Download Development Economics – Econ 682

14. Monetary &, Fiscal Policies
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Limitations of monetary policy in LDCs
Low tax rates in LDCs
Tax policy goals
Political constraints on tax policies
Limits of spending to stabilize income & prices
Explanations for inflation, its benefits & costs, &
relationship between inflation & growth
Banking & financial repression & liberalization
Capital market & financial system & instability
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Islamic banking
14. Monetary, Fiscal & Incomes
Policy & Inflation
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Monetary policy affects the supply of
money & the rate of interest.
Fiscal policy includes the rate of taxation &
level of government spending.
Incomes policy consists of anti-inflation
measures that depend on income & price
limitations, such as moderated wage
increases.
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Inflation
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LDC governments have even less capability than
DCs to use monetary & fiscal policies to attain
macroeconomic goals of output and employment
goals and price stability.
Look at tools: monetary, fiscal & incomes
policies to moderate high inflation (5.9% monthly
or 100% yearly price increases).
High inflation has included Argentina (1980-91),
Brazil (1980-93), Poland (1982, 1990), Mexico
(1983, 1986, 1994), Russia (1992-94, 1998),
1920s’ postwar Germany, Austria, Hungary,
Russia & Poland; Yugoslavia (late 1980s & early 4
1990s).
Limitations of monetary policy
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Many LDC commercial banks branches of large
private DC banks, with external orientation.
Many LDC governments lack control of money
supply to multiple of foreign currency held by
central bank.
Not much influence on amount of bank deposits:
few loans by central bank to commercial banks &
central bank usually buys & sells few bonds on
open market
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Limitations of monetary policy
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Commercial banks generally restrict loans to
large & medium enterprises in modern sector.
LDC banks less influence than DCs on interest
rate, investment, & GDP.
Checking accounts usually less than half total
money supply.
Links between interest rate, investment & GDP
questionable because of supply limitations&
many money lenders outside banks.
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Tax Ratios & GNP per Capita
Taxes/GNP in LDCs less than in DCs.
 Increase in taxex/GNP with increased GNP
per capita (Table 14-1).
- Demand for social goods relatively greater
(Wagner’s Law).
- Capacity to levy taxes increases, especially
direct taxes, primarily property, wealth,
inheritance, & personal & corporate
income taxes (Table 14-2).
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TABLE 14-1. Comparative Levels of Tax Revenue, 1985–1997 (percent of GDP)
(from Tanzi & Zee 2000)
1985–87
1995–97
OECD countriesa
36.6
37.9
America
30.6
32.6
Pacific
30.7
31.6
Europe
38.2
39.4
17.5
18.2
Africa
19.6
19.8
Asia
16.1
17.4
Middle East
16.5
18.1
Western Hemisphere
17.6
18.1
Developing countriesb
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Comparative tax revenue:
TABLE 14-2. Comparative Composition of Tax Revenue, 1985–97
(In percent of GDP)
1985–87
Income taxes
1995–97
Consumption taxes
Of which
Of which
Income taxes
Consumption taxes
Of which
Of which
Total Corporate Personal Total
General
Excises
Social
Trade Security
13.9
2.8
11.3
11.3
6.0
3.8
0.7
8.8
14.2
3.1
10.8
11.4
6.6
3.6
0.3
9.5
America
14.0
2.5
11.4
7.6
3.4
2.2
0.6
5.8
15.4
3.0
12.3
7.0
3.7
2.0
0.3
6.1
Pacific
17.1
3.9
13.2
7.5
2.3
3.7
0.8
2.8
16.3
4.3
11.4
8.4
4.3
2.6
0.6
3.5
Europe
13.3
2.7
11.0
12.4
6.8
4.0
0.7
10.1
13.7
2.9
10.6
12.4
7.3
4.0
0.3
10.8
4.9
2.8
1.7
10.3
2.3
2.6
4.2
1.2
5.2
2.6
2.2
10.5
3.6
2.4
3.5
1.3
OECD countries
Developing Countries
1
Total
Corporate
Personal
Total
General
Excises Trade
Social
security
Africa
6.3
2.9
3.1
11.7
3.2
2.3
5.7
0.4
6.9
2.4
3.9
11.6
3.8
2.3
5.1
0.5
Asia
5.7
3.5
2.1
9.5
1.9
2.5
3.6
0.1
6.2
3.0
3.0
9.7
3.1
2.2
2.7
0.3
Middle East
4.7
4.3
1.0
9.1
1.5
2.4
4.4
1.2
5.0
3.2
1.3
10.3
1.5
3.0
4.3
1.1
Western Hemisphere
3.7
1.8
1.0
10.6
2.6
3.0
3.7
2.4
3.7
2.3
1.0
10.6
4.8
2.3
2.6
2.3
1 A sample of 8 African; 9 Asian; 7 Middle Eastern; and 14 Western Hemisphere countries.
Source: Tanzi and Zee 2000:13.
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Goals of Tax Policy
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Mobilization of resources for public
expenditure
Stability of income & prices
Improved income distribution
Efficiency of resource allocation
Increase capital & enterprise
Administrative feasibility
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Bottom line: administrative
feasibility
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Where monetary sector small, literacy low, few
accounting records, little voluntary taxpayer
compliance, & not an honest & efficient
administration, many taxes that are good in
theory can’t be administered.
Value added tax (VAT on difference between
sales of firm & purchases from other firms) is
simple, uniform, & can generate buoyant
revenues if country has administrative capacity.
If VAT not feasible, LDC may have to rely on less
than ideal taxes such as international trade,
excise, or sales taxes.
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Political constraints to tax policy
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Rich & influential taxpayer may be able to
prevent tax reform.
Legal tax avoidance & illegal evasion
widespread in LDCs.
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Inflation from the 1970s to the
present
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Acceleration from 1960s through early 1990s.
Drop in inflation rates from the early 1990s to the
present (globalization ?).
Before 1960s, economists viewed inflation as
phenomenon affecting countries in isolation.
Since then, instability in international economy is
considered a contributor to an individual
country’s inflation.
For inflation, 1960-2003, see Table 14-4.
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TABLE 14-4 Inflation Rates in Developed and Developing Countries, 1960–2003
Average Annual Rate of Inflationa (Percent)
1960–70
1970–80
1980–92
1992–2003
4.3
9.1
4.3
1.7
Countries
8.9
26.2
75.7
16.5
Latin America
22.5
46.7
229.5
30.9
Afro-Asia
6.1
13.9
8.9
14.9
Country Groups
Developed
Countries
Developing
Developing Countries by Region
Latin America
22.5
46.7
229.5
30.9
Brazil
46.1
38.6
370.2
72.8
Excluding Brazil
9.3
50.9
157.2
10.5
Africa
5.3
14.2
14.7
21.3
Asia
6.4
13.9
7.6
6.5
India
7.1
8.4
8.5
7.3
Excluding India
5.3
16.2
7.2
6.2
Middle East &
Turkey
2.5
17.0
10.1
25.4
Note: China is not included in 1960–70 for developing countries, Afro-Asia, and Asia. In 1960–2003, developing
countries include developing Europe. Central Asia from the former Soviet Union is included among developing
countries but not Afro-Asia in 1980–2003. The Middle East (with Turkey) is included in the Afro-Asian total.
a
GNP deflator.
Sources: World Bank 1981i:134–35, 181; World Bank 1988i:222–23; World Bank
1994i:162–63; IMF 2001d:72; IMF 2002d:178–185.
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Types of inflation
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Demand-pull: demand in excess of
economy’s capacity to produce.
Cost-push: supply side pressure from prices
increasing because of higher costs.
Ratchet: with aggregate demand constant,
prices rise with increased demand but stay
constant when demand falls.
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Types of inflation: structural
inflation in Latin America
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Structural rigidities such as unstable
growth of foreign currency earnings &
inelasticity of agricultural goods.
Deterioration in terms of trade, cost of
import substitution, devaluation, & rise in
agricultural prices.
Orthodox demand-reduction policies won’t
work, structuralists argue.
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Types of inflation: structural
inflation in Latin America
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Orthodox economists say overvalued
domestic relative to foreign currency
contributes to inflation.
Moreover, food supply growth & terms of
trade changes not particularly bad in Latin
America.
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Types of inflation
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Expectational: inflationary expectations cause
workers, managers & consumers to behave to
make inflation a self-fulfilling prophesy.
Political: Government gives into efforts by
country’s major economic interests to make
excessive money demands that can only be
worked out with inflation.
Monetary: Excess demand for money (relevant
during periods of high inflation).
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Incomes policies & external
stabilization
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Should LDCs temporarily fix the price of
foreign exchange & undergo wage & price
freezes?
Subsequent crawling exchange-rate peg.
Foreign exchange rate fixidity can reduce
competitiveness.
Wage-price controls can be circumvented.
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Benefits of inflation
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Bid resources away from low-priority uses.
Redistribute income from wage earners to
capitalists who save more.
Reduce real interest rate & debt burden for
expanding business.
Inflationary pressures could more fully
utilize labor & other resources.
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Costs of inflation
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Government redistribution to high savers works
only in early inflationary stages. In later stages,
actors find ways to protect against inflation.
Tax on holders of money. People evade this tax
by holding onto goods.
Distortion of business behavior, undermining
rational calculation of profits.
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Costs of inflation
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Weakens creation of credit & capital markets
LDC instruments too weak to slow inflation
without sacrificing real income & social welfare
Little evidence that redistribution to high-income
groups increases savings
Reduces international balance of merchandise
trade
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Empirical evidence
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Mundell: inflation can increase real
economic growth.
Thirlwall et al. find growth declines when
annual inflation exceeds 10%.
Fischer: high inflation (>40% p.a.) not
consistent with sustained growth.
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Empirical evidence
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Improved proficiency of LDC monetary
management.
Bruno & Easterly: no negative correlation
between inflation & growth for inflation <
40% per annum.
Stiglitz: IMF preoccupation with
contractionary financial policies below
40% inflationary misconceived.
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Financial Repression &
Liberalization
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Repression: distortions of interest rate &
foreign exchange rates reduce growth &
size of financial sector.
Reducing nonprice rationing of loans &
repressed foreign exchange markets can
increase efficiency (see pre-1990s’ India,
pp. 491-492).
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Liberalization still requires
banking & financial regulation
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As an LDC moves toward a liberalized
economy, it needs to limit spending &
restrain “wildcat” bank lending.
Indeed Japan, South Korea, & Taiwan used
mild financial repression to spur rapid
growth during much of the post-World War
II period.
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Capital market & financial
system
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Banks are intermediaries between savers &
investors.
Bank provide discipline to market, providing
loans to higher quality borrowers & charging
premium to lower quality borrowers.
Banks can monitor borrowers & force them to
restructure.
Banks need to be supervised.
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Causes of financial instability
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Adverse selection - Asymmetric information
resulting in poor loans by the financial system,
which lacks the capability of making judgments
about investment opportunities. This asymmetry
is characterized by lenders having poor
information about potential returns of and risks
associated with investment projects and potential
bad credit risks being most eager to borrow.
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Causes of financial instability
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Moral hazard: The risk associated with a loan in
which the borrower has incentives to invest in
projects with high risk where the borrower does
well if the project succeeds but the lender bears
most of the loss if the project fails. The prospect
of “bail out” of failed projects by, for example,
the International Monetary Fund and the
international community means that borrowers
are more likely to shirk or use funds for personal
use or power.
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Islamic banking
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Interest-free banking can improve efficiency,
since profit shares are free from interest rate
controls.
Khan: shocks to economy are absorbed by
changes in the values of deposits held by public.
Kuran: Islamic banks match returns of
conventional banks.
Profit sharing problematic where business hide
profits for tax evasion.
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