Macroeconomic StabilityPesewa

Presentat ions

Macroeconomic Stability

• This is the cornerstone of the so-called Washington consensus

• According to this view macroeconomic stability is a pre-requisite for economic growth.

• So countries undertaking economic reform should first stabilise the macroeconomy before undertaking other policies to improve competitiveness, privatise state owned enterprises and so on?

What do we mean by the macroeconomy?

• The macroeconomy refers to the aggregate economy. The sum of the value of goods and services, expenditure and payments to factors of production.

• It can be measured on the production side: when it is sum of agriculture, services and industry. The latter is composed of manufacturing, mining and construction

It can also be measured on the expenditure side

• It is the sum of:• Private Consumption• Private Investment• Final government consumption and investment• Exports

• MINUS imports (as it is already counted above).

It can also be measured by payment to factors of production

• Wages and salaries• Dividends• Other profits• Rents • Interest payments

• All of the 3 methods should give the same figure: GDP or GNP.

Fluctuations in GDP or GNP

• When it goes up: boom• When it goes down: recession• Investment fluctuates more than consumption• Developing countries see bigger recessions

compared to developed countries

So what is macroeconomic stability?

• The old Keynesian view (after John Maynard Keynes) is that it is output that ought to be stabilised.

• This really meant that a goal of full employment should be pursued.

• But the monetarist or Washington consensus view is that it is inflation that should be controlled.

What is inflation?

• We all know that prices go up?• But inflation is a general rise in all or most

prices.• It is measured by indices such as the retail

price index (RPI) or the consumer price index (CPI).

The monetarist or Washington Consensus view

• It is that you cannot effect output and employment using the tools of macroeconomic policy.

• Attempts to do so will lead to inflation accelerating.• This will seriously destablise the economy, causing

capital flight and loss of confidence in the currency. • Furthermore, there is no long-run inflation-output

tradeoff.

So what should be the goals of macroeconomic policy?

• First and foremost: the control of inflation.• Secondly overall fiscal or budgetary stability (not

referring to any particular tax). • Maintaining balance of payments equilibrium via

sound exchange rate policies. • Economic growth will come from sound

microeconomic policies such as investment in infrastructure and education, provided that macroeconomic stability has been attained.

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Consider the three cornerstones of macroeconomic stability: Inflation

• The old view of Milton Friedman is that “inflation is always and everywhere a monetary phenomenon”.

• So controlling inflation is about restricting the supply of money.

• The money supply can be controlled either via altering interest rates (the price of money) or through some restrictions on the quantity of money. The latter can be tricky because of monetary innovation and choosing the appropriate monetary aggregate to control.

• But the money supply or aggregates also depend on the overall budget size and exchange rate policies.

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Fiscal Policy

• This refers to the overall budget and not particular taxes.

• The government may have a budget surplus, which means that revenues exceed expenditure. Or conversely it may have a deficit.

• For example, the Maastricht treaty on European currency union specified that no country should have a budget deficit in excess of 3% of GDP.

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Revenues and Expenditure

• Revenues to the state are mainly from taxes: income and corporation taxes, direct taxes: and indirect taxes (VAT, excise taxes, trade taxes).

• Expenditures are on the current account such as transfer payments (pensions and social security spending) plus the costs of running the military, health and education systems.

• Expenditures can also be on the capital account: building schools, hospitals, bridges, roads etc.

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Financing budget deficits• The mode of financing the budget deficit is important.• By borrowing from the domestic and international capital

markets. Most non-emerging developing countries cannot really borrow from abroad.

• Via open market operations: really borrowing from the central bank.

• By printing money: seignorage. Very inflationary. Unsustainable.

• All of the above have implications for inflation as some part of the money supply increases due to budget deficits.

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Borrowing• Borrowing from domestic and foreign sources to finance

current deficits can lead to the accumulation of the stock of debt.

• Cumulative budget deficits raise the stock of debt.• This stock of debt has to be serviced: interest payments have

to be made and some of the principal repayed.• This is a burden to taxpayers. Future generations have to

repay current debt.• The Maastricht treaty, for example, restricts the total size of

the national debt stock to 60% of GDP.• Generally, budget deficits in excess of the growth of the

economy are unsustainable.15

Exchange Rate policy

• This is mainly about the balance of payments.• The balance of payments has two components.• The current account which is composed of the

difference between exports minus imports of both goods and services plus net debt servicing.

• The capital account which includes net capital inflows, other factor income plus development aid.

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The aim of exchange rate policies is to maintain some degree of balance of

payments equilibrium. • If the balance of payments is excessively in deficit

then they are problems. • Notice that a current account deficit may be financed

by a capital account surplus and vice versa. • The country may simply run out of foreign exchange

reserves with which to finance the deficit.• More importantly, it may be running up international

debt by borrowing to finance its deficit.17

Exchange rate types and adjustment mechanisms

• Fixed exchange rates: this means that the exchange rate is fixed or pegged. Deficits mean a loss of foreign exchange, and surpluses a build-up of reserves.

• Flexible exchange rates: the exchange rate changes in response to market excess demand or supply. This means that surpluses cause the exchange rate to appreciate and balance of payments deficits cause the exchange rate to depreciate

• In reality exchange rates are never of the above polar type: managed floats means that sometimes the authorities allow the exchange rate to follow market forces, sometimes they intervene to prevent its slide or upward movement. Also there are systems known as crawling pegs: exchange rates can fluctuate inside a certain band.

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Balance of payments problems.

• These are known as external (im)balance.• One view is known as the absorption approach: if

income exceeds expenditure then there is a surplus. Deficits imply the opposite reasoning. This view emphasises the current account of the balance of payments.

• Another view is that the exchange rate is the relative price of foreign to domestic money. This view highlights the capital account. Exchange rate movements reflect the relative attractiveness of domestic to foreign money and assets.

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Policies for External Balance

• Monetary policy• Fiscal policy• The above two are specially relevant when

speculative capital is mobile across countries.• Devaluation of the currency under fixed exchange

rates. If successful this is an expenditure switching policy towards home goods. Imports more expensive at home, exports cheaper abroad in foreign currency.

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Debt Crises

• Many developing countries are bedevilled by international debt servicing.

• In some cases they have to export a lot, and a major portion of these export revenues go towards servicing debt.

• International debt has two causes: because of borrowing from commercial banks (the 1980s debt crisis) and because of foreign aid some of which takes the form of loans.

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Fiscal or Budgetary policy in the open economy.

• This is due to the famous Mundell-Fleming result. In the presence of short-term speculative capital flows. Fiscal policy alters the interest rate.

• Fiscal policy works under fixed exchange rates because it leads to changes in the money supply in the same direction.

• Fiscal policy fails under flexible exchange rates because it alters the exchange rate in the opposite direction.

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Monetary Policy• Again due to the famous Mundell-Fleming result. In

the presence of short-term speculative capital flows. Monetary policy alters the interest rate.

• Monetary policy fails under fixed exchange rates because it leads to changes in the money supply in the wrong direction. No independent monetary policy possible for small nations.

• Monetary policy is effective under flexible exchange rates because it alters the exchange rate in the right direction.

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Washington Consensus

• The Washington Consensus or monetarist views hold sway in the IMF and the World Bank, even elsewhere in Finance Ministries.

• It was the intellectual basis for structural adjustment policies.

• There is some loosening of these views due to the poverty impact of structural adjustment.

• Also because of a belief in supply side policies related to education and infrastructure.

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Questions for discussion

• Is macroeconomic stability a pre-requisite for sound growth in the economy and attracting investment from abroad?

• Is devaluation always going to make exports more competitive abroad and be good for the economy?

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