Macroeconomic Management: Programs and Policies [1 ed.] 9781455218424, 9781589060944

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Macroeconomic Management : Programs and Policies, International

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MACROECONOMIC MANAGEMENT

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PROGRAMS AND POLICIES

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MACROECONOMIC MANAGEMENT PROGRAMS AND POLICIES

Editors

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Mohsin S. Khan Saleh M. Nsouli Chorng-Huey Wong

IMF Institute International Monetary Fund Washington, D.C.

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Macroeconomic management: programs and policies / edited by Mohsin S. Khan, Saleh M Nsouli, and Chorng-Huey Wong — Washington, D.C. : IMF Institute, c2002 p. cm. Includes bibliographical references. ISBN 1-58906-094-6

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1. Monetary policy. 2. Fiscal policy. 3. Foreign exchange rates. 4. Growth. 5. Balance of Payments. 6. International Monetary Fund. I. Khan, Mohsin S. II. Nsouli, Saleh M . III. Wong, Chorng-Huey. IV. IMF Institute. HG230.3.M35 2002 Price: $28.00 Please send orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, U.S.A. Telephone: (202) 623-7430 Telefax: (202) 623-7201 E-mail: [email protected] Internet: http://www.imf.org

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Contents Foreword

vii ix

Acknowledgments 1 2

3

4 5 6 7

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8 9 10

11

Macroeconomic Management: An Overview Mohsin S. Khan, Saleh M. Nsouli, and Chorng-Huey Wong

1

Adjustment and Internal-External Balance Chorng-Huey Wong

10

Do IMF-Supported Programs Work? A Survey of the Cross-Country Empirical Evidence Nadeem Ul Haque and Mohsin S. Khan

38

Sources of Growth Xavier X. Sala-i-Martin

58

Current Account Sustainability Luis Carranza

98

The Framework of Monetary Policy Richard C. Barth

139

Inflation Targeting Jodi Scarlata

168

Fiscal Policy and Macroeconomic Management Samir El-Khouri

201

Assessment of the Fiscal Balance Enzo Croce

229

Determination of Nominal Exchange Rates: A Survey of the Literature Graciana del Castillo

257

The Long-Run Equilibrium Real Exchange Rate: Theory and Measurement Peter J. Montiel

307 345

Contributors

V

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Foreword Successful economic policymaking depends at least as much on the ability of countries to shape good policies as it does on the political will to implement them. This is particularly true today as the challenges of globalization raise new questions for economic policymakers everywhere. It is not surprising, therefore, that policy-based economic training by IMF member countries continues to increase steadily. Since its inception almost 40 years ago, the IMF Institute has been spearheading the IMF's economics training program and in recent years has expanded both the reach and depth of its program. Over the past four years, it has substantially increased overseas training through the formation of collaborative regional training centers. There are now six such centers operating worldwide. The IMF Institute has also revised and updated its curriculum to ensure that its program reflects new issues in economic management and exposes participants to wider perspectives. This book is one outcome of this effort. Each chapter addresses a key topic in economic management, such as sources of economic growth; appropriate monetary, fiscal, and exchange rate policies for redressing domestic and external financial imbalances; and the effects of IMF-supported programs. Each chapter reflects some of the most recent advancements in the economics literature, including inflation targeting, the application of time-series methods to estimating the equilibrium real exchange rate, and indicators for detecting risk factors that contribute to current account instability and financial crisis. But rather than offer definitive policy choices, the chapters present a variety of options, explaining the theoretical frameworks and highlighting the empirical considerations that go into the design of a successful macroeconomic adjustment program. Encompassing as it does many important issues with which governments and central banks around the world grapple every day, the book should be a valuable resource for any student or practitioner of economic policymaking. Anne O. Krueger First Deputy Managing Director International Monetary Fund

VII

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Acknowledgments

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This book is the product of the efforts and expertise of many current and former colleagues in the IMF Institute. We would like to thank each of them for their contributions to this volume. We are particularly indebted to Farah Ebrahimi of the IMF Institute for editing the volume and taking it through the various stages. We also thank James McEuen of the External Relations Department for copyediting the final manuscript and seeing the book through production. Mohsin S. Khan Saleh M . Nsouli Chorng-Huey Wong

IX

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Macroeconomic Management: An Overview

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Mohsin 5. Khan, Saleh M. Nsouli, and Chorng-Huey Wong

Since its establishment in 1964, the IMF Institute has trained more than 13,000 officials from 183 member countries in Washington and over 8,000 officials overseas. The training focuses on such subjects as financial programming and policies, monetary and exchange operations, public finance, financial sector issues, and macroeconomic statistics. This book includes some of the background material that the IMF Institute uses in the training of country officials. Although IMF Institute courses also cover structural issues—such as banking system, public enterprises, and labor market reform (which are also critical to the achievement of economic policy objectives), this book deals only with macroeconomic issues. Specifically, it addresses some of the key questions policymakers face in managing national economies: • What is the appropriate mix of monetary, fiscal, and exchange rate policies for redressing domestic and external financial imbalances? • Do policies pursued under IMF-supported programs lead to higher growth, lower inflation, and reduced external imbalances? • What policies help to promote economic growth? • What is the importance of current account sustainability, and how can it be determined? What indicators help policymakers to detect risk factors that affect current account sustainability and that contribute to financial crises? • How should monetary policy be designed? Does inflation targeting enhance the performance of monetary policy? • How should fiscal policy be used to achieve policy objectives? What are the criteria for assessing the fiscal balance? • What are the determinants of nominal exchange rates? How can the long-run equilibrium real exchange rate be assessed and measured? An understanding of the issues involved in these questions is at the heart of effective economic policymaking. The chapters in this book show that there are no definitive answers, but rather a variety of op1

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tions. In particular, they make explicit the pros and cons involved in any specific course of policy action.

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Program Design and Effectiveness The first part of the book focuses on the broader issues of economic adjustment, growth, program effectiveness, and current account sustainability. In Chapter 2, Chorng-Huey Wong reviews the design of macroeconomic adjustment programs in the context of a framework for determining the mix of monetary, fiscal, and exchange rate policies for restoring economic balance. Wong explains that both internal balance and external balance depend on two fundamental variables—the level of real domestic demand and the real exchange rate. Accordingly, various combinations of internal and external imbalances can be identified, depending on whether an excess or deficient real domestic demand exists and whether the real exchange rate is overly appreciated or depreciated. Each combination of imbalances requires a different combination of corrective measures. Wong focuses on the mix of policies required to deal with a situation in which excess real domestic demand and an overly appreciated real exchange rate combine to produce domestic inflation and a current account deficit. Although the combination of tight monetary and fiscal policies could be used in this case to restore internal and external balance, the combination could also adversely affect production and unemployment. Another approach would be to induce a nominal depreciation to improve the current account position, but that action could increase domestic inflation, unless it is complemented by demandrestraint monetary and fiscal policies. Wong points out that whether a nominal depreciation is required depends, among other things, on the size of the real exchange rate misalignment. This leads to the discussion of the concept and measurement of the macroeconomic balance real exchange rate, which corresponds to the simultaneous attainment of internal and external balance. Wong considers the relative effectiveness of monetary and fiscal policies in influencing domestic output and prices and the external sector position, which depend largely on the exchange rate regime adopted. He shows that an appropriate mix of policies, whereby each policy is "assigned" to address the particular imbalance for which it has a comparative advantage, will make adjustment convergent. In Chapter 3, NadeemUIHaque and Mohsin S. Khan focus more narrowly on the empirical evidence for the effects that IMF-supported ad-

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justment programs have on inflation, economic growth, and the external sector. They examine the methodologies used in, and the results obtained by, evaluations of IMF-supported programs, with a view to assessing the effectiveness of past programs and ways of improving future evaluations. They note that assessment results can provide an important input into the design of IMF-supported programs. They emphasize that the proper standard for measuring program effectiveness is to compare the macroeconomic outcomes under a program with the outcomes that would have emerged in the absence of a program, or under a different set of policies—the counterfactual case. Their study points to two important conclusions. First, the methodology of more recent studies, which applied the counterfactual criteria to evaluating program performance by estimating the policy-reaction functions for program and nonprogram countries, have yielded more reliable results than those from earlier studies. Haque and Khan are critical of the earlier studies, because these studies attempted to gauge program effectiveness by comparing macroeconomic outcomes in program countries with performance before the implementation of the program, or with the observed performance of nonprogram countries. Consequently, they failed to measure the counterfactual properly. Second, Haque and Khan conclude that IMF-supported programs do improve the current account balance and the overall balance of payments. Although the rate of inflation in most cases falls, the change is generally found not to be statistically significant. With regard to growth, output is depressed in the short run as the demand-reducing elements of a policy package dominate, but, as macroeconomic stability returns, growth recovers. Haque and Khan point out that for future work, even though the counterfactual is the most appropriate way of judging program effects, there are serious difficulties in using this criterion. They see some benefit in conducting case studies, as opposed to large multicountry studies, because case studies permit a deeper analysis of program implementation, but they caution that case studies are useful primarily as a means of supplementing the results from cross-country studies.

Sources of Growth In Chapter 4, Xavier X. Sala-i-Martin considers the sources of growth in rich countries and the causes of slow growth in countries that have lagged behind. To address these questions, he introduces some of the tools used in analyzing the growth performance of countries. He notes

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that the central element of the neoclassical theory of economic growth is the neoclassical production function, which assumes that all of the inputs for production can be aggregated into three basic ones: capital, labor, and technology. In neoclassical theory, the production function exhibits constant returns to scale and diminishing returns to each input. Thus, in a world with neoclassical technology and perfect competition, the main driving source of economic growth is technological progress. But, Sala-iMartin notes, the neoclassical researchers left unexplained the process by which technological progress occurs, by assuming that technology grows at an exogenous rate. This, he points out, is clearly unsatisfactory from a theoretical standpoint because it is tantamount to saying that the ultimate source of growth is unexplained. Accordingly, since the mid-1980s, a large number of researchers have worked to determine the sources of growth. The resulting studies are known as the "new growth literature." Sala-i-Martin divides the research into three broad categories: human capital, technology, and government, viewed within the context of the legal system, the macroeconomic environment, the imposition of taxes, and government spending. He examines the models for analyzing the effects of these issues on growth and the empirical evidence on its determinants. The evidence shows several variables to be strongly correlated with growth: the quality of government (positive); market distortions (negative); investment (positive); openness (positive); market-type economy (positive); education (positive); and sound macroeconomic policies (positive). Surprisingly, some variables appear unimportant for growth: for example, government spending, financial sophistication, scale effects (measured by total area and total labor force), and ethnolinguistic fractionalization (supposed to capture the level of internal strife among ethnic groups).

Current Account Sustainability Sala-i-Martin links growth to sound macroeconomic policies, which, as Luis Carranza explains in Chapter 5, are also critical to the achievement of a sustainable external current account position. Carranza defines the current account balance and its determinants and explores the relationship between the current account and the key underlying variables such as investment, saving, and capital flows. He points out that the recent econometric literature on determining current account sustainability focuses on issues of intertemporal solvency and other crucial factors, such as macroeconomic policy

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(including policy reversals and credibility) and the willingness of international investors to lend to countries with large deficits. Carranza examines the set of leading indicators (structural, macroeconomic, and overborrowing factors) proposed in the literature to help predict external crises and detect whether current account deficits could become unsustainable over the long term. He analyzes the various types of policy responses, concluding with a review of the structural characteristics and macroeconomic policy stances of five countries (Argentina, Canada, Chile, Mexico, and Thailand) that had experienced large current account deficits.

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Monetary Policy The second half of the book turns more specifically to monetary, fiscal, and exchange rate policies. In Chapter 6, Richard C. Barth describes the general framework for formulating monetary policy. He focuses on the objectives of monetary policy, the instruments available to attain those objectives, the basic elements of the relationship between exchange rate policy and monetary policy, and alternative views of the transmission process of monetary policy. Monetary policy objectives traditionally include economic growth, employment, and price stability. Depending on the country, monetary policy may assign equal weights to these objectives, or as is more common now, place greater emphasis on the objective of price stability. There are, of course, other objectives, such as the stability of long-term interest rates and financial markets, or the level of economic activity in particular sectors of the economy. Barth distinguishes between intermediate targets and operating targets, as well as direct and indirect monetary policy instruments. He also explains the difference between the money view of the transmission mechanism and the credit view, arguing that, in practice, most central banks that use indirect monetary instruments have been unable to exercise a high degree of control over credit aggregates in the short term, and monetary aggregates have been more popular as intermediate variables. Barth also reviews issues pertaining to the role of the central bank in conducting monetary policy: the inflationary bias of monetary policy, rules versus discretion in monetary policy implementation, and central bank independence. He provides examples of how various countries have operated under several types of monetary regime: exchange rate targeting, monetary targeting, inflation targeting, and discretionary policy with an implicit nominal anchor.

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Jodi Scarlata discusses inflation targeting in more detail in Chapter 7. Scarlata explains that the inflation-targeting framework is an operational regime intended to enhance the performance of monetary policy. In this type of regime, price stability is the primary goal of monetary policy, and the central bank has discretion in determining how monetary goals are attained and is accountable for achieving those goals. She notes that the inflation-targeting framework was adopted primarily to resolve conflicts among competing monetary policy objectives. Many countries adopted the framework to address the problems experienced with previous monetary regimes, such as those that used exchange rate pegs or monetary aggregates as the intermediate target. In a few countries, inflation targeting was used where earlier inflation stabilization efforts consisting of heterodox programs and crawling exchange rate bands had conflicted with efforts to maintain the official exchange rate regime and to control inflation. Scarlata argues that the inflation-targeting framework avoids these conflicts by serving as a clear statement that inflation fighting is the primary goal of monetary policy and by giving the central bank the freedom to conduct monetary policy independently of the influence of political cycles, thus making the central bank accountable for achieving monetary goals. She provides an overview of issues associated with the design of monetary policy rules. She assesses the rationale for, and the theory of, inflation targeting, including the prerequisites for adopting an inflation-targeting framework and the operational steps involved in implementing inflation targeting. Finally, Scarlata attributes the success of Israel, New Zealand, and the United Kingdom in reducing inflation directly to their policy of inflation targeting.

The Role of Fiscal Policy Turning to the role of fiscal policy in macroeconomic management, Samir El-Khouri in Chapter 8 specifies three main functions of fiscal policy: • the allocation function—the process of dividing total resource use between private and social goods and choosing the mix of social goods; • the distribution function—the process of adjusting the distribution of income or wealth in conformity with what society considers fair; and

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• the stabilization function—the achievement of the main macroeconomic objectives of economic growth, price stability, and sustainable external accounts. El-Khouri focuses on the function that is directly related to macroeconomic management: stabilization. He uses the traditional openeconomy IS-LM model to assess the short-run effects of fiscal policy on output, prices, and the current account balance of payments, as well as the interactions between fiscal policy and monetary and exchange rate policies. He explores several issues specific to fiscal policy and macroeconomic management, such as methods for assessing the fiscal stance, cyclical and structural deficits, the sustainability of the fiscal deficit, and policies for managing debt and fiscal surpluses. El-Khouri concludes by exploring how tax policy, expenditure policy, and overall budgetary policy can affect a country's long-term growth. The role of fiscal policy in price stabilization in the context of a sustainable balance of payments is the focus of Enzo Croce's discussion in Chapter 9. Croce explains that for successful stabilization to be achieved the public sector finances need to be balanced against the demand for investment and the supply of savings by the private sector and available external financing flows. Countries facing major macroeconomic difficulties are often associated with substantial disequilibria in public finances. Reducing the fiscal imbalance thus becomes a necessary condition for improving the macroeconomic situation in such countries. In defining the role of fiscal policy in adjustment programs, two key issues arise. First, a correct measure of the fiscal position is needed to calculate the true extent to which the public sector is preempting resources. However, since no single comprehensive and complete measure of the underlying fiscal position exists, policymakers must rely on a series of alternative indicators, each with its advantages and disadvantages. Second, once an operational measure of the fiscal position is set, the size of the needed fiscal adjustment has to be determined. Croce discusses how the stance of fiscal policy can be defined and estimated and reviews the use of various indicators and how they can provide a basis for assessing the impact of fiscal policy on macroeconomic variables. He explains how government operations interact with other macroeconomic variables within the framework of the intertemporal budget constraint of the public sector. In this context, Croce discusses how specific indicators, mainly associated with the dynamics of the debt-to-GDP ratio, can be useful parameters for targeting a timeline for reducing fiscal deficits. He concludes by examin-

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ing the criteria for fiscal solvency and sustainability and the framework for determining the amount of fiscal adjustment needed to achieve sustainable domestic and external balances within a set time frame.

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Exchange Rate Policy and Issues In Chapter 10, Graciana del Castillo examines the issues involved in determining nominal exchange rates. Her survey of the econometric literature on the determinants of nominal exchange rates notes that traditional models of exchange rate determination have focused on three types of explanatory variable: national price levels, interest rates, and the balance of payments. She begins with a discussion of the fundamental hypotheses underlying the models—purchasing power parity (PPP) and interest rate parity—and reviews the models' empirical validity. She examines early models of the current account and the asset-pricing equilibrium models of the balance of payments under fixed exchange rates. The latter became the basis for modeling the behavior of flexible exchange rates after the collapse of the Bretton Woods system. Del Castillo analyzes models of exchange rate dynamics during the transition to flexible regimes and reviews the models that have adopted the modern asset-markets approach to determining exchange rates during transition. She explains the testing of the models under both flexible-price and sticky-price assumptions and argues that the asset-market models offer a more refined portfolio-balance approach to exchange rate determination. In Chapter 11, PeterJ.Montiel turns to a discussion of the theory and measurement of the long-run equilibrium real exchange rate (LRER). He focuses on why it is important to get this particular macroeconomic relative price right and on how the value of the equilibrium real exchange rate can be estimated empirically. These questions have been at the center of macroeconomic policy advice that officials of developing and transition economies have received over the past decade—namely the importance of "getting prices right." The need to get relative prices right, Montiel points out, also has a macroeconomic dimension. The two central macroeconomic relative prices are the price of goods in the present relative to the price of goods in the future (the real interest rate) and the price of domestic goods relative to the price of foreign goods (the real exchange rate). These relative prices guide the broad allocation of production and consumption between today's and tomor-

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row's goods, as well as between domestic and foreign goods. Montiel explains that identifying conceptually or empirically the right level of these macroeconomic relative prices is not easy. Montiel reviews the conceptual and empirical issues that arise in defining the actual real exchange rate, as well as the conceptual issues involved in the definition of the appropriate real exchange rate. He concludes that the relevant measure is the LRER and sets out a theoretical model designed to identify the relevant set of fundamental determinants of the LRER. After discussing the theory, Montiel examines the measurement issues and reviews the state of the art in the empirical measurement of the LRER. He concludes that the techniques for estimating the LRER are lagging behind the theory, noting that there is no wide agreement on methodology. Montiel, thus, imparts a clear sense of urgency to further research on identifying and measuring the LRER. * * * The concepts and issues discussed in this book are indicative of the complexities involved in macroeconomic policymaking. The chapters reflect some of the most recent advancements in the literature on macroeconomic management, including the identification of the sources of growth, inflation targeting, and the application of time-series methods to estimating the equilibrium real exchange rate. The chapters highlight the theoretical and empirical considerations that need to be considered when designing a macroeconomic adjustment program. They show clearly that there can and should be a variety of policy packages for achieving a country's key economic objectives. But designing an effective macroeconomic adjustment program requires a good understanding of how such policies affect the economy. The chapters in this book are an attempt to aid in the deepening of that understanding.

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Adjustment and Internal-External Balance

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Chorng-Huey Wong*

This chapter provides a framework for determining the appropriate mix of monetary, fiscal, and exchange rate policies for correcting macroeconomic imbalances. It discusses the design of macroeconomic adjustment programs and the appropriate actions required of policy agencies facing imperfect coordination. Unless otherwise specified, the framework is based on the following assumptions: (1) flexibility of domestic interest rates; (2) some degree of capital mobility; (3) absence of a rigid indexation system; and (4) some degree of central bank independence. Structural reforms and real sector and labor market policies are not addressed here. For the most part, the discussion focuses on countries with fixed but adjustable or managed floating exchange rate systems, which constitute about two-thirds of IMF members. The chapter begins with a definition of internal and external balance—the two key objectives of macroeconomic policies—and discusses possible combinations of imbalances, with particular reference to IMF-program countries. Second, it introduces the concept and measurement of the "macroeconomic balance real exchange rate" that corresponds to internal and external balance. It presents a diagram of this concept to show how to assess the need for an exchange rate change and how to use policies to change real domestic demand and the real exchange rate to move an economy from a combination of imbalances to macroeconomic balance.1 Third, it examines the relative effectiveness of monetary and fiscal policies in influencing domestic output and prices and the external sector position, both of which depend on various factors, including the degree of exchange rate flexibility. In this context, it refers to the evidence presented in Schadler and others (1995), which reviewed IMF Stand-By and Extended Arrangements approved during 1988-91. Fourth, it discusses the appropriate mix of monetary, fiscal, and exchange rate policies to deal with specific as*The author thanks Joshua Aizenman for helpful comments on an earlier version. 1Abasic reference for this topic is Clark and others (1994).

10

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pects of imbalances, on the basis of the framework introduced earlier. In this connection, it reviews a recent World Bank study on macroeconomic policies in 42 countries supported by the Bank's structural and sectoral adjustment loans during 1980-89 (World Bank, 1992). The chapter concludes with a brief discussion of policy coordination versus policy assignment and the relevance of the appropriate mix of policies in the design of adjustment programs. An appendix to the chapter contains a brief discussion of issues arising from greater capital mobility that are particularly relevant to emerging market economies.

Internal and External Balance Definition

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Internal balance is defined as a situation in which real output is at or close to its potential or capacity level, and the inflation rate is low and nonaccelerating. According to this definition, neither of the following two situations is considered to be in internal balance: low inflation combined with slow or negative growth, or rapid growth combined with high inflation. External balance is often defined as a current account position that can be sustained by capital flows on terms compatible with the growth prospects of the economy without resort to restrictions on trade and payments, so that the level of international reserves is adequate and relatively stable. External balance does not necessarily correspond to a zero current account balance or a zero overall balance of the balance of payments, but for simplicity both notions, although not equivalent, can be used. Combinations of Macroeconomic Imbalances Both internal balance and external balance depend on two fundamental variables—the level of real domestic demand and the real exchange rate—which, in turn, reflect underlying economic conditions and macroeconomic policies. For example, a current account deficit occurs if the real exchange rate is overly appreciated, excess real domestic demand exists, or both. The opposite situation results in a current account surplus. Likewise, an overly depreciated real exchange rate or excess real domestic demand creates inflationary pressure, and the opposite situation results in depressed output. A country with a balance of payments concern usually also has one other policy objective: to correct either the rate of growth or inflation.

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Table 2.1. Combinations of Macroeconomic Imbalances Type of Imbalance

Countries Affected

Domestic excess demand and inflation Current account deficit

Most SBA countries

Domestic recession

Some PRGF and EFF countries

Current account deficit

United Kingdom in late 1980s and early 1990s

Domestic excess demand and inflation

Some oil producers

Current account surplus

China in first half of the 1990s

Domestic recession Current account surplus

Japan from 1992 to present

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Note: IMF financial arrangements, as follows: SBA = Stand-By Arrangement; PRGF= Poverty Reduction and Growth Facility; and EFF = Extended Fund Facility. PRGF is the successor facility of the Structural Adjustment Facility (SAF) and the Enhanced Structural Adjustment Facility (ESAF).

Internal balance and external balance could each be achieved through different combinations of the real exchange rate and the real domestic demand. However, policy authorities generally strive to achieve internal and external balance simultaneously, which requires a particular combination of the real exchange rate and real domestic demand. On the basis of the definitions of internal and external balance given above, the different combinations of macroeconomic imbalances can be broadly classified into four categories, as shown in Table 2.1. The first category—the combination of excess demand, inflation, and current account deficit—characterizes the situation in most IMF member countries that request Stand-By Arrangements. This category is given more attention in this chapter than are the other three categories.

Macroeconomic Balance Real Exchange Rate Concept and Measurement The macroeconomic balance real exchange rate is the real exchange rate at which an economy attains both internal and external balance.2 As already mentioned, both internal balance and external balance de2 This concept is discussed in detail in Clark and others (1994). Some recent extensions of this approach and the manner in which it is applied by IMF staff are described in Isard and Faruqee (1998).

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pend on the level of real domestic demand and the real exchange rate. Algebraically,

CA=f(A,R,...),¥- 0 and f ^ > 0; oA o£

(10.24)

F =f(A,E), with | ^ < 0 and f £ > 0. (10.25) oA ot The first equation, which has a negative slope, indicates that absorption and the real exchange rate must change in opposite directions to maintain full employment. The second, which has a positive slope, indicates that the balance of payments improves with an increase in the real exchange rate and deteriorates with a rise in absorption. Over time, the curves in Figure 10.1 will shift, and short-run disturbances may move the economy away from internal or external balance (or both). Within Swan's framework,27 the challenge to policymakers is to design policies—including expenditure-reducing and expenditureswitching policies (primarily exchange rate policy)—that affect absorption and relative prices. In this way the economy stays as close as 27 Swan's analysis was included in a paper presented in 1955 but not published until eight years later.

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Figure 10.1. Determination of Employment and the Balance of Payments

possible to the intersection of the two curves—that is, where internal and external equilibria are achieved simultaneously (Isard, 1995). In the early 1960s, Mundell (1960, 1961a, 1961b, 1962, 1963) and Fleming (1962) began exploring the policy implications of international capital mobility. The Mundell-Fleming model, based on the openeconomy extension of the IS-LM model, combines the simple Keynesian framework of the goods and money markets with the assumption that net international capital flows into the economy are positively related to the domestic rate of interest. The model assumes that foreign prices and interest rates are exogenously given. It focuses on the domestic interest rate or money supply as the instrument for monetary policy and on the budget deficit as the basic instrument for fiscal policy. Adding to the IS-LM framework a balance of payments equilibrium curve (FF) similar to Swan's external balance curve, Mundell (1961a) analyzes equilibrium in terms of domestic income (Y) and the interest rate (I): N = N(Y,i), with ^ > 0 , ^ < 0, 8Y 8i

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(10.26)

Monetary

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Figure 10.2. Mundell Model of International Equilibrium

L = L(Y,i), with — > 0, — < 0, and 8Y 8/

(10.27)

F = F(Y,i), with f£> 0, f? < 0,

(10.28)

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5Y

oz

where equation (10.27) describes the market-clearing conditions for money. In Mundell's framework (see Figure 10.2), the NN curve, along which the excess of home investment over home saving is equal to the trade deficit, and the LL curve, along which the demand for money is equal to the given supply, are drawn with the same slope as the traditional IS and LM curves, respectively. The FF curve, along which the overall balance of payments is zero, has a positive slope.28 While the trade balance depends on domestic income, the overall balance of payments is also affected by the capital account, which depends on the domestic interest rate. The influence of the exchange rate on the balance of payments is not direct but stems from a shift in the NN and FF curves induced by the impact of a change in the real exchange rate. A devaluation of the domestic currency shifts both curves to the right. With an improved trade 28

The slope is positive except in limited cases in which capital is either perfectly mobile or perfectly immobile, in which case the FF curve becomes horizontal or vertical, respectively.

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balance at any level of Y, a lower I is required for balance of payments equilibrium and a higher I for goods market equilibrium. Mundell recognizes that sustaining an unbalanced international payments position is difficult over the long run, since doing so requires a substantial level of foreign exchange reserves in deficit countries and a willingness to make unrequited capital exports in surplus countries. He notes that any secular change in the competitive situation, or a persistent tendency in some countries to inflate at faster rates than other countries, "must eventually bring the day of reckoning" (Mundell, 1961b). Because sustainability requires balance of payments equilibrium in addition to full employment, and given Tinbergen's principle, both monetary and fiscal policy are used in stabilization policy.29 One of the major conclusions of the Mundell-Fleming model is that the relative effectiveness of monetary and fiscal policies depends on both the existing exchange rate regime and the degree of international capital mobility. Mundell (1963) analyzes the case of perfect capital mobility under both fixed and flexible exchange rates.30 Under a fixed exchange rate system, an increase in the money supply through open market operations creates excess liquidity and exerts downward pressure on interest rates, causing a capital outflow. To prevent the exchange rate from depreciating, central banks intervene in the market, selling foreign exchange and buying domestic money until the money supply is restored to its original level. Thus, monetary policy has no sustainable effect on the level of income, but it does lead to a change in international reserves. An expansionary fiscal policy, conversely, has a multiplier effect on income and no effect on international reserves. The increase in income increases saving, taxes, and imports. The need for higher liquidity in the private sector leads to a capital inflow that offsets the deterioration in the trade balance, so that the balance of payments remains unchanged. Under a flexible exchange rate system, a monetary expansion has a strong effect on the levels of income and employment, not because it lowers the rate of interest but because it induces a capital outflow, depreciates the exchange rate, and (normally) improves the trade balance. 29 Tinbergen (1952) showed that attaining a given number of independent policy targets requires at least the same number of policy instruments. Simple application of this rule led to the principle of effective market classification, which posits that a system works best if policy instruments respond to the imbalances on which they exert the most direct influence (Mundell, 1960). 30 Related literature on the optimum currency area began to focus on the characteristics that made it optimal for countries to choose among exchange rate regimes (see Mundell, 1961c).

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A n expansionary fiscal policy, conversely, causes the trade balance to deteriorate without affecting domestic output or employment. In this case, the increase in the demand for goods raises the demand for money (hence the interest rate) and attracts a capital inflow, resulting in an appreciation of the exchange rate and in turn depressing income. The traditional flow model (Mundell, 1960) has been tested empirically in the following form: st = oco + 0Li(pt - pt*) + OL2(yt - yt*) + OL3(it - it*) + Mt,

(10.29)

where the hypothesis to be tested is that oc1, 0C2 > 0 and 0C3 < 0. This model assumes that prices adjust sluggishly—that is, the PPP hypothesis is not imposed. Rising domestic prices and income lead to a deterioration in the current account without affecting capital flows. Thus, the exchange rate must depreciate to improve the current account balance. Assets are imperfect substitutes, so an increase in the domestic interest rate (without a change in the foreign rate) induces capital inflows and an appreciation of the exchange rate. Asset Equilibrium Models of the Balance of Payments

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The primary criticism of the Mundell-Fleming model has been that it conceptualizes the capital account as a flow rather than as a function of the effort of economic agents to adjust asset stocks to their desired levels.31 By the second half of the 1960s, the analysis of exchange rates and the balance of payments entered a new phase with the monetary approach to the balance of payments and the portfolio-balance approach.32 31 Taylor (1995) points out that although the Mundell-Fleming model makes an important contribution by integrating asset markets and capital mobility into open-economy macroeconomics, its treatment of asset market equilibrium is inadequate, since the stock-flow implications of changes in the interest rate differential are not worked out. Other critics have also noted that the treatment of asset markets is the main problem with this model. The model implies that the exchange rate can be in equilibrium when a country is running a current account deficit if the domestic interest rate is high enough to maintain an offsetting capital inflow. This implication suggests that there may be a steady accumulation of domestic assets by foreigners (Isard, 1995). 32 Frenkel and Mussa (1985) point out that the key development in the analysis of the balance of payments in the late 1960s and early 1970s was the theoretical elaboration and empirical testing of the dynamic mechanism of balance of payments adjustment that dated back to Hume's price-specie-flow mechanism. The dynamic mechanism theory held that changes in asset stocks (especially the money supply) associated with payments imbalances alter the instantaneous equilibrium position of the economy over time, ultimately driving it to a longrun equilibrium at which the payments imbalance is eliminated. Frenkel and Mussa argue that much of the literature on the balance of payments and open-economy macroeconomics of the late 1950s and 1960s either ignores this dynamic mechanism or suppresses it through sterilization, but that it is notoriously present in Mundell's description of the international disequilibrium system (Mundell, 1961b), now frequently referred to as the Mundell-Fleming model.

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These approaches emphasize the role of money and other assets in determining the balance of payments when the exchange rate is pegged and in determining the exchange rate when the exchange rate is flexible (Frenkel, 1978; Frankel, 1993a). The origin of the monetary approach can be traced to Hume in the eighteenth century and Ricardo in the nineteenth century and was resurrected by Johnson (1956) and Mundell (1968b and 1971).33 Both models were originally formulated for a fixed exchange rate system and provide a convenient framework for analyzing discrete changes in exchange rates.

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The Monetary Approach Under Fixed Exchange Rates

The monetary approach focuses on the official settlements balance (that is, the monetary or money account, rather than the balance of trade or the current account).34 The monetary approach considers the imbalance between the demand for and the supply of money as the crucial determinant of balance of payments disequilibria. Indeed, its first general principle is that the approach itself is fundamentally (but not exclusively) a monetary phenomenon.35 The second general principle (as noted) is that the analysis of the balance of payments should center around the supply-of-money process and the demand for money, postulated as a stable function of a small number of macroeconomic variables. Under fixed exchange rates, the balance of payments becomes an additional source for the supply of money, increasing or reducing it according to whether the balance of payments is in surplus or deficit.36 The third general principle is that the monetary approach draws on several models of the adjustment process, since no single model of the process is always appropriate for all countries and all institutional arrangements. The approach combines a generalized theory of longterm behavior with these models (Mussa, 1976). Since the balance of payments is identically equal to the excess of expenditure over income, the analysis of the adjustment process must explicitly specify the mechanism that drives the adjustment of expenditure to income. 33

The monetary approach to the balance of payments was first developed by Johnson (1956) and Mundell (1963,1968a, 1968b, and 1968c). In the 1970s a large number of theoretical papers and empirical studies on the monetary approach appeared in various economics journals, many of which were compiled in two separate volumes (Frenkel and Johnson, 1976; IMF, 1977). 34 This section follows del Castillo (1986). 35 The monetary approach to analyzing the balance of payments explicitly incorporates the influence of such real variables as levels of income and interest rates. 36 This holds only if the monetary authorities do not follow sterilization policies. Deficits and surpluses in the balance of payments represent the adjustment of actual to desired money stocks.

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The most important policy implication of the monetary approach is that money supply adjusts to money demand through changes in the balance of payments, and hence that the monetary authorities cannot control the total money supply, only its composition. In open economies with a fixed exchange rate regime or any of its variants, balance of payments deficits or surpluses affect the supply of money (except possibly in the short run if the monetary effects of those deficits or surpluses are sterilized). In this scenario, the nominal supply of money is said to be demand determined, since the nominal supply of money adjusts to the nominal demand for money by exporting or importing money through deficits or surpluses in the balance of payments. Therefore, the banking system has no direct control over the nominal supply of money; it can only determine domestic credit (that is, one of the sources of supply of money). This is in strong contrast to the closed-economy and flexible exchange rate cases, where the rest of the economy cannot change the nominal supply of money. Another important policy implication of this approach is that changes in exchange rate parity affect the balance of payments only if the parity affects the equilibrium in the money market. The monetary approach to the balance of payments is often formulated for a small country in relation to the rest of the world, with which it maintains a fixed exchange rate system. It is formulated in general-equilibrium terms, incorporating both real and monetary sectors. Full equilibrium is achieved when stocks and flows are in equilibrium in both markets. The two basic postulates of the quantity theory of money are incorporated into the model: first, that money has no influence on real economic variables, at least in the long run (neutrality postulate), and second, that the level of prices will change in the same proportion as the quantity of money (equiproportionate postulate). A stylized version consists of a money supply equation (M) embodying a domestic component (D) and a foreign component expressed in foreign currency (R), and a stable money demand function (L), formulated in the classic way—that is, with real income (Y) exogenous to the system (constant at the full employment level) and all prices flexible. Perfect arbitrage is assumed in both commodity and financial markets, and, since the exchange rate is fixed, the price level and the rate of interest in the small country reflect those prevailing in the rest of the world. 37 That is: 37 This statement means that prices and interest rates are also exogenous according to the small country assumption.

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M = SR + D

Money supply equation

(10.30)

L = kPY^iv

Money demand equation

(10.31)

P = SP*

PPP, or the law of one price

(10.32)

I = I*

Law of one interest rate

(10.33)

SR + D = kPY^iv Money market equilibrium equation.

(10.34)

Models of the monetary approach derive the structural equation of the model (that is, the reserve flow or balance of payments equation) from the money market equilibrium condition. The exchange rate is fixed and, for simplicity, equal to unity (S = 1). Differentiating equation (10.34) logarithmically and finding first differences generates percentage changes in international reserves (or the balance of payments, r) and in domestic credit, d, as follows:

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xr = - (1 - T) d + v + r|y + (pi,

(10.35)

where, in general, x = d log X = (5X/5f)/X and x = SR/(SR + D), and r\ and (p are the elasticities of money demand with respect to income and the interest rate. The monetary approach challenged the conventional wisdom that a change in the exchange rate affects the balance of payments, holding that it affects the balance of payments only insofar as it creates an imbalance in the money market. A large accumulation of or a fall in reserves exerts pressure on the exchange rate parity. The monetary approach may also be formulated to include financial assets other than money that economic agents regard as perfect substitutes. Ruling out capital mobility, Frenkel and Mussa (1985) consider the case of a small, open economy facing specific world relative prices for all (tradable) goods produced and consumed by domestic residents.38 Using the Hicksian aggregate principle, they measure domestic real income (equal to domestic output), Y, and domestic real expenditure or absorption, A, in common units of a composite tradable good. Y is constant at the full employment level, and domestic real expenditure depends on domestic real income, the domestic real interest rate, r, and the real value of privately held domestic assets, W: A = A(Xr,m , w i t h M > 0 / M < 0 / - ^ > 0 . v PI 6Y 5r 8(W/P) 38

(10.36)

Frenkel and Mussa (1985) also present a model that accounts for capital mobility.

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Private residents of the home country hold domestic assets consisting of money, M , and domestic interest-bearing securities, BD, which are denominated in units of domestic currency:39 (10.37)

W = M + BD.

The real value of these assets depends on the domestic price level, P, which is equal to the foreign price level, P*, multiplied by the exchange rate, S: P = SP*.

(10.38)

Assuming for simplicity that the money multiplier is unity, the domestic money supply is high-powered money issued by the domestic central bank and is equal to the sum of the domestic-money value of the foreign exchange reserves of the central bank, SJR, domestic securities held by the central bank, BDC,40and the fiat issue (or "net worth")41 of the central bank, NW: (10.39)

M = SR + BDC + NW.

The home country's real trade balance, T, must equal the excess of real income (equal to domestic output) over domestic real expenditure (Alexander, 1952):

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T = Y-

A.

(10.40)

Since, by assumption, trade imbalances cannot be financed with private capital flows or with changes in the private holdings of foreign monies, they must be financed with drawdowns of international reserves, made by the central bank to maintain the fixed exchange rate. The magnitude of this reserve flow is shown by AR = P*T,

(10.41)

where AR = dR/dt. Based on equations (10.38) and (10.39), and under the assumption that BDC and NW are held constant, then A M = PT.

(10.42)

39

In the absence of capital mobility, these assets are assumed to be nontradable internationally. Since interest-bearing securities and national monies are not internationally tradable, the total stock of domestic securities issued by the government is held by either domestic residents or the central bank. 41 Net worth is the difference between the value of the central bank's monetary liabilities, M , and the value of its reserves and domestic security holding, SR + BDC.. 40

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This relationship is analogous to one of the central tenets of Hume's price-specie-flow mechanism—that trade deficits cause an outflow of money (gold), whereas trade surpluses create an inflow.42 The Portfolio-Balance Approach Under Fixed Exchange Rates

Like the monetary approach, the portfolio balance approach focuses on the link between balance of payments flows and adjustments to asset stocks. This approach holds that models of the capital account should be rooted in behavioral models of the supplies of and demands for portfolio stocks.43 Unlike the monetary approach, the portfolio balance approach assumes that portfolio holders are risk averse, hold assets other than money, and regard domestic and foreign assets as imperfect substitutes.44 Since the UIP condition holds only when assets are perfect substitutes, the interest rate on domestic bonds differs from the interest rate on foreign bonds plus the expected rate of change in the exchange rate. Assuming that policymakers determine asset stocks and that interest rates and exchange rates (current and expected future) are the endogenous variables that adjust to clear the markets, the portfolio balance approach focuses on the behavior of the differential between the expected rates of return of home and foreign bonds, expressed in domestic currency.45 The differential is the same for domestic and foreign bond holders. Following Dooley and Isard (1983),

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Ot = it - (it* - 8te) = (it - 5te) - it* = it - it* - (Etst+1 -

st),

(10.43)

where it is the nominal interest rate, 8^ is the expected rate of depreciation in the domestic currency, and the asterisk (*) captures foreign country variables. This equation differs from equation (10.19) in an important way. Whereas I and J* in equation (10.19) refer to interest rates on claims that are identical except in currency denomination and interest rates, in equation (10.43) they refer to interest rates on claims against governments of countries with different credit risks. Whereas £ 42 Extending this analysis to a behavioral model of the balance of payments requires a description of private sector behavior (see Isard, 1995). 43 Metzler (1951) and Tobin (1969) are credited with developing the portfolio approach. 44 Perfect substitutability implies that asset holders are indifferent about the composition of their bond portfolios as long as the expected rate of return on the two countries' bonds is the same when expressed in the same currency unit. 45 Each government finances its budget deficit entirely by issuing debt denominated in its own currency unit.

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in equation (10.19) represents the premium or expected yield differential for incurring exchange risk associated with holding assets denominated in different currencies, £1 represents the premium for incurring both exchange risk and the difference in credit risk. The magnitude of the risk premiums that are required to clear the financial markets depends on the relative stocks of the different types of net claims on other governments (outside assets).

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Exchange Rate Dynamics in the Transition to Flexible Exchange Rates As pointed out by Frenkel and Mussa (1985), the shift to a system of floating exchange rates among the major currencies in 1973 was accompanied by a corresponding shift in research interest away from the balance of payments to the economic determinants of the behavior of exchange rates. The unifying theme in much of this research was the asset market approach to exchange rates, which, as discussed earlier, emphasizes that conditions for equilibrium in the market for stocks of assets, especially national monies, are the primary determinant of the behavior of exchange rates. Mundell (1968a) and Johnson (1976a) have suggested that the monetary approach, which was once applied almost entirely to countries with fixed exchange rate regimes, can also be applied in countries with flexible regimes (Bilson, 1979). Frenkel and Johnson (1978) explain that the monetary approach can also be used to analyze the case of a floating rate world by shifting the focus of the analysis from the determination of the balance of payments to the determination of the exchange rate. They note that this switch in emphasis was already clear to Gustav Cassel, who saw PPP as determining either a nation's price level via its exchange rate under a fixed exchange rate system, or its exchange rate via its domestic money supply under a floating rate system. This section focuses on the transition from fixed to flexible exchange rates by presenting the simplest model of exchange rate determination and a model of exchange rate market pressure—an adaptation of the monetary approach in the context of a flexible exchange rate. The section also examines the role of expectations, which under flexible exchange rates strongly influence nominal interest rates. Finally, it presents the Dornbusch exchange rate dynamics model, which allows for short-run deviations from PPP to illustrate the role of consistent expectations, sticky prices, and exchange rate overshooting.

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A Simple Monetary Model of Exchange Rate Determination Bilson (1979) provides a simple specification of monetary models of exchange rate determination that is the foundation for later models. It consists of the following three equations:46 M = PL (i, Y), with f^- < 0 and — > 0, of oY

(10.44)

M* = P*L*(i*,Y*), with ^

(10.45)

< 0 and —^ > 0, and

(10.46)

P = SP*,

where the variables are defined as before and asterisks indicate foreign country variables. Under flexible exchange rates, the first two equations determine the domestic and foreign price levels,47 leaving the third equation to determine the exchange rate.48 The reduced-form solution for the exchange rate in this simple model is c^ML*(i*,Y*) M*L(i,Y) '

(10.47)

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This formulation clearly illustrates the position taken by Frenkel (1976), Mussa (1976), and others that the exchange rate, being the relative price of two assets (monies), is determined by the relative supply and relative demand for the two currencies.49 However, because the simple model does not provide the link among exchange rates, interest rates, and the exogenous variables, it limits the usefulness of the monetary model for policy and forecasting purposes.

The Girton-Roper Model of Exchange Market Pressure In the late 1970s, Girton and Roper (1977) developed a model of exchange market pressure that is based on the monetary approach de46

The monetary model presented here is essentially an extension of the PPP hypothesis. If, as pointed out by Frenkel (1976), the role of the exchange rate is to clear the money market by equating the purchasing power of the various currencies, then the relevant measure of PPP should be a consumer price index. 48 The particular exchange rate regime determines the set of market-clearing variables without fundamentally altering the underlying structure of the model. Under fixed exchange rates, the domestic price level is determined by the PPP condition, so that the first equation determines the size of the domestic money supply through balance of payments surpluses or deficits. 49 The equilibrium exchange rate is attained when existing stocks of the two monies are held willingly. As part of his doctrinal perspective to exchange rate determination, Frenkel (1976) shows that this view of the exchange rate dates back to classical economics, whereas analysis of the exchange rate based on components of the balance of payments is of relatively recent origin, gaining popularity with the domination of the Keynesian revolution. 47

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veloped in equation (10.35) and tested it for an earlier Canadian experience with a managed float (1952-62).50 They used the model to explain exchange rate movements and changes in official reserve holdings and to determine the volume of intervention necessary to achieve a certain exchange rate target. Connolly and da Silveira (1979) adapted the model to small economies and tested it for Brazil in the following form:51 rt - et = - aodt + ftpt* + hyt -