2

14. Monetary &, Fiscal Policies 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 Islamic banking

3

14. Monetary, Fiscal & Incomes Policy & Inflation 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.

4

Inflation 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 1990s).

5

Limitations of monetary policy 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

6

Limitations of monetary policy 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.

7

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).

8

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

Developing countriesb 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

9

Comparative tax revenue:

1 A sample of 8 African; 9 Asian; 7 Middle Eastern; and 14 Western Hemisphere countries.

Source: Tanzi and Zee 2000:13.

TABLE 14-2. Comparative Composition of Tax Revenue, 1985–97(In percent of GDP)

1985–87 1995–97

Income taxes Consumption taxes Income taxes Consumption taxes

Of which Of which Of which Of which

Total Corporate Personal Total General Excises TradeSocialSecurity Total Corporate Personal Total General Excises Trade

Socialsecurity

OECD countries 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

Developing Countries1

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

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

10

Goals of Tax Policy Mobilization of resources for public

expenditure Stability of income & prices Improved income distribution Efficiency of resource allocation Increase capital & enterprise Administrative feasibility

11

Bottom line: administrative feasibility

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.

12

Political constraints to tax policy

Rich & influential taxpayer may be able to prevent tax reform.

Legal tax avoidance & illegal evasion widespread in LDCs.

13

Inflation from the 1970s to the present 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.

14

TABLE 14-4 Inflation Rates in Developed and Developing Countries, 1960–2003

Average Annual Rate of Inflationa (Percent)

Country Groups 1960–70 1970–80 1980–92 1992–2003

Developed

Countries 4.3 9.1 4.3 1.7

Developing

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

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, developingcountries include developing Europe. Central Asia from the former Soviet Union is included among developingcountries but not Afro-Asia in 1980–2003. The Middle East (with Turkey) is included in the Afro-Asian total.

aGNP deflator.

Sources: World Bank 1981i:134–35, 181; World Bank 1988i:222–23; World Bank1994i:162–63; IMF 2001d:72; IMF 2002d:178–185.

15

Types of inflation 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.

16

Types of inflation: structural inflation in Latin America

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.

17

Types of inflation: structural inflation in Latin America

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.

18

Types of inflation 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).

19

Incomes policies & external stabilization 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.

20

Benefits of inflation 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.

21

Costs of inflation

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.

22

Costs of inflation

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

23

Empirical evidence

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.

24

Empirical evidence 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.

25

Financial Repression & Liberalization 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).

26

Liberalization still requires banking & financial regulation

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.

27

Capital market & financial system 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.

28

Causes of financial instability 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.

29

Causes of financial instability 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.

30

Islamic banking 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.