SWP-636

The Real Effects of Stabilizationand Structural Adjustment Policies

An Extension of the Australian Adjustment Model

Deepak Lal

WORLD BANK STAFF WORKING PAPERSNumber 636

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WORLD BANK STAFF W'ORKING PAPERSNumber 636

The Real Effects of Stabilizationand Structural Adjustment Policies

An Extension of the Australian Adjustment Model

Deepak Lal

The World BankWashington, D.C., U.S.A.

Copyright © 1984The International Bank for Reconstructionand Development / THE WORLD BANK1818 H Street, N.WWashington, D.C. 20433, U.S.A.

First printing March 1984All rights reservedManufactured in the United States of America

This is a working document published informally by the World Bank. Topresent the results of research with the least possible delay, the typescript hasnot been prepared in accordance with the procedures appropriate to formalprinted texts, and the World Bank accepts no responsibility for errors. Thepublication is supplied at a token charge to defray part of the cost ofmanufacture and distribution.

The views and interpretations in this document are those of the author(s) andshould not be attributed to the World Bank, to its affiliated organizations, or toany individual acting on their behalf. Any maps used have been preparedsolely for the convenience of the readers; the denominations used and theboundaries shown do not imply, on the part of the World Bank and its affiliates,any judgment on the legal status of any territory or any endorsement oracceptance of such boundaries.

The full range of World Bank publications is described in the Catalog of WorldBank Publications; the continuing research program of the Bank is outlined inWorld Bank Research Program: Abstracts of Current Studies. Both booklets areupdated annually; the most recent edition of each is available without chargefrom the Publications Sales Unit of the Bank in Washington or from theEuropean Office of the Bank, 66, avenue d'Iena, 75116 Paris, France.

Deepak Lal is economic adviser to the Development Research Department ofthe World Bank.

Library of Congress Cataloging in Publication Data

Lal, I)eepak.The real effects of stabilization and structural

adjustment policies.

(World Bank staff working papers ; no. 636)Bibliography: p.1. Economic stabilization--Developing countries--

Mathematical models. 2. Business cycles--Developingcountries--Mathematical models. 3. Wages--Developingcountries--Mathematical models. 4. Profit--Developingcountries--Mathematical models. 5. Balance of payments--Developing countries--Mathematical models. I. Title.II. Series.HB3732.L35 1984 339.5'0724 84-3646ISBN 0-8213-0353-8

Summary and ConcluLsions

This paper asks if there is anything useful that economists can sayabout minimizing the real costs of stabilization and the structural adjust-ment entailed by reforming various inefficient microeconomic policies in theeconomy.

Of particular concern are the effects of these policies on real wage(and real profit) rates in the economy. In many developing countries wherethe poor people's chief endowment is their labor, these changes in real wagesinduced by alternative policy packages should capture the major effects on thelevels of living of the poor. The policy packages considered are componentsof the deflationary fiscal and monetary package, changes in nominal exchangerates, reduction of the foreign trade and other commodity price distortions,and the reduction or removal of distortions in financial (capital) markets.

The paper first outlines a version of the orthodox trade theoretictreatment of the small, open economy (the so-called Australian model ofbalance of payments) which is sufficiently rich to think through the variousissues raised in debates over stabilization policies. This simple frameworkis then applied to a "model" case to show how it can be used to answer questionson how to minimize the welfare costs of tradlitional stabilization and adjust-ment packages.

The third part of the paper briefly discusses the usual reasons whycountries get into a "crisis," and whether ithere is anything which can beusefully said and done to prevent them from getting into fresh ones in thefuture. The implications of some radical ideas recently outlined by Max Cordenon the question: "What is a 'balance of payments' problem?" are outlined.The final part of the paper explains how the approach outlined in the firsttwo parts of the paper might be applied in practice in country economicanalysis by the Bank.

Acknowledgements

This paper was prepared as part of ongoing research on Wage

Employment Trends and Structure (RPO 671-84). The paper was written

while the author was a consultant to the Country Policy Department of

the World Bank. The views expressed are personal and should not be

identified in any way with the World Bank. Comments on an early draft

by members of a seminar at the World Bank and by Sebastian Edwards are

gratefully acknowledged.

Resume et conclusions

Ce document pose la question de savoir si les economistes ont quelquechose d'utile a dire sur la possibilite de minimiser les coats reels desmesures de stabilisation A prendre et les ajustements structurels A opererquand on veut modifier des politiques microeconomiques inefficaces.

On considere en particulier les effets de ces politiques sur lessalaires reels (et les b6nefices reels). Dans beaucoup de pays en deve-loppement oa la principale ressource des pauvres est leur capacite de tra-vail, les modifications de salaires reels provoquees par l'applicationd'une nouvelle politique sont a considerer dans leurs principales inci-dences sur le niveau de vie des pauvres. Les trains de mesures envisa-g6es sont des volets d'une politique fiscale et monetaire deflationnistemodifications des taux de change nominaux, reduction des distorsions ducommerce exterieur et, d'une maniere generale, des prix des produits, etreduction ou suppression des distorsions des marches financiers (decapitaux).

On presente d'abord une version du traitement theoriquement appli-cable, en bonne orthodoxie, A la petite economie ouverte (le modele "aus-tralien" de balance des paiements), assez riche pour prendre en comptetous les problemes qui alimentent le debat sur les politiques de stabili-sation. On applique alors ce cadre simple A un cas "modele" pour montrerque l'on peut ainsi savoir comment minimiser les incidences sociales desmesures de stabilisation et d'ajustement.

La troisieme partie expose brievement les raisons habituelles quifont qu'un pays entre en "crise", et pose la question de savoir s'il estpossible de dire ou faire quelque chose d'utile pour leur eviter d'en con-naitre d'autres plus tard. On tire ensuite les consequences de quelquesid6es revolutionnaires recemment enoncees par Max Corden sur la question"Qu'est-ce qu'un probleme de balance des paiements?" La derniere partiedu document montre comment la Banque pourrait appliquer la methode d6finiedans les deux premieres analyses economiques des pays.

Resumen y conclusiones

En el presente estudio se plantea la cuesti6n de si los economistaspueden aportar alguna idea uitil para minimizar los costos reales de laestabilizaci6n y el ajuste estructural que exige la reforma de las diver-sas politicas microecon6micas ineficaces en las economias de los paises.

Se han sefialado con particular preocupaci6n los efectos que talespoliticas tierien en las tasas salariales (y de utilidades) reales. Enmuchos paises en desarrollo, donde el principal activo de los grupospobres es su trabajo, las variaciones del salario real provocadas por losdiferentes conjuntos de medidas de estabilizaci6n y ajuste necesariamentehan de tener efectos importantes en los niveles de vida de esos grupos.Los conjuntos de medidas examinados en el estudio son los componentes delconjunto de politicas fiscales y monetarias deflacionarias, las variacio-nes de los tipos de cambio nominales, la reducci6n del comercio exterior yotras distorsiones de los precios de los productos basicos, y la reducci6no eliminaci6n de las distorsiones en los mercados financieros (de capital).

Se esboza primero en el estudio una versi6n del tratamiento te6ricoortodoxo del comercio en una economia pequefia y abierta (el llamado modeloaustraliano de balanza de pagos), que es suficientemente amplio para per-mitir un analisis de las diversas cuestiones que se plantean en los deba-tes sobre las politicas de estabilizaci6n. Este marco sencillo se aplicaluego a un caso "modelo" para mostrar la forma en que se puede usar pararesponder al interrogante de c6mo minimizar los costos en terminos debienestar social que suponen las medidas tradicionales de estabilizaci6n yajuste.

En la tercera parte del estudio se examinan brevemente las razonesusuales por las que los paises experimentan "crisis" y las soluciones omedios que podrian proponerse o usarse para evitar que vuelvan a experi-m,entarlas en el futuro. Asimismo, se esbozan algunas ideas radicalesexpuestas recientemente por Max Corden con el planteamiento de la pregunta"que es un 'problema de balanza de pagos'?". En la parte final seexplica c6mo podria el Banco aplicar en la practica, en los estudiosecon6micos de los paises, el metodo resefiado en las dos primeras partes.

TABLE OF CONTENTS

Page

Introduction ............................. *............................. 1

I. A SIMPLE FRAMEWORK FOR ANALYSING VARIOUS

REAL ASPECTS OF STABILISATION POLICIES ............................ 5

1. The Real Economy ........................ , 6

(A) With given stocks of capital and labour . ..................... 8(1) Removing the capital market distortion . . ................ 8(2) Removing or reducing product market distortions ......... 8

(a) with wage flexibility .............................. 8

(b) with sticky wages ........ . 10

(B) The effects of changing factor supplies ...................... 12

2. The Monetary Economy ................. .................... .. 13

(A) Exogenous Money Supply .-..-.- ... 131. Wage flexibility ..................................... .14

2. Sticky Wages ................. 17(B) The Financial and Fiscal System Introduced 19

1. High powered money, fiscal deBficits and exchange rates... 212. The real effects of disabsorption ........................ 24

3. Conclusions .31

II. MINIMISING THE WELFARE COSTS OF ADJUSTMENT................ . 31

1. Points of Comparison .322. 'Optimal' Sequencing of Policy ReformsE.......o.............. 33

III. SOME STYLISED 'CRISES' AND WHEN IS A 'CRISIS' A CRISIS?......... 42

1. Private sector windfalls. .............. ... . . . . . 43

2. Public sector windfalls . .... .. 453. Public sector crises and accounting procedures. . 47

IV. APPLYING THE FRAMEWORK ................................ . 43

REFERENCES. . o ..... ... .. ........... 5V)

TABLES ... 52

FIGURES ..................................................... 55

INTRODUCTION

There has been a great deal of concern recently about the effects of

various IMF stabilization and World Bank structural adjustment programmes on

the real economy, in particular on the incomes of the poorer sections in

developing countries. (See Dell (1981), Williamson (ed) (1983), Killick (ed.)

(1982), Nowzad (1981)). However, much of the discussion consists of (a)

identifying whether the 'crises' which give rise to these programmes are

caused by exogenous or endogenous factors, and (b) deriving rules for when the

ensuing payments deficits should be financed through foreign capital inflows

or through domestic real adjustment.

The impetus for these concerns are the problems developing countries

are supposedly facing because of the oil price rise of the '70s, or else a

worsening in the current external environment for their exports. Furthermore,

there is the growing recognition in many LDC's that many of their past trade,

exchange rate, and pricing policies have been inimical for their development

and a removal of these policy induced distortions is therefore sought. As the

long run 'solution' to all these perceived problems requires some reallocation

of resources, and a fresh deployment of available policy instruments, these

general worries can be considered to encompass the following general

questions: (i) What are likely to be the reallocations of domestic production

and consumption that are likely to arise during the process of adjustment?

(ii) What are the likely changes in the levels of living of the poorer

sections during this process? (iii) Are there policies, including their

-2-

correct sequencing which can be used to minimize the efficiency and equity

costs of the transition?

In answering these questions, a bewildering array of very different

theoretical frameworks are available and have been applied to various

countries.l/ Surprisingly, in applied work the orthodox trade theoretic

framework using a model of the small dependent economy (the so called

Australian model of balance of payments theory) has been rarely used to answer

these questions. Many of the seeming diverse theoretical frameworks being

applied to analyze the effects of stabilization policies turn out to be

special cases of this more orthodox model. The assumptions leading to these

"queer cases" from the viewpoint of the traditional theory, usually concern

odd assumptions about 'substitutability' in production or consumption. 2/

Cline (in Williamson (ed) (1983)) has recently provided a compendium of these

strange assumptions, and the evidence against them.3/

1/ For a sample see Cline & Weintraub (ed.).

2/ Thus some monetarist models assume the 'law of one price' so that thereis perfect substitutability between trade and non-traded goods. No roleis left :Ln these models for the determinants and effects of changes inthe real exchange rate, i.e., the relative price of traded to non-traded

goods, which is central to the workings of the orthodox model. Bycontrast, many of the so-called 'Keynensian' models assume no or littlesubstitutability in production and consumption so that relative pricesplay little part in their stories, which are dominated by changes in the

level of income.

3/ Also see J. Hanson (1982) for a critique of the models of the'contractionary' effects of devaluations.

It may be useful, therefore, to set out a version of the orthodox

framework, (not to be found in any one place), which is sufficiently rich to

think through the various issues raised iri the current 'stabilization'

debate. The next part of this paper outlines this simple framework. The

second part applies it to a 'modei' case to show how it can be used in applied

work, to answer the questions concerning the weltare cost minimising

deployment of policies in the traditiona'l stabilization and adjustment

packages.

Before we begin, however, it mar be useful to make some obvious

points which tend to get ignored in the usual discussion of these issues and

to pinpoint the nature of 'the problem.'

The typical stabilization cir, adjustment programme is launched when a

country is in a 'crisis'. This is usually an lncipient or actual balance of

payments crisis. Elementary considerations suggest that the crisis arises

because the payments deficit is unsustainable, that is, it cannot be financed,

and that in an immediate sense it entails an excess of domestic expenditure

over domestic output, or that the current ievei of income being enjoyed by a

country's inhabitarnts cannot be sustairned. In that sense, any immediate cure

for the 'crisis' must necessarily involve reducLng the level of current

expenditure. It may be possible, if the projper policy medicine is taken, that

the country may then be able to get some foreign resource inflows which could

allow it to make this reduction in reaL expenditure gradual rather than

sudden.

With any rate of social tin,,e preference which is greater than the

cost of the foreign borrowing, the gradual path must dominate the sudden shock

treatment, if the former is feasible. But, :t is this very feasibility which

- 4 -

is usually in question, essentially on grounds of the likely behavioral

patterns of particular governments. A long drawn out cut in real

expenditures, may be politically more disastrous for a government than a

quick, once for all, cut in real expenditure. This is a question of

judgement, mainly of a political nature on which economists can hardly claim

any expertise.

This leads to the second string of the usual 'easing of the pain'

type of arguments for gradualism in reducing real expenditures. It is argued

that, over time, particularly if various policy reforms are undertaken to

improve the overall efficiency of the economy, the future growth of real

income and output (from the ongoing processes of growth, as well as those

increments induced by the improved policies) might not require any real cut in

expenditures at all. Again in terms of economic theory, this would be

uncontroversial. The controversy arises because of differing judgements about

the tenacity and political will of governments to follow through such a phased

programme of policy reform, when the pain experienced by various sectional

groups hurt by the removal of various 'distortions' from which they had

benefitted, is more immediate (and more vocally expressed) than the promised

joys which the greater efficiency will bring in the future.

As such I take a completely agnostic position on the question of

whether, in general, it is better to administer shock therapy to the patient

in trouble, or to allow his immediate and unbearable pain to be turned into a

medium term headache! I will instead assume in what follows that the patient

has been given the usual IMF medicine in terms of reducing absorption

(reducing domestic expenditure relative to output), and ask is there anything

useful that economists can say about minimizing the real costs of

- j -

stabilization and the structural adjustment entailed by reforming various

inefficient microeconomic policies in the economy?

The real effects we shall be particularly concerned with are the

effects on the real wage (and real profit rate) in the economy, which, in many

developing countries where the poor's chief endowment is their labour, should

capture the major effects on the levels of living of the poor, through the

changes in real wages induced by alternative policy packages.

The instruments we consider are the components of the deflationary

fiscal and monetary package, changes in nominal exchange rates, reduction of

the foreign trade and other commodity price distortions, and the reduction or

removal of distortions in financial (capital) markets.

In the third part of the paper we briefly discuss the usual reasons

why countries get into a 'crisis', and whether there is anything which can be

usefully said and done to prevent them from getting into fresh ones in the

future. In this context we outline the implications for our subject of some

radical ideas recently outlined by Max Corden on the question: "What is a

'balance of payments' problem?"

The final part of the paper outlines how the approach outlined in the

first two parts of the paper might be applied in practice.

I. A SIMPLE FRAMEWORK FOR ANALYSING VARIOUSREAL ASPECTS OF STABILISATION POLICIES

There are two essential components of the framework: (1) a simple

two-good, three-factor trade-theoretic model, and (2) a simple model of the

domestic banking system. These real and monetary models are spelt out in

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fairly simple terms in the next two sections of this part. 1/ The next part

puts them together to analyse the real effects on real wages and output in

various stabilisation packages in different structural environments, and

outlines any distortions flowing directly from the adjustment processes which

may need to be corrected by alternative policy instruments. It also suggests

some welfare-theoretic considerations which might enable a welfare cost

minimising sequence of reforms in the standard stabilisation cum adjustment

package.

1. * The Real Economy

Consider a small open economy, which faces given terms of trade for

its exportables and importables, which can therefore be aggregated into a

Hicksian composite good labelled 'tradeables'. Besides these, there is a

single non-traded good. Both tradeables and non-tradeables are final consumer

goods, and as intermediate inputs are also combined with capital and labour to

produce the domestic outputs of the good. Capital throughout is assumed to be

sector-specific in the short run, but through depreciation and new investment

can be 'shifted' from one of the 'sectors' to the other, over time. Labour

force and capital growth are, throughout, assunmed to be exogenous.

The economy has distortions irn the foreign trade sector, and in both

its capital and labour market. The trade distortions could be due to the

1/ The real models are based on Jones (1971), Mussa (1974), Burgess(1980)and Neary(1982)(1978), the monetary models on McKinnon (1981),McKinnon and Mathieson (1981), Dornbusch (1974)(1980), Krueger (1974),and the integration of the real and monetary aspects in Corden (1977),and Corden and Jones (1976). Whilst Lal (1983) provides an algebraicformulation, and an application to the Philippines.

- 7 -

presence of either import tariffs, quantitative import controls and/or export

subsidies. The capital market distortion is due to the provision of explicit,

or implicit, interest rate subsidies through the banking system to, we assume,

the traded good sector. The labour markiet is distorted because the wage paid

by the traded good sector is above its social opportunity cost, and, hence,

higher than that in the production of non-tradeables, either because of "dual

economy" type reasons or because of labour market segmentation. We shall

assume that this particular wage distortion is not alterable, and represents a

constant fixed markup on the traded good money wage over that in non-traded

good production. This enables us to ignore it in what follows, and to work

with an "as if" uniform wage in both sectors. If the wage distortion can be

removed, its analysis on the real side is exactly the same as with the capital

market distortion--see below.

The economy is initially in an equilibrium (which is distorted), in

Figure 1 , where Panels I and II represent labour value added marginal

products (VAMPL) schedules in the two industries (panel 1), and the iso price

(or unit cost) curves for the given distorted product prices in panel 2. 1/

_LThese curves are given by:

a•w + akt r pt where Pi is all the commoditylt t t prices of the traded (t) and non-traded

(n) goods, and where the ai. are the

a w + akr P factor inputs of labour (Z3 and1= kn n n capital (k) pe unit of output, w & r are

the wage and rental rates.

- 8 -

As drawn, we have assumed that the non-traded good industry is labour

intensive relative to the traded one. Its unit cost curve, therefore, is less

steep at every wage-rental ratio than that for traded goods. We also make the

so-called "strong factor-intensity" assumption which entails that the two cost

curves only intersect once.

(A) With given stocks of capital and labour, given money prices of traded

and non-traded goods, the initial equilibrium of the economy is given by

points a in panel 1, and b & c in panel 2. The subsidy to capital in the

tradeable good industry means that its net of subsidy rental rate (rot) is

less than the rental rate (ron) in the non-traded good sector, but, b & c are

equilibrium points as the subsidy inclusive rental in the traded good sector

is = r.,

(1) Removing the Capital Market Distortion: Suppose that the

government eliminates the explicit or implicit subsidy to capital. This will

mean the private return to capital in the traded good sector will fall from

its subsidised level (=ron) to rot, and as a result, there will be a

tendency for on capital to be shifted from the traded to non-traded good

industries. The relative rise in the non-traded good sector's capital stock

will shift it mpl curve to the left; as will that of the traded good sector,

because of the fall in its capital stock. Equilibrium being achieved at

points d (panel a aktrt = Pt almw + aknr = P (P) 1) and e (panel 2)

with a higher nominal wage, wl, and uniform rental, r, in both

industries. As, ex hypothesi, commodity prices have not changed, the real

wage will rise unambiguously and the real rental rate will fall.

(2) Removing or Reducing Product Market Distortions.

(a) With Wage Flexibility. Suppose that simultaneously or subsequentlv,

the distortion in product markets (the composite "tariff" on the tradeables commodity)

is either reduced or removed. The 'effective' relative price of traded to non-traded

goods (PT/PN)' or as it is called, the "real exchange rate", now falls. This

will have three effects. First, it will lead to a proportionate shift,

downwards, in labour's marginal value added product (mvapl) and the unit cost

curve in the traded good industry (if there are no inter industry flows).

Secondly, to the extent traded inputs are used in the production of traded

goods, the reduction in their price (from the reduction of the 'tariff') will

lead to an upward shift in the mvapl and unit cost schedules for tradeables.

The net effect, with intermediate inputs, will depend upon the extent to which

the "effective protection" of the traded good industry is reduced. If it is,

the LDT schedule in Figure 2 will shift downward. Thirdly, for the non-

traded good industry, the reduction in the price of tradeable intermediate

inputs will shift the unit cost curve and its vmpal schedule upwards. The

extent of these shifts will depend upon the "tradeable intensity" of

production in both the sectors, as well as the relative reduction in the price

of tradeables.

As drawn, the net effect is for the money wage to fall to W2, but

as the price of non-traded goods has stayed constant, and, that of traded

goods has fallen by more than the fall in the money wage, real wages will

rise. 1/ The rental rates in this initial short run equilibrium will be given

by r2T for tradeables and r2N for non-traded goods. This difference in

rental rates will lead to the 'shifting' of capital from the traded to non-

1/ This can be derived from equation (7) in Lal (1983).

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traded good sectors. In the process, the economy will move to the point i

(the intersection of the 'new' unit cost curves) in panel (2), and j in

panel 1. The capital labour ratio (given by the slope of the tangent to the

respective iso price curves) will be higher at i than at e , in both

industries; employment and output will be higher in the non-traded good

industry and, as relative commodity prices remain unchanged in the movement

from e to i in panel 2, real wages will be higher and real rental rates lower

in this 'long run' Samuelson-Stolper equilibrium for the economy. During this

process there will be a monotonic increase in national income as measured by

the new 'distortion free' relative prices of commodities. 1/

(b) With Sticky Wages

Suppose wages are sticky. This implies that (at each particular

date, till the long run equilibrium is reached) the labour market does not

clear before the capital market, as was assumed in the previous case. There

is disequilibrium in the short run in both factor markets. If with the fall

in the price of tradeables, the wage is sticky (say in terms of the price of

the non-traded goods), then in Figure 2, short term equilibrium will be at k &

P in panel 1, and at m & n in panel 2. There will be unemployment of labour

of Pk , and, as before, there will be a rental differential in favour of non-

traded goods, which will induce the shifting of capital. As the sticky money

wage w1 is combined, ex hypothesi, with a fall in the price of tradeables

(with the price of non-traded goods unchanged), the real wage will be higher

in this sticky money wage 'short run' equilibrium.

1/ See Neary (1982), Figure 3.6.

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However, even if the unemployment does not exert downward pressure on

the money wage, then with the shifting of capital from the non-traded to

traded goods industries, and the subsequent: leftward shift of the two curves

in panel 1, money and real wages will rise above their sticky wage level, till

the long run equilibrium at i and j (as in the previous case) is

attained. 1/

1/ This is, of course, the result of our factor intensity assumptions.Thus, if, for simplicity, there were no interindustry flows andtradeables were labour intensive, then the long run equilibrium wouldhave entailed a lowering of the money and real wage. The initial stickywage would not have been validated in the process of adjustment with theshifting of capital stocks. There would be unemployment until the newlong run equilibrium was reached. Moreover, during this transition thepath of national income (measured at ithe 'new' relative commodityprices) need not be monotonic. It is possible that instead ofincreasing monotonically, there may be periods of "falling real nationalincome." This is due to the fact that, with unemployment, the shadowwage in this simple model becomes zero, and the shadow rentals ofcapital in the two sectors are then g:Lven by the average product ofcapital in the two industries. Private agents, however, will earn themarginal product of capital (our 'rental' rates), as they still have topay the slowly adjusting sticky wage, even though there isunemployment. It is possible, therefore, that the relative shadowrentals (= relative average product of capital) may not be the same asthe relative marginal products of capital, which are influencing theprivate shifts of capital. There may thus be overshooting with the wagefalling below its long run equilibrium level, leading to capital beingshifted back to the traded good industry. If, however, private agentsperceive the long run equilibrium wage, or else in the transition thegovernment can provide a wage subsidy which equates the sticky moneywage to the 'equilibrium' money wage, this problem will not arise.Given problems of information, however, it is unlikely that such asecond-best policy is likely to be feasible.

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(B) The Effects of Changing Factor Supplies

These can be readily accommodated within the above scheme, as they

will lead, at given relative commodity prices, to the so-called Rybczynski

effects. With perfect factor mobility it is well known that, at constant

relative commodity prices, if there is a relative expansion in the supply of

labour the output of the labour intensive commodity rises more than

proportionately to the increase in labour supply and that of the capital

intensive commodity actually falls. This can be seen from Figure 3.

Initially equilibrium is at A & B in panels I & 2. The expansion of the

labour supply relative to capital shifts the mvpal in both the industries

downwards so that the new equilibrium in panel 1 is given by point c, and at

d & e in panel 2. As commodity prices are unchanged (there is no shift in

the unit cost curves in panel 2) the real wage falls, and the rental rate

(both nominal and real) rises in both industries, but more in the labour

intensive non-traded good industry than in tradeables. This leads to a

shifting of capital from the tradeable to non-traded good industry and a

shifting leftwards of both the mvapl curves till the old wage-rental ratio

(wo,ro) is restored. But as (with the same capital stock) there is now at

f a larger proportion of a higher labour force in the production of non-

tradeables than tradeables, the output of non-tradeables expands whilst that

of tradeables contracts, as compared with the initial situation at A.

By this process, with wage flexibility real wages initially fall and

then rise back to their initial value.

2. The Monetary Economy

We turn to the determinants of the new exchange rate, of nominal

aggregate expenditure and of the process of monetary expansion or contraction

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through fiscal and monetary policy. We do this in two steps. Initially we

assume that the money supply is exogenously determined, we then formulate how

it is endogenously determined. The exchange rate is assumed to be controlled

throughout this section by the 'authorities'.

(A) Exogenous Money Supply

We now assume that the domestic demand for both tradeables and non-

tradeables (which are gross substitutes) depends upon the relative price

(PT/PN) of the two goods (that is, the real exchange rate) and the nominal

stock of money (M), as there is a constant money expenditure velocity (V, so

that money expenditure is equal to VM). The commodity balance conditions

imply that, whereas the domestic demand for non-tradeables must always equal

its supply, any excess demand (supply) for tradeables can be met by running a

trade deficit (surplus).

Given that the country is "small" in world trade and hence cannot

influence its terms of trade, any change in the domestic money price of

tradeables will depend upon changes in foreign currency prices and/or the

exchange rate. By contrast the relative price of non-traded goods will be

endogenously determined. The changes in real wages in turn will, for any

given level of factor market distortion and changes in relative factor

supplies, depend upon changes in the real exchange rate (the relative price

of PT/PN), as discussed in the previous section.

What are likely to be the movements in real wages (and real profits)

when there is an exogenous, ceteris paribus, change in (a) the money supply

and (b) in the exchange rate, assuming that there is short run fixity but long

run mobility of capital, but with (1) wage flexibility, and (2) with sticky

wages?

- 14

1. Wage Flexibility

Figure 4 is the familiar Salter (1959) diagram of so-called

Australian balance of payments theory, where TN is the full employment

transformation curve of the two composite goods traded (T) and non-traded

(N). Initial equilibrium is at A where a community indifference curve

representing the demands for the two goods is tangential to TN . The initial

real exchange rate (Pr/PN) is given by the slope of the line (1).

Now suppose that there is a devaluation or else, with a fixed nominal

exchange rate, the foreign currency price of the tradeable rises. 1/ With

initially no change in the price of non-traded goods, the real exchange rate

rises. The short run equilibrium is now at point B in Figure 4 where TONO iss sthe short run transformation function with sector-specific capital. At the

new real exchange rate 'consumption' will be at D, with excess demand for

N of CD matched by an excess supply of tradeables and a trade surplus of

BC. Ceteris paribus, given our factor intensity assumption that non-

tradeables are more labour intensive than tradeables, and if there are no

intermediate flows in production from Figure 5, the money wage will rise in

the short run with the rightward shift of the CT and LT curves, and the

money and real rentals on non-traded goods will fall and those on traded goods

will rise. As with the case of reducing the output price distortion in the

previous section, the movement in the short-run real wage is ambiguous. As

1/ The terms of trade, however, must remain constant or else the use of ourcomposite 'tradeable' would not be possible. In the 1970's a number ofprimary product exporters found that on balance their terms of trade didnot change, but the foreign currency prices of both exports and importsrose substantially.

- 15 -

the money wage rises by less than the rise in the real exchange rate, the real

wage falls in terms of tradeables but rises in terms of nontraded goods (whose

prices, ex hypothesi, remain unchanged).

If there are intermediate goods, however, then depending upon the

relative tradeable intensity of production of the two goods, the money wage

could remain constant, or fall, leading to an unambiguous fall in real wages

in terms of both commodities.

If, however, adjustments in both the capital and labor market are

instantaneous, the economy will move directly to point E in Figure 4, and e

in Figure 5. The consumption point will be at F in Figure 4 and there will

be an even greater excess supply of tradeables (and hence a larger trade

surplus) and excess demand for non-tradeaLbles than with short-run specificity

of capital. But now there will be an unambiguous fall in the real wage rate

and rise in the real wage rate (corresponding to this long run Stolper-

Samuelson equilibrium) as shown by point e in Figure 5.

However, the short-run position following the devaluation is not

sustainable for two reasons. First, the excess demand for the non-traded good

at points B & D in Figure 4 will leadi to their money price rising, unless

these prices are rigid for some unassumed1 reasons. But if they are, then

demand and supply for nontraded goods carL only be maintained by running an

even larger trade surplus equal to BG, and reducing money expenditure till the

point G is attained on the income consumption curve for the new relative

prices given by line 2. Secondly, the balance of payments surplus will lead

to a rise of foreign exchange reserves. If these are monetised (on which more

below), then the domestic money supply will rise, pari passu, with the trade

surplus and this will also tend to increase the demand for non-traded goods.

- 16 -

The real exchange rate will (in the absence of rigidity in non-traded good

prices) revert to its original level given by line (1) in Figure 4. All real

values will then revert to their original levels. The initial change in real

wages and real rentals will be reversed.

If, however, the change in the real exchange rate (from lines (1) to

(2) in Fig. 4, was initiated to deal with a shift in tastes, say, such that

the new long run equilibrium was given by point E, then the above real

exchange rate movement will not be reversed. The economy will move from point

A to B on the short run transformation curve. As this shifts along the

envelope of the long term curve the economy will travel (along the line of the

arrows) towards E, where at the full equilibrium, given our factor intensity

assumption, real wages will be lower and real rental rates higher.

Next consider the effects of a ceteris paribus monetary expansion,

starting off from the same internal equilibrium point A in Fig. 4. Assuming

that non-traded goods prices are flexible upwards, the monetary expansion will

raise monetary aggregate demand, and thence expenditure, leading to an excess

demand for both traded and non-traded goods. The former being met by running

the trade deficit, the latter by a rise in the price of the non-traded good

(the price of traded goods being fixed, ex hypothesi by the given foreign

currency price of tradeables and the exchange rate).

This rise in the price of non-traded goods (and in the real exchange

rate) using our previous diagram for the real economy will lead to a possible

rise in the short-run real wage if capital is sector-specific in the short-run

and a definite rise in the real wage in the 'long run', or if capital is

mobile.

But given the trade deficit, unless the country has access to

- 17 -

unlimited foreign borrowing, it cannot be fEinanced indefinitely. Some

corrective action will need to be taken. If the loss of foreign exchange

reserves flowing from the trade deficit is monetized, then the domestic money

supply will be contracting pari passu with the trade deficit. This will mean

that money expenditure will be reduced whic:h will in turn induce a fall in the

price of non-traded goods. This process will continue till the old

equilibrium point is reached.

Alternatively, if the government changes the real exchange rate

directly by devaluing at the start, then the devaluation will restore the

original position both because of the relative price change it entails as well

as because, by raising the price level (as the prices of traded goods rise) it

will lead to a contraction of real money balances. All real variables will be

back to their original levels, but during the transition real wages will be

higher and rental rates lower than they would otherwise have been.

2. Sticky Wages

With sticky wages and short run sector specificity of capital a

devaluation will raise the domestic money prices of traded commodities. As

money wages are rigid the economy will be at points A and f in Figure 6, with

an initially unchanged rental rate for N and a rise in the rental rate for

T. This will induce labor to move (at the fixed money wage) from N to T. But

with the same short run capital stock in N and a smaller amount of labor, the

capital-labor ratio will rise in N. With the given money wage the capital

stock in it can only be employed in the short run, if the price of N and thus

the rental on capital, falls so that the economy moves to point h in panel

(1) of Fig. 6, (and g, f in panel 2). Figure 7 illustrates this case within

the Salter diagram. In the short run the economy will be at a point G to the

- 18 -

left of B (corresponding to the flexible wage case) on TO NO and the tradeS S

surplus will be even larger (as the fall in non-traded goods prices

accentuates the switching effects of the devaluation).

The real rental clearly falls in the non-traded good and rises in the

traded good sector. As the money wage is ex hypothesi, rigid in the short

run, the movement in the real wage is ambiguous, as it falls in terms of

traded goods whose price has risen with the devaluation and rises in terms of

non-traded goods whose price has fallen.

If, as before in Fig. 7, suppose the devaluation induced relative

price line is given by 2. With the shifts of capital from the non-traded to

traded good industry, the economy will move from G but to a point to the

right of E , that is, with a smaller rise in real exchange rate than was the

case with wage flexibility. This is because as capital is shifted out of the

non-traded good industry, its marginal product and hence its rental rate

will rise, and this will push up its price so that in Figure 6 the final

outcome will be at i in panel 1 and at f in panel 2, with the same money

wage, and higher prices of both commodities, real wages will be lower than in

the initial or intermediate positions, but the (new unified) rental rate will

be greater in both nominal and real terms.

All this has implicitly assumed that the government has been

passively validating the level of domestic expenditure required to keep the

non-traded good market in balance at each stage of the process, that is,

consumption is at points directly below G and E in Figure 7. Associated

with each of these points there will be a trade surplus which, if monetised,

for the reasons given earlier, will lead to an excess demand for N . This in

turn will put upward pressures on the price of N till the real exchange rate

- 19 -

and all other real variables revert to their original position.

This will not be the case if tastes have changed so that a new real

equilibrium at E is required and sustained in Figure 7. In that case the

above real effects will remain.

(B) The Financial and Fiscal System Introduced

So far we have assumed that changes in the money supply and exchange

rates are exogenously determined. We neel to specify the mechanism through

which these changes are affected. The simplest model of the financial and

fiscal system would consist of the interrelationships between a central bank,

commercial banks, and the government treasury. 1/ There are only two monetary

assets that can be held by the general non-bank public -- non-interest bearing

cash, and short term interest bearing deposits with commercial banks. The

commercial banks are subject to a variable reserve requirement by the central

bank such that they have to hold k percent of their term deposits as non-

interest bearing deposits with the central bank. The commercial banks make

loans to the non-bank sector at a regulatedi interest rate iL and cannot pay

more than iD' the regulated interest rate, to depositors for their time

deposits. Table 1 presents the balance sheets for the central commercial and

consolidated banking systems. From the latter we can derive the well-known

identities relating domestic credit (DC), money supply (M), and the two

1/ An unorganized financial sector coulcd be included a la McKinnon, and therole of credit in financing firms working capital could be emphasized.However, no great analytical insights are gained by including theformer, and the empirical importance of the effects on output for areduction in credit flowing from the latter do not seem to be great.See Fry (1978), Cline (1982).

- 20 -

components of high powered money (H) - government debt (Z) and foreign

exchange reserves (F).

DC + F - M (3.1)

L + Z + F M - D + T (3.2)

where the symbols stand for

DC - total domestic credit which is made up of

L - loans by commercial banks to the non-bank public, and

Z - the covernment debt held by the central bank;

F - foreign exchange reserves;

M - money supply;

D - demand deposits: and

T - term deposits with the commercial banks.

High powered money (H) base is defined as

H = C + R - Z + F (3.3)

where C - currency, and the reserves held at the central bank against the

commercial banks demand deposits;

R - are the reserves held at the central bank against the

commercial banks time deposits.

If the commercial bank's 'cash ratio', which is the currency and

central bank reserves they hold against demand deposits, is Q , and the

reserve ratio against time deposits is k , there is a direct link between

- 21 -

high powered base money and the money supply given by

H = C + R F kD + kT (3.4)

If the proportion of the commercial banks' demand for time deposits

in the total money supply, which will depend upon the non-bank sector's

liquidity preferences and the deposit rate on time deposits, is given by m

so that, D = mM, and T = (l-m)M, then we have the relationship between high-

powered money H and the money supply M as

M = b.H (3.5)

where b = 1/[Qm + (1-m)k] is the money multiplier linking the high

powered money base to the economy's money supply.

Finally, we introduce the fiscal authorities, where the consolidated

budget (GB) of the public sector is represented by total government

expenditure G less taxes T or

GB = G - T (3.6)

This budget deficit is financed either by (i) borrowing from the central bank

or through (ii) foreign borrowing, so that,

G - T = AZ - AFg (3.7)

where AFg is the change in foreign reserves due to government borrowing

abroad.

1. High Powered Money, Fiscal Deficits and Exchange Rates

The links between the domestic banking system, the fiscal system, and

the balance of payments, B , can now be readily derived.

Any change in the balance of payments AB (assuming we start with

balance of payments equilibrium) will necessitate changes in the central

bank's foreign currency holdings A F so that we have the identity

- 22 -

AB - AF (3.8)

Combining (3.1), (3.7) and (3.8), we get

AB AF AM - AL - AZ

E [AM - AL] + [T - G - AF9] (3.9)

The first term on the right hand side shows the difference between changes in

the domestic money supply and in domestic credit to the non-bank public. The

second term gives the government's budget deficit that is not financed through

foreign borrowing, that is the change in total domestic credit due to the

budget deficits. This is the relationship which underlies the credit control

component of many stabilisation packages. With a balance of payments deficit,

and for any given level of government foreign borrowing, reducing domestic

credit creation used to finance both the government as well as the nonbank

public will, ceteris paribus, reduce the balance of payments deficit.

Obviously, the reduction of the government budget deficit entails

reducing government expenditure and/or raising its revenues. This will,

ceteris paribus, imply a decline (or smaller increase) in the amount of

government debt the central bank will be forced to hold. This implies that

from (3.3) the two components of the high powered money base H (viewed from

the assets side of the central bank's balance sheets) will both be declining

(as, ex hypothesi, a balance of payments deficit will imply - AF , and the

reduced government deficit,- A Z). As a result, from (3.5) the domestic money

supply will be shrinking [-AM - b - AH = b {-AF - AZ}].

Given the reserve requirements, from the commercial bank's balance sheets we

have

- 23 -

DL - A [D + T - R - C]

A{M - [R+C) }

A{ M - (Qm + k(I-m)]M}

A{ N - (1/b)M}

(1-1/b)AM

The contraction in the non-bank public's domestic credit AL will be greater

than the contraction of the money supply induced by the balance of payments

deficit and from any reduction in the government's fiscal deficit, as the

value of the money multiplier b is greater than unity. The reduction in

high powered money, partly induced by th,e loss of foreign exchange reserves

and partly by the reduction of the government deficit, will reduce domestic

money expenditure and hence absorption.

Alternatively, suppose the government did not reduce its budget

deficit, but chose to reduce domestic credit extended to the non-bank public

directly through raising the reserve ratio, k , for commercial bank reserves

against their term deposits. This will again lead to a direct reduction in

the money supply and thence on monetary expenditure, in addition to that

flowing from the flow of foreign exchange reserves.

There are three potential avenues, therefore, within this schema for

affecting money expenditure and thereby domestic absorption. The first two

are through the direct reduction of the high powered money base; (a) the

automatic reduction flowing from any foreign reserve losses, (b) the policy

induced reduction of the government budgiet, and (c) the policy induced rise in

the reserve ratio.

But the automatic effect under (a) is also a policy variable, for the

- 24 -

automatic loss of foreign reserves with a balance of payments deficit which

leads to a direct reduction in H and thence in M only follows if the

nominal exchange rate is fixed. If the exchange rate is fully flexible, the

balance of payments deficit will lead to an automatic devaluation which will

bring the balance of payments into balance without any loss of foreign

reserves. In that case there would be no effect on domestic H, M and thence

on domestic absorption as a result of attempts to cure the balance of payments

deficit. The same effect could be achieved in a fixed exchange rate (or a

managed exchange rate) system if the effects of the foreign currency flows

induced by the balance of payments deficit were sterilised. This essentially

means, in terms of the available instruments (if there is no private market in

government debt), that the central bank would either have to raise the reserve

ratios for the commercial banks (so that the money multiplier would be lower)

or the treasury would have to lower the budget deficit by reducing the

government debt (Z) held by the central bank (AZ = - ive).

The choice of the exchange rate regime (fixed versus floating), as

well as the government's ability to sterilise foreign exchange flows, are thus

important determinants of the degree of monetary independence the particular

country will have. Whilst irrespective of the exchange rate regime, there

will be an important policy choice in deciding whether the required dis-

absorption in the face of a trade imbalance and domestic price inflation is

brought about by a reduction in the government's budget deficit or changes in

the reserve ratios of the commercial banks (or some combination of the two).

2. The Real Effects of Disabsorption

The real effects of these methods of disabsorption can be categorised

as (1) those which only entail a shifting of the real exchange rate (the

- 25 --

PT/PN) line in the Salter diagrams of the previous section, and hence do not

entail any relative price changes, other than those we have already discussed.

But, in addition, (2) there may be further relative price changes

induced by these alternative methods of disabsorption, which we next need to

consider. For simplicity, we assume a fixed or managed exchange rate

throughout what follows; though, as discussed in the next part, this should

not be taken to mean that a fixed (or discretionary) exchange rate policy is

necessarily superior to a fully flexible rate one in welfare-theoretic terms.

With a fixed exchange rate the automatic disabsorption resulting from

the foreign currency losses associated with the payments deficit, discussed

above, will not entail any other relative price changes. In a sense, this

case coincides with the 'neutral' disabsorption policies we had assumed in the

previous section.

By contrast, reducing the budget deficit and/or reserve ratios could

have further relative price and thence real effects on the economy.

Consider (a), the reduction of the budget deficit. Concerned as we

are primarily in this paper with the effects of stabilisation policies on

income distribution, any change in the composition or levels of the transfer

payments associated with the reduction of the budget deficit will have obvious

direct distributional effects. Moreover, if these changes lead to a

different composition of demand for tradealbles relative to non-tradeables (at

given relative prices of the two), the community indifference curve map in the

Salter diagram will alter, and thence the 'new' long run equilibrium will

entail an alteration in the 'real' exchange rate, with the accompanying

changes in real wages and real profit rates discussed above.

- 26 -

Secondly, any change in the composition or level of the investment or

pure consumption part of the government budget, could also lead to a similar

change in the economy's 'tastes' (if these government expenditures are large

relative to total domestic expenditure), with similar 'real' effects as in the

case discussed above.

What of (b), changes in the reserve ratio? Their real effects will

depend upon the relationship between the domestic rate of inflation, the

distortion in the market for commercial bank term deposits, and lending to the

non-bank public. Most Third World governments levy an inflation tax. This

can be readily derived as the real income flow which accrues to the government

from increasing high powered money (H) through the budget deficit

GB =A H from (3.3) and (3.7). Denoting the price level by P and the

absolute rate of change of high powered money by H , we have

GB/P = A/P = (A/H) (H/P) = a(H/P)

where a A/H is the proportionate rate of change in base money. So the

real revenue that the government can extract from the banking system will

depend upon the percentage change in high powered money.

Furthermore, if the rate of inflation r is determined by the

difference between the rates of growth of money supply and real income (y),

and as the former is determined through the given money multiplier by the rate

of growth of high powered money,

7T = a y,

so that for any given rate of real income growth, a steady state inflation

rate will be associated with a given steady state budget deficit financed by

this inflation tax. Furthermore, following McKinnon [1981], a relationship

- 27 -

can be established between the rate of inflation, the reserve ratio

requirements, and the nominal and real term deposit rates and commercial bank

lending rates.

Figure 8 illustrates this market for loanable funds. The DL curve

shows the demand for commercial bank loans as a function of the real loan

interest rate (r. = i - i) for any given level of real income (Y.) .

The DT curve shows the demand for term deposits as a function of the real

deposit interest rate, rd = (id - t ). The supply of loanable funds

(assuming for simplicity that these form the only source of commercial bank

loans, as demand deposits have to be fully backed by cash and central bank

reserves), is then given by the curve SL , which is just (1-k) times the

term deposits that will be forthcoming at any real interest rate.

Initially, assuming no interest rate regulations and steady state

inflation at the rate X , which corresponds to a given steady state real

budget deficit GB/P, we have the equilibrium shown, with OR, the total time

deposits, induced by the equilibrium deposit rate rd, of which (given the

percent reserve requirement) LR are held as reserves at the central bank

and OL are lent out to the non-bank public at the marked clearing real loan

rate of ri . Given the relevant elasticities of demand for term deposits

and commercial bank loans, the inflation tax, for a given reserve ratio (k)

is in this steady state shown by the distance ab and is borne by both

depositors and borrowers, whose real market returns and costs differ from the

full equilibrium rate of r .

Assuming the banking system is competitive, it must be the case that

as it pays and receives the nominal interest rates (i)

- 28 -

id OR = it.OL = it(OR)(1-k)

or id = (1-k)l .

From this it can readily be derived that as

rd + = id and rI + =iQ

rg rd = l +rd) =i- id.

The difference in real and nominal rates will depend directly upon the

inflation rate r and the reserve ratio k for any given real return on

time deposits. For any given reserve ratio, k, an increase in inflation (r )

caused by a higher budget deficit will lead to a bigger wedge between

rk and rd (assuming that the nominal deposit rate id rises by the rise in

inflation). This can be seen from Figure 8.

Furthermore, if there are interest ceilings on the nominal deposit

rate, then the real deposit rate rd declines as much as the increase in the

rate of inflation r and the wedge between the real and nominal interest rate

remains constant. However, the deposit interest ceilings will, ceteris

paribus, reduce the size of the loanable funds market, leading to a "crowding

out' effect on the private borrowers, with the obvious inefficiencies that

this financial repression entails (see McKinnon (1981)). If there are also

ceilings on the nominal lending rate, then, with an increase in the inflation

rate, the real loan interest rate will decline and the excess demand for

loanable funds will have to be met by rationing, with the attendant

distortions that causes in the capital market. Removing interest ceilings,

therefore, will both expand the supply of loanable funds and remove the

- 29 -

capital market distortions discussed in section 1. This, as was shown, will

ceteris paribus, raise real wages both in the short and long runs.

Changing the reserve ratio is equivalent to shifting the 'inflation

tax' levied to finance the fiscal deficit. For the reserve ratio on interest

bearing deposits is a way of levying an inflation tax on the 'loanable funds'

of the banking system. However, McKinnon and Mathieson (1981) have recently

shown that, to finance a given fiscal deficit at minimum cost in terms of the

accompanying 'steady state' inflation rate, there will be an optimum reserve

ratio. This can be seen as follows. IfE there were no reserve requirements,

the government would have to finance its given fiscal deficit entirely through

the inflation tax levied on the 'currency and demand deposits' component of

the money supply, as it would receive no contribution from the "term deposit"

component. For any given composition oif demand and term deposits of the money

supply it would thus have to expand high powered money by more than it would

have if the 'tax' on term deposits could be levied. The higher money supply

will, ceteris paribus, entail a higher inflation rate. As the reserve ratio

is raised, the term deposit component will contribute its share to the 'tax'

and a lower inflation rate will therefore be sustainable.

However, with rising reserve ratios the term deposit component starts

shrinking, for any given total money stock, as the rising reserve ratio,

ceteris paribus, reduces the supply of term deposits because of the changes it

induces in the nominal deposit and loan interest rates. This shrinking of the

'term deposit' tax base, means that at some point (depending upon the relevant

elasticities of the demand for the two f-inancial assets) the revenue from

raising the 'tax' (on a reducing tax base) will start declining, and to

finance the same fiscal deficits, a larger 'tax' will have to be levied on the

- 30 -

'demand deposits' by increasing the money supply further, leading to a higher

inflation rate. Thus the relationship between the steady state inflation rate

associated with different reserve ratios jointly required to provide the

'revenue' to meet a given fiscal deficit will be U-shaped. Any reserve ratio

less than the optimal one (given by the bottom of the U) as well as a higher

one will entail higher inflation.

The steady-state inflation that is thus generated at the optimal

reserve ratio with a given fiscal deficit will entail a continuing rise in the

price of non-traded goods and if the nominal exchange rate is fixed, a

continuing fall in the real exchange rate. If this can be sustained, it would

imply a rise in real wages. But the fall in the real exchange rate will,

through its switching effects, entail a balance of payments deficit, which

with limited foreign exchange reserves cannot be sustained.

However, if the government adopted a floating exchange rate the

nominal exchange rate would alter to restore and maintain a constant, real

exchange rate (assuming as we are that this is the steady state one), and the

steady state inflation process could continue indefinitely. However, there

would be obvious real income losses associated with the levying of the

inflation tax, and the associated financial repression. If it is possible to

finance the fiscal deficit by other taxes which entail smaller by-product

distortion costs than the inflation tax, then it will be welfare improving to

reduce the fiscal deficit. In this process as the need to finance the fiscal

deficit through the 'seignorage' extracted from the banking system declines,

the optimal reserve ratio, as well as the inflation rate will decline.

- 31 -

3. Conclusions

Enough has been said to show that the short and long run real effects

of stabilisation and adjustment policies can be thought through in the above

simple general equilibrium framework. It may be useful to put together some

of these results in a schematic table, and this is done in Table 2.

II. MINIMISING THE WELFARE COSTS OF ADJUSTMENT

Suppose that the government of an LDC finds itself in a 'crisis' and

accepts the advice commonly contained in stabilisation and adjustment

programs. 1/ These are (a) to reduce absorption through (i) reducing the

fiscal deficit and through (ii) monitoring and controlling overall domestic

credit (DC) in the economy, (iii) and if expenditure switching is required--a

devaluation; (b) measures to improve the supply side of the economy, which

include (i) reducing trade distortions, (ii) reducing other commodity market

distortions caused by inappropriate administered prices, (iii) reducing

distortions in the capital market by reducing the degree of financial

repression through removing interest rate ceilings, changing reserve

requirements, and possibly removing exchange controls.

In a crisis situation, the disabsorption measures under (a) are

unavoidable. Only their extent is an issue. This, as we argued in the

introduction, depends upon the level of foreign financial accommodation avail-

able. The desirable level of this accommodation is a matter of judgment and I

have little to add to the earlier discussion.

1/ Discussions of these will be found in Guitian on the Fund'sconditionality, and in Stern in Williamson (ed.) on the Bank'sstructural adjustment programmes.

- 32 -

The remaining question concerns the sequencing of the 'supply-side'

policy reforms under (b) above, and whether there are any other policies which

might be able to minimise the inevitable costs of adjustment. For these

policies, by altering relative prices, will lead to changes in production as

well as in the distribution of income.

1. Points of Comparison

It is useful to consider the various policy reforms on the supply

side ((b) above] initially for an economy with wage flexibility and perfect

capital mobility so that the long run outcomes shown in Table 2 are

established. This provides a reference case to compare the various other

cases when the 'structure' of the economy is different. Two questions arise:

(i) whether there are any efficiency losses associated with the movement to

the new equilibria, and (ii) whether there are any harmful equity effects.

First, note that the unsustainable real expenditure at the start of the crisis

has already been dealt with by the disabsorption package [under (a)], so the

relevant point of comparison is either the situation before the unsustainable

"boom" got going for whatever reason, or with the situation after the

requisite disabsorption has been undertaken. It is not a valid criticism of

the stabilisation package that it leads to a fall in real expenditures and

(possibly) short run output as compared with the situation during the boom.

For, ex hypothesi, this level of expenditure is unsustainable, and the

relevant real expenditure reduction is unavoidable. A comparison of the

aftermath of stabilisation with the stituation immediately preceding it might

falsely suggest that the necessary cuts in expenditure represent avoidable

losses.

- 33 -

Of the other two points of comparison, in analyzing the effects of

the supply side adjustment package [under (b)] I would favor looking at the

situation preceding the boom, if that is possible. For typically it will be

difficult in practice to separate out the effects of particular instruments,

such as a devaluation, on stabilization as compared with adjustment so that

the position following the stabilization and before the adjustment begins may

not be clearly defined.

In fact, in most (but not all) of our comparative static exercises in

the previous part we have been making comparisons of the short run (impact)

and long run effects of particular policy changes on real output and real

factor returns based on comparisons before the boom and after the

stabilization has restored the status quo ante.

2. 'Optimal' Sequencing of Policy Reforms

We can now readily answer the welfare theoretic questions posed. It

is obvious that for an economy where the adjustments in both capital and

labour markets are rapid, all the policy changes proposed in the package must

necessarily improve efficiency and hence lead monotonically to higher levels

of real national income till the new 'undlistorted' equilibrium is reached.

Moreover, as is obvious from Table 2, the effects on real factor

returns, particularly real wages in the long run, of all these possible policy

reforms is positive (as we would expect, given our factor intensity assumption

and the assumption that most of the distortions are in the "traded" capital-

intensive sector). Thus there would (at least for the fairly flexible

'textbook' economy whose outcomes correspond to the Marshallian 'long run') be

no efficiency or equity losses entailed by the standard adjustment package.

- 34 -

It is short run immobilities of capital and rigidities of wages which

can lead to, in some cases, short run falls in real income and/or in real

wages (as we saw in Part II). Two questions then arise: (1) whether there

are likely to be feasible supplementary public policies which could minimise

these efficiency and/or equity losses during the transition; and (2) whether

there is a sequencing of policies within the adjustment package which will

reduce the 'pain' of the transition.

On the first question, initially consider the case with wage

rigidity. It is well known from the modern project evaluation literature that

any 'stickiness' or rigidity makes the shadow wage lower than the actual wage

rate [see Lal (1974) (1980a)]. In theory, a wage subsidy financed by lump sum

taxes would yield the best outcome along the transition. If this is not

possible, then some suitable tax-subsidy combination which essentially

subsidizes the output of the labor intensive industry may be desirable. As it

will not be usually feasible to institute a general wage subsidy in most

developing countries, where much of employment is self-employment, it may be

only feasible to use the output tax subsidy route. As we require a general

subsidy to the labor-intensive sectors, we can provide this by in effect

taxing the output of the capital intensive sector, that is, in effect by

lowering the real exchange rate (if this is feasible). Bhagwati (1979) and

Krueger (1978) detail various ways in which the removal of trade distortions

and changes in the nominal exchange rate can be combined to yield the

required lowering of the real exchange rate.

But whilst this is likely to improve efficiency if capital is quasi-

fixed, as it is likely to be, the combined effects of a reduction in output

distortions and devaluation (required to obtain the required real exchange

- 3S -

rate change) on short run real wages is likely to be ambiguous. It will

depend on the relative "traded" good intensities in the production of the two

composite goods, as well as on their elasticities of labour demand. If these

lie within a certain range, then the short-run real wage outcome can be

forecast and it may turn out that the real wage and real income effects are

both positive.

Suppose they are not. In that case, there may be a danger of real

wage falls, which could lead to inequitable short run outcomes.

By contrast, as we saw in part I, removing the capital market

distortion will entail a necessary improvement in both real output and real

wages in both the long and short runs. This suggests the following sequencing

of the adjustment package. First, remove the capital market distortion and,

as the real output and real wage gains began to appear, begin a phased

programme of reduction of distortions in the commodity markets (particularly

for traded goods). The possible short-run declines in real wages flowing from

the second phase being mitigated by the rises flowing from the continuation of

the first phase of policy reform.

Removing the capital market distortions, however, is a tricky problem

for a 'financially repressed' economy as we saw in the last section of Part

I. It is clear that, as a first step, interest ceilings on deposits and loans

should be removed. If the distributional impact of these changes is to be

spread over a period of time, then (parallel to the well known welfare

optimising method for a phased liberalization of a distorted trade regime) the

quantitative credit controls (which imply capital subsidies to favoured

borrowers) should be converted into explicit subsidies and shown as part of

the government budget. Without any increase in government revenues the

- 36 -

consequent rise in the fiscal deficit will require the levying of a higher

inflation tax, but, with a suitable adjustment of the reserve ratio (which

need not necessarily imply an increase in this ratio) 1/ on the interest

bearing component of the domestic money supply.

But, most important, to keep the economy at the new steady state

inflation rate 2/ it will be necessary to continuously alter the nominal

exchange rate at the same rate as the steady state inflation rate to maintain

a constant real exchange rate. A fixed nominal exchange rate would not be

sustainable. Over time, in order to reduce the inefficiencies flowing from

the financial repression associated with high reserve ratios, it will be

necessary to reduce the fiscal deficit and thence the inflation rate. But

whether or not this reduction in the steady state inflation rate will be

welfare improving depends, as was argued in the last section of Part I, on the

alternative net social costs of reducing government expenditure and/or raising

taxes to reduce the fiscal deficit. It may be better to sequence the

inflation control programme after the removal of interest ceilings, the

introduction of flexibility in exchange rates, and the phased programme of

trade liberalisation. In fact, to the extent government revenue rises with

real national income and the government's real expenditure remains unchanged,

1/ See McKinnon and Mathieson (1981). Thus if in Figure 9 the economyinitially had a steady state inflation rate and reserve ratio given by Afor the steady state fiscal deficit Z0, the rise in the steady statefiscal deficit entails an optimal reserve ratio of B < A, but of coursea higher steady state inflation rate. It is only if the initial steadystate inflation cum reserve ratio position was to the left of C, that arise in reserve ratios will be the optimum policy.

2/ Point B in Fig. 9.

- 37 -

the real fiscal deficit and hence the reserve ratio and inflation rate should

all fall to some extent through the feedback effects of the other policy

changes.

But against this we must set varioDus arguments concerning the

political economy of reducing the fiscal deficit as well as the distortionary

welfare costs of maintaining an inflationary environment. Though in theory we

can couch our arguments in terms of steady state inflation rates, in practice

it will be very difficult for a government to do so. It may, therefore, be

best to combine the reform of the domestic capital market with the reduction

of the fiscal deficit and inflation. The last part of this initial package

being made easier by the likelihood that some reduction in the fiscal deficit

will have formed part of the initial disabsorption required to deal with the

"crisis". So the first stage of the adjustment package should probably

combine the reduction of domestic capital market distortion with the reduction

of the fiscal deficit and inflation.

The next stage would be to remove exchange controls and institute

free floating of the exchange rate accompanied by an announcement of the

phased programme for removing commodity market distortions, which for the

reasons given above, should follow the freeing of the capital account after a

lag of, say, one year. The final stage would be to remove the commodity

market distortions according to a preannounced phased programme.

However, with the removal of domestic interest rate ceilings, if a

managed exchange rate regime is sought, then, as McKinnon and Mathieson have

argued, it may be necessary to maintain tight exchange controls. Without

these, they argue, the ability of the government to maintain a steady state

inflation rate to obtain the seignorage required to finance the fiscal deficit

- 38 -

is eroded. For without exchange controls domestic borrowers may find that at

a fixed exchange rate, or one indexed to changes in the domestic price level,

they can borrow more cheaply abroad as liberalised domestic interest rates are

much higher; that is, private foreign borrowing may be stimulated by the

domestic inflation tax. These inflows, moreover, will directly expand the

foreign currency component of high powered money and thereby the domestic

money supply and lead to higher inflation rates than are required to finance

the steady state fiscal deficit in their absence.

This argument, of course, assumes that full flexibility of exchange

rates is neither feasible nor desirable for the financially repressed

economy. I have argued elsewhere (see Lal (1980)) for the feasibility and

desirability of free floating for most LDC's and will not repeat the arguments

here. However, if free floating can be instituted, then exchange controls

will have to be removed; but, as under a free float, the effects of foreign

currency flows on the domestic money supply are automatically sterilised, the

policy of maintaining the new steady state inflation rate 1/ will be

sustainable.

The above suggests the following sequencing of policies in the

adjustment package may be second best welfare optima. First, remove the

capital market distortion by removing interest ceilings, converting implicit

into explicit interest subsidies by incorporating them in the government

budget, and if these cannot be financed at a lower welfare cost in terms of

taxation, then, accepting a slightly higher steady state inflation rate,

1/ Point B of Fig. 9.

- 39 -

coupled with possibly higher reserve ratios, these reforms being accompanied

by instituting a free floating exchange rate regime. Next, start reducing the

commodity market distortions, particularly those in the traded good sector.

Finally, bring the fiscal deficit down, ancd with it the inflation rate and

reserve ratios.

However, a number of objections can be raised against this

sequencing. These primarily concern the removal of exchange control and free

floating at the second stage of the reforms, and the postponement of the

disinflationary process through the reduction of the fiscal deficit to the

final stage. We take these in turn and see! whether they merit our altering

the above sequencing.

There are two major objections to removing exchange controls before

removing the distortions in the commodity market (chiefly through trade

liberalization). The first concerns the possibility of foreign capital

inflows which might be induced as a result of the liberalization of the

capital account of the balance of payments being immiserising. Theoretically,

the possibility of capital inflows into an economy with distortions in

domestic commodity markets being immiserising has been established by Brecher

and Diaz-Alejandro (1977). However, as in our proposed package, the

liberalization of the capital account would be accompanied by an announcement

of a future dated and phased programme of reduction in commodity market

distortions, it is unlikely that long term capital flows (based on a time

horizon of investors extending beyond the trade liberalization phase) would be

immiserising. Whilst to the extent that capital with shorter maturities is

likely to flow into activities where, during the trade liberalization phase,

private and social rates of return diverge, there may be a case for temporary

- 40 -

and preannouncei taxes on flows by maturity which decrease each year until

zero, as the trade liberalisation proceeds.

The second objection relates to the likelihood that the real exchange

rate will initially fall with the removal of exchange control in the above

sequencing of policies. The argument can be stated as follows. With the

liberalisation of the domestic capital market, real rates of interest will

rise domestically and, given the relative scarcity of capital, are likely to

be higher than foreign interest rates at the original exchange rate. With the

removal of exchange control and the institution of a free float, to establish

interest rate parity, the nominal exchange rate will appreciate, and if, in

the ensuing process of balance of payments adjustment, capital also flows into

the country, the real exchange rate will fall as the country runs a balance of

trade deficit to match the surplus on the capital account of the balance of

payments. However, given that the preannounced programme of trade

liberalisation is credible, investors in the domestic economy will expect the

nominal exchange rate to depreciate and the real rate to appreciate as the

trade liberalisation proceeds. It is unlikely, therefore, unless producers

are assumed to be myopic, that the immediate signal given by the initial fall

in the real exchange rate will lead to short run resource movements which are

the opposite of those required in the long run as trade liberalisation

proceeds. In fact, one of the major advantages of instituting a free float

before trade is liberalized is that the nominal exchange rate changes which

are required during the process of liberalisation become automatic. For it is

very difficult in practice to judge the precise extent of the required

exchange rate change as trade liberalisation proceeds in a system with a

managed exchange rate.

- 41 -

The major objection against sequencing the removal of the fiscal

deficit after the institution of a free float is that this will lead to a

higher steady state inflation rate and fiscal deficit in the interregnum than

would be the case with the fiscal deficit being eliminated before exchange

controls. This can be seen in terms of the relationship between the

proportionate change in base money ( a ), the price level (P), and the real

revenue the government can extract from the banking system (GB/P), which we

had outlined in the previous section. IE, with the institution of a free

float, the nominal exchange rate depreciates, it will lead to a rise in the

domestic price level (as the domestic price of tradeables rises). This will

lower the real revenue extracted for the initial level of the fiscal

deficit. To raise the same real revenue from the inflation tax, the rate of

growth of base money and the size of the steady state fiscal deficit will have

to be increased.

But it should immediately be apparent that this last objection rests

on assuming that the impact effect of instituting a free float will be a

depreciation of the nominal exchange rate, and hence implies a rise in the

real exchange rate. However, the previous objection to the phased sequencing

of a free floating rate regime was based on assuming that the linking of the

domestic and foreign capital markets by removing exchange control would lead

to a rise in the nominal and fall in the real exchange rate. As clearly the

nominal exchange rate cannot both rise and fall at the same time, critics of

the proposed sequencing cannot use both of the last two objections. If, as

seems likely, the removal of domestic capital market distortions leads to a

higher domestic real rate of interest thaLn abroad at the initial nominal

exchange rate, removal of exchange controls and the institution of free

- 42 -

floating will lead to an appreciation of the nominal exchange rate, and thence

an initial reduction in the domestic price level, with a consequent reduction

in the required growth of high powered money and a lower steady state fiscal

deficit, to collect the same real revenues from the inflation tax. To that

extent the proposed sequencing should make the subsequent task of avoiding

inflation easier.

III. SOME STYLISED 'CRISES' AND WHEN IS A 'CRISIS' A CRISIS?

In Part I we had worked through various cases in terms of some simple

typologies, where the major differences in 'structure' we considered were

differences based on (a) wage flexibility versus wage stickiness and (b)

flexible and quasi-fixed sectoral capital stocks.

Another useful taxonomy is based on the differing sources of the

excess absorption which usually leads to "crises".

The case of excess absorption generated through the monetary ex-

pansion accompanying increased government expenditure during the political

cycle has already been dealt with in previous parts. Lal (1983), provides an

illustration from the Philippines. In this case with money wage flexibility,

either allowing a leakage of the domestic money supply through the payments

deficit at a fixed exchange rate, or else a contraction of real money balances

through a devaluation, would restore all real variables to their original

values, and, in the process the initial rise in real wages would eventually be

reversed, as absorption fell back to its original and sustainable level.

Another 'cause' of 'crises' are windfall losses and gains of 'foreign

currency'. Here, it is useful to distinguish between those windfalls which

accrue directly to the public sector and those which accrue to the private

sector. The foreign currency rents derived from minerals by the public sector

- 43 -

and the foreign currency receipts derived from remittances by their relatives

working abroad by the private sector would be two instances.

1. Private Sector Windfalls

Take the case of remittances first. Assume the exchange rate is

fixed. The private sector now receives foreign exchange remittances, which it

exchanges for domestic currency at the Central Bank, whose foreign currency

assets rise, but are matched initially by an equivalent increase in the

currency and demand deposit component of the domestic money supply. High

powered money has, however, risen, and the domestic money supply will, pari

pasu, expand unless the government takes some countervailing action by either

reducing its own demand for credit by redlucing the fiscal deficit, or reducing

commercial credit through raising the reserve ratio.

Suppose it does not sterilize the effects of these inflows on the

domestic money supply. ceteris paribus the expansion in money supply will

lead, at the fixed exchange rate, to a rise in the price of non-traded goods

and a trade deficit. From Table 2, the i.mpact effect on the real wage will be

ambiguous. But with the loss of foreign exchange reserves accompanying the

trade deficit, the high powered money base and thus the domestic money supply

will automatically contract till the initial equilibrium will have been

restored. In this process the "real goods" counterpart, of the foreign

remittance transfer on capital account will have been affected through the

trade deficit.

Is there any problem or 'crisis' that such a country faces? It will

apparently have an initial boom in which inflation would pick up and a balance

of payments deficit will have appeared. Though these two are usually taken to

- 44 -

be signs of a 'crisis', such a diagnosis would clearly be mistaken in this

case.

However, suppose, as is likely, there is some time lag between the

receipt of the remittances on capital account and their 'implicit' spending

subsequently through the trade account. In the interim, foreign exchange

reserves would have risen. Suppose, as is only too likely in many developing

countries, the government does not use the notion of high powered money in its

budgetary planning. The treasury looks at the rising foreign exchange

reserves and is advised by various economists that it should use these

'reserves' for development purposes by in effect running a larger budget

deficit than it would otherwise. But as, ex hypothesi, (and usually in

practice) it has not sterilized the foreign exchange inflows, any further

increase in high powered money which would be entailed by the larger budget

deficit merely increases the money supply to an even higher level. Whereas,

without this increase in the government's fiscal deficit, both the domestic

inflationary process and the trade deficit would have been self-correcting,

this further expansion will entail further inflation and a larger trade

deficit. Their reversal through the "money-specie" flow mechanism would

entail a loss of foreign exchange reserves, greater than those that had been

received through the remittances. As the government, ex hypothesi, had not

intended to run down its initial level of reserves, it now finds itself de

facto with an incipient run-down. It now has a balance of payments problem

whose cure will require the disabsorption we have earlier discussed.

But this 'crisis' is due to a misperception of the correct accounting

system in an economy, on a fixed exchange rate, which is unable or unwilling

to sterilize foreign currency flows--in particular, the relationship between

- 45 -

high powered money, the fiscal deficit (properly defined) and the movements in

foreign reserves. Unless these are understood and the proper accounting

framework is adopted, even though the government may (through financing or

adjustment) tide over this crisis, it is likely that it will continually get

into such crises. The adoption of the correct accounting framework for

budgetary and monetary management may thus be as important a part of avoiding

crises as any shocks administered by 'nature' or by the 'external world'.

2. Public Sector Windfalls

The second 'crisis' is that flowing from windfall foreign currency

gains/losses accruing to the public sector, say, through obtaining the rents

from mineral exploitation. Consider two radically different ways in which the

government could in principle spend these rents. First, suppose it decides

to hand them out on some suitable criterion of equity as annual handouts to

its citizens. A seemingly equivalent policy would be for the government to

reduce general taxation by the annual inflow of these rents, or else to expand

government expenditure. If the social value of the tax cuts or increased

government expenditure is considered to be greater than that arising from

giving a form of national dividend to its populace (a doubtful proposition),

then the direct public use of these rents would seem to be desirable.

Moreover, as long as the increase in government expenditure is covered by

sales of the foreign currency to the central bank, the governments open fiscal

deficit which needs to be covered by domestic government borrowing need not

rise. But, nevertheless, unless the government actually reduces domestic

credit (see Section III of Part 2), high powered money will increase with

these inflows of foreign currency, that is, unless they are sterilized.

- 46 -

The consequent rise in domestic money expenditure will raise the

price level as (at a fixed exchange rate) the money prices of nontraded goods

rise; part of the excess money demand will spill over into a trade deficit

financed by running down the newly built up foreign currency reserves. This

will tend to reduce the domestic money supply and bring the prices of non-

traded goods down to their original level, and with it the overall price

level.

But at a fixed exchange rate the relative price of non-traded goods

is likely to remain permanently higher, as with a continuing inflow of foreign

currency rents the required size of the domestic tradeables sector has become

smaller. Tb induce and validate the relative expansion of non-tradeables, the

real exchange rate will have to remain permanently lower until the foreign

currency rents run out.

The requisite rise in the non-traded good relative price need not

come about through this inflationary process if instead the government chose

to appreciate the nominal exchange rate by the appropriate amount. But, in

all this, so far there does not appear to be any problem! True the country

will be running a balance of payments deficit and suffering inflationary

pressures if it seeks to maintain a fixed nominal or a higher than equilibrium

real exchange rate.

A problem would arise if the increased level of government

expenditure was unsustainable over the long run. This could happen if it

misjudged the size of the annual foreign exchange flows and committed itself

to long maturing investment or else unsustainable consumption support

programmes, which would need to be cut back if there were any falling off in

- 47 -

expected foreign exchange rents. The public sector programme may then be

unsustainable.

If, however, the rents had been transferred to the general populace,

each individual would have his current income increased as well as improved

expectations of future rises in income. On _this basis they would make decen-

tralized choices of their privately optima'L consumption/investment mix, which

would involve portfolio choices between diEferent financial assets. The

resulting pattern of deficits and surpluses on current/capital accounts of the

balance of payments would have no welfare significance.

3. Public Sector Crises and Accounting Procedures

These two examples, therefore, illustrate that most so-called balance

of payments "crises" are in larger part "crises" for the public sector and

reflect misjudgements about its appropriate size and or composition. 1/ The

cures, however, to the extent they involve the use of policy instruments which

entail changes in relative prices will have real, distributional

consequences. We have sought to provide a simple framework to think through

these effects, and to form judgements on the welfare-optimal sequence of their

deployment. But, in order to avoid 'crises', it may be more important to

reconsider the accounting and other procedures commonly used to manage and

control the public sector, and to see whether procedures can be derived which

will both show up an incipient 'problem' for the public sector before it

becomes a 'crisis' and also prevent such crises from happening. As a start,

the notion of high powered money and its links with the fiscal deficit need to

1/ This is the important insight contain,ed in Corden (1977).

- 48 -

be explicitly stated in the accounting procedures for designing monetary

policy as well as the government budget. Though elementary, the payoff from

such a reform may be quite high if most of the painful side effects of dealing

with many public sector generated 'crises' turn out to be merely the result of

improper accounting!

IV. APPLYING THE FRAMEWORK

In applying the framework provided in part I, it will be necessary to

obtain data anci form judgments on a few crucial features of the particular

economy. The first is on the relative factor intensities of 'traded' and

'nontraded' goods. For countries with relatively updated input-output tables,

by suitable aggregation of the various productive sectors, a composite table

can be obtained which provides a breakdown of the costs of production of the

two composite commodities into traded, non-traded, and primary factor

inputs. From these the crucial parameters required to predict the likely

movements in the real wage (in the short and long run) following a change in

the real exchange rate can be estimated (see Lal (1983)).

Secondly, as Table I shows, the impact effect of changes in relative

commodity prices (through the removal or reduction of product market

distortions), will differ depending upon the extent of money wage flexibility.

It will, therefore, be necessary to form a judgment whether, in the relevant

economy, money wages are likely to be sticky.

Thirdly, if a managed exchange rate regime is being operated it will

be necessary to determine both if there are any available instruments and if

they have been used to sterilise the monetary effects of foreign currency

flows. This can be indirectly inferred from monetary statistics on the

- 49 -

sources of past changes in high powered money by using the various accounting

identities summarised in Part I, Section 2 (B), above.

Fourthly, it will be necessary to form some estimate of the inflation

tax extracted by the existing reserve ratios, interest rate ceilings, and the

fiscal deficit. An estimate of this can be derived from past movements in

these variables and data on price inflation.

Finally, just as it is now commonplace to derive some estimates of

product market distortions in terms of the divergence between market and

shadow prices of commodities on well-known lines, it will also be necessary to

determine the pattern and size of capital market distortions by documenting

and if possible quantifying the implicit taxes and subsidies given to

different sectors through various forms of credit control.

Armed with this data, the first task must be to try and tell a

plausible story of the reasons for the 'crisis'. This will also provide the

basis for forming a judgment on the situation just after the disabsorption

required to deal with the immediate crisis has been accomplished (see Part II,

1). The real effects of alternative policy packages, including the sequencing

of their components can then be thought t]hrough in terms of the simple real

cum monetary framework outlined in Part I.

- 50 -

REFERENCES

J. Bhagwati 'l9,,,;Anatoniy- a&fs Con-equeasets of TLadt CoIL L-L W JRe ime LNBEr, NewYork).

R. A. Brecher and C. F. Diaz-Alejandro (1977): "Tariffs, Foreign Capital andImmiserising Growth", Journal of International Economics.

D.F. Burgess (1980): "Protection, Real Wages and the Neo-classical Ambiguitywith Inter-industry Flows," Journal of Political Economy, August.

W.R. Cline and S. Weintraub (1981): Economic Stabilisation in DevelopingCountries (Brookings, Washington, D.C.).

W.R. Cline (1982): "Economic Stabilisation in Developing Countries--Theoryand Stylised Facts," in J. Williamson (ed.).

W.M. Corden (1977): Inflation, Exchange Rates and the World Economy (Oxford).

W.M. Corden and R. Jones (1976): "Devaluation, Non-flexible prices, and theTrade Balance for a Small Country," Canadian Journal of Economics,February.

S. Dell (1981): "On Being Grandmotherly: The Evolution of IMFConditionality," Princeton Essays in International Finance, No. 144,October.

R. Dornbusch t1974): "Real and Monetary Aspects of the Effects of ExchangeRate Changes," in R.Z. Aliber (ed): National Monetary Policies and theInternational Finance System (Chicago).

R. Dornbusch (1980): Open Economy Macroeconomics (Basic Books, New York).M.J. Fry (1978): "Money and Capital or Financial Deepening in EconomicDevelopment?", Journal of Money, Credit and Banking. November.

M. Guitian (1981): Conditionality: Access to Fund Resources (IMF,Washington, D.C.).

J. Hanson (1982): "Contractionary Devaluation, Substitution in Production andConsumption and the Role of the Labour Market," mimeo, IBRD.

R. Jones (197L): "A Three Factor Model in Theory, Trade and History," in J.Bhagwati et. al.: Trade. The Balance of Payments and Growth (NorthHolland).

T. Killick (ed.) (1982): Adjustment and Financing in the Developing world(IMF, Washington, D.C.).

- 51 -

A. 0. Krueger (1974): "Home Goods and Money in Exchange Rate Adjustments," inW. Sellekaarts (ed.): International Trade and Finance (MacMillan).

A.O. Krueger(1978): Liberalisation Attempts and Consequences (NBER, NewYork).

D. Lal (1974): Methods of Project Analysis--A Review, world Bank OccasionalPapers No. 16, (Johns Hopkins).

D. Lal (1980): "A Liberal International Economic Order, the InternationalMonetary System and Economic Development," Princeton Essays inInternational Finance, No. 139, October.

D. Lal (1980): Prices for Planning, Heinemann Educational Books.

D. Lal (1983): "Real Wages and Exchange Rates in the Philippines, 1956-78--AnApplication of the Stolper-Samuelson-Rybczynski Model of Trade:, WorldBank Staff Working Paper No. 604, IBRD, Washington, D.C., April.

R. McKinnon (1981): "Financial Repression and the Liberalisation Problemwithin Less Developed Countries," in S. Grassman and E. Lundberg(ed.): The World Economic Order--Past and Prospects (MacMillan).

R. McKinnon and D.J. Mathieson (1981): "How to Manage a Repressed Economy,"Princeton Essays in International Finance, No. 145, December.

M. Musa (1974): "Tariffs and the Distribution of Income," Journal ofPolitical Economy. November/December.

J.P. Neary (1978): "Short-run Capital Specificity and the Pure Theory ofInternational Trade," Economic Journal..

J.P. Neary (1982): "Capital Mobility, Wage Stickiness and AdjustmentAssistance," in J. Bhagwati (ed.): Import Competition and Response(NBER, Chicago).

B. Nowzad (1981): "The IMF and Its Critics," Princeton Essays inInternational Finance. No. 146, December.

J. Williamson (ed.) (1983): IMF Conditionality (Institute for InternationalEconomics, Washington, D.C.).

- 53 -

TABLES

- 55 -

Table 1

Balance Sheets

Commercial Banks

Assets Liabilities

Loans to non-bank sector (L) Demand deposits D

Reserves with central bank (R) Term deposits Tagainst time deposits

Currency and reserves (C)apart from deposits

Central Bank

Assets Liabilities

Government debt (Z) Currency & reserves against demand deposits (C)

Foreign exchange reserves (F) Reserves against time deposits (R)

For the consolidated bank sector

L + R + C + Z + F = D + T + C + R

L + R + C =D + T

L = D + T C R C C

= D + T - kT - C

= (D-C) + (l-k)T

= (l-c)D + (l+k)T(where c is the cash ratio)

Domestic credit DC = Z + L

Money Stock = M2 = D + T

High Powered Money (H) = Z + F

Table 2

Summary of Real Outcome With Referenceto Initial Equilibrium (Direction of Change)

I LFXI kL7 WACES STICKY lACCS

PollcY__hanges _ __ _ Short Run Sector Speciftc Capttal Long Run Capital Mobility Short Run Sector Specific CRPItal LngR Capital Mubl

Real Real Real Real Real Real Real Real Real Real Real RealReal Rental Rental Exchange Real Rental Rental Exchang Real Rental Rental Exchange Real Rental Rental ExchangeWage inN in T Rate Wage in N in T Rate Wage In N In T Rate Waee tn N in T Rate(W) (rN (T T N () (rN)(rrT) (PT/pN (k)) (rN) (rT) (T/p) (W) UN) (rr) (PT/p)

1. Removing a capital arket dis-tortion (subsidy to T or tax nN). 0 0 - 0 + 0 0 0 - 0 + _ - 0

2. IRemving product market distortion(asmumed to be In T)-no devaluationand price of non-traded good keptconatant. by suitable variations Indoeatic expenditure. ? + - _ + _ _ _ + _ _ + _ _ _

3. Asouming fixed or no distortlina.Devaloatlon(a) no change Introduced ? - t + 0 0 0 0 ? - + + 0 0 0 0(b) tastes change-- 7 - + - + + + 7 - + + _ - tIncreased preference for t

4. AasumIng fixed or no distortions.Monetary Expansion(a) with fIxed exchange rates 1 + - - + - - - - + - - + -(b) flextble eachaoge rate 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Notes: Function Diversity Assu-ption: N - Labour intensive; T - Capital Intenaive.

N - Non-traded good

T - Traded good.

- 57 -

Figures

WT 0L

o

dT T9. N ~ .

(1)

WI

LTL

Wo CN (P )

l OT ONr

L L0r

(2)

Figure 1

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LT LN re r T r1 r N r

Figure 2

w

L~~~~~~~~~~~~~

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LN LT

Figure 3

- 61 -

TradedGood 1

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211~~

N Non-Traded

Good

Figure 4

W

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CN

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Figure 5

C- 1 - t4

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'-'1 ~ ~ ~ ~ ~ ~~- *. 1

- 63 -

real interestrate (i+ir) (1-k)D,

rQ ~Tr Tr /L )T

OL R R logarithm of demand and

/ / surplus of loanable demand

for loan deposits.

Figure 8

| ~~~~~~~~Z1 = fiscal deficitinflation V

rate \ >

NC A

c ~ ~ _ A

reserveratio

Figure 9

World Bank Aggregate Demand and Capital Market Imperfec-Macroeconomic Imbalances tions and Economic

Publications in Thailand: Simulations Development

of Related with the SIAM 1 Model Vinayak V. Bhatt andWafik Grais Alan R. Roe

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