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Ecomomics evelopment 10th y p todaro and smith chapter 15

Chapter 15
Finance and
Fiscal Policy for
Development

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The Role of Financial System


Providing payment services



Matching savers and investors



Generating/distributing information




Allocating credit efficiently



Pricing, pooling, and trading risks



Increasing asset liquidity

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15-2


Macroeconomic Stabilization Policy
Fiscal policy:



Taxation and spending actions of the government to affect employment and output



Expansionary: lower the income tax rate and/or increase public spending to create
jobs and income

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15-3


Macroeconomic Stabilization Policy
Monetary policy:



Changing the supply of money to affect interest rate, investment demand,

employment and output



Expansionary: increase the money supply to reduce interest rate, increase
investment demand, create jobs and income

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15-4


Requirements of Monetary
Policy


An independent central banking authority



Well organized financial market with banks and saving and loan institutions



Strong link between interest rate and investment demand



A floating exchange rate

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15-5


Role of Central Bank


Issue currency



Banker to the government



Banker to domestic banks



Regulator of domestic financial institutions



Operator of monetary policy

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15-6


LDC Financial Market


No central bank or a government-owned and managed central bank



Financial dualism
– Formal market: organized, but dependent financial institution, consisting of foreign
and domestic banks
– Informal market: unorganized, fragmented financial institutions, consisting of
landowners and money lenders

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15-7


LDC Financial Market


Weak or ineffective link between interest rate and investment demand



Structural inflation due to import substitution strategy



Fixed or pegged foreign exchange rate, giving rise to a “currency substitution”
problem

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15-8


LDC Central Banking Problems
• Public agency issuing money to cover
government deficit or finance the development
plan
• Foreign-owned commercial banks
• Informal financial markets
• Colonial heritage
• A money supply difficult to measure
• A fixed or pegged exchange rate
•Copyright
Unskilled
central
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15-9


Emergence of Development Banks


Specialized public and private financial institutions providing medium- and longterm loans for the creation and expansion of industrial enterprises



Receive bilateral and multilateral loans from international lending agencies



Receive loans from domestic government

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15-10


Criticism of Development Banks


Excessive concentration on large-scale loans



Excessive concentration on financing urban-industrial development



Neglect of small business expansion and rural-agricultural development

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15-11


Need for Financial Liberalization


Many LDCs suffer from “financial repression” since their central banks control
the rate of interest, causing
– A shortage of loanable funds
– Higher interest rate charged by the informal financiers

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15-12


Financial Repression
Interest rate

r1 = Market rate
r2 = Controlled rate
r3 = Black market rate

r3
r1

Credit shortage = L1L2

r2
S

D

L1
L2
Loanable funds
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15-13


Requirements of Fiscal Policy


Reasonable tax rates



Effective tax collection agency



Honest tax-collectors and tax-payers



Balanced-budget requirement



Independent central bank

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15-14


LDC Fiscal Problems


Low level of per capita income



High degree of income inequality



Low and non-progressive individual and corporate income tax rates



Low property tax rate



Excessive foreign trade tax rates



High excise tax rates

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15-15


LDC Fiscal Problems


Ineffective tax collection agency



Corrupt tax collectors



Deficit-financing growth policy



Inflationary-financing growth policy



Mounting public debt and external debt



Reliance of foreign aid and foreign direct investment

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15-16


Comparative Average Levels of Tax
Revenue, 1985–1997, as % of GDP

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15-17


Comparative Composition of Tax
Revenue, 1985–1997, as % of GDP

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15-18


Public Administration Problems


Fragmented society due to ethnicity, religion, political affiliation, and economic class



Employment rather than efficiency criterion



Shortage of skilled administrators



Low salaries and inadequate benefits



Lack of trust and prevalence of corruption

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15-19


State-Owned Enterprises
• Large capital investment
• Public utilities, transportation and
communication systems, financial institutions,
services, natural resources, agriculture, and
manufacturing
• Contributing an average of 7-10 percent to
GDP
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Addison• Employ
30-40
percent
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15-20


Problems of SOEs


Inefficiency: employment rather than profit maximization



Monopoly power



Higher wages inducing R-U migration



Import-intensive ISI strategy



Lack of trust and prevalence of corruption

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15-21


Solution to SOCs


Efficiency criterion: adopt a bottom-line focus in managing public enterprises



Privatization: sell ownership of public enterprises to private investors



The Latin American and East Asian NICs have been active in the privatization of
SOCs

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15-22


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15-23


Military Spending and Development
• MDCs’ military spending is significantly
higher than that of the LDCs (i.e., $527 vs.
$200 billion)
• LDCs’ military spending share of world
military spending has risen from 8.3 percent
in 1960 to 27.5 percent in 2000

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15-24


Trends in Global Military Spending,
1960–2000 (billions of U.S. dollars)

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15-25


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