SWP-636 The Real Effects of Stabilization and Structural Adjustment Policies An Extension of the Australian Adjustment Model Deepak Lal WORLD BANK STAFF WORKING PAPERS Number 636 WORLD BANK STAFF W'ORKING PAPERS Number 636 The Real Effects of Stabilization and Structural Adjustment Policies An Extension of the Australian Adjustment Model Deepak Lal The World Bank Washington, D.C., U.S.A. Copyright © 1984 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W Washington, D.C. 20433, U.S.A. First printing March 1984 All rights reserved Manufactured in the United States of America This is a working document published informally by the World Bank. To present the results of research with the least possible delay, the typescript has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. The publication is supplied at a token charge to defray part of the cost of manufacture and distribution. The views and interpretations in this document are those of the author(s) and should not be attributed to the World Bank, to its affiliated organizations, or to any individual acting on their behalf. Any maps used have been prepared solely for the convenience of the readers; the denominations used and the boundaries 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 or acceptance of such boundaries. The full range of World Bank publications is described in the Catalog of World Bank Publications; the continuing research program of the Bank is outlined in World Bank Research Program: Abstracts of Current Studies. Both booklets are updated annually; the most recent edition of each is available without charge from the Publications Sales Unit of the Bank in Washington or from the European Office of the Bank, 66, avenue d'Iena, 75116 Paris, France. Deepak Lal is economic adviser to the Development Research Department of the 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--Developing countries--Mathematical models. 3. Wages--Developing countries--Mathematical models. 4. Profit--Developing countries--Mathematical models. 5. Balance of payments-- Developing countries--Mathematical models. I. Title. II. Series. HB3732.L35 1984 339.5'0724 84-3646 ISBN 0-8213-0353-8 Summary and ConcluLsions This paper asks if there is anything useful that economists can say about minimizing the real costs of stabilization and the structural adjust- ment entailed by reforming various inefficient microeconomic policies in the economy. Of particular concern are the effects of these policies on real wage (and real profit) rates in the economy. In many developing countries where the poor people's chief endowment is their labor, these changes in real wages induced by alternative policy packages should capture the major effects on the levels of living of the poor. The policy packages considered are 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. The paper first outlines a version of the orthodox trade theoretic treatment of the small, open economy (the so-called Australian model of balance of payments) which is sufficiently rich to think through the various issues raised in debates over stabilization policies. This simple framework is then applied to a "model" case to show how it can be used to answer questions on how to minimize the welfare costs of tradlitional stabilization and adjust- ment packages. The third part of the paper briefly discusses the usual reasons why countries get into a "crisis," and whether ithere is anything which can be usefully said and done to prevent them from getting into fresh ones in the future. The implications of some radical ideas recently outlined by Max Corden on the question: "What is a 'balance of payments' problem?" are outlined. The final part of the paper explains how the approach outlined in the first two parts of the paper might be applied in practice in country economic analysis 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 quelque chose d'utile a dire sur la possibilite de minimiser les coats reels des mesures de stabilisation A prendre et les ajustements structurels A operer quand on veut modifier des politiques microeconomiques inefficaces. On considere en particulier les effets de ces politiques sur les salaires 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'application d'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 deflationniste modifications des taux de change nominaux, reduction des distorsions du commerce exterieur et, d'une maniere generale, des prix des produits, et reduction ou suppression des distorsions des marches financiers (de capitaux). 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 compte tous les problemes qui alimentent le debat sur les politiques de stabili- sation. On applique alors ce cadre simple A un cas "modele" pour montrer que l'on peut ainsi savoir comment minimiser les incidences sociales des mesures de stabilisation et d'ajustement. La troisieme partie expose brievement les raisons habituelles qui font qu'un pays entre en "crise", et pose la question de savoir s'il est possible 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 quelques id6es revolutionnaires recemment enoncees par Max Corden sur la question "Qu'est-ce qu'un probleme de balance des paiements?" La derniere partie du document montre comment la Banque pourrait appliquer la methode d6finie dans les deux premieres analyses economiques des pays. Resumen y conclusiones En el presente estudio se plantea la cuesti6n de si los economistas pueden aportar alguna idea uitil para minimizar los costos reales de la estabilizaci6n 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 tales politicas tierien en las tasas salariales (y de utilidades) reales. En muchos paises en desarrollo, donde el principal activo de los grupos pobres es su trabajo, las variaciones del salario real provocadas por los diferentes conjuntos de medidas de estabilizaci6n y ajuste necesariamente han de tener efectos importantes en los niveles de vida de esos grupos. Los conjuntos de medidas examinados en el estudio son los componentes del conjunto de politicas fiscales y monetarias deflacionarias, las variacio- nes de los tipos de cambio nominales, la reducci6n del comercio exterior y otras distorsiones de los precios de los productos basicos, y la reducci6n o eliminaci6n de las distorsiones en los mercados financieros (de capital). Se esboza primero en el estudio una versi6n del tratamiento te6rico ortodoxo del comercio en una economia pequefia y abierta (el llamado modelo australiano 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 aplica luego a un caso "modelo" para mostrar la forma en que se puede usar para responder al interrogante de c6mo minimizar los costos en terminos de bienestar social que suponen las medidas tradicionales de estabilizaci6n y ajuste. En la tercera parte del estudio se examinan brevemente las razones usuales por las que los paises experimentan "crisis" y las soluciones o medios que podrian proponerse o usarse para evitar que vuelvan a experi- m,entarlas en el futuro. Asimismo, se esbozan algunas ideas radicales expuestas recientemente por Max Corden con el planteamiento de la pregunta "que es un 'problema de balanza de pagos'?". En la parte final se explica c6mo podria el Banco aplicar en la practica, en los estudios econ6micos 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 .-..-.- ...13 1. Wage flexibility ..................................... .14 2. Sticky Wages ................. 17 (B) The Financial and Fiscal System Introduced 19 1. High powered money, fiscal deBficits and exchange rates... 21 2. The real effects of disabsorption ........................ 24 3. Conclusions .31 II. MINIMISING THE WELFARE COSTS OF ADJUSTMENT................ . 31 1. Points of Comparison .32 2. '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 . .... .. 45 3. 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 there is perfect substitutability between trade and non-traded goods. No role is left :Ln these models for the determinants and effects of changes in the real exchange rate, i.e., the relative price of traded to non-traded goods, which is central to the workings of the orthodox model. By contrast, many of the so-called 'Keynensian' models assume no or little substitutability in production and consumption so that relative prices play 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 VARIOUS REAL 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 - 6 - 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 algebraic formulation, 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 commodity lt 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 and 1= 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). - 10 - 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. - 11 - 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 and tradeables were labour intensive, then the long run equilibrium would have entailed a lowering of the money and real wage. The initial sticky wage would not have been validated in the process of adjustment with the shifting of capital stocks. There would be unemployment until the new long run equilibrium was reached. Moreover, during this transition the path of national income (measured at ithe 'new' relative commodity prices) need not be monotonic. It is possible that instead of increasing monotonically, there may be periods of "falling real national income." This is due to the fact that, with unemployment, the shadow wage in this simple model becomes zero, and the shadow rentals of capital in the two sectors are then g:Lven by the average product of capital in the two industries. Private agents, however, will earn the marginal product of capital (our 'rental' rates), as they still have to pay the slowly adjusting sticky wage, even though there is unemployment. It is possible, therefore, that the relative shadow rentals (= relative average product of capital) may not be the same as the relative marginal products of capital, which are influencing the private shifts of capital. There may thus be overshooting with the wage falling below its long run equilibrium level, leading to capital being shifted back to the traded good industry. If, however, private agents perceive the long run equilibrium wage, or else in the transition the government can provide a wage subsidy which equates the sticky money wage to the 'equilibrium' money wage, this problem will not arise. Given problems of information, however, it is unlikely that such a second-best policy is likely to be feasible. - 12 - (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 - 13 - 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 is s s the 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 our composite 'tradeable' would not be possible. In the 1970's a number of primary product exporters found that on balance their terms of trade did not change, but the foreign currency prices of both exports and imports rose 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 trade S 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 the role of credit in financing firms working capital could be emphasized. However, no great analytical insights are gained by including the former, and the empirical importance of the effects on output for a reduction 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's conditionality, and in Stern in Williamson (ed.) on the Bank's structural 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 economy initially had a steady state inflation rate and reserve ratio given by A for the steady state fiscal deficit Z0, the rise in the steady state fiscal deficit entails an optimal reserve ratio of B < A, but of course a higher steady state inflation rate. It is only if the initial steady state inflation cum reserve ratio position was to the left of C, that a rise 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, New York). R. A. Brecher and C. F. Diaz-Alejandro (1977): "Tariffs, Foreign Capital and Immiserising Growth", Journal of International Economics. D.F. Burgess (1980): "Protection, Real Wages and the Neo-classical Ambiguity with Inter-industry Flows," Journal of Political Economy, August. W.R. Cline and S. Weintraub (1981): Economic Stabilisation in Developing Countries (Brookings, Washington, D.C.). W.R. Cline (1982): "Economic Stabilisation in Developing Countries--Theory and 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 the Trade Balance for a Small Country," Canadian Journal of Economics, February. S. Dell (1981): "On Being Grandmotherly: The Evolution of IMF Conditionality," Princeton Essays in International Finance, No. 144, October. R. Dornbusch t1974): "Real and Monetary Aspects of the Effects of Exchange Rate Changes," in R.Z. Aliber (ed): National Monetary Policies and the International Finance System (Chicago). R. Dornbusch (1980): Open Economy Macroeconomics (Basic Books, New York). M.J. Fry (1978): "Money and Capital or Financial Deepening in Economic Development?", 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 and Consumption 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 (North Holland). 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," in W. Sellekaarts (ed.): International Trade and Finance (MacMillan). A.O. Krueger(1978): Liberalisation Attempts and Consequences (NBER, New York). D. Lal (1974): Methods of Project Analysis--A Review, world Bank Occasional Papers No. 16, (Johns Hopkins). D. Lal (1980): "A Liberal International Economic Order, the International Monetary System and Economic Development," Princeton Essays in International 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--An Application of the Stolper-Samuelson-Rybczynski Model of Trade:, World Bank Staff Working Paper No. 604, IBRD, Washington, D.C., April. R. McKinnon (1981): "Financial Repression and the Liberalisation Problem within 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 of Political Economy. November/December. J.P. Neary (1978): "Short-run Capital Specificity and the Pure Theory of International Trade," Economic Journal.. J.P. Neary (1982): "Capital Mobility, Wage Stickiness and Adjustment Assistance," in J. Bhagwati (ed.): Import Competition and Response (NBER, Chicago). B. Nowzad (1981): "The IMF and Its Critics," Princeton Essays in International Finance. No. 146, December. J. Williamson (ed.) (1983): IMF Conditionality (Institute for International Economics, 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 T against 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 Reference to 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 Real Real Rental Rental Exchange Real Rental Rental Exchang Real Rental Rental Exchange Real Rental Rental Exchange Wage 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 devaluation and price of non-traded good kept conatant. by suitable variations In doeatic 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 - + + _ - t Increased 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 z s-i w a) w CT AVb ~ ~ ~~~N CT ' P w CN(P 2 N. LT LN re r T r1 r N r Figure 2 w L~~~~~~~~~~~~~ T~~~~~~~~~C L 0 r0 rT rN r 1 LN LT Figure 3 - 61 - Traded Good 1 T / ~ ~ F 211~~ N Non-Traded Good Figure 4 W LTL N bu 5~ -- - BT N~~~~~~~~~ CN C T r L Figure 5 C- 1 - t4': w ~ ~ ~ r / '-'1 ~ ~ ~ ~ ~ ~~- *. 1 - 63 - real interest rate (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 deficit inflation V rate \ > NC A c ~ ~ _ A reserve ratio 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 and Wafik Grais Alan R. Roe Interest Focuses on the demand-side adjust- World Bank Staff Working Paper ments of the Thai economy to lower No. 338. July 1979. 87 pages agricultural growth andl to higher (including footnotes). energy prices. Discusses policy measures and structural changes that Stock No. WP-0338. $3.00. might enable the economy to over- come these problems and continue to maintain high GDP rates of growth. The Changing Ncature of World Bank Staff Working Paper No. Export Finance and Its 448. April 1981. 70 pages (including CoplintriensfrDvlpn 2 appendixes). Countes Stock No. WP-0448. $3.00. Albert C. Cizauskas World Bank Staff Working Paper Nlo. 409. July 1980. 43 pages (including An Analysis of 3 annexes). Developing Country Stock No. WP-0409. $3.00. Adjustment Experience and Adjustment Experiences in Growth Prospects of the the 1970s: Low-income Asia Semi-industrial Countries Christine Wallich Compounding and Dis- Frederick Jaspersen This background study for World counting Tables for This background study for World Development Report 1981 examines Project Evaluation Development Report 1981 examines low-income South Asia's adjustment J. Price Gittinger, editor the successful process of adjustment to the external shocks of the 1970s, Easily comprehensible, convenient to external "shocks" of the 1970s especially those factors that helped tables for project preparation and (rising prices of oil imports, reduced make the effects of these external. analysis. demand for exports, slower economic developments less severe in the growth in the OECD countries) in the region than in other parts of the The Johns Hopkins University Press, semi-industrial developing countries. developing world. 1973; 7th printing. 1982. 143 pages. Presents an analytical framework for World Bank Staff Working Paper No. LC 75-186503. ISBN 0-8018-1604-1, quantifying the effects of demand 487. August 1981. io + 39 pages $6.00 paperback. management and structural adjust- (including references). ment in forty-two countries, with par- Arabic: World Bank, 1973. (Available ticular reference to Uruguay, Brazil, Stock No. WP-0487. $3.00. from ILS, 1 715 Connecticut Avenue, Republic of Korea, and Turkey. N.W. Washington, D.C. 20009, U.S.A.) World Oank Staff Working Paper No. Aspects of Development $4.00 paperback. 477. August1981. 132 pages (including Bank Management French: Tables d'interets composes et 3 appendixes). William Diamond aind d'actualisation. Economica, 4th print- Stock No. WP-0477. $5.00. V. S. Raghavan ing, 1979. Deals exclusively with the manage- ISBN 2-7178-0205-3, 36 francs. AdUustment in ment of development banks. The Spanish: Tablas de interes compuesto y Low-Income Africa book is divided into eight sections, de descuento para evaluacion de proyec- Robert Liebenthal each dealing with one aspect of management of its problems, and tos. Editorial Tecnos, 1973; 4th print- This background study for World of the various ways of dealing ing, 1980. Development Report 1981 analyzes with them. ISBN 84-309-0716-5 380 pesetas. the adjustment to external shocks during the 1970s made by a group EDI Series in Economic Deuelopment. of middle-income and low-income The Johns Hopkins University Press, A Conceptual Approach to African countries, with particular 1982. 311 pages. the Analysis of External Debt reference to Keniya, Tanzania, Senegal, and Sudan. LC 81-48174. ISBN 0-80J8-2571-7, of the Developing Countries $29.95 hardcover, ISBN 0-8018-2572-5, Robert Z. Aliber World Bank Staff Working Paper No. $2.95 paperback. World Bank Staff Working Paper No. (includingubibl9vio+g 56ppages421. October 1980. 25 pages (including (tncludkng bibliography), appendLx, references). Stock NYo. WP-0486. $3.00. Stock No. WP-0421. $3.00. Development Banks Developments in and Food Policy Issues in William Diamond Prospects for the External Low-income Countries Operating experiences that serve as a Debt of the Developing Edward Clay and others practical guide for developing coun- Countries: 1970-80 A background study for World tries, with a selected list and and Beyond Development Report 1981. Discusses summary description of some Nicholas C. Hope food distribution-especially its development banks. insecurity in the face of external This background study for World economic pressures and potential The Johns Hopkins University Press, Development Report 1981 analyzes conflicts with internal production 1957; 5th printing, 1969.141 pages the debt situation and its implica- concerns-in general and with (including 2 appendixes, index). tions for future borrowing. reference to Bangladesh. Zambia, LC 57-13429. ISBN 0-8018-0708-5, World Bank Staff Working Paper No. and India. $5.00 (.3.50) paperback. 488. August 1981. 70 pages (including World Bank Staff Working Paper No. 2 annexes, references). 473. August 1981. vii + 125 pages. Development Finance Com- Stock No. WP-0488. $3.00. Stock No. WP-0473. $5.00. panies: Aspects of Policy and Operation Energy Prices, Substitution, A General Equilibrium William Diamond, editor; and Optimal Borrowing in Analysis of Foreign essays by E. T. Kuiper, the Short Run: An Analysis Exchange Shortages in a Douglas Gustafson, and of Adjustment in Oil- Developing Economy R M. Mathew Importing Developing Kemal Dervis, Jaime de Melo, The Johns Hopkins University Press, Countries and Sherman Robinson 1968.130 pages (including appendix, Ricardo Martin and Examines the consequences of alter- index). Marcelo Selowsky native adjustment mechanisms to LC-68-27738. ISBN 0-8018-0166-4, Develops a short-term model for foreign exchange shortages in semi- $5.00 (£3.25) paperback. evaluating the adjustment (par- industrial economies. Compares French: Les societes financieres de ticularly, extemal borrowing) of oil- devaluation to two forms of import developpement: quelques aspects de importing developing countries to the rationing and finds that adjusting by leur politique et de leurs activites. increases in oil prices during the. rationing is much more costly in (Avalabe fre fom e Wrld ank 1-970s. Discusses the borrowing terms of lost gross domestic product. (Avilable free fromt the World Bank strategies that can be expected in the World Bank Staff Working Paper No. Spanish: Las compafifas financieras made on multilateral institutions 443. January 1981. 32 pages (includ- de desarrollo: algunos aspectos de su ing references). politica y de sus actividades. Editorial World Bank Staff Working Paper No. Stock No. WP-0443. $3.00. Tecnos, 1969. 466. July 1981. 77 pages (including 300 pesetas. footnotes, references). Stock No. WP-0466, $3.00. NlEW Development Prospects Growth and Structural of Capital Surplus Oil- Exchange Rate Adjustment Adjutm in EastAsa Exporting Countries: Iraq, under Generalized Currency Adjustment in East Asia Kuwait, Libya, Qatar Floating: Comparative Parvez Hasan Saudi Arabia, UAE Analysis among Developing Analyzes the economic performance Rudolf HabICitzel Countries of the five large mnarket economnies of Rudolf Hablutzel Comeo East Asia-Korea, Thailand, the This background study for World Romeo M. Bautista Philippines, Malaysia, and Development Report 1981 Examines the experiences of twenty- Indonesia-during the last two discusses the production strategies two developing countries in adapting decades; focuses on the key factors and the development policies of the to the generalized floating of the explaining their remarkable economnic capital-surplus oil-exporting world's major currencies since 1975 and social progress; and identifies the countries. and discusses the implications that main economic issues for the 1980s. World Bank Staff Working Paper No. currency floating has on policymaking World Bank Staff Working Paper No. 483. August 1981. 53 pages (including nthns for further research. 529. 1982. 42 pages. statistical tables). World Bank Staff Working Paper No. ISBN 0-8213-0102-0. $3.00. Stock No. WP-0483. $3.00. 436. October 1980. 99 pages (including appendix). Stock No. WP-0436. $3.00. International Adjustment in Notes on the Mechanics of ect appraisal. To give substance to the 1980s Growth and Debt; the applied and policy dimensions, many of the readings are drawn from Vijay Joshi Benjamin B. King the experience of development prac- A backgound study for World A practical model to explore the way titioners and relate to such important Development Report 1981. Analyzes in which capital inflow from abroad sectors as agriculture, industry, the macroeconomics of international affects economic growth. power, urban services, foreign trade, adjustment. Highlights potential . - and employment. The principles market failures and areas for The Johns Hopkins Unwersi4J Press outlined are therefore relevant to a intervention. 1968. 69 pages (including 4 annexes). host of development problems. World Bank Staff Working Paper No. LC 68-8701. ISBN 0-8018-0338-1, $5.00 The Johns Hopkins University Press. 485. August 1982. 5 7 pages. (3.000) paperback. February 1983. About 304 pages. ISBN 0-8213-0062-8. $3.00. LC 82-7716. ISBN 0-8018-2803-1, The Policy Experience of $35.00 hardcover; ISBN 0-8018-2804-X, Twelve Less Developed $12.95 paperback. NEW Countries, 1973-1978 Bela Balassa Private Bank Lending to The Nature of Credit Uses the methodology applied in the Developing Countries Markets in Developing author's "The Newly Industrializing Richard O'Brien Countries: A Framework Developing Countries after the Oil for Policy Analysis Crisis" (World Bank Staff Working A background study for World *rvind *irman* Paper No. 473, October 1980) to Development Report 1981. Arvind Virmnani examine the policy experience of Describes the evolution of relat,oi i- The central purpose of the paper is to twelve less developed countries in ships between private banks and analyze various forms of government the period following the quadrupling developing countries. intervention in the loan market in of oil prices in 1973-74 and the World Bank Staff Working Paper No. terrns of their effect on efficiency. world recession of 197,'4-75. 482. August 1981. vi + 54 pages World Bank Staff Working Paper No. World Bank Staff Working Paper No. (including appendix. bibliography). 524. 1982. 204 pages. 449. April 1981. 36 pages (including Stock No. WP-0482. $3.00. ISBN 0-8215-0019-9. $5.00. appendix). Stock No. WP-0449. $3.00. Private Capital Flows to The Newly Industrializing Developing Countries and Developing Countries after The Political Structure of Their Determinations: the Oil Crisis the New Protectionism Historical Perspective, Bela Balassa Douglas R. Nelson Recent Experience, and World Bank Staff Working Paper No. This background study for World Future Prospects 43 7. October 1980. 5 7 pages (including Development Report 1981 Alex Fleming appendix). presents a political-economic analysis of what has been called the A backgound study for World Stock No. WP-0437. $3.00. "new protectionism.' Development Report 1981. Discusses the nature and determina- World Bank Staff Working Paper No. tion of recent private capital flows to Notes on the Analysis of 471. July 1981. 57 pages (including developing countries. Focuses on Capital Flows to Developing references). those flows passing through the Nations and the Stock No. WP-0471. $3.00. intemational ban nd examines the "Recycling" Problem developing countries' continuing Ralph C. Bryant access to the intemational capital A backgound study for World NEW markets. Development Report 1981 World Bank Staff Working Paper No. Summarizes and criticizes the con- Pricing Policy for Develop- 484. August 1981. 41 pages. ventlonal analysis of the interrela- ment Management tlons between financial markets in Gerald M. Meier Stock No. WP-0484. $3.00. the industrialized countries and capi- Pr tal flows to the developing nations. Pesupposing no formal training In economics, it explains the essential Private Direct Foreign World Bank Staff Working Paper No. elements of a price system, the Investment in Developing 476. August1981. 67 pages. functions of prices, the various Countri Stock No. WP-04 76. $3.00. policies that a government might Countiesbc n .Ysg pursue in cases of market failure, K. Billerbeck and Y. Yasugi and the principles of public pricing of World Bank Staff Working Paper No. goods and services provided by 348. July 1979. iu + 97 pages (includ- govermment enterprises. It also pro- in 2 a vides the would-be practitioner with g nnexes). an appreciation of the underlying Stock No. WP-0348. $5.00. logical structure of cost-beneflt proj- NEW Structural Adjustment implications in terms of income Policies in Developing generation, external deficit, and Short-Run Macro-Economic Economies itnflation. Adjustment Policies in Bela Balassa World Bank Staff Working Paper No. South Korea: A Quantitative Examines structural adjustment 513. June 1982. 93 pages (including Analysis policies (policy responses to external appendix). Sweder van Wijnbergen shocks, such as the quadrupling of ISBN 0-8213-0023-7. $3.00. oil prices and the world recession of An analysis of the startling reversal of the 1970s) of developing countries. performance of the South Korean Considers reforms in production World Debt Tables economy in 1979 and 1980 compared incentives, incentives to save and to A compilation of data on the exteral with the preceding fifteen years, and invest public investments, sectoral A and darantee ebt an exploration of the. short-run policies, and monetary policies, and ublic and publicly-guaranteed debt macro-economic policy options comments on the interdependence of of 101 developing countries plus available to Korea in 1981. Highlights the various policy measures and on eighteen additional tables of private the role of commercial banks, foreign the international environeaent in and nonguaranteed debt from the capital inflows, and money markets which they operate. System. Describes the nature, con- and the use of credit obtained from these sources to finance fixed and World Bank Staff Working Paper No. tent, and coverage of the data; working capital. 464. July 1981. 36 pages. reviews the external debt of 101 countries through 1981; contains World Bank Staff Working Paper No. Stock No. WP-0464. $3.00. tables on external public debt out- 510. November 1981. iv -- 178 pages standing, commitments, disbu-se- (including 3 append 'es). _ _ ments, service payments, and net ISBN 0-8213-0000-8. S5.00. NEW borrowings of 101 developing coun- tries, by country, 1972-1981. Structural Aspects of 'Fc-167/81). December 1982. Annual. fYEW Turkish Inflation: About 300 pages. IL950°b-9 i-r a 3ISNS 0253-2859. $75.00. State Finances in India M. Ataman Aksoy Computer tapes containing the data A three-volume set of papers that Inflation has been one of the major bases for the World Debt Tables are explores a range of issues relating to problems of the Turkish economy available from the Publications the nature of intergovernmeptal fiscal during the postwar period. This paper Distribution Unit. World Bank. The relations in India. develops alternative inflation models tapes are available to international and analyzes their performance in agencies and official nonprofit agen- Vol. I: Revenue Sharing light of the Turkish experience in cies of member governments at a Vol. I.- Revenue Sharing order to provide a framework on nominal fee. For information concern- in India which a more realistic macro model ing fees for other organizations, Christine Wallich can be developed. please write to the addressee listed Deals specifically with the principles World Bank Staff Working Paper No. above. of revenue sharing in India. 540. 1982. 118 pages. Supplements to World Debt Tables are ISBN 0-8213-0098-9. $5.00. issued periodically as information voL HIl: India-Studies in becomes available; the current State Finances updates are included with orders for Christine Wallich NEW World Debt Tables. Examines in detail the implications of revenue sharing for project finance. Thailand: An Analysis of TImR ta lvg Structural and NMon- The Impact of Contractual Savings on Structural and Non- Resource Mobilzation and Allocation: Vol. III: The Measurement of Structural Adjustments The Experience of Malaysia Tax Effort of State Govern- Arne Drud, Wafik Grais, and Social Security Funds in Singapore ments, 1973-1976 Dusan Vujovic and the Philippines: Ramiflcations of Raja J. Chelliah and This study was prepared as a Investment Policies Narain Sinha background paper for the preparation Investments of Social Security Funds Attempts io evaluate the tax perfor- of a structural-adjustment loan to in India and Sri Lankae Legislaion mance of particular states in terms of Thailand and is a follow-up to a pre- Parthasarathi Shome and the average tax effort of all states. ViOVS paper entitled "Aggregate ISatrine Anderson Saito Demand and Macroeconomic World Bank Reprint Series: Number 144. World Bank Working Paper No. 523. Imbalances in Thailand." Comparative Feprinted from The Malayan Economic Review, vol. September 1982. vol. 1, 85 pages, vol. II, statistics are used, within the frame- 23. no. 1 (April 1978):54-72; Labour and Society, 186 pages, vol. III, 85 pages. work of a four-sector macroeconomic vol. 5. no. I (January 1980).19-30: and The Indian model, to assess alternative ways of Joumal of Economics. vol. 60. part 3, no. 238 ISBN 0-8213-0013-X. vol. I, $3.00, vol. II, macroeconomic adjustment in the (January 1980):349-60. $5.00, vol. III, $3.00. Thai economy. Discusses specifically Stock Nlo. RP-0144. Free of charge. fiscal policy interventions, manipula- tions of the exchange rate, adid pro- ductivity improvements and their Policy Responses to External Shocks in Selecter, Iatin Am#riean C'rnsntri4 Bela Balassa World Bank Reprint Senes: Number 221. Reprinted forn Quarterly Review of Economics and Business, vol. 21, no. 2 (Summer 1981):131-64. Stock No. RP-0221. Free of charge. 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