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Public Disclosure Authorized THEWORLD BANK ERS6 DiscussionPaper Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized DEVELOPMENT POLICY ISSUES SERIES Report No. VPERS6 Macroeconomic Adjustment in DevelopingCountries: A PolicyPerspective Mohsin S. Khan August 1986 Office of the Vice President Economics and Research The views presented here are those of the author,and they should not be interpretedas reflectingthose of the World Bank. MACROECONOMIC ADJUSTMENTIN DEVELOPINGCOUNTRIES: A POLICY PERSPECTIVE by Mohsin S. Khan August 1986 The author is Chief, MacroeconomicsDivision, DevelopmentResearch Department, World Bank, on leave from the InternationalMonetary Fund. The author is grateful to Willem Buiter, Mansoor Dailami, Indermit Gill, Nadeem U. Haque, Malcolm Knight, Anne Krueger, Ricardo Martin, Costas Michalopoulos,and Peter Montiel for helpful comments and suggestions. for the viewsexpressedherein The WorldBank does not acceptresponsibility whichare thoseof the author(s)and shouldnot be attributedto the World Bank or to its affiliatedorganizations.The findings,interpretations, and conclusions are the resultsof researchsupportedby the Bank; theydo not necessarily representofficialpolicyof the Bank. The designations employed, the presentation of material,and any maps used in this documentare solely for the convenience of the readerand do not implythe expressionof any opinionwhatsoeveron the part of the WorldBank or its affiliatesconcerning the legalstatusof any country,territory, city,area, or of its authorities, or concerningthe delimitations of its boundariesor nationalaffiliation. Abstract Broadly speaking, a comprehensivemacroeconomicadjustmentprogram is expected to have the following objectives: a sustainablecurrent account position, a stable and high rate of economic growth that would allow for a steady rise in per capita consumption,a reduced rate of inflation,and a manageable level of foreign debt. Given these multiple objectives,the package that is designed would typically include a variety of policy measures that simultaneouslyrestrain aggregate demand and increase the availabilityof resources. These policies may be grouped as follows: demand-management policies; structuralpolicies; exchange rate policies;and external financing policies. The purpose of this paper is to describe how these policies can be expected to achieve the goal of macroeconomicadjustment. The focus is primarily on the theoreticaland empirical links between policy instruments and the ultimate objectives. An examinationof these links is necessary before issues of the appropriatemix of demand-management,structural, exchange rate, and external policies, and the sequencingof these policies in a program, can be properly addressed. Table of Contents Page No. I. II. III. Introduction ............................ I Demand-Management Policies ...... 5 ............................ A. Monetary Policy ........................................ 6 B. Fiscal Policy 9 Structural Policies A. ........................................ Policies to Improve Efficiency and Resource Allocation B. 11 ........................................ ......... ... *.... ... *... ... ... . Policies to Increase the Rate of Growthof Capacity Output ......................... IV. Exchange Rate Policies A. B. V. VI. 12 15 20 ...................................... Determiningthe Extent of Exchange Rate Adjustment ................... Policies to Achieve a Target Real Exchange Rate ....................... C. Effects of Exchange Rate Changes .... D. ExchangeRate Systems and Regimes .... 22 ............... ....... ................... .................. ..... . 23 25 26 External Financing Policies ................................. 28 Conclusions ................ 34 Macroeconomic Adjustmentin DevelopingCountries: A PolicyPerspective MohsinS. Khan I. Introduction In recentyears developingcountrieshave foundthemselvesin serious includingworseningbalanceof paymentspositions, economicdifficulties, risingratesof inflation,and decliningratesof growth. The predicament of thesecountrieshas led to a heightenedinterestin the subjectof on how to eliminatethe and particularly adjustment, macroeconomic in the economiesthat gave rise to theseproblemswithout disequilibrium growthin the process. The basicquestionthat is currentlybeing sacrificing in the developingworld,and the askedby academics,policymakers international economiccommunityat large,is what policiescan be employed, and in what combination, to achievethe goal of macroeconomic adjustment. The need for macroeconomic adjustmentariseswhen a countryhas a fundamental imbalancebetweenaggregatedomesticdemandand aggregate supply. This demand-supply imbalancecan be a resultboth of external factors,suchas a deterioration in the termsof tradeand an increasein domesticpoliciesthat expand foreigninterestrates,as well as inappropriate aggregatedemandtoo rapidlyand reducethe rate of growthof productive capacityof the economy. In principle,a countrycan avoidadjustmentby borrowingabroador imposingcontrolson tradeand payments,or a combination in the economycan persistfor an extended of the two,and the disequilibrium period. Thereare, however,costsassociatedwith this type of strategythat are well known. These includea wideningcurrentaccountdeficit,increasing -2- inflation,overvaluationof the domestic currency and loss of international competitiveness,an inefficientallocationof resources because of distortions in relative prices, reduced economic growth, and a heavier foreign debt burden. This type of disequilibriumcannot continue indefinitely,and in the absence of appropriatepolicy actions to correct the underlying imbalances, living standards in the country would be adversely affected. Moreover, the steady loss of internationalcompetitivenessand an increasinglevel of foreign debt would affect the country's creditworthinessand thus its ability to obtain additionalforeign financing. Naturally, a cessation of foreign financing would impose adjustmenton the country, and as recent experience in a number of countries has shown, this forced adjustment is likely to be very disruptive. The fundamentalobjective of an adjustment program is to provide for an orderly eliminationof the imbalancebetween aggregate domestic demand and resource availabilitybefore the point at which the economy becomes seriouslydistorted and external resources are exhausted. To achieve this objective the adjustmentprogram necessarilyhas to include a variety of policies that simultaneouslyreduce aggregate demand and increase the availabilityof 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-level of current and potential output -- demand-managementpolicies -- on the structuralpolicies-- on the compositionof absorptionand productionas between tradableand nontradable goods - exchangerate policies -- and finally, on the level of capital flows -- external financing policies. -3- Demand-managementpolicies 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, structuralpolicies are intended to increase the supply of goods and services in the economy at any given level of domestic demand. Included in structuralpolicies would be, among others, measures to increase the level and efficiencyof investment,reductionsin tariffs and eliminationof other trade distortions,removal of subsidies, raising the efficiencyand profitabilityof public sector enterprises, measures to raise public and private savings,and increases in producer prices. Policies to improve internationalcompetitivenessand expand the supply of tradablegoods through both reduced consumptionand increased production principallyinvolve changes in the real exchange rate. Exchange rate policies, therefore,have both demand-sideand structural characteristics,and thus are treated separately. Changes in the net flow of foreign financing, includingthe financingdirectly 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 sustainablelevel, changing the maturity and compositionof foreign debt, and reducing capital flight from developingcountries. Generally speaking,comprehensiveand long-term macroeconomic adjustmentwould involve elements of all four of the policies listed above. Programs aimed at adjustmentwith growth cannot rely exclusivelyon demandmanagement policies, nor for that matter solely on structuralpolicies. In fact, these policies are closely interrelated. For example, the achievement -4- of a higher growth rate in the medium term generally requires an increase in productiveinvestment,while stabilizationrequires a reduction in the savings-investment gap. The policy package, therefore,must be designed to reduce the level of aggregatedomestic demand and simultaneouslyto cause a shift in the compositionof demand away from current consumptionand toward fixed capital formation. Exchange rate policieswill assist in the adjustment process by dampening demand and creating incentivesfor investmentin the tradables sector. External financing policieswould set limits to the current and future availabilityof 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 adjustmentprograms is how should these policies be combined in the overall package? The relative emphasis placed on various policieswill depend primarily on two sets of criteria. First, the objectivesof the authoritiesand the constraints (institutional,timing, and structural)that they face. The choice in this case would inherentlybe country-specificand there is limited scope for generalizations. Second, the nature, magnitude, and timing of the effect of various policies on the key macroeconomicvariables,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 countriesat large. The purpose of this paper is to describe how demand-management, structural,exchangerate, and external financing policies can be expected to affect the targets to which they are directed and thereby achieve the goal of macroeconomicadjustment,characterizedby a sustainablecurrent account position,a low rate of inflation,a stable and high rate of economic growth, -5- and a manageable level of external debt. While an attempt is made to cover the main links between policy instrumentsand the ultimate objectives, the survey does not deal with all of the possible effects of macroeconomicpolicy measures. For example,no attempt is made to discuss the distributional effects of adjustmentpolicies, even though it is recognizedthat the pattern of income distributionis often a key objective for policymakers. Such exclusions were considerednecessary 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 macroeconomicadjustmentprograms. The remainder of the paper proceeds as follows: Section II discusses the role of demand-managementpolicies. Structuralpolicies to increase the efficiencywith 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 externalfinancing policies describes the methods for judging the sustainabilityof foreign borrowing and the issue of capital flight from developing countries. The concludingsection brings together the main points of the paper and discusses the issues that arise in combining the various policy measures into a comprehensiveadjustmentpackage. II. Demand-ManagementPolicies Macroeconomicadjustment is often viewed as synonymouswith policies to restrain aggregatedemand and absorption,and has accordingly received -6- considerableattention in the literature. 1/ The two main instrumentsfor controllingabsorptionare monetary policy and fiscal policy. 2/ A. Monetary Policy The standardview of the transmissionmechanism between monetary policy and aggregate demand emphasizes the role of interest rates. In the closed-economycase an increase in the supply of money causes individualsto purchase real and financial assets in an attempt to restore portfolio balance. This lowers market interestrates and stimulatesaggregate demand. A basic descriptionof 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 purchasingforeign 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 depreciationof the exchange rate. Most developing countries,however, possess neither the range of financialassets nor the degree of integrationwith internationalgoods and 1/ IMF adjustmentprograms, for example,are described by some observers as being primarily demand-oriented. See Dell (1982) and Diaz-Alejandro (1984). While demand-sidepolicieswere stressed in earlier Fund work on financial programs,namely by Polak (1957) and Robichek (1967), (1971), this is not necessarily a valid descriptionof present-dayprograms. 2/ The demand-sideeffects of exchange rate policies are treated separately in Section IV. 3/ See Frenkel and Johnson (1976) and IMF (1977). -7- financial markets that would make these descriptionsof the effects of monetary policy directly relevant. How then does monetary policy work, and what are its effects on aggregate demand in situationswhere financialmarkets are underdeveloped,interestrates are set below market-clearingrates by the government, a relativelyfree curb market operates, 4/ and there are foreign exchange controls? Since such featureswould tend to be present in many developingcountries,these questions would appear to be the more appropriate ones to consider for such countries. If exchange controls are effective then the authoritiescan control the monetary base via their control over the availabilityof 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 interestrate. Since this rate would represent the marginal cost of funds in the economy, the interest-sensitive componentsof aggregate demand will decline. In particular,the implicitvalue of real assets will fall relative to their productioncosts 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 interestrate. Aggregate demand is 4/ The assumptionof the curb market allows one to analyze interestrate effects on aggregatedemand. In the absence of such a market, monetary policy would only have wealth effects. 5/ This is basically the well-knownTobin's Q mechanism. -8- again reduced as a result of the reduced demand for real assets. If, on the other hand, exchange controlsare 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 propositionsassociatedwith 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 associatedwith 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 deflationaryeffect would naturally depend on the responses of aggregate demand and aggregate supply to a tighter monetary policy. More specificallyin this context, as argued by Khan and Knight (1982), the relevant factors would include: (i) the speed with which the initial monetary disequilibriumis offset by internationalreserve movements (an effect that depends on the presence and effectivenessof exchange controls); (ii) the stickinessof domestic prices, which in turn will be conditionalon wage-settingbehavior and the degree of excess capacity in the economy; (iii) the effect on investmentof a rise in 6/ The consequencesof macroeconomicpolicies on the labor market in developingcountries is certainly not well establishedat the theoretical level, and consequentlythere is also very little empirical evidence available on this relationship. -9- 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 prevailingwage contracts were negotiated. 7/ To determine the aggregate demand effects of monetary policy requires investigatingboth theoreticaland empirical validity of these factors. B. Fiscal Policy The effects of fiscal policy, whether through reductionsin governmentexpendituresor increases in taxes, on aggregate demand and absorptionare much debated. Public sector spending on currently-produced goods and services is itself a component of total domestic spendingand this, of course, representsits direct contributionto absorption. If government purchases are limited to nontradablegoods, they also representan addition to aggregate demand for domestic goods. Public sector spending on traded goods will, however, only contributeto 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 expenditurereduces or increases private spending, thus resulting in an increase in total spending. There are a variety of mechanisms through which private spendingwould 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 the extent to which changes in monetary policy are anticipatedby the private sector, the smaller would be the effect on output. For a discussionof the applicabilityof rational expectationsmodels to developing countries, see Corden (1985). - 10 - maintain portfolio equilibrium,the higher interest rates associatedwith 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 imbalancespersist, the excess demand for money may cause households to curtail spending in order to accumulatecash 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 "Ricardianequivalence"proposition developed by Barro (1974). 9/ Finally, if nominal wages are flexible, or if the increase in public spendingwas foreseen at the time wage contracts were entered into, the domestic price level could rise sufficientlyto 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 expenditureshas yet to be tested for developingcountries,and the debate has remained essentially on a theoreticalplane. 11/ 8/ See Khan and Knight (1981) for a model utilizing this type of effect. 9/ For a discussionof this effect in the context of developingcountries, see Corden (1985). 10/ This "policy neutrality"result has come to be known as the Lucas-SargentWallace (LSW) proposition;see Lucas (1972) and Sargent and Wallace (1975). 11/ Even the empirical evidence for developed industrialcountries does not suggest that changes in public sector saving are entirely offset by private saving. - 11 - 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 (temporarytaxes are expected to reduce saving), the characteristicsof the recipient which affect the marginal propensity to consume out of current income (includingdemographic 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 domesticabsorption can be expected to be the opposite of the effects of taxes described above. Although domestic absorption is not directly affected, a transfer should increaseprivate absorption, though not necessarily total absorption. The effect on the latter will depend on how the governmentfinances the payments of transfers. In summary,the effects of fiscal policy on aggregate demand would appear to be more complex than standard Keynesian macroeconomictheory 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 accordinglyrequire more testing. III. StructuralPolicies Structuralpolicies differ from demand-managementpolicies in two respects. First, they place more emphasis on growth rather than the control of domestic demand and immediate improvementin the current account. In - 12 - developingcountries the goal of achievingmore efficient resource allocation and increasedgrowth may sometimes conflict with that of reducing the current account deficit in the short run. Since these countries import a large proportionof capital goods, programs that place a greater emphasis on structuralmeasures 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 primarilyat reducing excess aggregate domestic demand. In particular, to the extent that major adjustmentsin aggregate domestic supply require an initial rise in the level of domestic investment, reductions in current account deficitswould not necessarilybe sought in the early years of the program. Second, substantialtime may be needed for structuralpolicies 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 structuralmeasures has to be longer than one that focuses on reducing aggregate demand. Structuralpolicies can take a wide variety of specific forms dependingon the economy in question and the types of problems faced by the domestic productivesector. They can, however, be categorizedunder two broad headings: policies to improve efficiencyand resource allocation;and policies to increase the level or rate of growth of capacity output. A. Policies to Improve Efficiencyand Resource Allocation This category basically includesall types of measures to reduce distortionsthat drive a wedge between prices and marginal costs. In a number - 13 - of developing countries distortionsare fairly pervasive in factor markets, credit markets, and goods markets. The distortionscan arise, for example, from price, wage, and interestrate controls; imperfectcompetition;taxes and subsidies;and trade and payments restrictions. The attractivenessof policies designed to improve the efficiencywith 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 eliminatemajor distortionspresent certain practicaldifficulties. First, if capital and labor are not mobile among different sectors of the economy, changes in the patterns of relative prices and incentivesmay necessitate an extended period of adjustmentduring which some factors, in particuLar labor, may be unemployed. Second, many government policiesthat create distortions may have been designed to achieve objectivesother than economic efficiency. These policies typically would include among others, employmentprograms, consumer subsidies,price controls on essential commodities,and restrictions on imports of luxury goods. Thus, political realitieshave to be recognized when advocating changes based purely on efficiencygrounds. Finally, the theory underlyingmicro-orientedpolicy measures is not sufficientlydeveloped to be able to yield precise answers on the effects of such policies. For example, well-known considerationsassociatedwith the theory of second best suggest that if a country has a number of significantdistortions,the elimination of only some of them will not necessarilyresult in an overall gain in efficiencyand welfare. By their nature, distortions tend to be both microeconomicand country-specific. Nevertheless,two sources of inefficiencythat have - 14 - macroeconomicsignificancehave gained importancein recent years, and accordinglyreceivedconsiderableattention from researchers. First, there are the inefficienciesthat result from imposing artificialbarriers to foreign trade. Tariffs, quotas, and other restrictionson trade and payments reduce the levels of trade and specialization,and tend to foster the developmentof import substitute industriesthat often fail to attain the degree of efficiencyand flexibility shown by firms that are continuously exposed to internationalcompetition. A number of studies (i.e., Balassa (1982) and Krueger, et al (1981)),have shown that at the broadest level, the countries adopting outward-lookingdevelopment strategieshave fared better in terms of growth, employment,economic efficiency,and adjustment to external shocks than those that have taken a more inward-lookingapproach to development. The outward-orientedstrategieshave been typically characterized,inter alia, by the provisionof incentivesfor export productionand the encouragementof import competition for most domestically produced goods. The relative success of outward-lookingpolicies has led to considerableefforts to encourage developingcountries to liberalizetheir trade systems. 12/ A second source of inefficiencyin a number of developingcountries arises from controls on producer prices. For example, agriculturalpricing policies often cause the prices of agriculturalcommoditiesto deviate from prices that would be established in competitivemarkets or prices in the internationalmarkets. Such policies have a strong impact on the level and 12/ See Edwards (1984) and Krueger (1985) for a discussion of trade liberalizationin developingeconomies. - 15 - allocation of agriculturalproduction,and on consumption. In many developing countries governmentmarketing boards control the purchase of a major portion of domestically-produced agriculturalcommodities. 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 disincentivesboth to domestic supply and exports, and can result in an increase in imports and a drain on the governmentbudget. In an adjustment program, therefore,an initial upward adjustment in the prices offered to domestic producers by the marketing board is frequentlyneeded. Indeed, there is now empirical evidence that suggests that pricing policies to increase the return to producerswould tend to stimulatethe output of major agriculturalcommodities,particularlyin 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 governmenthas to absorb the cost of subsidies in its budget. Aside from the budgetary effects, a policy of subsidizingenergy tends to slow down the shift to less energy-intensiveproductiontechniquesand patterns of consumptionby not providing the right incentivesfor efficient use of energy. B. Policies to Increasethe 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 proportionof current output to be invested in productivecapital rather than consumed, as 13/ See Bond (1983). - 16 - well as on the nature and quality of the capital stock being added. 14/ The appropriate structuralpolicies for this objectiveare those that tend to favor investmentand savings. As there is now general consensus that investment in developingcountries is largely constrainedby the availability of resources,policies that encourage public and private savings have to be given a special importancein adjustmentprograms 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 consideredto have a significantinfluenceon the supply of (domestic and foreign) savings as well as the level and composition of investment. 15/ In many developingcountries the financial systems are tightly controlledby the governments,with ceilings placed on nominal interest rates. Under inflationaryconditionssuch controlshave resulted in highly negative real rates of intereston domestic financial instruments for extended periods. 16/ Consequently,real financial savings have grown less rapidly than the real economy and disintermediation, particularlyin the form of development of parallelor curb markets in credit, has been a serious problem. When such developmentsoccur, they can severely restrict the availabilityof real credit through the financial system and 14/ See Krueger (1986) for a discussion of the role of capital formation in the growth and developmentprocess. See also Sen (1983). 15/ This view is generally referred to as the McKinnon-Shawhypothesis; see McKinnon (1973). 16/ The real interest rate is defined as the nominal interest rate adjusted for anticipated inflation. - 17 - thereby inhibit the level and efficiencyof investment. Since available credits are often first allocated to large firms and state enterprises, credits for small- and medium-sizedfirms and householderscan be especially limited and severelyrationed, with the consequencethat uneconomicprojects are undertakenat the expense of more efficient ones. To increase the availabilityof real credit, interestrate policy could be used to encourage the accumulationof domestic financial assets by offeringholders of these assets a sufficientlyattractivereturn. At the same time, other structural and institutionalreforms could be undertakento increase the general efficiencyof the financial system. The above considerationsindicatewhy raising real interest rates on domestic financial instrumentshas to be a key element in adjustmentprograms. In setting the level of nominal interestrates, considerablejudgment must thereforebe exercised regarding the future course of inflationduring the program. Nonetheless,establishingthe perception that holders of domestic financial instrumentswill earn positivereal returns that are to some degree competitivewith the real yields that can be obtained on comparableforeign instrumentsis necessary in promoting balance of payments adjustment, increasingforeign direct investment,and preventingcapital flight. Any changes in interest rates and other financial reforms, however, must also be coordinatedwith the other policy actions that are a part of the stabilizationprogram. The experiencesof a number of developingcountries with financialreforms suggeststhat this coordinationis especially important during the early phases of the stabilizationprogram. In particular,certain combinationsof policies can potentiallybe a source of instabilityfor a financial system undergoingmajor structuralchange. Two examples appear - 18 - particularlyrelevant 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 coordinatedwith exchange rate policy to ensure that capital movements do not destabilizethe financial reform. While most of the attentionhas been on the relationshipbetween savings (financialand real) and rates of return, there are other aspects of savings behavior that have to be considered. One important issue is the relationshipbetween public and private savings,which was referred to earlier in connectionwith the concept of Ricardian equivalence. If in fact public and private savings are substitutes,then clearly an adjustmentprogram that called for increasedpublic 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 to which foreign and domestic savings are substitutes. - 19 - in real rates of return and improvementsin the availabilityof savings instruments,are able to compensatefor the possible negative effects of public and foreign savings on domestic private savings. Despite the importanceattached to private investmentin the adjustment process, there is a serious lack of understandingof the factors that influence investmentdecisions in developingcountries. Although in recent years a broad consensus has emerged on the forms of several key macroeconomicrelations in developingcountries -- such as the aggregate consumptionfunction, money demand, imports,and exports -- no such convergenceof views is apparent in the case of private investment. The theoretical literatureon investmentis quite rich and has yielded a welldefined class of models, generally of the flexible acceleratortype. There is, however, quite a large gap between the modern investmenttheory and the models that have been specified for developingcountries. Because of institutionaland structuralfactors present in most developingcountries, such as the absence of well-functioningfinancialmarkets, the relatively large role of the governmentin the capital formation process,distortions created by foreign exchange constraints,wage rigidities,and other market imperfections,the assumptionsunderlyingthe standard optimizinginvestment models typically are not satisfied in those countries. As such, the standard models have to be adapted to allow for the structuralfeatures 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 theoreticaland empirical links between 18/ See Blejer and Khan (1984) for a discussionof the issues and an attempt to specify a model that takes such factors explicitlyinto account. - 20 - policy variables and private capital formationso as to evaluate the influence that government can exercise over private investmentdecisions that change the current and future growth rate of the economy. Assuming that measures are implementedthat are successfulin raising investment,what would be their impact on growth? This question can be addressed by formulatinga 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 importedinputs. Attempts at this type of analysis have only been partially successful. One of the problems is that the identifiablefactors listed above are only able to account for a relatively small proportionof 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 influencedby governmentpolicies, is a task that will undoubtedly occupy macroeconomicresearchers. IV. Exchange Rate Policies Exchange rate action to improve internationalcompetitivenessand increase the incentive to produce tradablegoods is often the centerpieceof any adjustment effort. Since devaluation,in the terminologyof Johnson (1958), is simultaneouslyan expenditure-reducing and expenditure-switching policy, it affects both domestic absorptionand domestic supply, and thus containselements of both demand-sideand structuralpolicies. - 21 - The basic demand-sideand supply-sideaspects of devaluationhave been discussedextensively in the literature. 19/ Consider, for example, a situationwhere excess real domestic demand shows up in a current account deficit. A devaluationincreases the level of foreign prices measured in domestic currency terms and thus the price of tradablegoods relative to nontraded goods in the domestic economy. On the demand side, the effect of a devaluationon domestic absorptionis unambiguouslynegative: the main demand-sideeffects 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 proportionallywith the devaluation. For these reasons, devaluationdecreases domestic demand and reduces current absorption. On the supply side, however, the effects of the devaluationtend to move output in the opposite direction. If the prices of (variable)domestic factors of productionrise less than proportionatelyto the domestic currency price of final output in the short run, devaluationwill have a stimulative impact on aggregate supply. 20/ Thus both the aggregate demand and aggregate supply effects of a devaluationwork 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 contractionaryeffects on aggregate domestic demand are outweighedby 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 discussionof the supply-sideaspects of devaluation,see Khan and Knight (1982), (1985). - 22 - price elasticitiesof imports and exports, on the relative shares of tradable and nontradablegoods 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 importanceof getting the "right" real exchange rate in the adjustment process. However, althoughexchange rate action may be the obvious way to correct a misalignmentof relative prices and thereby improve internationalcompetitiveness,there are still a number of difficult theoreticaland empirical issues involved. Here we consider four such issues, namely: (a) determinationof the degree of overvaluation,and thereforethe size of the real depreciationrequired; (b) achieving the target value of the real exchange rate; (c) determinationof the effects of a change in the real exchange rate; and (d) the exchangerate regime or exchange rate rules that the country should adopt. A. Determining the Extent of Exchange Rate Adjustment Ascertainingthe "equilibrium"exchange rate against which the current rate is compared, and thus the extent of the required devaluation,has proved to be a fairly intractableproblem, even for developed countrieswith sophisticatedfinancial systems,well-developedforward markets for currencies,and few distortionsin foreign trade and payments. Consequently, in the case of developingcountries it has become common practice to base judgments on the appropriatenessof the exchange rate at least in part on Purchasing Power Parity (PPP) calculations,such as indices of real exchange rates based on some combinationof export and import weights. However, these indices are only suggestiveand can be useful when domesticrates of inflation have been considerablyhigher than-thoseabroad. One should generally be careful in attaching an excessive degree of importanceto small changes in - 23 - such indices. The use of a PPP-based index to judge the appropriate level of exchange rate requiresan assumptionthat some past level of the rate was correct and then setting up that past level as a target. The size of the required devaluationis then determinedby the differencebetween 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 exchangerate is made more difficult once it is recognizedthat it is an endogenousvariable 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 interestrates, or a slowdown in the growth rates of partner countries,will all tend to depreciatethe long-run real exchange rate. Similarly,domestic supply shocks will alter the equilibriumreal exchange rate. Consequently,the "right" real exchange rate is conditionalon the state of the world, and in any realistic setting,changes in the latter are likely to occur. In judging the appropriatenessof the level of the real exchange rate these factors affecting its long-runbehavior have to be taken into account. B. Policies to Achieve a Target Real ExchangeRate Having determinedthe appropriatelevel of the real exchange rate, either through PPP calculationsor through some more sophisticatedmodel-based approach, it is then necessary to choose a set of policies that would achieve this target. Clearly a nominal devaluationby itself would not be sufficient. It is well known that in the absence of supportingpolicies that limit the increase in domestic prices, a nominal devaluationwill only have a transitoryeffect on the real exchange rate. In the long run, domestic prices - 24 - will rise by the full amount of the devaluationand the real exchange rate will return to its original level. Broadly speaking, therefore,any sustainablereal exchange rate change requires policies to restrain aggregate demand and factor costs. The extent to which a devaluationwill affect the real exchange rate, as well as the length of time over which the effects persist,are a direct function of the supportingpolicies -- fiscal, monetary, trade, and wage policies -- that are put in place. To calculatethe effects of a devaluationon the real exchange rate requires in the first instance informationon substitutionelasticities between tradable and nontradablegoods in consumptionand productionand the share of tradable goods in total expenditure.21/ This, however, is only the first-roundeffect which will only be sustained if supportingpoliciesare implemented. To determine the long-runvalue of the real exchange rate requires detailed specificationof these other policies. Without such information the level of the real exchangerate, for a given nominal devaluation,could not be predictedwith any certainty. If it is establishedthat the alignmentof relative prices is inappropriate,say because the existence of an unsustainablecurrent 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 deflationarypoliciesdesigned to force down domestic prices and wages, which 21/ A limiting case is when prices of nontradable goods are constant. The impact of a devaluationon domestic prices is then simply the product of the exchange rate change and the share of tradable goods in expenditure. The depreciationof the real exchange rate would, therefore,be equal to the nominal devaluationadjusted for the resulting increase in domestic prices. - 25 - in most countries tend to be resistant to downward changes without substantial falls in output and employment. C. Effects of ExchangeRate Changes One of the standardcriticismsagainst devaluationas a policy of adjustment is that it tends to induce stagflationand increases unemployment.22/ As mentioned previously,whether a devaluationexerts a net contractionaryor expansionaryeffect on domestic output and employment depends on the relative strengthson 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-runmarginal cost curves of the relevant (tradable goods) industriesare upward sloping. Naturally,the longer a real exchange rate change persists, the larger are the gains to be achieved. Furthermore,if the wealth and distributionaleffects of devaluationstimulate savings and investment,a long-run gain of increasedpotential output will likely be realized. Despite the controversysurroundingthe output and employmenteffects of exchange rate policy, there is surprisinglylittle empirical evidence available on the subject.23/ Furthermore,the relativelyfew 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 devaluationdoes alter the sectoraldistributionof income, as it is designed to do, it will not be completely costlessto some sectors. On the other hand, no strong empirical evidence can be brought forward to support the propositionthat devaluationnecessarilyreduces the overall growth rate and increases unemployment. Given the state of empiricalknowledge it would be dangerous to draw strong conclusionsone way or the other. Of more relevance are the short-termand long-termeffects that devaluationhas on trade flows, and here the empirical evidence points to the existence of relative price elasticities that satisfy the Marshall-Lernerconditions. What needs exploring is whether the result carries over to the case where importedinputs are important in the export productionprocess and where imports are constrainedby foreign exchange availability. D. Exchange Rate Systems and Regimes Unlike the developed industrialcountries there are very few developing countriesthat operate a freely-floatingexchange rate system. Most either maintain fixed parities or follow some type of crawling-peg rule. 24/ While there may be advantages to maintaininga fixed peg, such a system also has a number of disadvantageswhich have been dealt with at length in the literature. One of these drawbacks is that the policy leaves a country vulnerable to speculativeattacks and may result in exchange rate crises if the authoritiesare unwilling to alter the peg. 25/ 24/ The 1985 Annual Report of the IMF lists 50 developingcountries as having fixed pegs to a single currency, 38 as pegged to a currency composite,29 that follow an exchange rate rule, and only 7 countriesare classifiedas floating. 25/ See, for example, Blanco and Garber (1986). - 27 - At the otherextremefrom countrieswith fixedexchangeratesare high-inflation countrieswherecontinualexchangerate adjustmentis built into the economicsystem. Indeed,exchangerate changescan be regardedin some casesas merelya particulartypeof indexation.For thesecountries, the key decisionis at what rate the domesticcurrencyshouldbe depreciated; this dependson a numberof considerations, especiallythe policiesbeing simultaneously carriedout with respectto the interestrate,fiscalpolicy, and domesticcreditexpansion.Recentlysomewritershave questionedthe use of exchangerate rules,arguingthat they increasefluctuations in outputor increasedomesticinflation, and thus are inconsistent with macroeconomic stability. 26/ Also at issueis how and when rulesthat are designedto keep the realexchangerate constant,or slowlydepreciateover time,shouldbe changedwhen circumstances dictate. Confrontedwith persistentbalanceof paymentsproblems,some countrieshave resortedto a dual exchangesystemas an alternative to a uniformexchangerateadjustment.Under the dual system,certainselected transactions takeplaceat an officialexchangerate,which is maintainedby officialintervention, while the remainingtransactions take placeat a generallymore depreciated ("free"or "parallel") exchangerate,which is usuallydeterminedby marketforces. Dual exchangemarketshave not always been successfulin achievingthe objectivesthatmotivatedtheiradoption. In particular, they have been largelyineffective in preventingspeculative capitalflowsfrom affectinginternational reserves,as uncertainties concerningthe viabilityof the officialexchangerate have generallyproduced leadsand lags in importsand exportsin the officialmarket. Similarly,the 26/ See, for example,Dornbusch(1982)and Adams and Gros (1986). - 28 - large differentialsthat often arise between the free and the official exchange rate have motivated the over-invoicingof imports and the underinvoicing of exports in the officialmarket, thus contributingto a further erosion of internationalreserves. In addition, dual exchange rates are equivalent to a series of implicit subsidiesand taxes that may work against some of the objectivesof the country. For example, commodities that receive export promotion incentivesare sometimesassigned to the official market, thus implicitlytaxing 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 experienceswith 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 formalizedin a number of studies showing that countries can attain a desirable growth path by supplementingdomestic 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" literatureis 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 justificationfor paying this rate of return is usually 27/ See the useful survey by McDonald (1982). - 29 - thought of as the increased output made possibleby the additionalreal capital that can be accumulatedwith the aid of net foreign savings. 28/ Theoreticallyit is possible to calculate the sustainablelevel of net resource transfers,based, for example, on informationon the nature of the constraintson the supply of foreign loans and the availabilityover time of new loans that vary both in terms and maturity, but in practice this is a nearly impossible task since such informationis not often available.29/ Consequentlyit is thus necessary to make approximationsto the relationship between debt and the capacity to service debt through calculatingratios 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 profitablyemploy 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 profitablyutilize 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 situationsin which debt can grow 28/ It might also be optimal for countries to utilize external debt to smooth consumptionover time in the face of various internal and external shocks. A more general criterion would be that the pattern of distributionof world savings should be welfare enhancing. See Williamson (1973). 29/ Furthermore,any such calculation is by definitionconditionalon the assumptions of the future path of the interestrate on existing and new debt. What might be considered sustainableat a given interestrate may prove to be unsustainableif the interestrate should rise above the assumed value. Since most commercialdebt carries a floating interest rate, calculationsbased on some fixed rate are bound to be only conjecturalat best. - 30 - explosively. If additionalexternal debt increases investmentincome payments by more than it increasesthe 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 convenientway of stating this condition is that the real interestrate 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 relationshipbetween empirical indicatorsfor debt capacity and the criteria for foreign borrowing that emerge from the theoreticalliterature,there are neverthelesscircumstances in which the proxies are useful. For example, an unexpected rise in the external real interest rate can make the payments associatedwith 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 possibilityof explosive growth of debt. Therefore,the theory of real resource transfers is probablymost useful as a warning in circumstanceswhere concepts such as debt to GNP, debt to exports, or debt-serviceratios are changing or are expected to change rapidly. Such possibilitieswould call into question the sustainabilityof the country's external position. 30/ Strictly speaking, this result assumes that the rate of growth of imports is less than or equal to the rate of growth of exports. - 31 - In recent years the sharp decline in the availabilityof foreign financinghas created difficult adjustmentproblems for a large number of developingcountries. When private creditorshave already determinedthat the sustainabilityof the country's position is doubtful, the short-termoutlook 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-runadjustmentpath for the current account is largely determinedby 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 relativelycostless eventual return to a normal growth path for debt. The theory of "growth with debt" is not well-suitedto guide policy during such transitionperiods. 31/ The obvious solution is that the necessary adjustment should be accomplishedat the minimum cost in terms of loss of output, but this is obviously not an easy task. One practical considerationis that imports should not be compressedbelow the level which causes an unnecessaryreduction 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 adjustmentprogram can also advance the time in which the country's access to the internationalcapital markets and thus to foreign savings is restored. 31/ For a discussion of some of the issues that arise, and the policies that may be implemented,see Selowsky and van der Tak (1986). - 32 - In discussionsof capital flows in the context of developing countriesattention has focused almost exclusivelyon foreign borrowing by these countries. Recently some advances have been made to analyze the other side of these flows, namely the acquisitionof external claims by residents of developingcountries.32/ The interesthas 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 countrieshas caused the build-up of gross foreign debt, an erosion of the tax base, and to the extent that there was a net real transferof resources from the countries,a reduction in investmentand growth. Since the availableestimates of capital outflows from debtor countriesare surprisinglylarge, it stands to reason that capital flight is of concern to policymakersin these countriesas well as to international institutions. If increases in foreign debt in the past merely financed capital flight rather than productiveinvestment,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 repetitionof large scale private capital outflows from debtor countries facing acute financing needs? While there is some theoreticalsupport for the notion that expected devaluationsand interest rate differentialsdrive capital abroad, in general, the effects of changes in the macroeconomicenvironmenton preferences for 32/ See, for example, Cuddington (1985), Dooley (1985), Dornbusch (1985), and Khan and Haque (1985). - 33 - where wealth is held are not that straightforward. A change in the macroeconomicenvironmentwill generallybe recognizedby both residents and nonresidentsat the same time, limiting the incentivesfor trade between these groups of investors. Some market imperfectionis usually needed in order to predict changes in the location of investments. For example, in the case where a government is supportingan unrealisticexchange rate and where there are no opportunitiesfor the private sector to acquire domestic securities denominated in foreign currencies,private capital outflows would be expected. In this case the "differenceof opinion" between the government and the private sector (both residentand nonresident)will lead to a change in the preferred location of investments. In addition to the macroeconomiccauses behind capital flight, there are a whole host of incentivesthat may affect the decisions of investors on where and in what form to hold their wealth. The key to these "micro" incentivesis the actual and expected taxes, subsidies,and controls that various governmentsimpose 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 differentialtax on investmentincome will be very counterproductive since revenue can very rapidly fall to zero as the tax base shrinks. Of course, it should be recognizedthat it is highly unlikely that the governmentwill 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 authoritiescan 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 productivebase of the economy, and increasing its current and future debt-servicingcapacity. VI. Conclusions This paper has had a twofold purpose: first, to identify the policies that would be called for to achieve macroeconomicadjustment,and second, to describe the links between these policies and the ultimate objectivesof an improvementin the balance of payments, a reduction in inflation,and an increasedrate of economic growth. The resulting package would be a fairly complex mix of policies designed to simultaneouslyreduce aggregate demand and increaseaggregate supply and the production of tradable goods. As has been shown in this paper, the links between policies and the ultimate objectivesare equally complex and there are large gaps in knowledge on both the theoreticaland empirical fronts. The set of policiesconsideredhere would be broadly acceptableto most economistsconcerned with the issue of macroeconomicadjustment in developingcountries. For example, in one of the few concrete expositionsof an adjustmentstrategy,Diaz-Alejandro(1984) describes a policy package that containsmany of the same elementsas described in this paper. Considering the case of a country that has an unsustainablebalance 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; eliminationof distortions;incomes and wage guidelines; a gradual liberalizationof imports;provision of incentivesfor exports; a crawling-pegexchange rate regime, with emphasis on undervaluationof the real exchange rate to support export promotion and import liberalization;and positivereal 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 adjustmentthat is quite consistentwith the package described here. This real economy approach basically emphasizes structuralpolicies at the sectoral level, in addition to demand-oriented policies. While there may be agreement on the policy measures to be implemented,there is certainlya 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 essentiallymicroeconomicin nature but have macroeconomic implications. It has to be recognizedthat the analyticalbasis for a number of micro-orientedpolicies typically includedin an adjustmentprogram is relativelyweak. The theory underlyingthe effects of eliminatingdistortions (real and financial)is not well-suitedto policymakingas it very quickly gets into welfare-relatedissues. For example,whether the removal of consumer subsidies or a devaluationraise overall efficiencyand production, when there are significantdistortionsin the economy, or not, are still very much open questions. Even on the macroeconomicfront there are serious theoreticaland 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 importantexample of which existing analysis does not yield definitive conclusions. The available literaturegives only a limited amount of informationon the important policy questions of precisely how a devaluationis expected to work, how to determine the size of the required depreciation,and whether a nominal depreciationcan alter the real exchange rate sufficientlyto 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 emphasizinglong-term growth, it is crucial to establish the theoreticaland 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 developingcountries,and in particularof the relationship,or trade-off,between short-run stabilizationand long-run growth. Many of these questions will clearly have to be answered through concerted empiricalanalysis. Even when the theoreticalunderpinningsof the relevant relationshipsare clear-cut, it has to be stressed that economic theory providesa guide only to the basic equilibriumrelationships,and does not provide informationon how long it takes for a change in an exogenous variable or policy instrumentto have an impact on the endogenousvariable. Such questions concerningdynamicsand lags in adjustmentobviously have to be approachedfrom an empirical standpoint,and thus empirical analysiswill be crucial in the design of an adjustmentpackage. Furthermore,in many instancescomparisonsof alternativemodels may prove necessary to decide which are the more appropriateto form the basis of the policy package. This paper has provided only very general guidelineson the type of measures that should be includedin an adjustmentpackage. The issues of the appropriatemix of demand-management,structural,exchange rate, and external financing policies,and the sequencingof these policies,which are basic from an operationalpoint of view, were not directly addressed. An analysis of these issues would require in the first instancedetailed theoreticaland empirical knowledge of the relationshipbetween policies and the ultimate objectives. However, this would not in itself be sufficientsince the ways in which policies are combined depends on a number of other factors. These - 37 - include,among others, the relativeweights assigned to objectivesof the program. If, for example, an improvementof the current account is considered a higher priority, more stress would be given to demand-managementand exchangerate policies. On the other hand, the achievementof higher mediumterm growth would call for more emphasis on structuralpolicies. Equally important in the decision about the mix of policies would be the initial conditions,such as the external payments situation,the outstandingstock 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 structuralpolicies 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 structuraland institutionalcharacteristicsof the country in question. For example, in countries where indexationis importantand inflationhas become ingrained in the system, policies directed towards restrainingaggregate demand may be very costly in terms of output and employment. All these factors argue strongly for the tailoring of adjustment programs to the circumstancesof the individualcountry. Nevertheless,it is crucial to have an analytical frameworkwhich can be adapted to the particularcountry undergoingadjustment. Only then would it be possible to predict the effects of alternativecombinationsof policies on the importantmacroeconomicvariables in the system. 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