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Class 3 macroeconomic policies in developing countries 2018

Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

Class 3 Macro-Economic Policies in Developing Countries
1. What Are Macro-Economic Policies?
The macro-economic policies in principle consist of the fiscal policy and the monetary
policy. A broader definition includes the foreign exchange policy (or the balance of
payments policy) in relation to the monetary policy and to a lesser degree the fiscal
policy.
The government exercises these policies in order to manage the macro-economy,
which would imply, in the Keynesian sense, that the government achieves particular
objectives/targets in the following three areas:
i.
Redistribution of Income
ii.
Regulation of the Level of Economic Activity, or Management of
Aggregate Effective Demand
iii.
Promotion of Economic Growth (including economic development in
LDCs)

In our present discussion, our main concern will be centered on the “promotion of
economic growth”. In understanding the relationship between macro-economic
policies and economic growth, it is useful to refer to the GNP/GDP’s algebraic
expression as follows:
Y = Cp + Cg + Ip + Ig + X – M ----------------------------------------- (1)
where Y stands for gross national expenditure, Cp for private consumption, Cg for
government consumption, Ip for gross domestic private investment, Ig for gross
domestic government investment, X for export of goods and services and factor
income received from abroad, and M for import of goods and services and factor
income paid abroad.
The various expenditure components generate identical streams of private and
public incomes whose total constitutes gross national income and must equal gross
national expenditure. Gross national income is in turn partly consumed by the private
and public sectors and the remainder is saved. (Principle of Equivalence of Three
Aspects of National Income)
Y = C + S ------------------------------------------------------------------- (2)
C = Cp + Cg ---------------------------------------------------------------- (3)
S = Sp + Sg ----------------------------------------------------------------- (4)
where C stands for total consumption, S for gross national savings, Sp for gross
private savings and Sg for gross government savings.
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

If we substitute in equation (2) for C and S from equations (3) and (4) and compare
the result with equation (1), we obtain
Cp + Cg + Sp + Sg = Cp + Cg + Ip + Ig + X – M
or
Sp = – Sg + Ip + Ig + X – M --------------------------------------------- (5)
But public savings (Sg) is equal to ‘disposable public revenue’, defined as public
revenue (other than borrowing) from taxation and other sources less the transfer
payments, minus public consumption, so that
Sg = T – Cg ------------------------------------------------------------------ (6)
where T stands for government revenue.
Substituting for Sg in equation (5) from equation (6), we obtain
Sp = (Cg – T) + (Ip + Ig) + (X – M) ------------------------------------- (7)
where (Cg – T) represents budget balance on current account, (Ip + Ig) is total


domestic investment and (X – M) is external balance on current account. The
equation can also be presented in the form,
Sp = (G – T) + Ip + (X – M) --------------------------------------------- (7a)
where G stands for total government expenditure and is equal to (Cg + Ig); and (G
– T) is overall budget balance on current and capital account combined.
Combining equations (4), (6) and (7), we can write,
S = Id + (X – M) ------------------------------------------------------------ (8)
where Id is gross domestic investment (Ip + Ig).
This discussion continues to analyze impacts of macroeconomic policies on national
income. (See Eprime Eshag) But it should be noted that in understanding impacts of
macroeconomic policies the algebraic equation of national income is of quite help.
(1) The Fiscal Policy
There are two policy measures in fiscal policy, budget (revenue and expenditure)
and taxation. Their functions in terms of economic growth or development are as
follows.
i. Expansion and Reduction of Expenditure
➢ Expansion of Expenditure (e.g. Public Investment) → Increase in Effective
Demand → Expansion of Economy (Activation of Economy)
➢ Reduction of Expenditure → Decrease in Effective Demand → Contraction
of Economy
ii. Reduction in Taxes and Increase in Taxation
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

➢ Corporate Tax Reduction → Expansion of Private Sector Fixed Investment
→ Economic Expansion
Income Tax Increase → Reduction in Consumption → Economic
Contraction
(2) The Monetary Policy
There are two major policy measures in monetary, interest rate and supply of money.
Their functions in terms of economic growth or development are as follows.
i. Increase and Decrease in Interest Rates


➢ Interest Rate Increase → Contraction of Private Sector Fixed Investment and
Housing Investment → Economic Contraction
➢ Interest Rate Decrease → Expansion of Private Sector Fixed Investment and
Housing Investment → Economic Expansion
ii. Increase and Decrease in Money Supply
➢ Increase in Money Supply → Decrease in Interest Rate → Increase in
Investment → Economic Expansion
➢ Decrease in Money Supply → Increase in Interest Rate → Decrease in
Investment → Economic Contraction
The logic of the sequence above can be understood as follows. The volume of
private domestic investment in any period is determined primarily by the
anticipated profitability of investment on the one hand, and the supply of
finance available on the other. An increase in the supply of money can
influence private investment in two ways: (a) by increasing the availability of
finance and thus raising the ceiling of borrowing available to the individual
investor, and (b) by lowering the real rate of interest, or the cost of finance. A
reduction in the supply of money will have the opposite effect.
Apart from the direct impact on the private domestic investment, the monetary
policy can have an indirect impact on foreign investment, or the balance of
payments (X – M), and hence on the level of domestic economic activity, in an
open economy with floating exchange rates. A tightening of monetary policy, for
example, which raises domestic interest rates in relation to those prevailing abroad,
will tend to stimulate the inflow of foreign financial capital and to lead to an
appreciation of the rate of exchange. Thus, the tightening of monetary policy will
have the effect to increase foreign investment as well as to reduce the volume of
exports and to increase the volume of imports through local currency appreciation,
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

which may result in a fall or a rise in real national income.
(3) The Balance of Payments (BP) Policy vis-à-vis The Monetary Policy
In pursuing the monetary policy, it inevitably influences foreign capital flows and
foreign exchange rates. Thus, monetary policy has to take into account the effects
on foreign capital flows and exchange rates.
➢ High Interest Rates (by Monetary Policy) → Inflow of Foreign Capital
(Increase in Foreign Exchange Reserves) → Appreciation of Domestic
Currency → Decrease in Exports (Increase in Imports) → Decrease or
Increase in GNP
➢ Low Interest Rates (by Monetary Policy) → Outflow of Domestic Capital
(Decrease in Foreign Exchange Reserves) → Depreciation of Domestic
Currency → Increase in Exports (Decrease in Imports)→ Increase or
Decrease in GNP
2. Significance of Macro-Economic Policies in Less-Developed Countries (LDCs)
Sound macro-economic policies’ eventual targets are to achieve: (a) a Balanced Budget,
(b) Low Inflation, (c) an Appropriate Level of Interest Rates, (d) a Stable
Foreign Exchange Rate as well as a Sound Level of Foreign Exchange
Reserves (Balance of Payments) and (e) a Stable Business Cycle.
These macro-economic targets are known as “Macro-Economic Fundamentals.”
(1) From the Viewpoint of Economic Growth Management
Stable and lasting macro-economic fundamentals are the prerequisite to promote
economic growth and development. When a country faces any of the five problems
listed above (e.g. high inflation, high interest rates and volatile business cycle),
private sector investors cannot make feasible investment plans and so refrain from
future investment in new and/or expansion projects. At the same time, savings are
not encouraged, resulting in the failing to secure funds for investment. Economic
growth is, thus, hampered.
Take the case of high inflation, for example. Investors face difficulty in
estimating profitability for a new investment project. They, then, refrain from
investing as its profitability cannot be foreseen. As a result, productive capacity
and production remains stagnant. In other words, the economy does not grow or
develop.
(2) From the Viewpoint of Balance of Payments Management
To stabilize or regulate the sound level of the balance of payments, the macroeconomic policies need to be utilized. When a country confronts a large current
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

account deficit, it has to reduce imports to avoid foreign exchange shortage. Under
the circumstances, it often implements a fiscal tightening as well as monetary
tightening policies. By doing so, the country reduces consumption and lowers
investment activities, which results in reducing imports.
Incidentally, as measures to restrict imports, there are other measures such as
tariffs and import quotas that are usually discussed within the framework of the
trade policy.
The problem of current account deficit in developing countries arises often
from export and import issues. On the export side, developing countries face the
problem of low prices as well as price fluctuation of primary goods exported, low
or non-competitiveness of manufactured products, higher valuation (higher than
the real value) of local currencies and so on. On the import side, they confront the
problems of strong demand for capital goods (for economic development, yet
cannot afford), strong demand for luxury goods (for the rich and privileged, and
thus usually do import) and so on.
(For reference)

Balance of Payments Headings

Current Account
Goods and Services
Trade Balance
Exports
Imports
Services
Income ・・・・・・・・・・・・・・・・・ (interest payment, remittance by migrant workers, etc.)
Current Transfers ・・・・・・・・・ (grants for consumer goods, contributions to international
organizations, etc.)

Capital and Financial Account
Financial Account
Direct Investment
Portfolio Investment
Other Investment ・・・・・・・・ (loans, trade credits, etc.)
Capital Account ・・・・・・・・・・・・・ (grants for capital projects, etc.)
Changes in Reserve Assets
Errors and Omission
(Current Account + Capital and Financial Account = Changes in Reserve Assets)

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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

3. The Fiscal Policy in LDCs
(1) Three Roles of the Fiscal Policy
The fiscal policy usually plays three roles in managing macro-economy of a country.
The roles are: (a) provision of public goods such as economic infrastructure,
education, health and medical care, defense, diplomacy and so forth, (b)
redistribution of income through progressive taxation, social security and
unemployment benefits including the social safety net, and (c) macro-economic
stabilization.
(2) LDC-Specific Fiscal Issues and Problems
On the expenditure side, LDCs are inclined to spend an excessive portion of their
budget on the increasing demand for public goods such as infrastructure, education
and health, minimizing the increasing gap between the rich and the poor including
the creation of or the improvement in the social safety net, foreign debt services,
and salaries and benefits of public servants. On the revenue side, they fail to secure
sufficient revenue due to a defective tax collection system, and unstable revenue
sources such as oil and gas. (Hence, they face difficulty in projecting a medium and
long-term budget plan.)
Thus, in LDCs, expenditures tend to surpass revenues. There are several
measures to cope with this condition. Issuance of bonds (local currency and foreign
currency denominated), borrowing from international financial organizations and
foreign governments are some of them. In any case, LDCs have to be most careful
to avoid excessive foreign debt that may cause what is often called the “Debt
Problem”.
4. The Monetary Policy in LDCs
(1) Roles of the Monetary Policy*
The ultimate role of the monetary policy is to maintain price stability which
contributes to achieving high levels of economic activity and employment. For this
purpose therefore, the monetary policy regulates the volume of money supply and
interest rates by means of its operational instruments such as money market
operations including the buying and selling of government bonds.
Price stability is important because it provides the foundation for the nation’s
economic activity. In a market economy, individuals and corporations make
decisions on whether to consume or invest, based on future prospects of the prices
of goods and services. When prices fluctuate, individuals and corporations find it
difficult to make appropriate consumption and investment decisions, and this may
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

hinder the efficient allocation of resources in the economy. Unstable prices can also
distort income distribution. For example, in times of high inflation, the poor’s
monetary income is not adjusted in accordance with inflation, while the rich can
adjust their income without any time lag. (In times of high inflation, people holding
only financial assets whose value is fixed in nominal terms, such as bank deposits,
will suffer a decline in the value of those assets in real terms.)
*

The experience of a number of countries shows that the conduct of
monetary policy tends to come under pressure to adopt inflationary
policies. For that reason, it has become the norm throughout the world for
monetary policy to be conducted by the central bank, which is set-up to be
neutral, equipped with the requisite expertise, and independent from the
government as well as free from political pressures.

(2) LDC-Specific Monetary Issues and Problems
i. Underdeveloped Financial Sector
In almost all LDCs, the financial sector is not fully developed. The financial
system, therefore, is not functioning properly. The monetary policy often cannot
produce the expected outcome within a certain expected period of time, which is
quite different than the case of developed countries. For example, Friedman
wrote, “so the total delay between a change in monetary growth and a change in
the rate of inflation, averages something like 15 to 24 months (in developed
countries).” Besides, it is quite hard to grasp its degree of effects or impacts
themselves.
ii. Difficulty in Pursuing Antinomic Twin Objectives: Inflation Control and
Economic Growth
In order to reduce inflationary pressures, LDCs have to keep the rate of interest
high, while on the other hand they have to keep the interest rate low to promote
economic growth.
iii. Impacts on External Balance
The monetary policy has unavoidable impacts on inflows and outflows of capital
and the rate of exchange (as touched upon above). In this regard, in managing
the open economy, special attentions need to be paid.
➢ High Interest Rate → Capital Inflow (Investment Funds) from Abroad →
Appreciation of the Value of Local Currency → Decrease in Exports
(Increase in Imports) as well as Decrease in Foreign Debt Services in Local
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

Currency Terms
➢ Low Interest Rate → Capital Outflow to Abroad → Depreciation of the
Value of Local Currency → Decrease in Imports (Increase in Exports) as well
as Increase in Foreign Debt Services in Local Currency Terms
Here, it is clearly identified that the monetary policy and the balance of
payments policy (or more specifically, the trade policy) are closely linked. This
raises a question on relationships between trade performance and management
of aggregate demand. That is, there are at least four measures to expand
effective demand, such as an increase in budgetary expenditure, a tax cut, an
interest rate drop and liquidity increase(s) (increase in money supply). By
employing those measures, when a country’s economy starts to undergo an
upswing in its activity, its trade balance begins to deteriorate through import
expansion and export decline.
Further, there are at least two policy measures to keep the value of local
currency strong, namely high interest rate /low inflation (the monetary policy
measure) and foreign exchange market intervention (the foreign exchange policy
measure). If a country wants to maintain a strong local currency, its trade balance
cannot help being deteriorated.
5. The Balance of Payments Policy in LDCs
We have already seen the linkage between the fiscal/monetary policies and the foreign
exchange rate policy which forms a part of the trade policy or balance of payments
policy. In this section, we review five BP policy related issues that the LDCs have to
take into consideration in promoting economic growth/development in an appropriate
manner.
(1) Trade-off between Economic Growth Rate and BP
When an economic growth rate is high, BP worsens. This is mainly because
imports increase and exports decrease in order to satisfy the high domestic
demand.
(2) Long-term Growth Strategy and BP Improvement
The IMF supports to improve the BP difficulty for the LDCs who suffer from the
lack of foreign exchange reserves, based on macro-economic analysis. This is,
however, a short-term treatment and, therefore, long-term structural reforms are
not taken into consideration. In recent years, it has been recognized that the
positive effects of IMF’s support, without the structural reforms, are short-lived.
The World Bank has long tried to tackle the structural reform issue without much
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Development Finance, MPP, VJU

Prof. Koji FUJIMOTO

success. PRSP (Poverty Reduction Strategy Paper) alone cannot solve this
problem.
(3) Liberalization of Trade, Foreign Exchange and Capital, and BP
Believers of neo-classical economics such as the IMF and the World Bank stress
that liberalization of trade, foreign exchange and capital always benefits the
economies of LDCs’. However, it should be warned that such measures involve
risks in amplifying BP difficulty. For example, the liberalization of trade such as
abolition of tariff reduces foreign exchange earnings. The liberalization of foreign
exchange such as free overseas remittance reduces foreign exchange reserves. The
liberalization of capital such as non-restricted overseas investment (FDI and
portfolio investment) may reduce foreign exchange reserves.
(4) Financial Gap (FG)
LDCs make it a rule to minimize the FG to achieve a targeted economic growth
rate. The FG is usually analyzed by the LDCs in collaboration with the IMF and
the World Bank and is presented at CG meetings for assistance from multilateral
development banks (MDBs) and donor governments. Until the Asian
currency/financial crisis, its analysis had concentrated on “Current Account
(above the line)”. Today, it is becoming increasingly important to analyze the
“Capital and Financial Account (below the line)” as well.
(5) Evaluation of Accumulated Foreign Debt
LDCs have already learned, through the experience of the Debt Crises in the ’80s,
that accumulated foreign debt, depending on its volume and individual repayment
capability, seriously hampers economic growth/development. LDC governments
should keep this lesson in mind and need to carry out a prudent foreign debt
management policy as a part of their BP policy.

Reference
Eprime Eshag, Fiscal and Monetary Policies and Problems in Developing Countries,
Cambridge University Press, Cambridge, 1983

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