices and with smaller wage adjustments (owing to the decline of commodity prices during the third stage), price behavior should be remarkably stable.

Although domestic interest rates should fall, they will probably remain above international interest rates owing to lack of confidence in the value of the domestic currency and to persistent capital outflows.

Aggregate demand should weaken further during this stage as a consequence of capital outflows, and nontradables prices should be very stable. However, wages might play an important role in the maintenance of disequilibria, since the shorter the lags between wage adjustments and the greater the distortions of cost of living baskets, the greater are the chances that nominal wages will overshoot and, because of the downward inflexibility of nominal wages, the greater the chances of a serious balance of payments disequilibrium and of losses in sectoral competitiveness. In these circumstances, exchange speculation might reach massive proportions, amplifying the decrease in demand and the sacrifices implicit in adjustment policies.

The fiscal deficit should be reduced during this stage, since stable nominal expenditures and reduced interest payments, coupled with increased nominal taxes, should more than compensate for the corresponding wage adjustments.

The central bank should also confront a reduction in its operative surplus and a reduction in the excess flow demand for base money. With smaller (but still positive) capital outflows and a smaller (but also still positive) fiscal deficit, monetary equilibrium should only be consistent with additional reserve losses.

Profits of financial institutions should be considerably reduced during this stage, in response to lower nominal interest rates and higher wages. Spreads, however, should remain larger than normal. The main problem for financial institutions during this stage should be increased losses on account of bad loans that are the result of two consecutive stages of serious deterioration in profits for most sectors, and particularly for commodity producers.

Finally, if capital outflows are positive but smaller than those registered during the previous stage, and interest payments are also positive but smaller, the balance of payments should show a smaller global deficit, including a small surplus in the trade account and a smaller deficit in the current account. Imports should decrease, both in value and in volume.

X. Analysis of Results Under Floating Exchange Rates

Up to now, the analysis of the international transmission mechanism for economic disturbances and of the effects of a stereo-typed cycle upon a small, semi-open economy has been carried out under the assumption of a fixed exchange rate system. Would the results be altered significantly if the small country operated as part of a flexible exchange rate system? To answer this question, one need only reproduce the analysis of the preceding subsections, modifying the fixed rate assumption.

A floating exchange rate system is defined here as a system in which the monetary authorities abstain from intervening in exchange markets, letting the rate be determined by market forces. A definition as global as this poses serious difficulties in real life, since in most countries the public sector tends to be by far the largest participant in exchange markets, not as a regulator but as a sectoral operator. With large outstanding external debts and increased nominal interest rates, financial transactions considerably exceed trade transactions in exchange markets. Since the government in most countries in the region is the country’s major external debtor, the government is also the largest transactor in the market. Consequently, it affects the exchange market and exchange rates, not as a regulator but as a transactor.

Leaving aside this and other problems that would arise in the operation of floating exchange rate systems in developing countries, in order to be able to answer the question posed in this section’s first paragraph, it seems convenient to define a floating exchange rate system more precisely as a system in which the existing nominal stocks of reserves and public external debts remain fixed, with the sole exception of accrued interest on such reserves. No other restriction will be imposed on day-to-day official transactions.

It seems clear that assuming no variation in central bank reserves is equivalent—in this model—to assuming that there is no disequilibrium in the domestic market for base money issued by the central bank—that is, if demand for base money is larger or smaller than its flow supply, the exchange rate will tend to adjust until equilibrium in this market is restored.

Returning to the first stage of the stereotyped cycle, the increase in international inflation and the improvement in the terms of trade that are assumed to be taking place during this stage should simultaneously generate, under a floating exchange rate system, an excess supply of foreign assets and an excess demand for base money. At the same time, exports should increase, as a consequence of the improvement in the terms of trade, and import volume and foreign asset holdings should decrease as a consequence of the excess demand for base money. In these circumstances, there is a clear tendency for the exchange rate to be revalued.

With revaluation, domestic prices and interest rates tend to rise by less than they do in the rest of the world and the flow demand for money tends to fall, which contributes to the restoration of equilibrium. If the improvement in the terms of trade is large enough, the revaluation might force prices of imports and import substitutes to fall in nominal terms and thus turn the incipient fiscal deficit into a surplus. If this occurred, revaluation would continue until the reduction in the nominal demand for base money equaled the reduction in supply derived from the fiscal surplus.

With larger interest payments abroad and larger nominal domestic asset hoardings (generated by international inflation), imports (both volume and value) should decline. Because of the private sector budget constraint, however, if the improvement in the trade account brought about by the improvement in the terms of trade is larger than the increase in global interest payments abroad, a decline in imports would be inconsistent with market equilibrium. There would also be a tendency for the exchange rate to be revalued, reducing exports and expanding imports—a tendency that would be stronger the larger the inflow of capital. But, on the other hand, if there were extremely large external debts and an extremely weak demand for base money—a special case mentioned earlier in this paper—the exchange rate would tend to depreciate rather than appreciate.

The new equilibrium in exchange and money markets should also imply much lower inflation and nominal interest rates and—perhaps—absolute declines in some prices. It should also imply a surplus in the public sector budget and a global balance of payments equilibrium.

It is impossible to determine ex ante the sign and size of the trade and current account balances without specifying the behavior and size of capital flows. With large capital inflows, the current account is necessarily in deficit, while the trade account should show a balance exactly equal to the difference between the inflow of capital and net interest payments abroad. As interest payments on international liquidity holdings may, in practice, be registered in either the capital account or the current account, the above-mentioned conclusion may be distorted.

In summary, floating exchange rates tend to insulate the domestic economy more effectively against external shocks, such as inflation and interest rate shocks. However, since variations in output and employment, as well as in sectoral competitiveness, tend to be much larger under floating rates than under fixed rates, real sector cycles tend to be amplified.

If the economy is completely open to capital movements, the situation tends to be even more unstable, since capital inflows (undertaken in anticipation of exchange rate developments) will tend to be reflected in larger fluctuations of exchange rates, prices, and aggregate demand. The analysis of the components of the balance of payments in a previous paragraph of this section clearly shows why floating rates tend to generate larger variations in real variables, the principal reason being that under alternative exchange rate regimes, external shocks may also be absorbed by changes in holdings of assets and liabilities.

The evaluations of the other stage of the cycle would be similar to those made in the preceding subsections that assumed a fixed exchange rate system. Obviously, during the third stage of the cycle, capital would tend to flow outward and the exchange rate to depreciate, stabilizing domestic prices and interest rates but amplifying variations in output in the process.

Stabilizing speculation, if it were successful, might dampen exchange rate fluctuations and, in the process, amplify the fluctuations of nominal variables and diminish those of real variables. Distortions derived from the selection of national baskets for cost of living indices might, however, reduce the chances of success for this kind of speculation.


Domestic Sectoral Effects of International Economic Cycles Under Fixed Exchange Rates and Partial Opening to Capital Movements

(In arbitrary units of account)

Sectoral liquid assets and liabilities in the steady state
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Real and financial flows in the steady state

Assumptions: (i) Absolute price stability

  • (ii) Domestic and foreign interest rates

    • Time deposits—2 percent

    • Bonds—3 percent

    • Loans—5 percent

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The balance of payments expressed in domestic currency is in equilibrium, while the balance of payments expressed in international currency is in surplus. This discrepancy is caused by the fact that interest on international reserves does not generate any domestic monetary creation. The “national” current account balance is also in equilibrium; but, if normal accounting practices centered around the official balance are used, the “international” current account balance may be either in surplus or in deficit, depending on the treatment of interest earned on reserves and, in particular, on private holdings of international liquid assets.

Real and financial flows during the cycle’s first stage

Following the framework of the stereotyped cycle, this paper assumes the following behavior of the principal macroeconomic variables during the first stage of the cycle:

  • (i) International and domestic prices of exportables increase 10 percent.

  • (ii) International and domestic prices of imports and import substitutes increase 5 percent

  • (iii) International interest rates on time deposits and on loans rise to 4 percent and 7 percent, respectively.

  • (iv) International arbitrage, together with indexation practices and other domestic forces, determines domestic interest rates of 5 percent on deposits, 6 percent on bonds, and 8 percent on other loans.

  • (v) Domestic wages increase 2 percent, on average for the period, responding to indexation clauses and lags in adjustments.

  • (vi) Domestic nontradables prices increase 5 percent.

  • (vii) The public sector finances part of its emerging disequilibrium by borrowing in international capital markets.

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Mohsin S. Khan

This is a most interesting paper containing a number of ideas, some of which will be fairly familiar to international economists, and other ideas that may seem unusual, perhaps even controversial. The paper starts with the observation that a number of Latin American countries have experienced similar economic problems in recent years, even though domestic policies and circumstances were quite different in each of them. The author goes on to argue, although in a somewhat conjectural fashion, that these economic problems must be the result of common external factors. This is probably a correct inference, and one can certainly find empirical support for it.

A number of recent studies, some of which have been done at the Fund, find strong statistical relationships between the main macroeconomic aggregates of developed and developing countries. For example, growth rates in developing countries appear to be linked to growth rates in the industrial world (Goldstein and Khan).1 Most studies of the inflationary process in developing countries also find a significant role for foreign inflation. Finally, it has been demonstrated that changes in the terms of trade have a strong impact on the current account balances of developing countries (Khan and Knight).2 One could come up with other examples, but it should suffice to say that on balance there is considerable evidence of linkage or, to use the author’s terminology, “interdependence” between developing countries and the rest of the world.

The paper makes a reasonably persuasive case for the proposition that such interdependence in the goods and capital markets has increased in the past few years. Whether one can proceed from this to say that this can be attributed to the adoption of generalized floating is, however, not readily apparent. It could be argued that the progressive and deliberate removal of restrictions on trade and capital flows made developing countries more susceptible to foreign influences in the 1970s than did generalized floating per se. To make the case that floating resulted in a greater degree of interdependence, one would have to abstract from domestic policy changes and exogenous external shocks, such as the oil price increases, and this is quite difficult to do. Consequently, one has to be cautious in making this causal connection between the floating of exchange rates of the developed countries and increasing integration.

The main purpose of the paper is to analyze the nature and degree of interdependence between a small, semi-open (Latin American) developing economy and the rest of the world under alternative exchange rate regimes. Basically, this is done by tracing out the effects—both at the macroeconomic level and, to a limited extent, the sectoral level—of a particular type of external shock. Most of the analysis is conducted for the fixed exchange rate case, and there is a very cursory treatment of the polar case of freely floating rates. In fact, the latter would hardly seem to be relevant to the case of developing countries, particularly the ones in Latin America. It would have been far more realistic to discuss the fixed exchange rate case with some other type of hybrid regime where the exchange rate moved according to a rule, say to maintain purchasing power parity. Variants of some type of exchange rate rule have certainly been utilized by several countries in the region on occasion. The author is well aware of these schemes and in fact was closely involved with the preannounced exchange rate experiment in Argentina during 1979–81.

The issue of interdependence is examined within the framework of a stylized general equilibrium model that is believed to fit a broad range of Latin American economies. The overall structure is quite standard, although there are some interesting features not typically found in such models. The model itself contains three goods—exportables (which are taken to be primary commodities), importables, and nontradables. Demand for each of these is determined by relative prices and, although this is not explicitly stated, by the stock of real money balances or real wealth. The domestic supply of these goods is fixed. Prices of exportables and importables are given by the foreign price level times the exchange rate; excess demand for importables determines imports; and excess supply of exportables equals exports. Any disequilibrium in the nontradables sector leads to changes in the price of nontradables. So far this is all very straightforward, and the model would be relevant for most countries—developing and developed alike.

The economy being modeled also has a reasonably developed financial system, so that it can be assumed that so-called financial reforms have already occurred. Interest rates are determined by market forces, and the private sector can hold assets at home or abroad. The latter assumption is very crucial, since currency substitution and private capital movements in response to changes in actual and expected relative rates of return play an important role in the workings of the model. The public sector can also borrow domestically, either from the banking system or from the public through the sales of bonds, or contract external debt. While there is nothing surprising here, this assumption of a well-functioning financial system relatively free from distortions does limit the applicability of the model to only a few developing countries. Government controls over interest rates, credit flows, and capital transactions are still the norm in Latin America, so that the model would properly fit only a very small number of economies.

The author then takes this model and superimposes three special characteristics regarded as necessary to fit Latin American economies. First, wages and financial instruments are assumed to be indexed in some form to the rate of inflation. Such indexation is fairly commonplace in Latin America and thus must be taken into account. Incidentally, in describing the indexation issue, the author goes into a very interesting discussion of the choice of basket to be used in constructing price indices to calculate the real rate of interest and in defining cost of living changes for wage earners and the rest of the economy. This discussion brings out quite clearly the distortions that can be created by using incorrect baskets to measure aggregate price indices.

Second, lags in government revenues in response to a rise in prices are assumed to be generally longer than the corresponding lags in expenditures. This, of course, creates a negative fiscal drag. As inflation rises, for whatever reason, governments are assumed to attempt to maintain the real level of expenditures while real tax revenues tend to fall behind. This creates a fiscal deficit without any conscious action being taken by the authorities. The negative fiscal drag effect has been documented for Argentina (Tanzi)3 and other developing countries (Aghevli and Khan).4

Finally, the model assumes that even though there are no restrictions on capital movements interest arbitrage is not perfect. In other words, domestic interest rates (adjusted for exchange rate expectations, risk, transaction costs, etc.) tend to be a good deal higher than foreign interest rates on supposedly comparable instruments. The paper does not state explicitly why interest parity does not emerge, but simply imposes this condition artificially on the model. There have been a number of theoretical arguments advanced explaining this lack of perfect arbitrage, but the issue is far from settled. However, even a very casual look at the experiences of countries such as Argentina, Chile, and Uruguay would make one quite sympathetic to the assumption.

Apart from the macroeconomic relationships underlying the model that have been discussed above, special mention ought to be made of the careful spelling out of the intersectoral relationships. The author goes to considerable length in detailing how the government, the monetary authorities, the financial system, the real sector, and the public all interact. This is by far the most innovative part of the paper, and while the relationship and results can be questioned, there is no doubt that sectoral aspects are important and deserve much more attention than they have hitherto received. The author should be commended for having made a start in this direction.

There are a number of problems, of course, with the type of model that the author has decided to work with, and this comment will focus basically on three main ones. First, it seems that all goods in the model are final goods, and there are no intermediate inputs. This is a very strong assumption to make for a developing country that typically relies on intermediate imports (raw materials, capital equipment, etc.) as inputs in the production process. The absence of intermediate imports tends to weaken the external linkage and, at the same time, has a bearing on the effects of changes in external prices (or in the exchange rate) on domestic output. Devaluation, or a rise in foreign prices, could also be deflationary if the economy was heavily dependent on basic or necessary imports. This possibility is excluded from consideration by the model as it is presently specified.

The second problem relates to the treatment of output. It is never made clear whether output is fixed or not. The paper states at one point that relative prices do not affect supply, which could be taken to mean that output is constant. As such, there are no real effects of any type of shock, external or internal, and the discussion in the paper about variations in output and employment owing to such shocks does not appear to be pertinent. Later on in the paper, one finds that while the domestic supply of tradables is fixed, the supply of nontradables seems to vary. Certainly in the example presented in the Appendix, the supply of nontradables is variable. What causes it to change is never made clear. One way of dealing with this issue would be to fix trend, or potential, output but let deviations of actual output from this trend value be determined by relative prices. This would be more realistic, since it would allow output to vary in the short run and, at the same time, would make unnecessary the difficult task of specifying sectoral production functions.

Third, the model is strictly speaking an accounting model and has no explicit functions, parameters, or elasticities to speak of. In a sense, the approach is similar to the antecedents of the monetary approach to the balance of payments. The latter also grew out of a set of accounting relationships and identities, with the basic behavioral relationships specified later. The problem with this type of accounting approach is that the results are conditional on the choice of initial values, and one does not know whether the set of values chosen is realistic or not. In such circumstances, it is always advisable to engage in a sensitivity analysis and vary the initial values to see what differences result. It would be useful to know whether this was done and what emerged.

Taking this model, a particular simulation experiment is conducted. The actual experiment is supposed to reproduce the international picture faced by Latin American countries during 1979–82. The author identifies a stereotyped economic cycle in this period that has four stages. In essence, this cycle involves a rise in international inflation and interest rates and then a subsequent fall. Commodity prices, being flexible spot prices, are more volatile than the prices of other goods and services, so that there are sharp changes in the terms of trade for developing countries. Starting from a steady-state position and assuming a fixed exchange rate, this cycle is imposed on the model and a pseudo-dynamic (since the cycle involves the four distinct stages) path is traced out for the system. Since the model is quite complex, the verbal description of the dynamic process following the external shock is quite difficult to follow. One obvious suggestion would have been to put in some simple charts that displayed the paths followed by the variables in question. This would certainly have led to a better appreciation and understanding of what exactly was going on.

Given the model, the results of the simulation seem to be generally sensible. There are, however, a couple of results that deserve mentioning. First, it is interesting to note that an increase in foreign interest rates results in a fiscal deficit because of the rise in interest payments on external public debt. This point has not been widely recognized by model builders and deserves to be. The counterpart to the interest payments is the increased interest earnings of the central bank on its stock of international reserves. Whether these two should be netted out in some sense, perhaps through a transfer to the public sector from the central bank, is an interesting question. Second, in the example in the Appendix, the price of exportables rises by 10 per cent while the price of importables by only 5 per cent. One would have thought that both should have risen at the same rate, given the structure of the model, so this discrepancy deserves some explanation. Last, on the downside of the cycle, foreign interest rates decline but domestic interest rates remain high. However, capital outflows now occur rather than inflows, so that somehow exchange rate expectations seem to have been brought in. This sudden introduction of exchange rate expectations warrants explanation and elaboration.

At the end of the paper, there is a short and quite cryptic discussion of what would happen if, instead of being fixed, the exchange rate were allowed to float freely. Some of the results naturally change, but although the conclusion that floating insulates nominal variables and not real variables from nominal external shocks is not particularly surprising, it does not follow directly from the model. The author argues that variations in output and employment are larger under floating, but as was said before, if output does not respond to changes in relative prices, how can such a conclusion be drawn?

In conclusion, the paper has much to offer from a theoretical standpoint. At the same time, it contains the insights of someone who has been closely involved in policy formulation for a number of years and has obviously thought carefully about the issues. While one may not agree with all of the conclusions, one has to commend the effort to formalize views and judgments about the functioning of a small, semi-open economy. It is certain that some of these ideas will start to show up in the growing literature on stabilization in developing countries.

Michel Aglietta

Mr. Arriazu presented a very substantial analysis of the repercussions of international economic instability on Latin American countries. He rejected the pertinence of internal causes—inadequate exchange rate policies and excessive government spending—and emphasized the importance of external constraints in his explanation of the economic difficulties facing these countries. The special method he used derives from this hypothesis.

An international cycle, according to Mr. Arriazu, takes place in four phases. These phases can be distinguished from the relative evolution of international raw materials prices vis-á-vis other commodities prices and interest rates. This criterion is justified by the hypothesis according to which fluctuations in materials prices constitute the main effect of external shocks on these economies. The effects of the cyclical shock are meticulously analyzed, and the dynamic sequence undergone by the concerned countries is described.

What renders this analysis complex and makes it difficult to follow is also what makes it greatly interesting. The author does not work solely with a global pattern. He identifies the sectoral distortions caused by the great variability of nominal prices. However, this technical and sophisticated paper does not discuss economic policy matters. The impression given is that all Latin American countries are at the mercy of the external forces that dominate the world economy and have no freedom of choice. Such a conclusion may, unfortunately, be right. However, one cannot help wondering if this conclusion is not a fallacious by-product of the method the author has adopted. Indeed, the relationships described are deliberately presented as mechanical. Whatever they do, neither the private sector nor the state seems to be able to counteract these evolutions. Besides, in a framework that pretends to take economic structures into account in order to stress sectoral repercussions, it is odd that no distinction is drawn among countries on the basis of the variation in the resistance of their economic structures to shocks. Such an omission could lead one to underestimate the wide variation in the repercussions of shocks on different countries on account of differences in their exchange rate regimes. It could also lead one to overlook the peculiarities of the present Latin American situation, which is dominated by debt constraints. These constraints can provoke strong reactions—among lenders as well as borrowers—that alter the cycle itself. At present, we are perhaps in a very important, long-lasting phase of declining growth that has resulted from the large amount of debt that has accumulated and that is not the result of standard cyclical evolution.

Now, I shall deal with each of these two points in more detail.

Exchange rate regimes and sectoral distortions. It is possible to take advantage of cyclical phases by investing in the export sector when relative prices are favorable. The accumulation of capital has—as long as it reinforces export production capacity—an irreversible and favorable effect, which ensures that a country’s export sector will have expanded when the cycle ends. To convert transitory gains in the world market into a permanent improvement of the productive system, domestic relative prices should be altered to channel profits to economic agents able to decrease the country’s dependence on imports or to increase its exports, at least within the following cycle. The success of such measures depends crucially on the state’s domestic pricing policy for agricultural products, its control of public spending, and its choice of exchange rate regime. Increased resilience in the face of international fluctuations can only stem from a high degree of food self-sufficiency and from a diversification of industrial production. The achievement of these two goals would allow a reduction in raw materials costs in the production of exports.

Thus, maintaining an overvalued currency—using a fixed exchange rate policy in order to limit the inflationary repercussions of the rise in world prices—can lead to disaster. If it is coupled with high interest rates that attract short-term capital flows and stifle industrial profits, this exchange rate policy weakens export industries and import substitution industries. The gains from the transitory improvement in the terms of trade—in the first phase described by Mr. Arriazu—are not invested in the sectors that could improve the country’s competitiveness. They are instead either absorbed by the financial sector or dissipated in imports of luxuries. Moreover, an overvalued currency forces firms in the international sector to put intolerable pressures on real wages.

To alleviate this pressure, the authorities set very low prices on agricultural and food products—that is, they subsidize them. Thus, agricultural income deteriorates considerably. There is a consequent speeding up of the ongoing disorderly exodus from rural to urban areas. Necessities are subsidized in order to keep their prices low, and the continued existence of a large unemployed urban population is assured by minimal assistance. Thus, public spending is increased to the point where the situation becomes hopeless, and the state has to use the gains received from the terms of trade to finance public spending. Such a policy, which weakens the economy during the favorable phases of the cycle, paves the way for a serious crisis during phases when the terms of trade turn against the country. The balance of payments deficit then adds to the budget deficit. The latter is financed by inflationary money creation. Then an exchange rate crisis becomes inevitable, which, in its turn, provokes a brutal recession—the only means of reducing imports.

If the exchange rate is fairly well managed, the pattern can be substantially altered. If this is so, there cannot be a unique pattern, contrary to Mr. Arriazu’s hypothesis. The difficulty of carrying out such a policy is how to bring about a regular and orderly depreciation of the currency and maintain an undervalued currency without fostering destabilizing speculation. This aim can only be achieved if internal policies are deliberately geared to production capacities in the labor-intensive sectors in order to make use of the comparative advantage provided by a cheap labor force. The relative price of agricultural products is the crucial variable. If individual farmers can be assured of a decent income, this will make it possible to maintain a balance between rural and urban populations and to reduce the country’s dependence on imported food. The experience of Southeast Asian countries is proof of this. Within this context, a high level of productive investment maintains growth, which, in turn, stimulates productivity improvements. These improvements will prevent inflation—which is fed by permanent currency devaluations—from getting out of hand. Also, cyclical evolution could be much smoother than it is when there is an overvalued currency. The high investment rate will give the economy an increased capacity to adapt.

Problems caused by excessive debt. Most of the Latin American countries have overborrowed, leading to the building up of tensions and the creation of considerable uncertainty. A climate of rivalry is fostered between debtors and creditors as soon as default threatens. The appearance on the economic scene of the insolvency problem fosters instability in the behavior of private agents and forces governments to take action. The usual hypothesis of a predictable set of cyclical linkages with given behavior and economic policies becomes highly questionable. Overvaluation of currencies for too long can only worsen the problem by releasing destabilizing speculative forces. It then becomes necessary to look directly at the interaction between the financial fragility of countries and the behavior of foreign lenders. The international financial market can no longer be regarded as a reserve of capital communicating with the borrowing countries by means of variations in the interest rate. On the contrary, overborrowing can lead to dramatic changes in creditors’ expectations that can foster instability in the market.

A rupture occurs in the asset and liability structure when no interest rate whatsoever can clear the credit market. This can happen when default becomes likely and leads the two sides of the market to adopt conflicting strategies. First and foremost, debtors are anxious to renew debts or, in other words, to finance assets that do not yield the cash flow that was expected from them when they were bought. Debtors are also compelled to enhance their liabilities in order to pay off increased financial costs.

Creditors do not know whether the money they are lending will be invested productively or dissipated in private or public consumption. This uncertainty alters the nature of the interaction between debtor and creditor. An anonymous market can no longer determine appropriate lending rates. Creditors become obsessed with the quality of their loans, which can lead them to excessively restrict credit. Moreover, the accumulated debt is a factor of uncertain weight that is influenced by the probability of default, which is linked to the amount of future debt. But current creditors ignore what the future debt—which depends on the borrower’s strategy—will be.

The more new lenders the borrower is able to attract, the more freedom this strategy permits. Thus, current creditors, who have neither control over nor knowledge of their borrowers’ future debts, become very cautious. They require risk premiums and shorten the maturities of their loans. This shortening of maturities increases the debt service burden, which, in turn, causes a deterioration of the current account and a stifling of growth.

When the debtor-creditor antagonism reaches fever pitch, the choice of an exchange rate regime has become secondary. The appropriate method of dealing with the situation is to appoint a mediator. There are two reasons why this would be helpful. First, a mediator would be able to guarantee borrowers a debt rescheduling compatible with their export capacities. Second, a mediator would be able to reassure lenders by putting limits on future loans and by controlling the uses made of these loans by borrowers.

Stopping runaway borrowing without provoking a collapse of debtor countries is a delicate exercise in international monetary cooperation. However, it is the only means of alleviating the negative repercussions of cyclical fluctuations.


Ricardo H. Arriazu is Economic and Financial Consultant to the Banco Comercial del Norte in Buenos Aires. He was formerly an Advisor to the Presidency of the Central Bank of Argentina and an Alternative Executive Director of the Fund. He has written numerous papers on international finance, capital and financial markets, monetary theory, and the problems of small, semi-open economies.


Many developing countries have systematically announced that their currencies were floating freely in moments of crisis, but have generally returned to pegging to their major intervention currencies after very short intervals.


This assumption could be justified by differences between the speeds of adjustment, between consumption and production, to changes in relative prices, which imply that producers anticipate cyclical changes in relative prices while consumers do not.


An even stranger development could take place in beef exporting countries, where the improvement in the terms of trade—if thought to be permanent—might induce a retention cycle that would involve a short-run reduction in the volume of exports.


In moments of exchange speculation, leads and lags in payment for exports and imports tend to reinforce or modify the normal behavior of these variables. Since this model has assumed total consumption during the period, however, commodity speculation is excluded.


Goldstein, Morris, and Mohsin S. Khan, Effects of Slowdown in Industrial Countries on Growth in Non-Oil Developing Countries, IMF Occasional Papers Series, No. 12 (August 1982).


Khan, Mohsin S., and Malcolm D. Knight, “Some Theoretical and Empirical Issues Relating to Economic Stabilization in Developing Countries,” World Development, Vol. 10 (September 1982), pp. 709–30.


Tanzi, Vito, “Inflation, Real Tax Revenue, and the Case for Inflationary Finance: Theory with an Application to Argentina,” IMF Staff Papers, Vol. 25 (September 1978), pp. 417–51.


Aghevli, Bijan B., and Mohsin S. Khan, “Government Deficits and the Inflationary Process in Developing Countries,” IMF Staff Papers, Vol. 25 (September 1978), pp. 383–416.