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Managing an Open Economy
I. Although most development policies relate to long-term outcomes, short-run
stabilization problems often dominate the policy agenda. Serious macroeconomic
imbalances can arise from external or internal shocks or from the cumulative effects
of prior mismanagement. Stabilization problems were especially widespread during
the 1970s and 1980s, following wide swings in oil prices, real interest rates, major
exchange rates, and the availability of foreign financing.
II. The basic model for analyzing stabilization policies in developing countries is the
Australian model, which starts from the presumption that most developing countries
are small, open economies. They are small in the sense of being price takers in the
world markets for tradable goods (including both importables and exportables). They
are open in that the domestic economy is heavily affected by international trade and
finance. Nontradables, including most services, also account for a substantial share of
output. The domestic price of tradables is determined by the world price and the
official exchange rate, while the price of nontradables is a function of domestic
supply and demand conditions. The relative price of tradable to nontradable goods
measures the real exchange rate (P) in this model.
III. External balance is defined as equality between the supply and demand for
tradables. With zero net foreign financing, this is equivalent to a zero balance of
trade; with a net inflow of foreign savings, a corresponding balanceof- trade deficit is
consistent with external balance. External imbalance can take the form of an
unsustainable trade deficit or, less critically, an excessive trade surplus. In like
fashion, internal balance is defined as equality between the supply and demand for
nontradables. Internal imbalance can take the form 153 of inflationary excess demand
or contractionary excess supply, which idles factors of production and leads to
excessive unemployment. These concepts are easy to depict using supply-anddemand analysis for tradables and nontradables, with P as the price variable.
IV. Two key variables determining the macroeconomic outcome are aggregate
expenditure (absorption) and the real exchange rate. A rise in absorption increases
demand for both tradables and nontradables. A rise in the real exchange rate, by
altering relative prices, induces a shift in consumption toward nontradables and a shift
in production toward tradables. Although the markets possess self-correcting
tendencies, structural rigidities can render the adjustments too slow to solve short-run
crises; in addition, the automatic adjustments can be counteracted by inappropriate
policy responses.
V. The model reveals which combination of changes in absorption (A) and real
exchange rate (P) is needed to restore macroeconomic balance, starting from any
initial situation of external or internal imbalance. To simplify the analysis, the model
is presented in the form of a phase diagram with A and P on the axes. In this diagram,
the external balance line (EB) delineates combinations of A and P for which the
tradables market has a balance, a surplus, or a deficit. Similarly, the internal balance
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line (IB) shows the combinations of A and P for which the market for nontradables
has a balance, a surplus of capacity (unemployment), or excess demand (inflation).
VI. Two main instruments are available to the government to help move the system
toward overall balance. First, monetary and fiscal policies directly affect absorption;
second, official exchange-rate policy affects the real exchange rate.
VII. The Australian model is used to analyze the nature of macroeconomic
imbalances and the mix of policies needed to achieve stabilization. In general, both
policy instruments must be used in a coordinated fashion to reach the equilibrium.
The essence of stabilization policy is to identify the disequilibrium condition and then
determine the warranted policy adjustments. For countries suffering large external
deficits and high domestic inflation, the indicated response is austerity plus a real
depreciation. This is the standard IMF prescription. One important detail is that aid
inflows ease the adjustment process by reducing the necessary dose of austerity and
devaluation. The model also provides a basis for analyzing Dutch disease, the nature
of the debt repayment problem, and the macroeconomic effects of drought.
Chapter 19 has three case studies. The first surveys Chile’s rocky road to stabilization
over the period 1973 to 1984. Since Chile was a pioneer in this endeavor, the
problems it encountered proved to be very instructive for countries that later adopted
stabilization programs. One of the most important lessons was the need to coordinate
fiscal and monetary policies with exchangerate policies. The second case study tells
how Ghana, starting in 1983, went about recovering from a decade of
mismanagement. The adjustment program focused on exchange-rate reforms, fiscal
adjustment, and monetary controls. The third case study involves a very different
situation, Taiwan’s adjustments following a period of excellent domestic performance
with a large trade surplus. In this case, the adjustment problem was to reduce the
buildup of foreign exchange reserves without hampering growth.
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