2 Adjustment and Internal-External Balance

Chorng-Huey Wong, Mohsin Khan, and Saleh Nsouli
Published Date:
April 2002
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Chorng-Huey Wong*

This chapter provides a framework for determining the appropriate mix of monetary, fiscal, and exchange rate policies for correcting macroeconomic imbalances. It discusses the design of macroeconomic adjustment programs and the appropriate actions required of policy agencies facing imperfect coordination.

Unless otherwise specified, the framework is based on the following assumptions: (1) flexibility of domestic interest rates; (2) some degree of capital mobility; (3) absence of a rigid indexation system; and (4) some degree of central bank independence. Structural reforms and real sector and labor market policies are not addressed here. For the most part, the discussion focuses on countries with fixed but adjustable or managed floating exchange rate systems, which constitute about two-thirds of IMF members.

The chapter begins with a definition of internal and external balance—the two key objectives of macroeconomic policies—and discusses possible combinations of imbalances, with particular reference to IMF-program countries. Second, it introduces the concept and measurement of the “macroeconomic balance real exchange rate” that corresponds to internal and external balance. It presents a diagram of this concept to show how to assess the need for an exchange rate change and how to use policies to change real domestic demand and the real exchange rate to move an economy from a combination of imbalances to macroeconomic balance.1 Third, it examines the relative effectiveness of monetary and fiscal policies in influencing domestic output and prices and the external sector position, both of which depend on various factors, including the degree of exchange rate flexibility. In this context, it refers to the evidence presented in Schadler and others (1995), which reviewed IMF Stand-By and Extended Arrangements approved during 1988–91. Fourth, it discusses the appropriate mix of monetary, fiscal, and exchange rate policies to deal with specific aspects of imbalances, on the basis of the framework introduced earlier. In this connection, it reviews a recent World Bank study on macroeconomic policies in 42 countries supported by the Bank’s structural and sectoral adjustment loans during 1980–89 (World Bank, 1992). The chapter concludes with a brief discussion of policy coordination versus policy assignment and the relevance of the appropriate mix of policies in the design of adjustment programs. An appendix to the chapter contains a brief discussion of issues arising from greater capital mobility that are particularly relevant to emerging market economies.

Internal and External Balance


Internal balance is defined as a situation in which real output is at or close to its potential or capacity level, and the inflation rate is low and nonaccelerating. According to this definition, neither of the following two situations is considered to be in internal balance: low inflation combined with slow or negative growth, or rapid growth combined with high inflation. External balance is often defined as a current account position that can be sustained by capital flows on terms compatible with the growth prospects of the economy without resort to restrictions on trade and payments, so that the level of international reserves is adequate and relatively stable. External balance does not necessarily correspond to a zero current account balance or a zero overall balance of the balance of payments, but for simplicity both notions, although not equivalent, can be used.

Combinations of Macroeconomic Imbalances

Both internal balance and external balance depend on two fundamental variables—the level of real domestic demand and the real exchange rate—which, in turn, reflect underlying economic conditions and macroeconomic policies. For example, a current account deficit occurs if the real exchange rate is overly appreciated, excess real domestic demand exists, or both. The opposite situation results in a current account surplus. Likewise, an overly depreciated real exchange rate or excess real domestic demand creates inflationary pressure, and the opposite situation results in depressed output. A country with a balance of payments concern usually also has one other policy objective: to correct either the rate of growth or inflation.

Internal balance and external balance could each be achieved through different combinations of the real exchange rate and the real domestic demand. However, policy authorities generally strive to achieve internal and external balance simultaneously, which requires a particular combination of the real exchange rate and real domestic demand.

On the basis of the definitions of internal and external balance given above, the different combinations of macroeconomic imbalances can be broadly classified into four categories, as shown in Table 2.1.

Table 2.1.Combinations of Macroeconomic Imbalances
Type of ImbalanceCountries Affected
Domestic excess demand and inflationMost SBA countries
Current account deficit
Domestic recessionSome PRGF and EFF countries
Current account deficitUnited Kingdom in late 1980s and early 1990s
Domestic excess demand and inflationSome oil producers
Current account surplusChina in first half of the 1990s
Domestic recessionJapan from 1992 to present
Current account surplus
Note: IMF financial arrangements, as follows: SBA = Stand-By Arrangement; PRGF = Poverty Reduction and Growth Facility; and EFF = Extended Fund Facility. PRGF is the successor facility of the Structural Adjustment Facility (SAF) and the Enhanced Structural Adjustment Facility (ESAF).
Note: IMF financial arrangements, as follows: SBA = Stand-By Arrangement; PRGF = Poverty Reduction and Growth Facility; and EFF = Extended Fund Facility. PRGF is the successor facility of the Structural Adjustment Facility (SAF) and the Enhanced Structural Adjustment Facility (ESAF).

The first category—the combination of excess demand, inflation, and current account deficit—characterizes the situation in most IMF member countries that request Stand-By Arrangements. This category is given more attention in this chapter than are the other three categories.

Macroeconomic Balance Real Exchange Rate

Concept and Measurement

The macroeconomic balance real exchange rate is the real exchange rate at which an economy attains both internal and external balance.2 As already mentioned, both internal balance and external balance depend on the level of real domestic demand and the real exchange rate. Algebraically,

where CA is the the current account position; A is real domestic demand; and R is the real exchange rate (in units of foreign currency per unit of domestic currency, deflated by relative prices).

Since real domestic demand depends on real income or output, among other things, and real income, in turn, is identically equal to the sum of real domestic demand and the real current account balance, the level of real income (Y) can be expressed as

where YY¯, with Y¯ indicating full-capacity output. Any excess aggregate demand will result in inflation.

In Figure 2.1, the horizontal axis measures the level of real domestic demand, and the vertical axis measures the real exchange rate.3 An upward movement means an appreciation of the real exchange rate. The external balance schedule, CA*, is downward sloping, because a rise in real domestic demand, other things being equal, will worsen the current account balance, unless it is offset by a depreciation of the real exchange rate. The internal balance schedule, Y*, is upward sloping, because an increase in real domestic demand will raise the demand for domestic output, unless an appreciation of the real exchange rate shifts demand away from domestic goods. It follows that any point above (below) the CA* schedule implies a current account deficit (surplus). Any point to the right (left) of the Y* schedule implies inflationary pressure (depressed output).

Figure 2.1.Macroeconomic Balance and the Real Exchange Rate

The intersection of CA* and Y* determines the level of real domestic demand and the real exchange rate at which the economy attains simultaneous internal and external balance. This particular real exchange rate (R* in Figure 2.1) is, therefore, called the macroeconomic balance real exchange rate, or the equilibrium real exchange rate.

The macroeconomic balance real exchange rate can change over time, because it is affected by economic fundamentals (sometimes called real exchange rate fundamentals). These include technological progress or productivity growth, the terms of trade, import tariffs and export taxes, composition of government expenditures and revenues, real interest rates, and capital controls. For example, a permanent increase in the international price of oil will raise the equilibrium real exchange rate of an oil-exporting country, because the CA* schedule will shift to the right. An increase in productivity in the traded-goods sector in any country will shift both the CA* schedule and the Y* schedule upward, because the productivity shock will give rise to an incipient current account surplus and a reduction in output of nontraded goods, resulting in excess demand in the nontraded-goods market. A real appreciation is required to restore both external and internal balance. Both effects contribute to an appreciation of the equilibrium real exchange rate. Since the CA* schedule is likely to shift relatively more than the Y* schedule, the equilibrium real domestic demand is likely to be higher.

To design appropriate domestic macroeconomic and exchange rate policies to move the economy from a combination of imbalances to internal and external balance, one must first know how to estimate the equilibrium real exchange rate to decide whether the exchange rate needs to be changed. In the literature, three approaches have been followed; (1) simulations based on macroeconomic models; (2) estimates based on partial-equilibrium current account models; and (3) estimates based on cointegrating equations (see Clark and others, 1994; Montiel, 1999; and Williamson, 1994b).

The first approach is more feasible for industrial countries. In this approach, an empirical dynamic macroeconomic model is first established. Model simulations are then performed for specified paths of policy and exogenous fundamentals to generate steady-state values of the real exchange rate over time. The steady-state real exchange rate is considered to be the equilibrium real exchange rate that satisfies the internal and external balance conditions (see, for example, Clark and others, 1994, and Williamson, 1994a).

In the second approach, which has been applied in both industrial and developing countries (see, for example, A filers and Hinkle, 1999, and Wren-Lewis and Driver, 1997), individual behavioral relationships must first be estimated for the major items in the current account. From this, the quantitative relationship between the current account balance and its major determinants can be established. For example, this relationship may take the following form:4

where YFt is the level (or index) of world real income, or real income of major trading partners, in period t, and a, b, c, and d are estimated parameters. Given YFt and by assigning reasonable values for CAt and Yt that correspond to external and internal balance, Rt can be derived from equation (2.3), which represents the equilibrium real exchange rate. Allowing for estimating and judgment errors, the equilibrium real exchange rate could be obtained as a range of values rather than as a single value. In order for equation (2.3) to be operational, the current account balance must be responsive to changes in domestic activity, foreign activity, and the real exchange rate. Although this approach has the advantage of being simple and transparent, its main disadvantage is that it ignores certain dynamic factors, including the impact on the real exchange rate of the path to equilibrium. During adjustment, for example, there will be interactions between CA and R and between Y and R. Moreover, the choice of the policy variable used to achieve external balance has different effects on potential output and the real exchange rate.

The third approach involves applications of unit-root econometrics (see, for example, Elbadawi, 1994, and Montiel, 1997). The first step in this approach is to test the nonstationarity of the real exchange rate (R). If R is nonstationary, it means that the equilibrium real exchange rate has changed over the sample period. The second step is to identify those fundamentals that are nonstationary. Changes in these fundamentals during the sample period are presumed to have contributed to changes in the equilibrium real exchange rate. The next step is to estimate the cointegrating equation, linking the nonstationary R to the set of nonstationary fundamentals. The final step is to derive estimated R from the equation using “permanent” values of the fundamentals. Permanent values for each fundamental can, for example, be generated by taking five-period averages of the observations. The estimated R so derived represents the equilibrium real exchange rate for each period.

Adjustment Toward Macroeconomic Balance

The four quadrants in Figure 2.1 show four different combinations of imbalances, which correspond to those in Table 2.1. Imbalances can be caused by domestic or external shocks, structural rigidities, or inappropriate policies. The design of adjustment policies must take these underlying causes into account. For example, imbalances may or may not be associated with a real exchange rate misalignment (that is, a real exchange rate that is different from R* in Figure 2.1), which, in turn, could be policy induced. An overly appreciated real exchange rate, for example, could reflect an unsustainable expansionary fiscal policy or a monetary policy favoring disinflation. It could also be caused by changes in international interest rates or speculative movements in the foreign exchange market. Again, the appropriate exchange rate policy will depend on the underlying causes of the misalignment.

Whatever the causes of the misalignment of the real exchange rate, the question often raised is whether to alter the nominal exchange rate and, if so, by how much. The case for a change in the nominal exchange rate can be made when the real exchange rate is significantly misaligned, and the cost of adjustment associated with the exclusive use of monetary and fiscal policies is considered too high, particularly when the real exchange rate is overly appreciated.

The framework presented in this section is useful for assessing whether a change in the exchange rate is necessary. Consider the situation of point E’ in Figure 2.1—a situation in which the economy is suffering from inflation and a current account deficit. At the same time, the real exchange rate appears to be significantly above the equilibrium rate (that is, overly appreciated). In such a situation, two options are available to move from E’ to E. The first is to pursue a combination of restrictive monetary and fiscal policies to lower both real domestic demand and domestic prices, while maintaining the nominal exchange rate. The second option is to combine a depreciation of the nominal exchange rate with restrictive monetary and fiscal policies.

For the first option, the restrictive monetary and fiscal policies will reduce domestic demand for both importables and exportables, leading to an improved current account position. At the same time, the demand for nontradables will also decrease, dampening domestic inflation and depreciating the real exchange rate. The reduction in domestic demand could, however, adversely affect production and increase unemployment. For the second option, a nominal depreciation is expected to raise the domestic price of tradables relative to the price of nontradables. This, in turn, will increase the supply of tradables and decrease the supply of nontradables, and it will reduce the demand for tradables and increase the demand for nontradables, resulting in an improved current account position. However, the resulting excess demand for nontradables could result in domestic inflation, unless complementary monetary and fiscal policies to restrain demand are implemented.

In addition to the size of the real exchange rate misalignment and the adjustment cost, as mentioned above, decisions on a nominal depreciation are often affected by considerations of the effectiveness of depreciation in improving the current account position, the choice of a nominal anchor, and policy credibility. In general, exchange rate policy is considered the most powerful instrument for improving the current account position, mainly because the change in relative prices affects both exports and imports.5

Related Issues

Use of Real Exchange Rate Indicators

The concept of an “equilibrium” real exchange rate is used to judge whether a country’s real exchange rate is misaligned. One such concept is the macroeconomic balance real exchange rate. Another approach widely used is the equilibrium exchange rate based on relative purchasing power parity (PPP), With the PPP approach, the equilibrium exchange rate is proportional to the relative price levels of the home country and its trading partners—that is, to the purchasing power of the domestic currency relative to the currencies of the trading partners. The application of relative PPP involves using the actual exchange rate to compute relative price levels in common-currency terms. The calculation of the real effective exchange rate (REER) is based on this concept.

Algebraically, the REER can be expressed as follows:

where Sit is an index of the price of one unit of the domestic currency in terms of the ith trading partner’s currency in period t; Pit is the ratio of the price index of the ith trading partner in period t to the price index of the home country in period t, with the base period equal to the base period of Si; wi is the normalized weight of the ith trading partner’s currency, Σwi = 1; and REERt is the real effective exchange rate in period t as an index.

The REER, therefore, is the geometric average of a country’s exchange rate (units of foreign currency per unit of domestic currency) against a number of other currencies, each deflated by a measure of relative prices. It measures the extent to which the purchasing power of the domestic currency (or the country’s competitiveness) has changed over time. Note that an increase in domestic prices relative to prices in the countries trading with it would result in an appreciation of the REER.

The base period chosen for calculating the REER is usually one in which the real exchange rate is considered to be in equilibrium. Thus, a deviation in the actual real exchange rate from the base-period value is taken as an indication that the exchange rate has diverged from its equilibrium PPP value, and a change in the nominal exchange rate may be justified, subject to the considerations mentioned.

Bear in mind, however, that the equilibrium real exchange rate may change over time because of changes in economic fundamentals. In other words, the equilibrium real exchange rate at the base period a few years back may no longer be the equilibrium rate today.

Figure 2.2 shows REERs based on the consumer price index (CPI) and on export unit values in manufacturing for Japan over the period 1975–93, using 1985 as the base period. Both indices indicate that the real exchange rate in Japan has appreciated since 1985, although the one based on the CPI has appreciated far more than the other. During this period, however, Japan continued to record large trade surpluses, ranging from 2 to 5 percent of GDP a year. Therefore, it would have been inappropriate to suggest that Japan should have depreciated its nominal exchange rate during 1985–93, especially during 1990–92 when the ratio of the trade surplus to GDP was rising. The fact is that Japan’s equilibrium real exchange rate has been rising since 1985 because productivity in its traded-goods sector has been growing faster than that of its trading partners.

Figure 2.2.Japan: Real Effective Exchange Rates

(Index, 1980 = 100)

Source: Clark and others (1994).

1Does not include China from 1975 to 1980.

Money-Based Versus Exchange Rate-Based Stabilization

Where the misalignment in the real exchange rate is large, the usual conclusion is to realign the nominal exchange rate, but when the misalignment is small, the answer is not as clear-cut. One reason is that policymakers, particularly those in developing countries, have different approaches to stabilizing inflation, two of which can be described as money-based and exchange rate-based. Money-based stabilization programs rely on monetary restraint to provide a nominal anchor for the economy, often with specific monetary targets; they use changes in the exchange rate to maintain external balance. In contrast, exchange rate-based stabilization programs rely on exchange rate pegging to provide the nominal anchor.

Since the early 1970s, academics and practitioners have widely discussed the rationale and the preconditions for successful implementation of money-based and exchange rate-based stabilization programs, particularly in the context of Latin America and, more recently, the transition economies (see Citrin and Lahiri, 1995). Empirical evidence on both approaches, however, shows a mixed record. For example, in the exchange rate-based programs, although disinflation is generally accompanied by real economic growth, the real exchange rate tends to appreciate, with a concomitant increase in the current account deficit and an increased dependence on capital inflows. Country experiences also show that recessionary effects tend to appear in the early stages of money-based programs and that lack of credibility is more disruptive under fixed exchange rates than under flexible exchange rates. The reason for the latter is that the failure of an exchange rate peg results not only in losses of foreign reserves as monetary authorities attempt to maintain the peg, but also in higher inflation because of the loss of policy credibility. In contrast, deviations from a monetary target could be reversed, or the program adjusted, without drawing as much public attention.

Impact of Monetary and Fiscal Policies on Domestic Demand and the Balance of Payments

The previous section made no distinction between monetary and fiscal policies, although each has its comparative advantage in dealing with a certain aspect of macroeconomic imbalances. The relative effectiveness of monetary and fiscal policies generally depends on, among other things, (1) the exchange rate regime; (2) interest rate flexibility and the stage of capital market development; (3) the degree of capital mobility; (4) the degree of central bank independence; and (5) the size and composition of the government’s budget and the way in which the deficit is financed.

Recent Empirical Evidence

It is well known that, under a fixed exchange rate system, a change in government expenditure or taxation can have a multiplier effect on the level of income in the short run, although direct evidence on such relationships is scarce for developing countries. Moreover, unlike monetary policy, which operates through the cost and availability of credit, fiscal policy affects income streams directly. Recent studies have shown that different types of government expenditure in developing countries can have different effects on private investment, and hence on output. For example, increased public investment in infrastructure can stimulate private investment, whereas other forms of public investment can crowd out private investment.

Empirical results generally show that, under a fixed exchange rate system, the effect of monetary or credit policy on output tends to be small, particularly in the long run. For example, most studies indicate that a 10 percentage point reduction in the growth of money or domestic credit would reduce the rate of output growth by less than 1 percentage point over one year. The estimated size and duration of the change in output depend on the extent to which changes in domestic credit are offset by movements in foreign reserves, among other things.6

The recent IMF staff review by Schadler and others (1995) made the observation that, with regard to the effects of monetary and fiscal policies on inflation, “there was a reasonably close correspondence on average between progress in reducing fiscal imbalances and containing inflation” (page 40). They noted (page 42) that

There was remarkably little correspondence, on average or for individual countries, between the degree of credit restraint—as reflected in the growth of real net domestic assets—and success in reducing inflation. This reflects the tendency for increases in net foreign assets—stemming from stronger-than-expected current account positions and larger-than-expected capital inflows—to offset the effects of restrained domestic credit policies on the growth of broad money.

In this context because of the underdevelopment of financial markets in developing countries, there is often a strong link between fiscal and monetary policies, to the extent that the government deficit is financed by borrowing from the banking system. In such a case, an increase in the deficit is likely to be associated with expansion of domestic credit, unless there is a corresponding reduction in credit to the private sector.

The effects of monetary and fiscal policies on the balance of payments under a fixed exchange rate regime have been widely studied, particularly in the context of the absorption and monetary approaches to the balance of payments. With the absorption approach, a government budget deficit is a source of external current account deficit. It follows that, other things remaining constant, a reduction in the budget deficit will improve the current account position. However, fiscal measures to reduce the budget deficit or increase government saving (for example, by increasing taxes and reducing subsidies and transfers) could adversely affect private sector saving. Also, in developing countries, government capital expenditure typically has a sizable import component, which is largely financed through foreign aid. A cut in capital expenditure, therefore, may have a proportionately small effect on the overall balance of the balance of payments. These arguments can be seen clearly from the following accounting identity:

where CA is the current account balance; KP is net private capital inflows; KG is net official capital inflows; SP is private sector saving; IP is private investment; SG is government saving; and IG is government capital expenditure.

The left-hand side of the identity is the overall balance of the balance of payments, and the right-hand side represents the domestic borrowing requirements of the private sector and the government. To the extent that an increase in SG is partially offset by a decrease in SP, and a decrease in IG is partially offset by a decrease in KG, the effects of the fiscal measures on the overall balance of the balance of payments would be weakened.

Empirical results generally support the monetary approach to the balance of payments. Following this approach, in a small, open economy operating under a fixed exchange rate regime, a reduction in domestic credit tends to be offset by an increase in net foreign assets that will restore the money stock to the level desired by the public. This argument can easily be seen from the monetary survey identity:

where ΔNFA is change in net foreign assets of the banking system; ΔMO is change in broad money; and ΔNDC is change in net domestic credit.

Equilibrium in the money market requires that the change in the supply of broad money be equal to the desired change in the demand for broad money. It follows that any decreases (increases) in net domestic credit below (above) the desired change in money will be offset by increases (decreases) in net foreign assets.

In their review of IMF Stand-By and Extended Arrangements, Schadler and others (1995) observed that “a pattern of domestic credit restraint and sizable increases in net foreign assets persisted on average throughout programs. Consequently, there was a considerable shift from net domestic asset creation to the accumulation of net foreign assets, but little change, or, in about 60 percent of the countries, an increase in the growth of broad money” (page 20).

The Comparative Advantage of Monetary and Fiscal Policies

The comparative effectiveness of the monetary and fiscal policy tools for influencing domestic demand and output and the balance of payments depends largely on the degree of exchange rate flexibility. In this context, it is useful to review the Mundell-Fleming model, which is basically an open-economy version of the IS-LM model, with capital mobility.7 The major conclusions of the Mundell-Fleming model can be summarized as follows.

First, under a fixed exchange rate regime with imperfect capital mobility, fiscal policy is more effective than monetary policy in dealing with internal imbalance (that is, in influencing income). The impact of monetary policy on income tends to be limited because monetary policy is dedicated to maintaining the fixed exchange rate. A credit restraint, for example, would increase net foreign assets both because of a decrease in imports and because of an increase in net capital inflows caused by higher domestic interest rates. The increase in net foreign assets would need to be converted into money supply in order to maintain the fixed exchange rate, thus offsetting the contractionary effect of credit tightening. By the same token, monetary policy is more effective than fiscal policy in restoring external balance (in terms of the overall balance of the balance of payments), because the effects of monetary policy on the current and capital accounts tend to be reinforcing, as described above. By contrast, the favorable effect of a tight fiscal policy on the current account through a reduction in imports tends to be offset, at least partially, by its adverse effect on the capital account through a decrease in domestic interest rates. An expansionary fiscal policy, on the other hand, would worsen the current account, although it might improve the capital account.

Second, under a floating exchange rate regime with less than perfect capital mobility, monetary policy could affect income through changes in the exchange rate and domestic interest rates. For example, an expansionary monetary policy would lower domestic interest rates. This, in turn, would stimulate private investment, leading to an increase in income and output. At the same time, the lower interest rates would discourage net capital inflows, resulting in an exchange rate depreciation, which would improve the current account position and, hence, increase income and output. By contrast, the expansionary impact of fiscal policy on income would likely be at least partially offset by a decrease in private investment and a worsening of the current account, as a result of higher domestic interest rates and an exchange rate appreciation.8

Appropriate Mix of Monetary, Fiscal, and Exchange Rate Policies

From the previous discussion, it can be generally concluded that, in a small, open economy with limited exchange rate flexibility (including fixed but adjustable exchange rate and managed floating systems) and some capital mobility, fiscal policy is relatively more effective in affecting domestic demand or inflation, whereas monetary policy is relatively more effective in dealing with the balance of payments. Although exchange rate policy can affect domestic demand or inflation, its comparative advantage lies in its effect on the current account. With these concepts in mind, one can now consider the appropriate mix of the three policies in dealing with different combinations of imbalances.

Exchange Rate as a Policy Priority

When faced with a combination of internal and external imbalances, policy authorities normally first try to decide whether the exchange rate needs to be changed, mainly because of the pervasiveness of its effect on the entire economy and its complementarity with the otherwise costly adjustment of monetary and fiscal policies. Once this question is decided, they need to formulate monetary and fiscal policies based on the considerations discussed earlier, taking into consideration the impact of the change in the exchange rate, if any, in determining the magnitude of monetary and fiscal adjustments. In so doing, they must not only consider the effects of the change on the external sector position, but also its effects on production, domestic demand and prices, government budgetary operation, and the valuation of foreign assets and liabilities in the banking system.

Possible Assignments for Monetary and Fiscal Policies

Theory and empirical evidence have shown that, given the exchange rate, optimal adjustment can usually be achieved by assigning a mix of monetary and fiscal policies in such a way that each policy addresses the particular imbalance for which it has a comparative advantage.

Algebraically, in the two-target and two-instrument case, the reduced-form equations for the two target variables are


where B is the overall balance of the balance of payments; Y is the level of real income or output and is subject to YY¯; DC is the change in domestic credit; and G is government expenditure.9

Figure 2.3 shows a diagram of an external balance schedule, B*, and an internal balance schedule, Y*, in which the change in domestic credit is measured on the horizontal axis and government expenditure is measured on the vertical axis. Both schedules are downward sloping, because a larger expansion in domestic credit would worsen the balance of payments and create inflationary pressure, unless it is offset by reduced government spending.

Figure 2.3.Internal-External Balance at a Given Exchange Rate

The area to the right of or above the B* schedule implies a balance of payments deficit because of excessive government expenditure, excessive credit expansion, or both. By the same token, the area to the left of or below the B* schedule implies a balance of payments surplus. Similarly, the area to the right of or above the Y* schedule implies inflation, and the area to the left of or below the Y* schedule implies recession.

The difference in the absolute values of the slopes of the B* and Y* schedules, or

reflects the comparative advantage of DC over G in influencing the balance of payments, or the comparative advantage of G over DC in affecting income. This could be explained intuitively as follows. Starting from point E, where the economy is at internal and external balance, an increase in government expenditure from E to A would result in a balance of payments deficit and inflation. To restore external balance, credit expansion has to be reduced by the amount represented by the distance from A to C. This reduction is relatively smaller than that required to restore internal balance, which is represented by the distance from A to D. The comparative advantage of G over DC in influencing real income could be explained in the same way.

Consider point E’ in Figure 2.3. This is a situation in which the economy is suffering from inflation and a balance of payments deficit. Usually, a credit restraint combined with a tightening of fiscal policy is required to deal with this combination of imbalances, with or without a change in the exchange rate. An appropriate mix of these policies would enable the economy to move from E’ to E. This would best be achieved by the monetary and fiscal authorities coordinating their policies to avoid any overadjustment or overshooting that would require future corrections.

In the absence of policy coordination, macroeconomic balance can still be restored, provided that each policy instrument tries to attain the target over which it has the greatest influence. For example, from point E’, the fiscal authorities may decide to tighten fiscal policy, moving the economy toward F, thereby achieving internal balance. At point F, the monetary authorities may tighten credit, bringing the economy toward H, so as to restore external balance. At point H, however, the economy is experiencing a recession. This may prompt the fiscal authorities to pursue a moderate fiscal expansion to bring the economy toward internal balance. This pattern of policy reaction and adjustment will eventually move the economy toward E.

Another convergent adjustment pattern would be for the monetary authorities to try first to tighten credit to achieve external balance at point C. Subsequently, the fiscal authorities could tighten fiscal policy to move the economy toward internal balance at J. Since at J the balance of payments reaches a surplus, the monetary authorities would need to expand credit moderately, bringing the economy toward external balance. This pattern could continue until the economy arrives at E.

Likely Results of an Inappropriate Mix of Policies

Inappropriate policy mixes, or policies that do not follow according to their comparative advantage, can be destabilizing, thwarting efforts to effect simultaneous internal and external balance. Consider the case of a Southeast Asian country. This country undertook comprehensive structural reforms while maintaining macroeconomic stability in the 1980s. The successful macroeconomic and structural adjustment program created an investment boom in the early 1990s. However, inflation began to accelerate, and the balance of payments began to show signs of strain, while the economy continued to grow rapidly. This was a situation that could be represented by point E’ in Figure 2.3.

To contain inflation, the monetary authorities curtailed credit sharply, while maintaining the fixed exchange rate. In Figure 2.3, this meant a move from point E’ to point D. The sharp credit tightening, however, resulted in a steep increase in domestic interest rates. Partly because of this and partly because of the economy’s good performance, the country experienced a surge in capital inflows and a rapid accumulation of foreign reserves. To restore external balance, particularly to increase imports, the government implemented an expansionary fiscal policy, moving the economy from point D to point L. But the expansionary fiscal policy worsened inflation, while capital inflows continued. The monetary authorities responded by tightening credit further, which moved the economy from point L to point M. As can be seen, the inappropriate combination of tight monetary policy and expansionary fiscal policy moved the economy away from point E.

Table 2.2 shows the results of macroeconomic policies undertaken in 42 countries supported by the World Bank’s structural adjustment and sectoral adjustment loans during the 1980s (World Bank, 1992). The years indicate the adjustment periods during which the World Bank loans were disbursed plus one year after the final disbursement. Out-comes were observed during both adjustment and postadjustment periods, up to 1990. They are sorted into four categories: The countries that followed the right policy and obtained the right result constitute the majority for each policy area, for a total of 87 out of 126 cases. There are 17 cases in which countries followed the wrong policy and got the wrong result, consistent with the analytical framework presented above. For countries that followed the right policy but got the wrong result, the reason could generally be explained by unanticipated exogenous shocks, such as drought, civil strife, or deterioration in the terms of trade. There are nine cases in which countries followed the wrong policy but got the right, or seemingly perverse, result. Some of these cases could be explained by unanticipated favorable exogenous events, but others cannot. Côte d’Ivoire, for example, experienced a terms-of-trade deterioration after 1986. The authorities tightened monetary policy to compensate for expansionary fiscal policy to reduce domestic demand and to contain inflation. This combination generated an extended recession. The improvement in the resource balance came entirely from import compression. The REER appreciated because of an increase in domestic prices vis-à-vis the country’s trading partners.

Table 2.2.Policies and Results in 42 Adjusting Countries
Policy IndicatorReduce Fiscal DeficitReal DepreciationCredit Restraint
Desired OutcomeReduce InflationIncrease Resource BalanceIncrease Net Foreign Exchange Reserves
Right policy24 countries32 countries31 countries
Right outcome
Wrong policy10 countries:2 countries:5 countries:
Wrong outcomeBolivia1980-81Nicaragua1980-85Bolivia1980-81
Right policy4 countries:3 countries:6 countries:
Wrong outcomeCosta Rica1982-89Ghana1983-88Brazil1983-85
Ecuador1984-89Jamaica1982-85Côte d’Ivoire1980-87
Wrong policy4 countries:5 countries:
Right outcomeCôte d’Ivoire1980-87Bolivia1980-81
Pakistan1982-83Côte d’Ivoire1980-87

Conclusions: Policy Coordination Versus Policy Assignment

Policy Assignment

Policy coordination is crucial in the formulation and implementation of comprehensive economic adjustment programs. All relevant policy agencies must work together to set common objectives and quantitative targets, and agree among themselves on the economic projections and required policy measures. Typically, a country will formulate such an adjustment program if it seeks a financial arrangement with the IMF. Also, during surveillance, the IMF staff mission consults with the country’s authorities to ensure policy consistency. Other than on these occasions, however, the general tendency is for policy authorities to operate without coordinating among themselves.

What are the reasons for lack of policy coordination? First, the fiscal and monetary authorities may have different policy objectives. For example, the monetary authorities may aim at a lower inflation rate than the fiscal authorities, and the fiscal authorities may be more concerned about economic growth than are the monetary authorities. Second, the two authorities may have different forecasts of the likely outturns in the absence of policy changes. Divergent forecasts reflect different theories or models used in forecasting, which in turn are the results of different training backgrounds and experiences. The third and related reason is that the two authorities may have different opinions on the likely effects of policy measures on the economy, because they may adhere to different theories or use different forecasting models.

In the absence of policy coordination, and particularly if precise quantitative information is lacking about the location of general equilibrium (that is, simultaneous internal and external balance) relative to the current situation, policy assignment could avoid destabilizing actions, as has been shown above.

Financial Programming

A financial programming exercise is an example of perfect policy co-ordination. All forecasts and policy measures are internally consistent within the same accounting and analytical frameworks used to formulate the program. However, it is important not only to analyze the causes of the imbalances but also to consider the comparative advantage of each policy when determining the policy objectives and the required measures. For example, if the predominant problem is inflation, which is mainly caused by unsustainable fiscal policy, then cutting the budget deficit should be made the linchpin of the program design. On the other hand, if the main issue is an unsustainable current account deficit and the real exchange rate is significantly overappreciated, then depreciation of the nominal exchange rate could be a key policy measure, supported by appropriate monetary and fiscal policies. Finally, if the problem is not only an unsustainable current account deficit but also a capital outflow caused by inappropriate interest rate differentials, monetary policy should be given prominence in the program design. The degree of credit restraint should take into account the extent to which both government and private sector borrowing requirements would be met by the banking system, consistent with the overall quantitative targets.

Appendix 2.1: Greater Capital Mobility and the Internal-External Balance

The greater integration of capital markets in the 1990s has important implications for the analytical framework presented in this chapter. First, exogenous changes in the attractiveness of capital inflows influence both the external and the internal balance. Large capital inflows, for example, are likely to be associated with rising investment, consumption, imports, and money demand. Depending on the exchange rate arrangement, policymakers can face either accelerated inflation or a nominal appreciation in the first instance if the large inflows, particularly of a short-term nature, are not sterilized. Box 2.1 shows the basic analytics of short-term capital inflows. In a small, open economy operating under a free float, capital inflows (K) normally will result in an appreciation of the nominal exchange rate (e) with no change in either international reserves (NFA) or broad money (M2). The exchange rate appreciation will lead to a worsening of the current account balance (CA). Under a fixed exchange rate regime and without sterilized intervention, money market equilibrium will be achieved via an increase in net foreign assets and a corresponding increase in the money supply. With full sterilization, the increase in net foreign assets will be offset by a decrease in domestic credit (NDA), with no change in broad money. For intermediate cases with a managed floating regime, the degree of monetary expansion following capital inflows depends on the extent to which the inflows are sterilized and the nominal exchange rate is allowed to appreciate.

Box 2.1.Basic Analytics of Capital Inflows

Floating Exchange Rate Regime

Fixed Exchange Rate Regime

No sterilization

+ K→ ΔNFA > 0 → ΔM2 > 0

Full sterilization

+ K → ΔNFA > 0 → ΔNFA - ΔNDA = 0 → ΔM2 = 0

Partial sterilization

+ K → ΔNFA > 0 → (ΔNFA - ΔNDA) > 0 → ΔM2 > 0

Managed Floating Regime (Partial Intervention)

Continued sterilized intervention without complementary fiscal tightening generally results in higher domestic interest rates and real exchange rate appreciation. Starting from the initial position E’ in Figure 2.1, a credit tightening in response to capital inflows could move the economy in the northwestern direction toward internal balance, possibly further worsening the current account imbalance. In fact, the role of monetary policy in dealing with the short-run trade-off between a real exchange rate appreciation and inflation has been one of the main themes of recent debate about the appropriate response to surges in capital inflows and the causes of currency crises in emerging market economies. Moreover, since sterilization may involve increasing the quantity of government securities to offset the currency inflow, it may result in an undesirable rise in public debt and interest costs.

Conversely, when economies experience currency pressure because of a loss of market confidence or contagion, tightening of monetary policy with high interest rates is expected to discourage capital out-flows and stabilize the exchange rate. Higher domestic interest rates not only raise the nominal returns to investors from assets denominated in domestic currency but also make speculation more expensive by increasing the cost of shorting the domestic currency. Moreover, tight monetary policy is expected to lower domestic demand, improve the current account, and reduce expectations of future inflation and, therefore, of future currency depreciation. However, until market confidence is regained and interest rates are gradually lowered, the tight monetary policy could cause insolvency of weak banks and firms and could have a long-term adverse effect on output.10 This situation can be described in Figure 2.1 by a move in the northwestern direction from a point below the equilibrium real exchange rate in the “inflationary pressure plus current account deficit” quadrant to the “depressed out-put plus current account surplus” quadrant.

Discussions of appropriate responses to large capital inflows and currency crises emphasize policy coordination. It has been suggested, for instance, that during the initial phase of large capital inflows, credit tightening should be complemented by fiscal restraint to reduce the differential between domestic and foreign interest rates and to decrease the current account deficit. A cut in government spending is also expected to reduce the demand for nontradables relative to the demand for tradables, thus limiting the appreciation of the real exchange rate. Similarly, countries have combined fiscal stimulus with lower interest rates to reduce the recessionary effects of the initial adjustment in response to currency crises.

As regards exchange rate policy, the recent crises in some Asian and Latin American countries have reopened the question of whether a fixed exchange rate system is consistent with free capital mobility, particularly in view of rapid adjustment in globalized capital markets. There is no generally agreed answer to that question, although experience has shown that fixed rates are more vulnerable to speculative attacks.

When a country is experiencing large capital inflows, policymakers need to decide on the direction of the exchange rate. If capital inflows are predominantly portfolio investment or other short-term inflows, the equilibrium real exchange rate will probably depreciate if the capital is used to finance consumption or unproductive activities and will probably appreciate if it is channeled into productive capital formation. The argument has been made that, because of the difficulties in predicting the equilibrium real exchange rate and the advantages in adjusting the real exchange rate through a change in the nominal exchange rate rather than through domestic prices, it is better to make the nominal exchange rate sufficiently flexible for market forces to establish equilibrium. Flexible exchange rates would isolate the monetary base from changes in net foreign assets, thus enabling monetary authorities to exercise more control over the monetary aggregates and to focus on other necessary measures, such as strengthening the financial system. Moreover, greater exchange rate flexibility, by letting foreign investors and domestic borrowers bear higher exchange risks, could discourage speculative capital flows. In the event of a reversal of capital inflows, exchange rate flexibility would make it easier for the central bank to perform its “lender of last resort” function.

A disadvantage of a free float, however, is that it may be associated with high volatility in both the nominal and the real exchange rate. Large capital inflows, for example, may induce a drastic exchange rate appreciation that could have negative long-lasting effects on the export sector. To reduce the risk of excessive exchange rate volatility, several countries have adopted crawling exchange rate bands, which can be regarded as an intermediate stage between fixed and flexible exchange rate regimes. However, even when a country adopts an exchange rate-band, the policy authorities should stand ready to move the band, if circumstances warrant. Such an action would also require coordination with monetary and fiscal policies to ensure its effectiveness.


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The author thanks Joshua Aizenman for helpful comments on an earlier version.

A basic reference for this topic is Clark and others (1994).

This concept is discussed in detail in Clark and others (1994). Some recent extensions of this approach and the manner in which it is applied by IMF staff are described in Isard and Faruqee (1998).

Figure 2.1 is known as the Swan diagram, because it was first developed by Trevor Swan in 1955 to explain how employment and the balance of payments were jointly determined in Australia (see Swan, 1963). Subsequently, the framework was refined by IMF staff and academics, mainly in their work on the fundamental equilibrium exchange rate (FEER).

An alternative single-equation approach is offered in Edwards (1994a), In this approach, the real exchange rate (defined as the relative price of tradables to nontradables) is specified as a semilog linear function of the following: (1) potential fundamentals such as the rate of growth of total factor productivity, the terms of trade, the share of government consumption in GDP, the openness of the trade regime, and the degree of capital controls; (2) other variables that could cause the real exchange rate to deviate from its equilibrium value, including proxies for transitory aggregate demand shocks and the change in the nominal exchange rate; and (3) a lagged dependent variable. The equilibrium real exchange rate is derived by using estimated permanent values of the fundamentals, setting the coefficients of the transitory aggregate demand variables and of nominal exchange rate changes equal to zero, and setting the current and lagged real exchange rates equal to each other in the estimated equation.

For a survey of empirical evidence on the effects of exchange rate policy on exports and growth, see Khan and Knight (1985), among others.

Khan and Knight (1985) summarize some of the empirical results of the effects of monetary and fiscal policies on growth.

This model, originated by Mundell (1963) and Fleming (1962), has been extended during the past three decades by others, including Frenkel and Razin (1987).

It could be argued that in a small, open economy with managed floating and high capital mobility, monetary policy should be used to manage the exchange rate, leaving the management of domestic demand to fiscal policy. This is because monetary policy would have little or no effect on domestic interest rates.

The two instruments could be represented by the rate of credit expansion in percent and the budget deficit as a ratio to GDP. The reduced-form equations are derived under the assumption that the exchange rate is given.

For this and other issues in dealing with the recent Asian crisis, see, for example, Goldstein (1998) and Lane and others (1999).

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