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Macroeconomic Policy Analysis in Low Income Countries THE MACROECONOMIC FRAMEWORK and the THEORY of FINANCIAL PROGRAMMING By Dr. Mark Ellyne Course will teach you: How to analyse a country like the IMF does, using financial programming and the 4-sector approach to the economy: Basic forecasting of macro variables How to build a simple model of an economy Understand sectoral linkages and Consistency Policy diagnosis and advice 2 Financial Programming Framework 1) Real Sector - National income accounts Output (GDP) and Prices 2) External sector - Balance of Payments Exchange rate Trade and capital flows Foreign debt 3) Fiscal - Government Budget Fiscal deficit Domestic borrowing and Public debt 4) Money and banking – Monetary Survey Money and the interest rate 4 EXTERNAL OUTPUT REAL Foreign Inflows Trade Flows Foreign Reserves Foreign Prices ABSORBTION Output Prices PRICES NFA DEMAND NCP DEMAND MONETARY Exchange Rate Credit to Government Credit to Economy NFA PPP Interest Rates IMPORTS, DONOR AID NCG FISCAL Tax Revenue &Grants Foreign Financing Expenditure Domestic Financing (T-Bills) 5 Key Economic Accounts 6 National Accounts - GDP Table 1. Zambia: Baseline Scenario, Gross Domestic Product by Sector of Origin at 2010 Constant Prices at 2010 constant prices (In billions of 1994 kwacha) Primary sector Agriculture, forestry and fishing Mining and quarrying Secondary sector Manufacturing Electricity, gas and water Construction Tertiary sector Wholesale and Retail trade Restaurants, Bars and Hotels Transport, Storage and Communications Financial Intermediaries and Insurance Real Estate and Business services Community, Social and Personal Services Plus: Financial intermediation services indirectly measured 1/ TOTAL GROSS VALUE ADDED Taxes less subsidies on Products TOTAL G.D.P. AT MARKET PRICES 1994 1995 1996 1997 1998 1999 2000 2001 11,795 8,394 3,402 8,656 3,804 1,523 3,329 17,407 6,005 644 1,116 3,827 1,574 4,241 13,684 11,120 2,564 8,491 3,797 1,495 3,199 17,546 5,414 676 1,064 4,536 1,623 4,234 13,719 10,967 2,753 8,253 4,018 1,406 2,828 19,750 7,282 731 1,170 4,129 2,013 4,426 13,262 10,313 2,949 9,315 4,233 1,460 3,622 20,580 7,696 782 1,196 4,105 2,298 4,502 12,662 10,335 2,327 9,051 4,326 1,462 3,263 21,388 8,071 809 1,335 4,080 2,629 4,464 13,095 11,243 1,853 9,290 4,463 1,491 3,335 22,870 8,558 757 1,456 4,133 3,045 4,921 13,233 11,261 1,972 9,656 4,642 1,501 3,513 23,970 8,905 847 1,543 4,049 3,633 4,992 13,201 10,798 2,403 10,404 4,860 1,678 3,866 25,491 9,565 1,049 1,648 3,986 3,845 5,398 -2,496 -2,962 -2,700 -2,688 -2,676 -2,717 -2,753 -2,785 35,362 3,212 38,574 36,758 2,934 39,692 39,022 3,138 42,160 40,468 3,300 43,768 40,425 3,175 43,599 42,538 3,089 45,627 44,105 46,311 3,300 3,615 47,405 49,926 7 Table. Zambia: Baseline Scenario, Central Government Operations, 1994-2008 (in billions of kwacha) Government Budget 1994 1995 1996 1997 665 450 414 129 70 76 139 36 216 856 595 527 172 85 108 163 68 260 1,058 817 729 222 127 137 243 88 242 1,262 1,023 936 296 168 184 288 86 239 1,459 1,131 1,077 381 211 200 285 55 328 1,862 1,324 1,276 470 222 248 336 48 538 855 625 115 249 261 230 1,000 727 178 290 259 … 273 -189 -405 189 107 82 25 82 -50 -144 -404 144 196 200 -4 -52 -81 1,214 869 221 326 322 … 345 … … -155 -397 155 -152 -164 12 307 -51 1,407 1,017 324 367 326 … 390 … … -145 -384 145 -72 -83 10 217 10 1,943 1,318 327 515 476 … 625 … … -484 (812) 484 363 139 224 122 (67) 2,193 1,464 402 519 543 … 729 … … -179 -717 179 -947 -982 35 1,127 385 132 0 29 0 358 0 207 0 Revenue and grants Revenue Tax revenue Income Tax Excise taxes Sales tax/value-added tax (VAT) Trade taxes & import duties Nontax revenue Grants Total expenditures and net lending Current expenditure Wages and salaries Goods and services Interest due 2/ Other (subsidies+transfers+social benefits) Capital expenditure Foreign financed Domestic financed Overall balance (accrual) Overall balance excluding grants Financing Domestic borrowing (net) Nonbanks Banking systems 4/ Foreign borrowing (net) Foreign borrowing (net) Debt securities/bonds Debt relief ( including rescheduling) Change in arrears (net) Memorandum items: GDP (billion of kwacha) Domestic treasury bill debt (in kwacha bn) % of GDP 2,448 4,171 170.4 Sources: IMF and Zambian sources, and estimates. 3,290 4,367 132.8 4,345 4,216 97.0 5,656 4,143 73.3 1998 189 6,587 4,506 68.4 1999 741 0 8,130 3,559 43.8 Balance of Payments Monetary Accounts Table 11. Zambia: Monetary Survey, 1994-2008 (In billions of kwacha; end of period) 1994 1995 -965.4 -1,011.9 46.5 -985.2 -1,092.1 106.9 Net domestic assets Net domestic credit Net claims on government 1/ Claims on nongovernment Other items (net) 1,313.6 247.9 85.4 162.5 1,065.7 Broad money (M3) Narrow money (M1) Currency outside banks Demand deposits Quasi money (QM) Savings deposits Time deposits Foreign currency deposits 348.2 144.3 57.1 81.7 203.9 67.0 108.6 28.3 Net foreign assets Central Bank Commercial Banks 1996 1997 1998 1999 -1,217.4 1,934.8 -3,152.2 -1,129.3 -1,334.7 205.4 -2,261.3 -2,676.6 415.3 -2,423.5 -2,893.0 469.5 1,525.9 397.6 91.9 305.7 1,128.3 1,944.4 541.9 112.7 429.2 1,402.5 2,030.7 579.2 122.3 456.9 1,451.5 3,366.4 1,131.7 580.7 551.0 2,234.7 3,851.6 1,505.3 693.2 812.1 2,346.3 540.7 228.3 79.0 140.2 312.4 73.8 151.1 87.5 727.0 270.1 106.3 163.1 456.9 114.0 182.0 160.9 901.4 355.3 136.7 217.2 546.1 141.5 197.2 207.4 1,105.1 397.6 169.7 226.4 707.5 146.4 167.3 393.8 1,428.1 504.0 212.2 289.9 924.1 189.8 200.8 533.5 10 Strategy Build accounting framework with behavioural equations where appropriate Create a “No-Policy-Change” Scenario for future projections Identify future problems/disequilibria Determine what policy changes are needed to correct disequilibria 11 How Does Financial Programming Work? Create sectoral projections for the real sector, the balance of payments, and the fiscal deficit. Then check to see if they are consistent in the monetary context. Need to understand the sources of money supply and demand. 12 Money Supply and Demand Money Demand/Supply M = NFA + NCG + NCP External Net Foreign Assets Government Net Credit to Government Private Net Credit to Private Sector 13 Structure of the Monetary Survey Assets Liabilities Net foreign assets (NFA) Central bank Comm. Banks Domestic Credit Net claims on govern. (NCG) Net claims on private sector (NCP) Other items, net (OIN) Broad Money (M3) Foreign currency deposits M2 Time & savings deps. M1 Currency in circulation Demand depos. 14 Sectoral Linkages of the Monetary Accounts Accounting Behavioral determinants Net foreign asset BOP ∆NFA = Change in Foreign Reserves Net domestic credit to gov. Gov Domestic borrowing = Deficit – Foreign borrowing Net domestic credit to private Real NCP = η GDP – βr Other items net Banks Valuation adjustments, bank capital and profits Broad money Money QTM: Mv=PY 15 What is the Correct Money Supply? The amount of money needed to satisfy transaction and store of value demand for given combination of growth, inflation, sustainable fiscal balance and sustainable current account 16 Quantity Theory of Money Mv = PY %∆M = %∆P + %∆Y - %∆v Inflation Growth Velocity Money that does not get absorbed by growth and velocity of circulation, goes into inflation. 17 Why Does Velocity Change? Velocity, how fast money circulates, depends on the interest rate, inflation, banking sector technology, financial development. What would make velocity increase or decrease? 19 EXTERNAL OUTPUT REAL Foreign Inflows Trade Flows Foreign Reserves Foreign Prices ABSORBTION Output Prices PRICES NFA DEMAND NCP DEMAND MONETARY Exchange Rate Credit to Government Credit to Economy NFA PPP Interest Rates IMPORTS, DONOR AID NCG FISCAL Tax Revenue &Grants Foreign Financing Expenditure Domestic Financing (T-Bills) 20 Real: Y(GDP) = C + I + G + (X-IM) (X-IM) = (T-Cg-Ig) [Fiscal] + ([Y-TI]-Cp-Ip) [Pvt] BOP: (X-IM+TR+FI) + [FDI + Port + BORg +BORp] = ∆RES Fiscal: T + TR – Cg – Ig = DB + FB Money: M = NFA + NCG + NCP %∆M = %∆P + %∆Y - %∆v 21 Madagascar: Simplifed Example of Financial Programming 22 1-Real Sector 1-Real Sector Assumptions for 2008: • Real growth = 7% • Inflation = 8.8% 2007 GDP = 18,782 bn MGA How big is nominal GDP in 2008? %GDP = (1.07)*1.088) = 1.164 =>16.4% GDP 2008 = 1.164*18782= 21,862 bn MGA 23 2-Domestic fiscal financing 2-Domestic financing is 1.3% of GDP How much will government borrowing contribute to the money supply? = .013*21,862 = 284.2 bn MGA What is the impact on government debt? 24 3-Overall Balance of Payments 3-Overall balance (CAB+CFA) is $206 ml surplus • What is the BOP contribution to money demand in 2008? • Projected Exchange rate based on PPP = 2050 MGA/$ $206*2050MGA = 422.3 bn MGA money creation 25 4-Private Sector Credit Demand 4. Private sector needs sufficient credit to meet desired nominal GDP growth. • Target NCP growth = = (Elasticity of NCP to GDP)*(%GDP) Ƞ ~ [0.7 – 1.5] say 1.0 (Check previous years elasticity or assume Ƞ = 1.0) • What is NCP for 2008 if it was 1827 bn MGA in 2007? ∆NCP = [1.0*(0.164)]*1827 = 299.6 bn MGA 26 5-Calculating Money Demand from the Bottom Up + ΔNFA (422.3 from BOP) + ΔNCG (284.2 from budget) + ΔNCP (299.6 private sector) = ΔM3 = 1006.1 M3(2007) = 3915 = 1006.1/3915 = 25.7% growth 28 How do we know if our projected money demand is appropriate? Need to check with Top-Down approach Quantity Theory of Money 29 6-Money from Top Down Quantity Theory of Money Mv = PQ or M = kPQ %∆M = %∆P + %∆Y - %∆v Assume %Δv = 0% %∆M = 8.8% + 7% - (0%) Approx = 15.8% Or (1.088)*(1.07)=1.164 => 16.4% 30 Consistency Bottom up money projection => 25.7% growth Aggregate top down projection=>16.4% The sectoral calculations indicate 26% growth in M3 needed, but this is not consistent with aggregate economic requirements of 16% growth in money! 31 What Does the Discrepancy Mean? Inflation projection is too low for given scenario; or Fiscal deficit is too large, i.e. needs to be smaller; or BoP surplus (overall balance) is too large. If central bank buys less foreign reserves, there will be some real appreciation, which would help reduce inflation. 32 “No-Policy-Change” Scenario The simulation of the “no-policychange” scenario into the future is a strategy to identify potential problems or disequilibria. Then alternative policies have to be determined. 33 Simulate to Find Equilibrium Program Objectives (g, π, ∆𝑟𝑒𝑠, 𝑑𝑒𝑏𝑡) Program Design & Revision Policy Measures (no policy change) Projections Monetary Survey Balance of Payments Fiscal Accounts 34 Macroeconomic Policy Design “Having looked at monetary policy from both sides now, I can testify that central banking is as much art as science. Nonetheless, while practicing this dark art, I have always found the science quite useful.” Alan S. Blinder (1997) (quoted from Clarida, Gali and Gertler) 35 How to Do Sectoral Analysis Interpret accounts Project accounts based on “no-policychange” Identify disequilibria What policies need to change? 36 Real Sector IS Schedule Y = GDP = C+I+G+(X-IM) 37 Demand - Behavioural Relations Accounting Behavioral determinants Private consumption Real C = K + b1 (Y-T) – b2r Gov. Cons. (CG) Govt. Accts G (policy decision) I = K + b3E{Y} – b4r ICOR = (I/GDP)/(%ΔGDP) Private investment Gov. Inv. (IG) Govt. Accts Ig Policy decision Exports (X) BOP Accts. X = K + b7Yf + b6RER Imports (M) BOP Accts. IM = K + b5Y – b8RER 38 Real Sector Activity National Accounts GDP=GDP_R*PGDP Nominal GDP = Real output*Price level Balance of Payments X-IM = Capital Flows + ∆Res Fiscal Budget Revenue - Expenditure 39 Real Sector IS Schedule Y = K + b1Y- b2r +b3E{Y}-b4r + b6RER+ b7Yf - b5Y -b8RER +C +I +X -M Y(1-b1-b5) = K+b3E{Y} + b7Yf – (b2+b4)r + (b6- b8) RER multiplier 40 Identifying the Price Level Augmented Philips curve: π = β(πe) + φ(y- ye) (Supply) (demand) Inflation(π) is a function of expected inflation(πe) and the output gap (y- ye) π = ẞ1π-1 + ẞ2 ygap 41 Nominal vs Real Measures 1. Forecast the real (or quantity) movement (Y) 2. Project the price (P) or use exogenous estimate (e.g. WEO) 3. Calculate the Nominal Value=P*Q GDP_N = GDP_R * PGDP (1+%GDP_N) = (1+GDP_R) (1+%PGDP) %GDP_N ≈ g + π 42 Other Key Prices Real interest (r) = nominal rate (i) - inflation (πt) rt = (it – E{πt}) Real Exchange Rate RER = NER Pf/P NER = Nominal exchange in local/Foreign currency, R/$ 43 Always Look at the Real Exchange Rate The real exchange rate (RER) is the nominal rate adjusted by relative prices e.g.: RER_ZAR = (ZAR/US$) (P_US/P_SA) or = (US Price level in Rand)/(SA price level) An increase is a depreciation. NER, RER in local currency/foreign, 45 Question? If the RER depreciates, What happens to imports? What happens to inflation? If interest rate is raised, what happens to the RER? 46 What Does The Exchange Rate Affect: Prices and inflation; Value of external debt; Value of foreign assets (wealth); Amount of imports versus exports. 47 External Sector CAB: Goods, Service X + IM + TRansfers + Factor Income + Capital and Financial Account (FDI + Port + Borrowing) = Change in Official Reserves Private Govt. 0 if float Not 0 if fixed 48 Balance of Payments Accounts Current Account Goods Imports (-) Exports (+) Services (nonfactor) Factor Income Compensation of employees Investment income, dividends, & debt interest Current transfers Official (Foreign Aid) Private (NGOs) Capital and Financial Accounts Capital Account Capital transfers Acquisition/disposal of nonproduced nonfinancial assets Financial Account Foreign direct investment Portfolio investment Other investment, net loans Trade credit Errors & omissions Change in Reserves Foreign exchange Gold & IMF position 49 Behavioural Determinants of the Current Account (X-IM) = K +b1Yf +b2RER – b3Y CAB = F{-Domestic demand, +Foreign demand, +Real exchange rate} The CAB must be consistent with the level of domestic GDP (C+I) and world GDP, and the real exchange rate. 50 Behavioural Determinants of Foreign Capital Flows AID Official borrowing FDI Portfolio debt and equity Private borrowing Momentum is often important Government is a major borrower in most LICs, so policy is a key determinate. Private capital flows (besides FDI) are only important if there is a developed domestic capital market. 51 Determinants of Foreign Reserves CAB+CFA = ∆NFA If the exchange rate is floating does the central bank have to buy or sell foreign reserves? How does the central bank keep the exchange rate fixed? 53 Question? If the central bank buys foreign reserves, what happens to the money supply? 54 Fiscal Sector Tax+Transfers - Gov Spend = Financing T + TR – Cg – Ig = = Foreign Borrowing + Domestic Borrowing (CB + B + NB) 55 Summary of Budget Revenue & Grants Expenditure & Net Lending Tax Revenue Current Direct Taxes Taxes on income Taxes on wealth Indirect Taxes Goods & services Imports Other Non-Tax Revenue Fees CB profits Grants Non-interest Wages & salaries Goods & services Transfers Pensions Subsidies Interest Capital Expenditure Foreign financed Domestic financed Net Lending -Overall Balance = Financing 56 Determinants of Fiscal Flows What drives tax revenues? What drives wages? What drives interest cost? What drives other non-interest costs? 57 Question? To finance its deficit, is there a difference if the government borrows from the central bank or the private sector? 58 Domestic Fiscal Financing Inflation: If the government borrows money from the Central Bank (printing money) it is likely to be inflationary. Crowding Out: If the government sells to many treasury bills to the domestic (private) market they will push up interest rates. 59 Financial Programming Model Money Demand/Supply M = NFA + NCG + NCP External Net Foreign Assets Government Net Credit to Government Private Net Credit to Private Sector Monetary sector provides judgement about consistency of sectoral balances with aggregate macroeconomic performance. 60 Dealing with Disequilibria Medium-term (no-policy-change) projections help identify inconsistencies among sectors Inconsistencies lead to policy recommendations 61 Course will teach you: How to do a country economic analyse How to build a simple model of an economy with consistent sectoral linkages Forecast macro variables Diagnose problems and offer policy advice 62 End of Lecture Appendix follows 63 EXTERNAL OUTPUT REAL Foreign Inflows Trade Flows Foreign Reserves Foreign Prices ABSORBTION Output Prices PRICES NFA DEMAND NCP DEMAND MONETARY Exchange Rate Credit to Government Credit to Economy NFA PPP Interest Rates IMPORTS, DONOR AID NCG FISCAL Tax Revenue &Grants Foreign Financing Expenditure Domestic Financing (T-Bills) 64 Output and Price Variable Definitions Y = domestic demand/output - GDP Yf = foreign demand/output P = price level π = inflation rate i = nominal interest rate r = real interest rate = r = (i – πt+1e) ≈ i – π 65 National Account Variable Definitions C = Consumption Cg = Consumption by the government Cp = Consumption by the private sector FI = Factor Income, includes interest on external debt & worker remittances G = noninterest Government expenditure I = Investment _R= Real value 66 BOP Variable Definitions CAB=Current Account Balance IM = IMports X = Exports TR = Foreign Transfer/grants FI =Factor Income NER = Nominal exchange rate (generally local/foreign currency, ie R/$) RER = Real exchange rate = NER [Pf/P] = Pf/P in rand 67 BOP Variable Definitions CFA=Capital and Financial Account FDI = Foreign direct investment FB = Foreign borrowing Port = Portfolio investment ΔNFA=Net Foreign Assets ΔRes =change in international Reserves (ΔRes = -ΔNFAcb) 68 Fiscal Variables Rev = Revenue T = Tax (and nontax) fiscal revenue TR = Foreign Transfer/grants Ex = Expenditure BORf = Foreign borrowing BORd = Domestic borrowing 69 Money Variable Definitions RM = Reserve Money M = Money ΔNDA = Net Domestic Assets of monetary survey ΔNCG = Net Credit to Government by banking sector ΔNCP = Net Credit to Private sector ΔOIN = Other Interest Net 70