Macroeconomic Adjustment in Developing Countries

THEWORLD BANK E RS6

Discussion Paper

DEVELOPMENT POLICY ISSUES SERIES

Report No. VPERS6

Macroeconomic Adjustment inDeveloping Countries:A Policy Perspective

Mohsin S. KhanAugust 1986

Office of the Vice President Economics and Research

The views presented here are those of the author, and they should not be interpreted as reflecting those of the World Bank.

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MACROECONOMIC ADJUSTMENT IN DEVELOPING COUNTRIES:

A POLICY PERSPECTIVE

by

Mohsin S. Khan

August 1986

The author is Chief, Macroeconomics Division, Development Research Department,World Bank, on leave from the International Monetary Fund.

The author is grateful to Willem Buiter, Mansoor Dailami, Indermit Gill,Nadeem U. Haque, Malcolm Knight, Anne Krueger, Ricardo Martin, CostasMichalopoulos, and Peter Montiel for helpful comments and suggestions.

The World Bank does not accept responsibility for the views expressed hereinwhich are those of the author(s) and should not be attributed to the WorldBank or to its affiliated organizations. The findings, interpretations, andconclusions are the results of research supported by the Bank; they do notnecessarily represent official policy of the Bank. The designations employed,the presentation of material, and any maps used in this document are solelyfor the convenience of the reader and do not imply the expression of anyopinion whatsoever on the part of the World Bank or its affiliates concerningthe legal status of any country, territory, city, area, or of its authorities,or concerning the delimitations of its boundaries or national affiliation.

Abstract

Broadly speaking, a comprehensive macroeconomic adjustment program isexpected to have the following objectives: a sustainable current accountposition, a stable and high rate of economic growth that would allow for asteady rise in per capita consumption, a reduced rate of inflation, and amanageable level of foreign debt. Given these multiple objectives, thepackage that is designed would typically include a variety of policy measuresthat simultaneously restrain aggregate demand and increase the availability ofresources. These policies may be grouped as follows: demand-managementpolicies; structural policies; exchange rate policies; and external financingpolicies. The purpose of this paper is to describe how these policies can beexpected to achieve the goal of macroeconomic adjustment. The focus isprimarily on the theoretical and empirical links between policy instrumentsand the ultimate objectives. An examination of these links is necessarybefore issues of the appropriate mix of demand-management, structural,exchange rate, and external policies, and the sequencing of these policies ina program, can be properly addressed.

Table of Contents

Page No.

I. Introduction ............................ I

II. Demand-Management Policies ...... ............................ 5

A. Monetary Policy ........................................ 6

B. Fiscal Policy ........................................ 9

III. Structural Policies ........................................ 11

A. Policies to Improve Efficiency andResource Allocation ......... ... *.... ... *... ... ... . 12

B. Policies to Increase the Rate ofGrowth of Capacity Output ......................... 15

IV. Exchange Rate Policies ...................................... 20

A. Determining the Extent of ExchangeRate Adjustment ................... ............... 22

B. Policies to Achieve a Target RealExchange Rate ....................... ....... ..... . 23

C. Effects of Exchange Rate Changes .... ................... 25

D. Exchange Rate Systems and Regimes .... .................. 26

V. External Financing Policies ................................. 28

VI. Conclusions ................ 34

Macroeconomic Adjustment in Developing Countries:A Policy Perspective

Mohsin S. Khan

I. Introduction

In recent years developing countries have found themselves in serious

economic difficulties, including worsening balance of payments positions,

rising rates of inflation, and declining rates of growth. The predicament of

these countries has led to a heightened interest in the subject of

macroeconomic adjustment, and particularly on how to eliminate the

disequilibrium in the economies that gave rise to these problems without

sacrificing growth in the process. The basic question that is currently being

asked by academics, policymakers in the developing world, and the

international economic community at large, is what policies can be employed,

and in what combination, to achieve the goal of macroeconomic adjustment.

The need for macroeconomic adjustment arises when a country has a

fundamental imbalance between aggregate domestic demand and aggregate

supply. This demand-supply imbalance can be a result both of external

factors, such as a deterioration in the terms of trade and an increase in

foreign interest rates, as well as inappropriate domestic policies that expand

aggregate demand too rapidly and reduce the rate of growth of productive

capacity of the economy. In principle, a country can avoid adjustment by

borrowing abroad or imposing controls on trade and payments, or a combination

of the two, and the disequilibrium in the economy can persist for an extended

period. There are, however, costs associated with this type of strategy that

are well known. These include a widening current account deficit, increasing

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inflation, overvaluation of the domestic currency and loss of international

competitiveness, an inefficient allocation of resources because of distortions

in relative prices, reduced economic growth, and a heavier foreign debt

burden.

This type of disequilibrium cannot continue indefinitely, and in the

absence of appropriate policy actions to correct the underlying imbalances,

living standards in the country would be adversely affected. Moreover, the

steady loss of international competitiveness and an increasing level of

foreign debt would affect the country's creditworthiness and thus its ability

to obtain additional foreign financing. Naturally, a cessation of foreign

financing would impose adjustment on the country, and as recent experience in

a number of countries has shown, this forced adjustment is likely to be very

disruptive. The fundamental objective of an adjustment program is to provide

for an orderly elimination of the imbalance between aggregate domestic demand

and resource availability before the point at which the economy becomes

seriously distorted and external resources are exhausted. To achieve this

objective the adjustment program necessarily has to include a variety of

policies that simultaneously reduce aggregate demand and increase the

availability of total resources. Following Khan and Knight (1982), (1985),

these policies can be broadly grouped according to whether their primary

impact is on the level of absorption -- demand-management policies -- on the

level of current and potential output -- structural policies -- on the

composition of absorption and production as between tradable and nontradable

goods - exchange rate policies -- and finally, on the level of capital flows

-- external financing policies.

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Demand-management policies typically include monetary and fiscal

measures designed to affect the aggregate level or rate of growth of demand

relative to production. On the other hand, structural policies are intended

to increase the supply of goods and services in the economy at any given level

of domestic demand. Included in structural policies would be, among others,

measures to increase the level and efficiency of investment, reductions in

tariffs and elimination of other trade distortions, removal of subsidies,

raising the efficiency and profitability of public sector enterprises,

measures to raise public and private savings, and increases in producer

prices. Policies to improve international competitiveness and expand the

supply of tradable goods through both reduced consumption and increased

production principally involve changes in the real exchange rate. Exchange

rate policies, therefore, have both demand-side and structural

characteristics, and thus are treated separately. Changes in the net flow of

foreign financing, including the financing directly provided by international

institutions, also affect absorption, and if they assist domestic capital

formation, raise potential output as well. External financing polic:ies

generally include measures to ensure that the supply of funds, both from

official as well as private external sources, are at a sustainable level,

changing the maturity and composition of foreign debt, and reducing capital

flight from developing countries.

Generally speaking, comprehensive and long-term macroeconomic

adjustment would involve elements of all four of the policies listed above.

Programs aimed at adjustment with growth cannot rely exclusively on demand-

management policies, nor for that matter solely on structural policies. In

fact, these policies are closely interrelated. For example, the achievement

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of a higher growth rate in the medium term generally requires an increase in

productive investment, while stabilization requires a reduction in the

savings-investment gap. The policy package, therefore, must be designed to

reduce the level of aggregate domestic demand and simultaneously to cause a

shift in the composition of demand away from current consumption and toward

fixed capital formation. Exchange rate policies will assist in the adjustment

process by dampening demand and creating incentives for investment in the

tradables sector. External financing policies would set limits to the current

and future availability of foreign resources, and this in turn would define

both the degree and speed of the necessary adjustment.

The crucial question that arises in the design of adjustment programs

is how should these policies be combined in the overall package? The relative

emphasis placed on various policies will depend primarily on two sets of

criteria. First, the objectives of the authorities and the constraints

(institutional, timing, and structural) that they face. The choice in this

case would inherently be country-specific and there is limited scope for

generalizations. Second, the nature, magnitude, and timing of the effect of

various policies on the key macroeconomic variables, which would determine not

only the mix of policies but also the sequence in which these policies are

enacted. This is a more general issue that would have relevance for

developing countries at large.

The purpose of this paper is to describe how demand-management,

structural, exchange rate, and external financing policies can be expected to

affect the targets to which they are directed and thereby achieve the goal of

macroeconomic adjustment, characterized by a sustainable current account

position, a low rate of inflation, a stable and high rate of economic growth,

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and a manageable level of external debt. While an attempt is made to cover

the main links between policy instruments and the ultimate objectives, the

survey does not deal with all of the possible effects of macroeconomic policy

measures. For example, no attempt is made to discuss the distributional

effects of adjustment policies, even though it is recognized that the pattern

of income distribution is often a key objective for policymakers. Such

exclusions were considered necessary in order to limit the scope of the

paper. Nevertheless, the paper will highlight a number of the important

theoretical and empirical questions that need to be addressed in the course of

designing macroeconomic adjustment programs.

The remainder of the paper proceeds as follows: Section II discusses

the role of demand-management policies. Structural policies to increase the

efficiency with which resources are utilized, and the overall supply of

resources, are described in Section III. Section IV takes up questions of how

to determine the size of the exchange rate change and the effects of a

devaluation on the economy. This section also discusses briefly questions

relating to the exchange rate systems and rules a country might adopt.

Section V on external financing policies describes the methods for judging the

sustainability of foreign borrowing and the issue of capital flight from

developing countries. The concluding section brings together the main points

of the paper and discusses the issues that arise in combining the various

policy measures into a comprehensive adjustment package.

II. Demand-Management Policies

Macroeconomic adjustment is often viewed as synonymous with policies

to restrain aggregate demand and absorption, and has accordingly received

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considerable attention in the literature. 1/ The two main instruments for

controlling absorption are monetary policy and fiscal policy. 2/

A. Monetary Policy

The standard view of the transmission mechanism between monetary

policy and aggregate demand emphasizes the role of interest rates. In the

closed-economy case an increase in the supply of money causes individuals to

purchase real and financial assets in an attempt to restore portfolio

balance. This lowers market interest rates and stimulates aggregate demand.

A basic description of the way monetary policy works in a small open economy,

on the other hand, is that which appears in versions of the monetary approach

to the balance of payments. 3/ In such simple models, under fixed exchange

rates, the public disposes of surplus cash balances produced by an expansion

of domestic credit through purchasing foreign goods and securities, leaving

domestic output and prices unaffected. Under flexible exchange rates, a

similar expansion in domestic credit results in an increase in the money

supply, a rise in the domestic price level, and a depreciation of the exchange

rate.

Most developing countries, however, possess neither the range of

financial assets nor the degree of integration with international goods and

1/ IMF adjustment programs, for example, are described by some observers asbeing primarily demand-oriented. See Dell (1982) and Diaz-Alejandro(1984). While demand-side policies were stressed in earlier Fund work onfinancial programs, namely by Polak (1957) and Robichek (1967), (1971),this is not necessarily a valid description of present-day programs.

2/ The demand-side effects of exchange rate policies are treated separatelyin Section IV.

3/ See Frenkel and Johnson (1976) and IMF (1977).

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financial markets that would make these descriptions of the effects of

monetary policy directly relevant. How then does monetary policy work, and

what are its effects on aggregate demand in situations where financial markets

are underdeveloped, interest rates are set below market-clearing rates by the

government, a relatively free curb market operates, 4/ and there are foreign

exchange controls? Since such features would tend to be present in many

developing countries, these questions would appear to be the more appropriate

ones to consider for such countries.

If exchange controls are effective then the authorities can control

the monetary base via their control over the availability of foreign exchange

and over credit extended by the central bank. Starting from portfolio

equilibrium, a fall in the supply of bank credit to the private sector will

cause borrowers to shift towards the curb market, thus leading to an increase

in the curb market interest rate. Since this rate would represent the

marginal cost of funds in the economy, the interest-sensitive components of

aggregate demand will decline. In particular, the implicit value of real

assets will fall relative to their production costs and demand for such assets

would be reduced. 5/ With the decline in aggregate demand there would be

downward pressure on inflation. Similarly, a decrease in the money supply

leaves the private sector with too little money in its portfolio relative to

loans and real assets. The resulting decrease in the supply of curb market

loans leads to a rise in the curb market interest rate. Aggregate demand is

4/ The assumption of the curb market allows one to analyze interest rateeffects on aggregate demand. In the absence of such a market, monetarypolicy would only have wealth effects.

5/ This is basically the well-known Tobin's Q mechanism.

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again reduced as a result of the reduced demand for real assets. If, on the

other hand, exchange controls are ineffective, then the power of monetary

policy to affect aggregate demand would be diminished. Some of the effects of

a reduction in the money supply would be offset by changes in foreign exchange

claims or liabilities. Therefore, the effects on the curb market interest

rate and on the demand for real assets are weakened. In the limit, the

propositions associated with the monetary approach to the balance of payments

would become operative.

While it is possible to argue that even in a world of credit and

foreign exchange rationing changes in the growth of money would be neutral in

the long run, it is clear that during the adjustment process a restrictive

monetary policy would be associated with a reduction in capacity utilization

and a rise in unemployment, since prices would normally tend to be sticky

downwards. 6/ The estimated size and duration of the deflationary effect

would naturally depend on the responses of aggregate demand and aggregate

supply to a tighter monetary policy. More specifically in this context, as

argued by Khan and Knight (1982), the relevant factors would include: (i) the

speed with which the initial monetary disequilibrium is offset by

international reserve movements (an effect that depends on the presence and

effectiveness of exchange controls); (ii) the stickiness of domestic prices,

which in turn will be conditional on wage-setting behavior and the degree of

excess capacity in the economy; (iii) the effect on investment of a rise in

6/ The consequences of macroeconomic policies on the labor market indeveloping countries is certainly not well established at the theoreticallevel, and consequently there is also very little empirical evidenceavailable on this relationship.

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the cost, or a reduction in the availability, of credit; and (iv) the extent

to which the policy measures were anticipated at the time that currently

prevailing wage contracts were negotiated. 7/ To determine the aggregate

demand effects of monetary policy requires investigating both theoretical and

empirical validity of these factors.

B. Fiscal Policy

The effects of fiscal policy, whether through reductions in

government expenditures or increases in taxes, on aggregate demand and

absorption are much debated. Public sector spending on currently-produced

goods and services is itself a component of total domestic spending and this,

of course, represents its direct contribution to absorption. If government

purchases are limited to nontradable goods, they also represent an addition to

aggregate demand for domestic goods. Public sector spending on traded goods

will, however, only contribute to a worsening of the trade balance while

having no effect on real aggregate demand, or on output and inflation.

It is the indirect effects of public sector purchases that have

generated some controversy. At issue is the extent to which an increase in

public expenditure reduces or increases private spending, thus resulting in an

increase in total spending. There are a variety of mechanisms through which

private spending would fall as a result of increased public spending. For

example, increased public spending could raise domestic economic activity and

thereby the private sector's demand for money. If interest rates adjust to

7/ It has been argued by Lucas (1972), among others, that the greater theextent to which changes in monetary policy are anticipated by the privatesector, the smaller would be the effect on output. For a discussion ofthe applicability of rational expectations models to developing countries,see Corden (1985).

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maintain portfolio equilibrium, the higher interest rates associated with the

increased demand for money would, other things equal, tend to reduce the

aggregate demand. This is, of course, the familiar "financial crowding-out"

proposition. Even if interest rates do not adjust immediately, and portfolio

imbalances persist, the excess demand for money may cause households to

curtail spending in order to accumulate cash balances. 8/

Private spending can also be reduced if the increased public spending

gives rise to an equal tax liability for the private sector, either in the

present through tax financing or in the future due to the need to retire

public debt. This is the well-known "Ricardian equivalence" proposition

developed by Barro (1974). 9/ Finally, if nominal wages are flexible, or if

the increase in public spending was foreseen at the time wage contracts were

entered into, the domestic price level could rise sufficiently to reduce

private spending by an amount equal to the increase in public spending,

thereby leaving total real aggregate demand unchanged. 10/ The validity of

rational-expectations models relating public sector and private sector

expenditures has yet to be tested for developing countries, and the debate has

remained essentially on a theoretical plane. 11/

8/ See Khan and Knight (1981) for a model utilizing this type of effect.

9/ For a discussion of this effect in the context of developing countries,see Corden (1985).

10/ This "policy neutrality" result has come to be known as the Lucas-Sargent-Wallace (LSW) proposition; see Lucas (1972) and Sargent and Wallace(1975).

11/ Even the empirical evidence for developed industrial countries does notsuggest that changes in public sector saving are entirely offset byprivate saving.

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Tax receipts from the private sector have no direct effect on

absorption. They do, however, affect private disposable income and may

thereby have an indirect effect on private spending. The effect of a given

tax on private spending is likely to depend on whether the tax is viewed as

permanent or temporary (temporary taxes are expected to reduce saving), the

characteristics of the recipient which affect the marginal propensity to

consume out of current income (including demographic factors such as age and

household size), and the nature of the financial system (which will affect the

extent to which the taxpayers are liquidity-constrained). Transfers are

essentially the negative of taxes. Their effects on domestic absorption can

be expected to be the opposite of the effects of taxes described above.

Although domestic absorption is not directly affected, a transfer should

increase private absorption, though not necessarily total absorption. The

effect on the latter will depend on how the government finances the payments

of transfers.

In summary, the effects of fiscal policy on aggregate demand would

appear to be more complex than standard Keynesian macroeconomic theory would

suggest. At this stage it is debatable whether on balance a restrictionary

fiscal policy would reduce aggregate domestic demand and growth or not.

Ultimately, the issue is an empirical one and will accordingly require more

testing.

III. Structural Policies

Structural policies differ from demand-management policies in two

respects. First, they place more emphasis on growth rather than the control

of domestic demand and immediate improvement in the current account. In

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developing countries the goal of achieving more efficient resource allocation

and increased growth may sometimes conflict with that of reducing the current

account deficit in the short run. Since these countries import a large

proportion of capital goods, programs that place a greater emphasis on

structural measures frequently take a different view about the objectives

regarding the current account in the early years of the adjustment program

than do programs that aim primarily at reducing excess aggregate domestic

demand. In particular, to the extent that major adjustments in aggregate

domestic supply require an initial rise in the level of domestic investment,

reductions in current account deficits would not necessarily be sought in the

early years of the program.

Second, substantial time may be needed for structural policies to

show results. Major shifts in resource allocation may entail a significant

rise in fixed capital formation in expanding sectors, combined with the

release of capital and labor from contracting sectors. Such major adjustments

tend to occur slowly, so that the time frame for a program involving

structural measures has to be longer than one that focuses on reducing

aggregate demand.

Structural policies can take a wide variety of specific forms

depending on the economy in question and the types of problems faced by the

domestic productive sector. They can, however, be categorized under two broad

headings: policies to improve efficiency and resource allocation; and

policies to increase the level or rate of growth of capacity output.

A. Policies to Improve Efficiency and Resource Allocation

This category basically includes all types of measures to reduce

distortions that drive a wedge between prices and marginal costs. In a number

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of developing countries distortions are fairly pervasive in factor markets,

credit markets, and goods markets. The distortions can arise, for example,

from price, wage, and interest rate controls; imperfect competition; taxes and

subsidies; and trade and payments restrictions. The attractiveness of

policies designed to improve the efficiency with which scarce resources are

utilized lies in the fact that such measures can potentially increase the

output that can be produced from a given stock of resources without

necessarily lowering the level of current consumption. Nevertheless, attempts

to eliminate major distortions present certain practical difficulties. First,

if capital and labor are not mobile among different sectors of the economy,

changes in the patterns of relative prices and incentives may necessitate an

extended period of adjustment during which some factors, in particuLar labor,

may be unemployed. Second, many government policies that create distortions

may have been designed to achieve objectives other than economic efficiency.

These policies typically would include among others, employment programs,

consumer subsidies, price controls on essential commodities, and restrictions

on imports of luxury goods. Thus, political realities have to be recognized

when advocating changes based purely on efficiency grounds. Finally, the

theory underlying micro-oriented policy measures is not sufficiently developed

to be able to yield precise answers on the effects of such policies. For

example, well-known considerations associated with the theory of second best

suggest that if a country has a number of significant distortions, the

elimination of only some of them will not necessarily result in an overall

gain in efficiency and welfare.

By their nature, distortions tend to be both microeconomic and

country-specific. Nevertheless, two sources of inefficiency that have

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macroeconomic significance have gained importance in recent years, and

accordingly received considerable attention from researchers. First, there

are the inefficiencies that result from imposing artificial barriers to

foreign trade. Tariffs, quotas, and other restrictions on trade and payments

reduce the levels of trade and specialization, and tend to foster the

development of import substitute industries that often fail to attain the

degree of efficiency and flexibility shown by firms that are continuously

exposed to international competition. A number of studies (i.e., Balassa

(1982) and Krueger, et al (1981)), have shown that at the broadest level, the

countries adopting outward-looking development strategies have fared better in

terms of growth, employment, economic efficiency, and adjustment to external

shocks than those that have taken a more inward-looking approach to

development. The outward-oriented strategies have been typically

characterized, inter alia, by the provision of incentives for export

production and the encouragement of import competition for most domestically

produced goods. The relative success of outward-looking policies has led to

considerable efforts to encourage developing countries to liberalize their

trade systems. 12/

A second source of inefficiency in a number of developing countries

arises from controls on producer prices. For example, agricultural pricing

policies often cause the prices of agricultural commodities to deviate from

prices that would be established in competitive markets or prices in the

international markets. Such policies have a strong impact on the level and

12/ See Edwards (1984) and Krueger (1985) for a discussion of tradeliberalization in developing economies.

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allocation of agricultural production, and on consumption. In many developing

countries government marketing boards control the purchase of a major portion

of domestically-produced agricultural commodities. If the marketing board

attempts to increase its revenues (or reduce its losses) by holding the prices

it pays below world levels, this policy can act as a tax on output. This type

of tax creates disincentives both to domestic supply and exports, and can

result in an increase in imports and a drain on the government budget. In an

adjustment program, therefore, an initial upward adjustment in the prices

offered to domestic producers by the marketing board is frequently needed.

Indeed, there is now empirical evidence that suggests that pricing policies to

increase the return to producers would tend to stimulate the output of major

agricultural commodities, particularly in the longer term. 13/ Another

example in this area is pricing policies for energy and energy products.

Again if these prices are held below world market prices, the government has

to absorb the cost of subsidies in its budget. Aside from the budgetary

effects, a policy of subsidizing energy tends to slow down the shift to less

energy-intensive production techniques and patterns of consumption by not

providing the right incentives for efficient use of energy.

B. Policies to Increase the Rate of Growth of Capacity Output

The rate at which the aggregate potential supply of output can be

expanded depends, among other things, on decisions about the proportion of

current output to be invested in productive capital rather than consumed, as

13/ See Bond (1983).

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well as on the nature and quality of the capital stock being added. 14/ The

appropriate structural policies for this objective are those that tend to

favor investment and savings. As there is now general consensus that

investment in developing countries is largely constrained by the availability

of resources, policies that encourage public and private savings have to be

given a special importance in adjustment programs that emphasize growth. On

the public sector side this involves steps to improve the fiscal position,

while in the case of private savings the focus has to be primarily on interest

rate policies.

Interest rate policy is considered to have a significant influence on

the supply of (domestic and foreign) savings as well as the level and

composition of investment. 15/ In many developing countries the financial

systems are tightly controlled by the governments, with ceilings placed on

nominal interest rates. Under inflationary conditions such controls have

resulted in highly negative real rates of interest on domestic financial

instruments for extended periods. 16/ Consequently, real financial savings

have grown less rapidly than the real economy and disintermediation,

particularly in the form of development of parallel or curb markets in credit,

has been a serious problem. When such developments occur, they can severely

restrict the availability of real credit through the financial system and

14/ See Krueger (1986) for a discussion of the role of capital formation inthe growth and development process. See also Sen (1983).

15/ This view is generally referred to as the McKinnon-Shaw hypothesis; seeMcKinnon (1973).

16/ The real interest rate is defined as the nominal interest rate adjustedfor anticipated inflation.

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thereby inhibit the level and efficiency of investment. Since available

credits are often first allocated to large firms and state enterprises,

credits for small- and medium-sized firms and householders can be especially

limited and severely rationed, with the consequence that uneconomic projects

are undertaken at the expense of more efficient ones. To increase the

availability of real credit, interest rate policy could be used to encourage

the accumulation of domestic financial assets by offering holders of these

assets a sufficiently attractive return. At the same time, other structural

and institutional reforms could be undertaken to increase the general

efficiency of the financial system.

The above considerations indicate why raising real interest rates on

domestic financial instruments has to be a key element in adjustment programs.

In setting the level of nominal interest rates, considerable judgment must

therefore be exercised regarding the future course of inflation during the

program. Nonetheless, establishing the perception that holders of domestic

financial instruments will earn positive real returns that are to some degree

competitive with the real yields that can be obtained on comparable foreign

instruments is necessary in promoting balance of payments adjustment,

increasing foreign direct investment, and preventing capital flight.

Any changes in interest rates and other financial reforms, however,

must also be coordinated with the other policy actions that are a part of the

stabilization program. The experiences of a number of developing countries

with financial reforms suggests that this coordination is especially important

during the early phases of the stabilization program. In particular, certain

combinations of policies can potentially be a source of instability for a

financial system undergoing major structural change. Two examples appear

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particularly relevant in this context. First, it is crucial that the fiscal

accounts be brought under control to avoid the sharp changes in the flow of

funds in and out of the financial system. Second, interest rate policy has to

be coordinated with exchange rate policy to ensure that capital movements do

not destabilize the financial reform.

While most of the attention has been on the relationship between

savings (financial and real) and rates of return, there are other aspects of

savings behavior that have to be considered. One important issue is the

relationship between public and private savings, which was referred to earlier

in connection with the concept of Ricardian equivalence. If in fact public

and private savings are substitutes, then clearly an adjustment program that

called for increased public savings, as typically programs do, would cause a

reduction in private savings. In the limit, if the offset is complete, total

domestic savings may remain unchanged with the private sector reducing its

savings as the public sector improved its fiscal position. A second issue

relates to the the effects of capital inflows on domestic savings, both public

and private. If an increase in foreign savings, i.e., a rise in the current

account deficit, results in lower domestic savings then total resources

available to the country would be unchanged. 17/ In general, if the supply

curve for foreign financing is upward sloping, the level of domestic savings

(and investment) will depend directly on the amount of foreign savings the

country can generate. Even though such offsets are unlikely to be complete in

reality, care has to be taken to ensure that other policies, such as increases

17/ The net effect on national savings would obviously depend on the extent towhich foreign and domestic savings are substitutes.

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in real rates of return and improvements in the availability of savings

instruments, are able to compensate for the possible negative effects of

public and foreign savings on domestic private savings.

Despite the importance attached to private investment in the

adjustment process, there is a serious lack of understanding of the factors

that influence investment decisions in developing countries. Although in

recent years a broad consensus has emerged on the forms of several key

macroeconomic relations in developing countries -- such as the aggregate

consumption function, money demand, imports, and exports -- no such

convergence of views is apparent in the case of private investment. The

theoretical literature on investment is quite rich and has yielded a well-

defined class of models, generally of the flexible accelerator type. There

is, however, quite a large gap between the modern investment theory and the

models that have been specified for developing countries. Because of

institutional and structural factors present in most developing countries,

such as the absence of well-functioning financial markets, the relatively

large role of the government in the capital formation process, distortions

created by foreign exchange constraints, wage rigidities, and other market

imperfections, the assumptions underlying the standard optimizing investment

models typically are not satisfied in those countries. As such, the standard

models have to be adapted to allow for the structural features of developing

countries, but this has not been an easy task in general. 18/ What is needed

in particular is a clearer idea of the theoretical and empirical links between

18/ See Blejer and Khan (1984) for a discussion of the issues and an attemptto specify a model that takes such factors explicitly into account.

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policy variables and private capital formation so as to evaluate the influence

that government can exercise over private investment decisions that change the

current and future growth rate of the economy.

Assuming that measures are implemented that are successful in raising

investment, what would be their impact on growth? This question can be

addressed by formulating a growth model that relates the rate of growth of

output to increases in various factors of production, such as the capital

stock (of both domestic and foreign origin) and the labor force, as well as

technical progress and the use of imported inputs. Attempts at this type of

analysis have only been partially successful. One of the problems is that the

identifiable factors listed above are only able to account for a relatively

small proportion of the variation in growth rates over time or across

countries. There is a large unexplained source of growth remaining, which

could reflect efficiency changes in investment, changes in human capital

(education, skills, and health), or exogenous events. What precisely these

factors are, and whether they can be influenced by government policies, is a

task that will undoubtedly occupy macroeconomic researchers.

IV. Exchange Rate Policies

Exchange rate action to improve international competitiveness and

increase the incentive to produce tradable goods is often the centerpiece of

any adjustment effort. Since devaluation, in the terminology of Johnson

(1958), is simultaneously an expenditure-reducing and expenditure-switching

policy, it affects both domestic absorption and domestic supply, and thus

contains elements of both demand-side and structural policies.

- 21 -

The basic demand-side and supply-side aspects of devaluation have

been discussed extensively in the literature. 19/ Consider, for example, a

situation where excess real domestic demand shows up in a current account

deficit. A devaluation increases the level of foreign prices measured in

domestic currency terms and thus the price of tradable goods relative to

nontraded goods in the domestic economy. On the demand side, the effect of a

devaluation on domestic absorption is unambiguously negative: the main

demand-side effects are a reduction in private sector real wealth and

expenditure, owing to the impact of the rise in the overall price level on the

real value of private sector financial assets, and on real wages and other

factor incomes, of which nominal values do not rise proportionally with the

devaluation. For these reasons, devaluation decreases domestic demand and

reduces current absorption.

On the supply side, however, the effects of the devaluation tend to

move output in the opposite direction. If the prices of (variable) domestic

factors of production rise less than proportionately to the domestic currency

price of final output in the short run, devaluation will have a stimulative

impact on aggregate supply. 20/ Thus both the aggregate demand and aggregate

supply effects of a devaluation work toward reducing the excess demand in the

economy and the current account deficit. Whether total output rises or falls

during this process obviously depends on whether the contractionary effects on

aggregate domestic demand are outweighed by the supply-stimulating aspects of

this policy. This depends, among other things, on the relative sizes of the

19/ See, for example, Cuitian (1976) and Dornbusch (1981).

20/ For a discussion of the supply-side aspects of devaluation, see Khan andKnight (1982), (1985).

- 22 -

price elasticities of imports and exports, on the relative shares of tradable

and nontradable goods in total production, and on the other policies that are

adopted at the same time.

The above analysis is, of course, very standard, but it does

highlight the importance of getting the "right" real exchange rate in the

adjustment process. However, although exchange rate action may be the obvious

way to correct a misalignment of relative prices and thereby improve

international competitiveness, there are still a number of difficult

theoretical and empirical issues involved. Here we consider four such issues,

namely: (a) determination of the degree of overvaluation, and therefore the

size of the real depreciation required; (b) achieving the target value of the

real exchange rate; (c) determination of the effects of a change in the real

exchange rate; and (d) the exchange rate regime or exchange rate rules that

the country should adopt.

A. Determining the Extent of Exchange Rate Adjustment

Ascertaining the "equilibrium" exchange rate against which the

current rate is compared, and thus the extent of the required devaluation, has

proved to be a fairly intractable problem, even for developed countries with

sophisticated financial systems, well-developed forward markets for

currencies, and few distortions in foreign trade and payments. Consequently,

in the case of developing countries it has become common practice to base

judgments on the appropriateness of the exchange rate at least in part on

Purchasing Power Parity (PPP) calculations, such as indices of real exchange

rates based on some combination of export and import weights. However, these

indices are only suggestive and can be useful when domestic rates of inflation

have been considerably higher than-those abroad. One should generally be

careful in attaching an excessive degree of importance to small changes in

- 23 -

such indices. The use of a PPP-based index to judge the appropriate level of

exchange rate requires an assumption that some past level of the rate was

correct and then setting up that past level as a target. The size of the

required devaluation is then determined by the difference between the target

and actual values of the real exchange rate. However, it should be remembered

that the choice of the target rate can be quite arbitrary, and thus subject to

error.

The question of the appropriate real exchange rate is made more

difficult once it is recognized that it is an endogenous variable that

responds to a variety of factors. For example, as shown by Khan (1986),

exogenous foreign shocks such as worsening of the terms of trade, an increase

in foreign real interest rates, or a slowdown in the growth rates of partner

countries, will all tend to depreciate the long-run real exchange rate.

Similarly, domestic supply shocks will alter the equilibrium real exchange

rate. Consequently, the "right" real exchange rate is conditional on the

state of the world, and in any realistic setting, changes in the latter are

likely to occur. In judging the appropriateness of the level of the real

exchange rate these factors affecting its long-run behavior have to be taken

into account.

B. Policies to Achieve a Target Real Exchange Rate

Having determined the appropriate level of the real exchange rate,

either through PPP calculations or through some more sophisticated model-based

approach, it is then necessary to choose a set of policies that would achieve

this target. Clearly a nominal devaluation by itself would not be

sufficient. It is well known that in the absence of supporting policies that

limit the increase in domestic prices, a nominal devaluation will only have a

transitory effect on the real exchange rate. In the long run, domestic prices

- 24 -

will rise by the full amount of the devaluation and the real exchange rate

will return to its original level. Broadly speaking, therefore, any

sustainable real exchange rate change requires policies to restrain aggregate

demand and factor costs. The extent to which a devaluation will affect the

real exchange rate, as well as the length of time over which the effects

persist, are a direct function of the supporting policies -- fiscal, monetary,

trade, and wage policies -- that are put in place.

To calculate the effects of a devaluation on the real exchange rate

requires in the first instance information on substitution elasticities

between tradable and nontradable goods in consumption and production and the

share of tradable goods in total expenditure. 21/ This, however, is only the

first-round effect which will only be sustained if supporting policies are

implemented. To determine the long-run value of the real exchange rate

requires detailed specification of these other policies. Without such

information the level of the real exchange rate, for a given nominal

devaluation, could not be predicted with any certainty.

If it is established that the alignment of relative prices is

inappropriate, say because the existence of an unsustainable current account

balance, it is possible to correct this situation, in principle, through

policies other than exchange rate adjustment. In general, however, the latter

is likely to be a much simpler way of achieving the correct alignment than are

deflationary policies designed to force down domestic prices and wages, which

21/ A limiting case is when prices of nontradable goods are constant. Theimpact of a devaluation on domestic prices is then simply the product ofthe exchange rate change and the share of tradable goods in expenditure.The depreciation of the real exchange rate would, therefore, be equal tothe nominal devaluation adjusted for the resulting increase in domesticprices.

- 25 -

in most countries tend to be resistant to downward changes without substantial

falls in output and employment.

C. Effects of Exchange Rate Changes

One of the standard criticisms against devaluation as a policy of

adjustment is that it tends to induce stagflation and increases

unemployment. 22/ As mentioned previously, whether a devaluation exerts a net

contractionary or expansionary effect on domestic output and employment

depends on the relative strengths on the effects it has on aggregate demand

and aggregate supply, and the time period in question. As long as devaluation

succeeds in altering the real exchange rate by raising product prices in

domestic currency relative to factor incomes, it should exert a stimulative

effect to the extent that the short-run marginal cost curves of the relevant

(tradable goods) industries are upward sloping. Naturally, the longer a real

exchange rate change persists, the larger are the gains to be achieved.

Furthermore, if the wealth and distributional effects of devaluation stimulate

savings and investment, a long-run gain of increased potential output will

likely be realized.

Despite the controversy surrounding the output and employment effects

of exchange rate policy, there is surprisingly little empirical evidence

available on the subject. 23/ Furthermore, the relatively few studies

examining this question yield mixed results. Basically, the direction and

magnitude of the growth effects depend on such issues as the extent and

duration of the real exchange rate change, the structure of production, and

22/ See, for example, Diaz-Alejandro (1965), Cooper (1971), Krugman and Taylor(1978), and Hanson (1983).

23/ See, for example, the studies described in Khan and Knight (1985).

- 26 -

the responses of trade flows to relative price changes. If devaluation does

alter the sectoral distribution of income, as it is designed to do, it will

not be completely costless to some sectors. On the other hand, no strong

empirical evidence can be brought forward to support the proposition that

devaluation necessarily reduces the overall growth rate and increases

unemployment. Given the state of empirical knowledge it would be dangerous to

draw strong conclusions one way or the other. Of more relevance are the

short-term and long-term effects that devaluation has on trade flows, and here

the empirical evidence points to the existence of relative price elasticities

that satisfy the Marshall-Lerner conditions. What needs exploring is whether

the result carries over to the case where imported inputs are important in the

export production process and where imports are constrained by foreign

exchange availability.

D. Exchange Rate Systems and Regimes

Unlike the developed industrial countries there are very few

developing countries that operate a freely-floating exchange rate system.

Most either maintain fixed parities or follow some type of crawling-peg

rule. 24/ While there may be advantages to maintaining a fixed peg, such a

system also has a number of disadvantages which have been dealt with at length

in the literature. One of these drawbacks is that the policy leaves a country

vulnerable to speculative attacks and may result in exchange rate crises if

the authorities are unwilling to alter the peg. 25/

24/ The 1985 Annual Report of the IMF lists 50 developing countries as havingfixed pegs to a single currency, 38 as pegged to a currency composite, 29that follow an exchange rate rule, and only 7 countries are classified asfloating.

25/ See, for example, Blanco and Garber (1986).

- 27 -

At the other extreme from countries with fixed exchange rates are

high-inflation countries where continual exchange rate adjustment is built

into the economic system. Indeed, exchange rate changes can be regarded in

some cases as merely a particular type of indexation. For these countries,

the key decision is at what rate the domestic currency should be depreciated;

this depends on a number of considerations, especially the policies being

simultaneously carried out with respect to the interest rate, fiscal policy,

and domestic credit expansion. Recently some writers have questioned the use

of exchange rate rules, arguing that they increase fluctuations in output or

increase domestic inflation, and thus are inconsistent with macroeconomic

stability. 26/ Also at issue is how and when rules that are designed to keep

the real exchange rate constant, or slowly depreciate over time, should be

changed when circumstances dictate.

Confronted with persistent balance of payments problems, some

countries have resorted to a dual exchange system as an alternative to a

uniform exchange rate adjustment. Under the dual system, certain selected

transactions take place at an official exchange rate, which is maintained by

official intervention, while the remaining transactions take place at a

generally more depreciated ("free" or "parallel") exchange rate, which is

usually determined by market forces. Dual exchange markets have not always

been successful in achieving the objectives that motivated their adoption. In

particular, they have been largely ineffective in preventing speculative

capital flows from affecting international reserves, as uncertainties

concerning the viability of the official exchange rate have generally produced

leads and lags in imports and exports in the official market. Similarly, the

26/ See, for example, Dornbusch (1982) and Adams and Gros (1986).

- 28 -

large differentials that often arise between the free and the official

exchange rate have motivated the over-invoicing of imports and the under-

invoicing of exports in the official market, thus contributing to a further

erosion of international reserves. In addition, dual exchange rates are

equivalent to a series of implicit subsidies and taxes that may work against

some of the objectives of the country. For example, commodities that receive

export promotion incentives are sometimes assigned to the official market,

thus implicitly taxing their export and defeating the initial purpose of

export promotion. In summary, there is a need to study the workings of dual

exchange rate systems in more detail to determine the reasons why they have

not survived, and what lessons can be learned from the experiences with such

systems.

V. External Financing Policies

It is generally thought that as developing countries face a scarcity

of capital they should be net foreign borrowers during the development

process. This idea has been formalized in a number of studies showing that

countries can attain a desirable growth path by supplementing domestic savings

with foreign savings. The rate at which they borrow abroad, or in other words

the "sustainable" level of foreign borrowing, depends on the relationships

among foreign and domestic savings, capital formation and growth. The main

lesson of the "growth with debt" literature is that country can and should

acquire foreign savings (in the form of net imports of goods and services) as

long as this provides the basis for paying the required rate of return to the

supplying country over the time period during which the resources are made

available. 27/ The justification for paying this rate of return is usually

27/ See the useful survey by McDonald (1982).

- 29 -

thought of as the increased output made possible by the additional real

capital that can be accumulated with the aid of net foreign savings. 28/

Theoretically it is possible to calculate the sustainable level of

net resource transfers, based, for example, on information on the nature of

the constraints on the supply of foreign loans and the availability over time

of new loans that vary both in terms and maturity, but in practice this is a

nearly impossible task since such information is not often available. 29/

Consequently it is thus necessary to make approximations to the relationship

between debt and the capacity to service debt through calculating ratios of

debt to exports or debt to GNP. However, it is very difficult to determine

the "sustainable" level of such ratios. If a country can profitably employ a

stock of foreign savings that is large relative to domestic savings, it

follows that its debt to exports ratio will be high relative to a country that

has a lesser capacity to profitably utilize foreign savings. The equilibrium

level of such ratios will thus vary from country to country and for a given

country over time.

The main practical value of the existing empirical measures is that

they can provide signals to the danger of situations in which debt can grow

28/ It might also be optimal for countries to utilize external debt to smoothconsumption over time in the face of various internal and external shocks.A more general criterion would be that the pattern of distribution ofworld savings should be welfare enhancing. See Williamson (1973).

29/ Furthermore, any such calculation is by definition conditional on theassumptions of the future path of the interest rate on existing and newdebt. What might be considered sustainable at a given interest rate mayprove to be unsustainable if the interest rate should rise above theassumed value. Since most commercial debt carries a floating interestrate, calculations based on some fixed rate are bound to be onlyconjectural at best.

- 30 -

explosively. If additional external debt increases investment income payments

by more than it increases the capacity to make such payments, this must be

reversed through net exports of goods and services. If it is not, additional

debt will be incurred in order to make payments, and the stock of foreign debt

will grow faster than debt service capacity. A convenient way of stating this

condition is that the real interest rate paid on additional debt must be less

than or equal to the expected growth in the volume of exports. 30/

While it may be difficult to see the relationship between empirical

indicators for debt capacity and the criteria for foreign borrowing that

emerge from the theoretical literature, there are nevertheless circumstances

in which the proxies are useful. For example, an unexpected rise in the

external real interest rate can make the payments associated with existing

debt excessive relative to the outlook for a country's debt service

capacity. Moreover, a country's debt service capacity could deteriorate

because of unwise domestic policies that reduce the expected return of foreign

borrowing in terms of export capacity. Finally, less favorable external

factors such as slow growth in trading partners or adverse changes in the

terms of trade could introduce the possibility of explosive growth of debt.

Therefore, the theory of real resource transfers is probably most useful as a

warning in circumstances where concepts such as debt to GNP, debt to exports,

or debt-service ratios are changing or are expected to change rapidly. Such

possibilities would call into question the sustainability of the country's

external position.

30/ Strictly speaking, this result assumes that the rate of growth of importsis less than or equal to the rate of growth of exports.

- 31 -

In recent years the sharp decline in the availability of foreign

financing has created difficult adjustment problems for a large number of

developing countries. When private creditors have already determined that the

sustainability of the country's position is doubtful, the short-term outlook

for the current account is constrained since only official financing may be

available. In this case, to the extent that the country cannot influence

official capital flows, the short-run adjustment path for the current account

is largely determined by forces outside the control of the adjustment program.

The issue remains, however, as to what policies (perhaps involving debt

reduction relative to domestic output for some interval) will allow a quick

and relatively costless eventual return to a normal growth path for debt.

The theory of "growth with debt" is not well-suited to guide policy

during such transition periods. 31/ The obvious solution is that the

necessary adjustment should be accomplished at the minimum cost in terms of

loss of output, but this is obviously not an easy task. One practical

consideration is that imports should not be compressed below the level which

causes an unnecessary reduction in the rate of economic growth and, to the

extent that exports require imported inputs, the growth of exports. It should

be recognized, however, that there may be little room to maneuver where

credits from private sources are no longer available. Official financial

assistance obviously plays an important role in these circumstances, and an

adjustment program can also advance the time in which the country's access to

the international capital markets and thus to foreign savings is restored.

31/ For a discussion of some of the issues that arise, and the policies thatmay be implemented, see Selowsky and van der Tak (1986).

- 32 -

In discussions of capital flows in the context of developing

countries attention has focused almost exclusively on foreign borrowing by

these countries. Recently some advances have been made to analyze the other

side of these flows, namely the acquisition of external claims by residents of

developing countries. 32/ The interest has been triggered because of what has

been termed the phenomenon of "capital flight." It has been argued by some

studies that the outflow of capital has caused serious economic difficulties

for developing countries. For example, Cuddington (1985) and Dornbusch (1985)

contend that capital flight in a number of countries has caused the build-up

of gross foreign debt, an erosion of the tax base, and to the extent that

there was a net real transfer of resources from the countries, a reduction in

investment and growth.

Since the available estimates of capital outflows from debtor

countries are surprisingly large, it stands to reason that capital flight is

of concern to policymakers in these countries as well as to international

institutions. If increases in foreign debt in the past merely financed

capital flight rather than productive investment, then what is to prevent

future lending from leaking out in the same way? Furthermore, following from

the first question, what policies if any, can be enacted to prevent a

repetition of large scale private capital outflows from debtor countries

facing acute financing needs?

While there is some theoretical support for the notion that expected

devaluations and interest rate differentials drive capital abroad, in general,

the effects of changes in the macroeconomic environment on preferences for

32/ See, for example, Cuddington (1985), Dooley (1985), Dornbusch (1985), andKhan and Haque (1985).

- 33 -

where wealth is held are not that straightforward. A change in the

macroeconomic environment will generally be recognized by both residents and

nonresidents at the same time, limiting the incentives for trade between these

groups of investors. Some market imperfection is usually needed in order to

predict changes in the location of investments. For example, in the case

where a government is supporting an unrealistic exchange rate and where there

are no opportunities for the private sector to acquire domestic securities

denominated in foreign currencies, private capital outflows would be

expected. In this case the "difference of opinion" between the government and

the private sector (both resident and nonresident) will lead to a change in

the preferred location of investments.

In addition to the macroeconomic causes behind capital flight, there

are a whole host of incentives that may affect the decisions of investors on

where and in what form to hold their wealth. The key to these "micro"

incentives is the actual and expected taxes, subsidies, and controls that

various governments impose on holdings of wealth within their jurisdiction.

For example, countries that have taken over large debts have a clear need to

generate revenue. To the extent this is likely to fall on investment income,

residents will attempt to find a tax haven outside the country. The effort to

impose a differential tax on investment income will be very counterproductive

since revenue can very rapidly fall to zero as the tax base shrinks.

Of course, it should be recognized that it is highly unlikely that

the government will be able to prevent all private capital outflows even in

the best of circumstances, since many of the causes are well beyond its

control. What the authorities can do is to try and change existing

incentives, both macro and micro, in the economy to minimize the amount of

capital flight, and thus direct more resources, both domestic and foreign,

- 34 -

towards expanding the productive base of the economy, and increasing its

current and future debt-servicing capacity.

VI. Conclusions

This paper has had a twofold purpose: first, to identify the

policies that would be called for to achieve macroeconomic adjustment, and

second, to describe the links between these policies and the ultimate

objectives of an improvement in the balance of payments, a reduction in

inflation, and an increased rate of economic growth. The resulting package

would be a fairly complex mix of policies designed to simultaneously reduce

aggregate demand and increase aggregate supply and the production of tradable

goods. As has been shown in this paper, the links between policies and the

ultimate objectives are equally complex and there are large gaps in knowledge

on both the theoretical and empirical fronts.

The set of policies considered here would be broadly acceptable to

most economists concerned with the issue of macroeconomic adjustment in

developing countries. For example, in one of the few concrete expositions of

an adjustment strategy, Diaz-Alejandro (1984) describes a policy package that

contains many of the same elements as described in this paper. Considering

the case of a country that has an unsustainable balance of payments deficit

and high inflation, Diaz-Alejandro (1984) proposes that the policy package

should contain the following: fiscal and monetary restraint to reduce

aggregate demand; elimination of distortions; incomes and wage guidelines; a

gradual liberalization of imports; provision of incentives for exports; a

crawling-peg exchange rate regime, with emphasis on undervaluation of the real

exchange rate to support export promotion and import liberalization; and

positive real interest rates to encourage savings. The "real economy"

- 35 -

approach advocated by Killick and others (1984) is yet another example of a

specific set of proposals for adjustment that is quite consistent with the

package described here. This real economy approach basically emphasizes

structural policies at the sectoral level, in addition to demand-oriented

policies.

While there may be agreement on the policy measures to be

implemented, there is certainly a lack of consensus on how these policies work

to achieve the principal goals. This is specially true in the case of policy

measures that are essentially microeconomic in nature but have macroeconomic

implications. It has to be recognized that the analytical basis for a number

of micro-oriented policies typically included in an adjustment program is

relatively weak. The theory underlying the effects of eliminating distortions

(real and financial) is not well-suited to policymaking as it very quickly

gets into welfare-related issues. For example, whether the removal of

consumer subsidies or a devaluation raise overall efficiency and production,

when there are significant distortions in the economy, or not, are still very

much open questions.

Even on the macroeconomic front there are serious theoretical and

empirical issues that are still up in the air. For example, as pointed out in

this paper, both the direction and size of the effects of fiscal policy on

aggregate demand are ambiguous. The subject of devaluation in a developing

economy is yet another important example of which existing analysis does not

yield definitive conclusions. The available literature gives only a limited

amount of information on the important policy questions of precisely how a

devaluation is expected to work, how to determine the size of the required

depreciation, and whether a nominal depreciation can alter the real exchange

rate sufficiently to generate a shift in resources between sectors. A third

- 36 -

example is the issue of savings and resource mobilization. Since raising

private savings is a key element in programs emphasizing long-term growth, it

is crucial to establish the theoretical and empirical links between private

and public savings, interest rates, and exchange rate policies. Finally, and

perhaps most importantly, there is still much to be learned about the factors

.hat drive growth in developing countries, and in particular of the

relationship, or trade-off, between short-run stabilization and long-run

growth.

Many of these questions will clearly have to be answered through

concerted empirical analysis. Even when the theoretical underpinnings of the

relevant relationships are clear-cut, it has to be stressed that economic

theory provides a guide only to the basic equilibrium relationships, and does

not provide information on how long it takes for a change in an exogenous

variable or policy instrument to have an impact on the endogenous variable.

Such questions concerning dynamics and lags in adjustment obviously have to be

approached from an empirical standpoint, and thus empirical analysis will be

crucial in the design of an adjustment package. Furthermore, in many

instances comparisons of alternative models may prove necessary to decide

which are the more appropriate to form the basis of the policy package.

This paper has provided only very general guidelines on the type of

measures that should be included in an adjustment package. The issues of the

appropriate mix of demand-management, structural, exchange rate, and external

financing policies, and the sequencing of these policies, which are basic from

an operational point of view, were not directly addressed. An analysis of

these issues would require in the first instance detailed theoretical and

empirical knowledge of the relationship between policies and the ultimate

objectives. However, this would not in itself be sufficient since the ways in

which policies are combined depends on a number of other factors. These

- 37 -

include, among others, the relative weights assigned to objectives of the

program. If, for example, an improvement of the current account is considered

a higher priority, more stress would be given to demand-management and

exchange rate policies. On the other hand, the achievement of higher medium-

term growth would call for more emphasis on structural policies. Equally

important in the decision about the mix of policies would be the initial

conditions, such as the external payments situation, the outstanding stock of

foreign debt, the rate of inflation, and the level and growth of per capita

income, when the program is implemented. The time period over which

adjustment is to be achieved also has an obvious bearing on the choice of

policies to be undertaken. Since structural policies generally act with a

lag, the longer the time horizon of the adjustment the easier it would be to

utilize such policies. Finally, the choice would be dictated by the

structural and institutional characteristics of the country in question. For

example, in countries where indexation is important and inflation has become

ingrained in the system, policies directed towards restraining aggregate

demand may be very costly in terms of output and employment. All these

factors argue strongly for the tailoring of adjustment programs to the

circumstances of the individual country.

Nevertheless, it is crucial to have an analytical framework which can

be adapted to the particular country undergoing adjustment. Only then would

it be possible to predict the effects of alternative combinations of policies

on the important macroeconomic variables in the system. The advances in

macroeconomic theory for developing countries have been significant in recent

years, but as this paper has tried tolshow, there are large number of issues

in the area of macroeconomic adjustment, and the policies to be applied to

this end, that are as yet unresolved.

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