Download Macroeconomic Policy

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