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 options. In particular,
they make explicit the pros and cons involved in any specific course of
policy action.
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 demand-restraint 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, Nadeem Ul Haque and Mohsin S. Khan focus
more narrowly on the empirical evidence for the effects that IMF-supported
adjustment 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
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-i-Martin
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 (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.
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.
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
- 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 open-economy 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 examining 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.
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, Peter J. 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 tomorrow'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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