- Email: [email protected]
Financial repression, the new structuralists, and stabilization policy in semi-industrialized economies
Jlausnal of Develo:>~l~ent Economics 14 f 1984j 305-322. North-Hohand
Received April 1982,final version received December 1982 This paper,exzMes the short- and long-run effects of a variety of macroeconomic policies in a simple ,mod$ I+here the curb market plays a pivotal role as the marginal supplkr of loanable funds. !f-‘s lou ad t+t ,,financial libcralizatson may fail in the short-run and, ccntrary to the claims of the a& ~&r~uralists, that the fiaancial market repercussions of devaluation may be fawc-@e. in ev~ahmtingany policy, the time horizon is criticai. Short- and long-run multipliers ma; &Berin sign in all cases, save that of a contraction in the stock of bank credit.
Numerous less developed and semi-industrialized countries, particularly those in Latin America, have recently found themselves saddled with high inflation rates and large balance of payments deficits Usually, after several vacillations, these countries have agreed to the terms of a stabilization plan sponsore.$ by the IMF. ‘Ihe plans have invariably reflected a monetarist outIoolc and have typically called for sharp reductions in the government budget deficit. and the rates of growth of wages and the money supply, a contra&on of real credit, and ‘a stiff devaluation of the domestic currency or an increase in its rate of depreciation. The distinctly uneven, frequently disappointing, results of these plans’ have led to a growing recognition of the need to analyze stabilization policies in models constructed to take account. of the special features of less developed and semi-industrialized economies ~!SIEs).A feature singled out for particular emphasis in the models of the ‘hew structuralists’ [Bruno (1979), Taylor (1979, 1981) and van Wi.nbergen (1982)] and in recent variants of the *I would like to thank Carlos Dh4jaudro,
Jonathan Eaton, Louka Katseli, Lance Taylor and an anonymous refpm for helpful con.u~e~s slnd criticisms. lI;%cellent surveys of the d&uhies GnGounteredin Latin American stabi!izatic:Yp,~ograms may be ‘found in Diax4I~~~aamdro (1981) and Foxley (1981). Reichmann. and Stillson ( 1978) examine country performances for eight quarters before and after implementation of IMF programs and find a very wide range of outcomes. 0304-3878/84/$3.00 @JI1984, Elsevier Sc&~ Publishers B.V. North-Holland)
model of financial repressil)n [Basant (19X$, Mathieson is the dependemx of firms on credit ta finance their pital (intermediate inputs, raw materials, labor), An irrsport43ntSimitAon of this literature is 2s inadequate treatment of the curb IIIou%d. The cwb market is an informal (sometimes illegal) credit .r@4+ Aeoording .to most; accour@ the -.v&une ,-ofloans curb market is at 1-t: 8s ~$;reat,and perhaps several fold tramwted k oficiat credit raarkets,2 Yet, the curb market found in the, analysis ,or models of financial repression t,s. It ai least makes an appei,rance in rhe new structuralists” models, I$ut birth the notable exoeption of van Wijnbergen, the financial modeling n detailed enough to portray correetl:~ the functioning of and their interaction with tie realIside of t!)lreeconomy. paper, an attempt is made to remedy this shortcoming by g 2 very s%nplemodel which focuses on ,the interaction between the ,a1 S&XX and brings out’c9early the prominent role plaied by curb mark& The simplicity of the model D&withstanding, a number of g co~&.&ons emerge. We concur with Siiancial repression theorists and the new structural&s that contractionary monetary policies give rise to eontractionary supply side [email protected] on other issu.eswe come out with very different ~~nchrsions. Financial liberalization is a risky urrdertaking, a step in WE the present state of our empirical knowledge. WC also dissent haqAy from the new structurahsts in finding that the favorable neoclzsical .s of devaluation may be reinforced by adjustments in financial markets. the results of the section deaiing with dynamics make evident, the b~rizon matters a great deal. Short- and long-run multiphers di@erin tight in ali cases, save that of a oDntraction in the stock of bank L Our model of a financially repressed, structiJralist economy is developed in ion 2 Section 3 examines the comparative statics effects of monetary financial liberalization and devaluation. In section 4, long-run results dynes are anal~yzed.The last section summarizes our main findings.
or n&n aim is to delineate clearly the role played by the curb mmket in lly re;p economy. To do so, we abstract from demand factors ther by assuting a small open economy that produces a single good, the supply of in the official baby ~ch &&II that the share Chamiavarkar
ftmds ila’the curb md~et is probably some system. Park ( 1973) cites various studies of of tbe curb market in the t&al supply of (1971).
E.F. iidjie, Financial repression and stabilization pdicy a,
K whose domestic price, P, world market price, P*,
Y=
Y(L,,
isset
R),
P=eP’,
by
307
the exchange rate, e, and the exogenous
(0 (2’
where L is labor and R is the capital stock. The capital stock is fixed in the short-run and diminishing returns apply to increases in just labor. Since the economy is small, employment is entirely supply determined. For simplicity, we assume a CES production function L= iiY[w( 1 + Q/P] -O,
(3)
where W is the ncc:ninal wage, i, is the curb mar% interest rate, o is the elasticity of substit>tionj and a’ is an irrelevant constant. Total labor costs depend on the interest r-ate because of a lag between the time when labor is paid and the sale of output becomes possible.3 The government has zet the interest rates that may be paid on demand deposits, &, and charged for bank loans, iL, far below the market clearing rares and consequently an in.formal, ‘curb’ market charging high real rates of irterest has arisen to give savers an adequate real return and to supply the res_.dual demands of firms rationed in official credit markets. As it is borrowing costs at the margin that matters, the relevailt interest rate is the curb market rate alone. Implicit in (3) is the assumption that firms receive loans only from domestic sources. No doubt those firms turned away by commercial banks would prefer to borrow in world capital markets, but due either to institutional constraints (borrowing demands that are too small, government regulation of foreign borrowing) or the precarious position of tJhe country’3 balance of paY&ents, they find themselves cut off from foreign loans. The next set of equations represents the financial sector of the model. There are four financial assets: currency, CU, demand deposits, Q foreign bonds, F, and curb market Icans, C. Walras’ law has bezn used to eliminate the equilibrium condition in the currctni:y market. The supply of curb market loans in (5) has been modeled as the dembnd for an asset stock. EoanF ma& 3Thoughlihere is a production la?:. the analysis .3an be confined to one period if we take this period to be a ‘Hicksian week’ which spans the entire production cycle from the hiring of labor produced at tht: end of the periocf. Et at the beginning of the period until e:he sale of the o ;:pt ai the exchange-rate is set at the start of thy period and hence that P is observable conternCnc ~sdywith W and i,. Eq. (3) cao be derived formally from :an intertemporal profit maximization problem in which firm access IG bank loans is rationed, there is a one period production lag for aI1 inputs, and it takes one p:niod for investment r’n % r&z44 in an increasd capital stock. (Capital is more ‘roundabouit’ than other inputs.)
r+present a form af (direct finance’, or ‘primary dhtioa’, ts we Gurley and Shaw’s terminol~ogy.0~ may think of wch llaaas as one-period bonds issued by firms and taken g only by (wmercial banks do not opera& in the ct;trb*,,rn&~&)~At the of a& p&xi, finw repay in full the loans they ‘to& o,uitfro;m the rcid &u&a an’d retire the bonds they issued to househ,oMsatthe start period. Come the be&r&g of the next period, firms issue a new set of in taken up by households with. surplu~~income;’
aa
ttsls wb
market
D pl
f
‘(id, i,,
Y)A,
M+eF
A
(4)
(7)
=-p.
W=(l --k)D, w+c==wL
(9)
Following the standard portfolio approach, :thgshare of each asset in totai upon all rates of return and real income. There is no ongoing currency depreciation and, for ;tiot&onal ease, the constant ‘ tenst rate has be& iet eqd to ‘$6, (Alte&&ely, one may think ign asset as foreign currency). We make the usual assumption that are gross substitutes. Due to the abseinceof an equities market, it is umed that it is not possible ta m.z&esubstitutions between capital and al assets.’ The return on capital, therefore, does not appear +50&rproblem in the model. Stocks and flows in the curb market are thing This ig slightly unorthodo~~, but rezdistic since the curb market does not, mUketabwinan~claims. ocher assets is not crucial to any of the is that there be’sorpe o&er assets which market: ‘loans and. which are good hedges he p&t level do not, Gcessarily, a&ct real !n our model. Allowing some additional nds) adds more 5exibility to adjustments
E.F. Buftie, Financial repression and stabilizationpolicy
309
as an argument in anv of the asset demand functions? There being substitutability among only the financial assets, the relevant scale variable is the .,totql .stock ,ofreal financial wealth. Summing over the balance sheets for ..&ns$.households and commercial banks (see table 1) gives private sector net financial worth in (7) as the sum of the stocks of high-powered money and foreign bon:.3s. Table Babce
3
sbmts.
Assets
Liabilities
Household sector
0
CU,~ C eF D Firms C&b Commercial banks LO kD ‘CU, = curreq
LO C
D
held
by
households. bCV,= currency held by firms.
Equilibrium in financial markets occurs through fluctuation of the curb rate is (9) to equate supply and demand for loanable funds. With interest rates controlled by the goverrunent, the commercial banking system has no choice but to passively accept the demand deposits supplied to it by the %ince apitai does not appear in the wealth variable in the asset demand functions it is ignored in the balance sheets. In our model there is no Knancial counterpart to physical capital because there are no equities or bond markets and all loans are repaid at the end of every period. (The loans financing the increment to last year’s capital stock were tepaid at the end of last year.) The simplest accounting solution would be to register the value of the physical capits stock as an asset of households: Alternatively, one could follow the conventional approach and enter physical capital as an asset of fums and ‘equity’ as a liability of l%ms and an asset of households. E@aity then would just be the net worth built up by family firms out of retained profits. There must be some financial counterpart to firms’ working capital and we have assumed it to be currency. Taylor (1981) assumes that firms hold working mpital balances as dexnand deposits with the commertial banks. It is easy to show, by replacing @UCby Df (demand depositi, held by firms) and D by (D+ Da) in the firms and commercial banks’ balance sh&s, that no’ting is changeid if we adopt this specification instead.
3.1. Mowtary po1ic.y
In a m‘_.ei such as sur’;; which alllowsfor both insicle and outside money, art: he42 ,distinct financial instruments the goverlnment can manipulate: aiupply of h&jr-powered money, the. supply of bank credit, and the t Irate p&8 on demand deposits. In this section and the next, we of changes in (each of these instruments. Somewhat the first two instruments monetary policy and Lh.elast r&Giibertition, :th a fixsd ex&.ange-rate regime and given world market prices, the ~ti wage is constant and the results will thus depend sol4y upon the variation in the particular financiai instrument ha:s on i,:. It is ea,c,yto in the required rbzrve ratio and decreases in the stock of money exert contractionary effects. The former directly reduces loans, forcing 5rms to raise more funds in the curb by driving up the curb market rate. I’%::latter pushes up i, private sector weaiah and reducing the stock of demand expenditures could easily bcz incorporated but would ure the basic workings of the model. There would simply t side of eq. (9) reflecting nominal invedment expenditure. Real lion of the productivity c.f cal:fej’l and the real curb rate. in the expressions that follow ik tf:e text. Investment does f lxxauw output is entirely su~plly-cletermined and over %e t
E.F. B@k, Finuncial repression and ?tabiiizationpal.cy
deposits and curb market loans supplied by the household precisely, using eqs. (1) (3)+), and (7)--(g), we get
311
seetar, More
a,
-4, dk=(l-k)R
<”
where sb= S,=
LO
LO+C’ C LO+C’
V+iJ
fj 1
=
share of bank loans in total loan supply, share of curb market loans in total loan supply, , the interest inclusive cost share of labor,
PY
k, = &,(f‘/aQ + &(32/&), the credit-share weighted average of the semielasticities of demand for demand deposits and curb market loans with respect to i,, h, =s,(p’/?) + &(3”/r>, the credit share weighted average of the income elasticities of demand for demand deposits and curb market loans,
A,==
M
the share of high-poweaed money in total financial wealth, A=h,(l
+iJ(l-OJ+b(l
-h,tJ)>O.
The gross substitutes assumption ensures that h, is. positive. Since CIc 1 3 a weak sufficient condition for A to be positive is h,.s l/0,. These results are in agreement with the now familiar theme of NICK,nnonShaw and adherents and the new structuralists: contractionxy monetary policies have adverse supply side effects. We part company with th.2 former group, however when we come to consider the consequences of thl;* third financial instrument, interest rate policy. 3.2. Financial liberalization Analysts of financial repr sion have repeatedly adwca ed increases in the interest rate paid on time, ~ma~d and savings deposits (all proxie derikand deposits in our model) as a reliable method of increasing the SuppiY of bank zedit and loosening the working capital bottleneck. As the s4ution bellow indicatfes, however, there is no guarantee that interest rate pol.icFi* alone
1 do the job.
/#& :=&($‘/&,$ + sdJZ/8i&, the credit-share weighted average of semiof d,emand for demand deposits and curb maekat loans with in id expands the sup& of bank credit but does not the total supply af loanable funds. When & is raised, from the curb market, foreign bonb9 and currency sits. Portiolio shifts out of foreign bonds and currency gate loan supply. But, because of tlhe reserve ratio every &&r switched from the curb market to demand deposits te loan supply by a factor of k. if curb loans constitute a large ble funds and are relatively good substitutes with demand supply of credit in the economy can contract. The limited ble suggests that this is not an unlikely outcome. ‘ahesize of Ihe curb market at several times that of banking system (see footnote 2). Such estimates are itent with the very large currency-M2 ratios (0.5475) and reeluired ‘e ratios (O.HM) observed in many high.ly inflationary, financially SIEs. Taking the normal currency442 rati. in a non-financially SIE to be approxiinately 0.25, a value close to thart found in the ted States in the Iate 1870s [see Cagan (1958)], these hi@ ratios imply t SJ& will generally be in the two to four range. For financial hation to succeed, demand deposits must be much biter substitutes th currency and foreign bonds than with curb loans. Van Wijnbergen’s fur South Korea, however, show just the opposite to be true: it is its and mib loans that are relatively good s.ubstitutes.8 at finan.cial liberalization is an exceedingly &ion+ But lest opponents of fmancial Ijiberalizajtionmake too ults, it should be stressed that they depend &criticallyupon k
the household sector alloclites its wealth between time deposits ts plus currency held by the public:). in terms of our as D and Ml as CU,. %nce the required rmmve ratio MI toward TD increase aggregate loan supply while
it. VanWijnbergen’sestimates rshowtime dep0sit.sto be faar with MI. In f&t, the demand for A41is completely rate. Fittiqg this result into OUPmodel, it says that auppk falls on subsliitution aut of foreign bonds. will often be far above csod substitutes and S a.?! ex
portfblio shift out of
E.F. h&k, Finmcial repression and stddization policy
.I13
the short-run time frame of the analysis. Mctinnon and Shaw assume that increases in id will signif&antly raise the savings rate [McKinnon (1973, pp. 15, 67), Shaw, (1973, pp. 73, 237)], As we shall see in section 4, a stro:ag savings response may, in the long run, increase the stock of wealth enough to offset the unfavorable substitution effects tending to contract aggregate lam supply. In the time frame assumed in conventional short-run macro models, however, savings flows cannot atyect asset stocks. The results here argue f,or the desirability of linking increases in the interest deporit rate with inc:reares in the money stock or decreases in the marginal reserve ratio as safeguards against unexpected short-run effects.g 3.3, Beoaluation Devaluation has long been a favorite whipping boy of structural&s, bcth old and new. ‘The rather vague, old structural% arguments have now been supplemented by the new structuralist claim that devaluation creates stagflationary pre ssure3 by reducing real loan supply and raising interest costs.
WCle devaluation may be stagflationary for any number of reasons [(Krugman and Taylor (1978)], the solutions below cast some Coubt on the new structural% critique. 2, H&+-g) -= 6 di, -= t?
+(I -gM A
(1 -OJ(g-&)+a(1
A(l+i,)-’
+ Ql
-g)(l
614)
9
-h,BJ
-9
(23
I
where At =eF/PA, the share of foreign bonds in total financial wealth. From (14) it may be seen that devaluation operates on totd real labor cost, W(1+ i&/P, through two distinct channels. First, deva.luation lowers the product wage, W/P, if there is not full feedback from prices onto wages.. This favorable effect appears in the second term of the numerator, which is positive if g< 1. Second, devaluation influences ‘both the dem;and fcr anA supply of loanable funds. This shows up in the first bracketed expxssion. For a dven level of employment, devaluation raises ICEUIdemand bj, gtl. On 9McKinnon (1980, p, 119) advocates combining the freeing of intere:it rates with a decrease in the required reserve ratio, but for a daerent reason. In a compeGve banking syseem, every increase in the real interest deposit: rate raises the real bank ICGXA rate by a factor of Ql --a) - I. ‘4 decrease in k is required following financial liberalization if real Iozn rates are not to rise to heights chokialg off economic growth. Increases in the real t;ank loan rate are meiev,ant in our model since the real curb rate is’ the critical interest rate (at least until full integration of financial markets is achieved).
tfrtr;increase in the domestic currejncy value. of foreign bonds’ joan Supply by A+? and this must bch&mccd aghwt the i.n losn demand. Corttntryto the new structuralist critique, we find uation’s favorable neoclassical effect may be reinforced by in M markets. This occurs when the..-&me of’-indexed & w& ,(here0 ,R,).,*;eyg&; It&# &$v -af wage. ,”
()‘...
.,
. .‘., ,. :
.:
,
:
L
at least say something :abo.ut M&h. one : or the other- view .&Imoru3:likey to be qualitative effect of ::‘devaluationup~a empkqment t d tk ela&city of substitution (a).fO The crit.~til pirrameter out to be g, the degree of wage indexation. If t&e is a of real wage rigidity, one should def& to the new not, it is best to remain in the orthodox camp. Setting to mu, the crutial, borderline value of g that makes one’s aver is found to be are
ambigrrous,
we
can
is h, and the larger is A,, the greater the degree of real wage to preserve the orthodox conclusion that devalua;tion is Large values for A, result in the emergence of strong excess loan market and a small value for h, means that the excess tes into a sharp increase in iC.Since normally A,< 1, nominal not necessary,Ii but the real wage must fall to a certain tent to offset rising iMerest costs.
g
analysis dealt with the short run, or impact, eff!
of We would also like to know how the economy will evolve to these pohcies. Analysis of the adjustment process 2 of iC_WIN&~or not
fiinciai market repercussic!ns are favorable to My on the sign of Af -g. Large values ‘of CTfai.vsr increases. in i, skngs in labor demand. For example, eva when g < 4, if Q is large, strongly enough that ultimately ic rises. This means that in ic will not tell one whether the financial market repercussions or diminished labor demand required if impoa’ced inputs are sign&ant. Whether the devaluation are favorable or not then depends upon the sign of the shares of labor and imported inputs in total variable i,canrise,A~inthenominalwa~mayBcnaededto labor demand of both rising interest costs and a decrease in the ned input demand.
E.F. Bugle, Finmlcial repression und stabilization policy
315
particularly important in an economy of the type modeled here bec;!use as the payments deficit alters the stock of 15nancial wealth then: are feedback effects through financial markets to the real side of the economy. As we shall see, the adjustment process may be unstable, and even with a stable adjustment process, impact and long-run multipliers may differ in sign. In egs, (16) and (17) below we state the budget constraint for households and a pair of identities for the stock of high-powered mone,y. The second part of (17) follows afte substituting for CUc and kD from the balance sheet constraints (see table 1) for firms and commercial banks. An olrerdot denotes a time derivative and a tilde that a variable has been deflate11 by the price level. CN is real consumption.
M=kD+CUf+CU,=C-tD+CU;.
(17)
High-powered money is held either as cunency (C&J or demand deposits by households, or used to make loans to firms in the curb mr rket. Chans:s in the desired stocks of these assets tand the desired stock of foreign bonds constitute increases in the desired stock of real financial wealth. We take the latter to depend positively upon all interest rates as well as real income a,nd assume a standard, Metzler-type saving:; function. Substituting (17) in: / (16), setting P* = 1 by choice of units so th;,t P=e, and moving CN to thie lefthand side we have
B=k=A[i$j,
ic)Y-A],
a,VI, V&O,
where B is the current account deficit measured in domestic prices (or foreign exchange since P = e),’ 2 V is the Desired ratio of wealth to income (the dependence on the constant foreign interest rate has been suppressed) and II is a parameter measuring the speed with which the gap between the actu.al and the (desired stock of wealth is closed. (18) is the familiar specie-flcbw mechanism emphasized by the monetary approach to the balance of payments: individuals save or dissave when the aggregate stock of finaiat:!,.al wealth is not at its d - Cxd level and wealth accumulation/decumulation tak.es place through the4L:lirrent account. ,.--
“With the foreign interest rate set equal to zero, there are no interest flows to worry abcut. Neglecting the it;teres? se:,+x account does not affect any of the results qualitatively. With a posr tive foreign intere: r’ate, both BB and CC become flatter in slope. BB becomes flar ter because an increase in i, reduces foreign bond hoidings and thus worsens the interest service account. CC becomes flatter because the decrease in interest income on foreign bonds reduces total income and total loan supply, assuming h, ~0. As the effects involved are relatively small and do not, (2 priori, enhance OF lessen the ‘likelihood ;;f Lstability, we retain the simplifying assumption thlat the foreign interest rate is equal to zero.
‘-interest elastic&y of demand for f?&anciaIwe&h t J. BB’s slope is indetegninatc. A larger stock of i savhgk and wors&s the balance of”&~en&. An uces iS reduce84Output but lower!3&+enditu,re as weIl if in&&MS thir holdings of curb market loans. The s&&s efM the paymenti balanti but the output effect worsens it if the propens& to save is positive. Provided the savings rate is not rily sensitive to iC and G is not negligible, the output effect will and BB’s slope wilf be negative.
E.F. Bugle, Financial reprmsion and stabilization policy
317
With instantaneous clearing in the loan market, the economy is always on the CC sqhedule, .T’a the left of BB there is a payments surplus and i, is falling ,.whiletwits right ,:there is % de&it and & is rising. Stability requires that J3I3~if negatively sloped, cut CC from above. Comparing (19) and (20), it is seen that, inst&ility rem&s when ~(l+ii3(1-83+1-h,B,
A Fig.
2
perspective alters a number of our earlier conclusions. tigid real wage, devaluation is neutral in th.c long run, As .l,.a devitluation reduces the stockof real-&ancia& wealth .from : wcount & &, j-p :.froa”.; $$ .&. ikr;-A ‘ wgi@s s:g$::&#,ggea$ gq~~~y
bhgs
the mnamy
b&
$0
point.
&i
0,&&j&Y,
,Qg.
I-
without m&&&ion to a reduction in the stack of high-powered muney which lowers total real financial wealth by E$. Even in this new udkt modeL then, the monetary app&&h to the balanceof payments I ~~~ a a loag-run theory. Devaluation and contracticurs in the stock of which -~ventuNy mtore flcioneygquxate~:payments sucplu~s The new structur8list eonttibution.. ,comes in uilibrium, the transition. path be@een equilibrium states i, and are everywhere higher than in the initial equrlibrium, uation can ,achieve a permanent cut in the real wage, it- is ilwa &at in the long run, empioyrnent :must .increase and that reperc~~ions always augznent -4qbor.demand, For in the full stocHlow equilibrium is a&ieved and an x”/, devaluation luan supply by an equal tslmount.Ac .in (14) and (15) is by one in detamining the..long-run effects upon 1, and 5,. 1 +&)A then represents the additional positiv;;: sjoost to ng from excess supply in the loan market at the initial l3 Ail of this, of course, applies only to the long run. 7%e economy may still have to contend with short- and medium-run in in unemployment before it reaps the long-run reward. with devaluation, a long-run perspective makes a critical difference to r u&&ate ver& on the McKinnon-Shaw policy of raising the interest te: the impact and long-run multipliers may be opposite in sign. a and Shaw maintain that anincrease in the real interest deposit Fwrate a poweM savings response. This shifts the BB schedule tight in fig. 3. If the horizontal shift of BB exceeds that of CC (PI > , ic fdfes in tb long run Initially iCrises for reasons analyzed earlier ia 3. Brett,cwer time, the powerful savings effect comes into play and a *on ,of current account surpluses eventually raises the real stock of enough to overcome the adverse substitution effects tending to gate loan supply.” ~%oug policies analyzed earlier, only contractions in the stock of or iower in the new equilibrium depends on the sign of (15) when f -g). ic falls if crx( f -Q/(1 - h,8,). Though the long-run financial always fAvorable to fabor demand, i, may, for reasons discussed in m new equilibrium_ sible. If the substitution effects are strong relative to the ~ceed that of BB and the adverse short-run by a series of payments Micits lowering lthe
E.F. Buflc, Financial repression and stabilizationp&y
Fig. 3
319
-7,
bank credit retclin like signed short- and long-run multipkrs. An increase in k sh.fts CC upward while leaving the BB schedu1.e in place in fig. 4. If BB is negatively sloped (the most plausible case), there is an immediate payments defic 3 and .,de long-run eflects upon i, and employment are even more harmful than in the short run. A cumulative payment:!; surplus: results if 3B is positively sloped. This mitigates, but only partly, the adverse short-run effects. Finally, the IMF package of devaluation-cum-credit and money stock contraction can be represented by simuhaneous upward sl&fts of BB and CC and a leftward displacement from point S. If the package relies too heavily upon credit contraction, a deficit will result as in fig. 4,. Si.nce i, increases strongly, for this policy to have a.ny chance of success it must be accompanied by severe wage repression.
5. Conclusions In their first efforts to develop macro models appropriate for SIEs and LDCs, development economists have made some significant departures from standard macroeconomic analysis. The usual assumption that reduction is point-input-point-output has been drllpped in favor of the old Austrian view: inputs affect output with a lag s,.nd capital ifiers from other inputs only in being more ‘roundabout’. Labor lis characterizeld as working capital
a
with the result that real interest costs are a significant determinant of employment. In variants of the McICinnon-Shaw model of financial rewessian and the models of the view structuralists, the Austrian mode of production has been integrated with. analysis of a heavily regulated financial system in which commercial banks are the predominant source of firm finance. The model developed in this -paper conforms to this broad outline but difhxs crucially in certGn de&. The commercial banking &stem is as an important source of finance, but it is the curb maiket that votal role as the margina’. supplier of funds. This sets the model agirrt from those of financial rzpres?don theorists, who have neglected the arket altogether, and from the new structuralists, who, using ad /WC cations, have assumed the relevant interest rate to be some weighted of the commercial bank aud c:~b market rates. The di&rex~ in specification turns out to be of considerable importacce in certain cases- Once we allow for repercussions in the curb market, al liber&zation becomes a p&lous undertaking. Devaluation has effects but is not in%-ariably contractionary as the new claim. If there is substantial real wage rigidity, the new correct, but, if not, devaluation will actually be trument than in conventional models,
E.F. B@e, Financial repression and slabiliza;ion policy
321
Extending the time frame to the long run also makes a significant difference. Short- and long-run multipliers can QiEer in sign if the policy in questbn #enerates current account surpluses (deficits) that offset initial adverse (beneficial) effects in financial markets. Thus, devaluation: in the presence of a rigid real wage and variations in the stock of high-powered money are neutral in the long run, though harmful in the short run. And if real wages can be cut at all, devaluation must ultimately increase employment and real output. The short-run contractionary effects of reductions in the stock of bank credit, however, are likely to be exacerbated in the long run by a series of current account deficits, This may also be the fate of financial liberalization if the savings rate does not respond much to an increase in id, but a sufficiently powerful savings response eventually eliminates any difIiculties that arise in the short run. Our main concern was to develop a rigorous treatment of the interaction between the financial sector and the real side of the economy. In order to bring this interaction into sharp relief, we abstracted from demand factors by assuming a small, totally open econo,my. To test the robustness of the results in this paper and to cast the model in a form suitable for empirical testing or policy prescription, further work integrating the analysis presented here with a detailed treatment of the demand side of the economy is needed. References Basant, ICqxur L, 1976, Alternative stabilization policies for less developed economies, Journal of Political Economy w, no. 4, Aug., 777-795. Bruno, Michael, 1979, Stabilization and stagflation in a semi-mdustrialized economy, in: Rudiger Dornbusch and Jacob A. F’renkel, eds., International economic policy (Johns Hopkins University Press, Baltimore, MD, Londo=t). Cagan, Phillip, 19S8, The demand for currency relative to the total money supply, Journal of . Political Economy 66, no. 4, Aug., 303-328. Chandavarkar, Anand G., 1971, Some aspects of interest rate policies in less developed economies: The experience of selected Asian countries, Imemational Monetary Fund Staff Papers 18, no. 1, March, 48-112. Diaz-Alejaadro, Carlos F., 1981, Southern cone stabilization plans, in: William R. Cline and Sidney Weintraub, eds., Economic stabilization in developing countries (The Brookmgs Institution, Washington, DC). Foxley, Alejandro, 1981, Stabilization wlicies and their effects o:l employment and income distribution: A Latin American pers,f-stive, in: William R. C!ine and Sidney Weintraub, eds., Economic stabilization in developing countries (The Brookings Institut;on, Washington, DC). Keller, Peter M., 1980, Implications of credit policies for output anu the balance af payments, International Monetary Fund Staff Papers 27, no. 3, Sept., 45 t-478 ‘I(rugman, Paul and knee Taylor, 1978, Contractionary effects G: devaluation, Journal of International Eco-;_;tics 8, no. 3, Aug., 445-456. Mathieson, Donald J., 1979, Financial reforms and capital flows in a develcpiq econom. International Monet;tiy Fund Staff Papers 26, no. 3, Sept ,450-489. McKinnon, Ronald I., 1973, Money and capital in economic development (The Brooking Institutron, Washington, DC). GRinnon, Ronald I., 1986, Financial policies, in: John Cody, l-lelen Hughes alid David Wall, eds., Policies for industrial progress in developing countries (Oxford University. Press, London).
_’
Received April 1982,final version received December 1982 This paper,exzMes the short- and long-run effects of a variety of macroeconomic policies in a simple ,mod$ I+here the curb market plays a pivotal role as the marginal supplkr of loanable funds. !f-‘s lou ad t+t ,,financial libcralizatson may fail in the short-run and, ccntrary to the claims of the a& ~&r~uralists, that the fiaancial market repercussions of devaluation may be fawc-@e. in ev~ahmtingany policy, the time horizon is criticai. Short- and long-run multipliers ma; &Berin sign in all cases, save that of a contraction in the stock of bank credit.
Numerous less developed and semi-industrialized countries, particularly those in Latin America, have recently found themselves saddled with high inflation rates and large balance of payments deficits Usually, after several vacillations, these countries have agreed to the terms of a stabilization plan sponsore.$ by the IMF. ‘Ihe plans have invariably reflected a monetarist outIoolc and have typically called for sharp reductions in the government budget deficit. and the rates of growth of wages and the money supply, a contra&on of real credit, and ‘a stiff devaluation of the domestic currency or an increase in its rate of depreciation. The distinctly uneven, frequently disappointing, results of these plans’ have led to a growing recognition of the need to analyze stabilization policies in models constructed to take account. of the special features of less developed and semi-industrialized economies ~!SIEs).A feature singled out for particular emphasis in the models of the ‘hew structuralists’ [Bruno (1979), Taylor (1979, 1981) and van Wi.nbergen (1982)] and in recent variants of the *I would like to thank Carlos Dh4jaudro,
Jonathan Eaton, Louka Katseli, Lance Taylor and an anonymous refpm for helpful con.u~e~s slnd criticisms. lI;%cellent surveys of the d&uhies GnGounteredin Latin American stabi!izatic:Yp,~ograms may be ‘found in Diax4I~~~aamdro (1981) and Foxley (1981). Reichmann. and Stillson ( 1978) examine country performances for eight quarters before and after implementation of IMF programs and find a very wide range of outcomes. 0304-3878/84/$3.00 @JI1984, Elsevier Sc&~ Publishers B.V. North-Holland)
model of financial repressil)n [Basant (19X$, Mathieson is the dependemx of firms on credit ta finance their pital (intermediate inputs, raw materials, labor), An irrsport43ntSimitAon of this literature is 2s inadequate treatment of the curb IIIou%d. The cwb market is an informal (sometimes illegal) credit .r@4+ Aeoording .to most; accour@ the -.v&une ,-ofloans curb market is at 1-t: 8s ~$;reat,and perhaps several fold tramwted k oficiat credit raarkets,2 Yet, the curb market found in the, analysis ,or models of financial repression t,s. It ai least makes an appei,rance in rhe new structuralists” models, I$ut birth the notable exoeption of van Wijnbergen, the financial modeling n detailed enough to portray correetl:~ the functioning of and their interaction with tie realIside of t!)lreeconomy. paper, an attempt is made to remedy this shortcoming by g 2 very s%nplemodel which focuses on ,the interaction between the ,a1 S&XX and brings out’c9early the prominent role plaied by curb mark& The simplicity of the model D&withstanding, a number of g co~&.&ons emerge. We concur with Siiancial repression theorists and the new structural&s that contractionary monetary policies give rise to eontractionary supply side [email protected] on other issu.eswe come out with very different ~~nchrsions. Financial liberalization is a risky urrdertaking, a step in WE the present state of our empirical knowledge. WC also dissent haqAy from the new structurahsts in finding that the favorable neoclzsical .s of devaluation may be reinforced by adjustments in financial markets. the results of the section deaiing with dynamics make evident, the b~rizon matters a great deal. Short- and long-run multiphers di@erin tight in ali cases, save that of a oDntraction in the stock of bank L Our model of a financially repressed, structiJralist economy is developed in ion 2 Section 3 examines the comparative statics effects of monetary financial liberalization and devaluation. In section 4, long-run results dynes are anal~yzed.The last section summarizes our main findings.
or n&n aim is to delineate clearly the role played by the curb mmket in lly re;p economy. To do so, we abstract from demand factors ther by assuting a small open economy that produces a single good, the supply of in the official baby ~ch &&II that the share Chamiavarkar
ftmds ila’the curb md~et is probably some system. Park ( 1973) cites various studies of of tbe curb market in the t&al supply of (1971).
E.F. iidjie, Financial repression and stabilization pdicy a,
K whose domestic price, P, world market price, P*,
Y=
Y(L,,
isset
R),
P=eP’,
by
307
the exchange rate, e, and the exogenous
(0 (2’
where L is labor and R is the capital stock. The capital stock is fixed in the short-run and diminishing returns apply to increases in just labor. Since the economy is small, employment is entirely supply determined. For simplicity, we assume a CES production function L= iiY[w( 1 + Q/P] -O,
(3)
where W is the ncc:ninal wage, i, is the curb mar% interest rate, o is the elasticity of substit>tionj and a’ is an irrelevant constant. Total labor costs depend on the interest r-ate because of a lag between the time when labor is paid and the sale of output becomes possible.3 The government has zet the interest rates that may be paid on demand deposits, &, and charged for bank loans, iL, far below the market clearing rares and consequently an in.formal, ‘curb’ market charging high real rates of irterest has arisen to give savers an adequate real return and to supply the res_.dual demands of firms rationed in official credit markets. As it is borrowing costs at the margin that matters, the relevailt interest rate is the curb market rate alone. Implicit in (3) is the assumption that firms receive loans only from domestic sources. No doubt those firms turned away by commercial banks would prefer to borrow in world capital markets, but due either to institutional constraints (borrowing demands that are too small, government regulation of foreign borrowing) or the precarious position of tJhe country’3 balance of paY&ents, they find themselves cut off from foreign loans. The next set of equations represents the financial sector of the model. There are four financial assets: currency, CU, demand deposits, Q foreign bonds, F, and curb market Icans, C. Walras’ law has bezn used to eliminate the equilibrium condition in the currctni:y market. The supply of curb market loans in (5) has been modeled as the dembnd for an asset stock. EoanF ma& 3Thoughlihere is a production la?:. the analysis .3an be confined to one period if we take this period to be a ‘Hicksian week’ which spans the entire production cycle from the hiring of labor produced at tht: end of the periocf. Et at the beginning of the period until e:he sale of the o ;:pt ai the exchange-rate is set at the start of thy period and hence that P is observable conternCnc ~sdywith W and i,. Eq. (3) cao be derived formally from :an intertemporal profit maximization problem in which firm access IG bank loans is rationed, there is a one period production lag for aI1 inputs, and it takes one p:niod for investment r’n % r&z44 in an increasd capital stock. (Capital is more ‘roundabouit’ than other inputs.)
r+present a form af (direct finance’, or ‘primary dhtioa’, ts we Gurley and Shaw’s terminol~ogy.0~ may think of wch llaaas as one-period bonds issued by firms and taken g only by (wmercial banks do not opera& in the ct;trb*,,rn&~&)~At the of a& p&xi, finw repay in full the loans they ‘to& o,uitfro;m the rcid &u&a an’d retire the bonds they issued to househ,oMsatthe start period. Come the be&r&g of the next period, firms issue a new set of in taken up by households with. surplu~~income;’
aa
ttsls wb
market
D pl
f
‘(id, i,,
Y)A,
M+eF
A
(4)
(7)
=-p.
W=(l --k)D, w+c==wL
(9)
Following the standard portfolio approach, :thgshare of each asset in totai upon all rates of return and real income. There is no ongoing currency depreciation and, for ;tiot&onal ease, the constant ‘ tenst rate has be& iet eqd to ‘$6, (Alte&&ely, one may think ign asset as foreign currency). We make the usual assumption that are gross substitutes. Due to the abseinceof an equities market, it is umed that it is not possible ta m.z&esubstitutions between capital and al assets.’ The return on capital, therefore, does not appear +50&rproblem in the model. Stocks and flows in the curb market are thing This ig slightly unorthodo~~, but rezdistic since the curb market does not, mUketabwinan~claims. ocher assets is not crucial to any of the is that there be’sorpe o&er assets which market: ‘loans and. which are good hedges he p&t level do not, Gcessarily, a&ct real !n our model. Allowing some additional nds) adds more 5exibility to adjustments
E.F. Buftie, Financial repression and stabilizationpolicy
309
as an argument in anv of the asset demand functions? There being substitutability among only the financial assets, the relevant scale variable is the .,totql .stock ,ofreal financial wealth. Summing over the balance sheets for ..&ns$.households and commercial banks (see table 1) gives private sector net financial worth in (7) as the sum of the stocks of high-powered money and foreign bon:.3s. Table Babce
3
sbmts.
Assets
Liabilities
Household sector
0
CU,~ C eF D Firms C&b Commercial banks LO kD ‘CU, = curreq
LO C
D
held
by
households. bCV,= currency held by firms.
Equilibrium in financial markets occurs through fluctuation of the curb rate is (9) to equate supply and demand for loanable funds. With interest rates controlled by the goverrunent, the commercial banking system has no choice but to passively accept the demand deposits supplied to it by the %ince apitai does not appear in the wealth variable in the asset demand functions it is ignored in the balance sheets. In our model there is no Knancial counterpart to physical capital because there are no equities or bond markets and all loans are repaid at the end of every period. (The loans financing the increment to last year’s capital stock were tepaid at the end of last year.) The simplest accounting solution would be to register the value of the physical capits stock as an asset of households: Alternatively, one could follow the conventional approach and enter physical capital as an asset of fums and ‘equity’ as a liability of l%ms and an asset of households. E@aity then would just be the net worth built up by family firms out of retained profits. There must be some financial counterpart to firms’ working capital and we have assumed it to be currency. Taylor (1981) assumes that firms hold working mpital balances as dexnand deposits with the commertial banks. It is easy to show, by replacing @UCby Df (demand depositi, held by firms) and D by (D+ Da) in the firms and commercial banks’ balance sh&s, that no’ting is changeid if we adopt this specification instead.
3.1. Mowtary po1ic.y
In a m‘_.ei such as sur’;; which alllowsfor both insicle and outside money, art: he42 ,distinct financial instruments the goverlnment can manipulate: aiupply of h&jr-powered money, the. supply of bank credit, and the t Irate p&8 on demand deposits. In this section and the next, we of changes in (each of these instruments. Somewhat the first two instruments monetary policy and Lh.elast r&Giibertition, :th a fixsd ex&.ange-rate regime and given world market prices, the ~ti wage is constant and the results will thus depend sol4y upon the variation in the particular financiai instrument ha:s on i,:. It is ea,c,yto in the required rbzrve ratio and decreases in the stock of money exert contractionary effects. The former directly reduces loans, forcing 5rms to raise more funds in the curb by driving up the curb market rate. I’%::latter pushes up i, private sector weaiah and reducing the stock of demand expenditures could easily bcz incorporated but would ure the basic workings of the model. There would simply t side of eq. (9) reflecting nominal invedment expenditure. Real lion of the productivity c.f cal:fej’l and the real curb rate. in the expressions that follow ik tf:e text. Investment does f lxxauw output is entirely su~plly-cletermined and over %e t
E.F. B@k, Finuncial repression and ?tabiiizationpal.cy
deposits and curb market loans supplied by the household precisely, using eqs. (1) (3)+), and (7)--(g), we get
311
seetar, More
a,
-4, dk=(l-k)R
<”
where sb= S,=
LO
LO+C’ C LO+C’
V+iJ
fj 1
=
share of bank loans in total loan supply, share of curb market loans in total loan supply, , the interest inclusive cost share of labor,
PY
k, = &,(f‘/aQ + &(32/&), the credit-share weighted average of the semielasticities of demand for demand deposits and curb market loans with respect to i,, h, =s,(p’/?) + &(3”/r>, the credit share weighted average of the income elasticities of demand for demand deposits and curb market loans,
A,==
M
the share of high-poweaed money in total financial wealth, A=h,(l
+iJ(l-OJ+b(l
-h,tJ)>O.
The gross substitutes assumption ensures that h, is. positive. Since CIc 1 3 a weak sufficient condition for A to be positive is h,.s l/0,. These results are in agreement with the now familiar theme of NICK,nnonShaw and adherents and the new structuralists: contractionxy monetary policies have adverse supply side effects. We part company with th.2 former group, however when we come to consider the consequences of thl;* third financial instrument, interest rate policy. 3.2. Financial liberalization Analysts of financial repr sion have repeatedly adwca ed increases in the interest rate paid on time, ~ma~d and savings deposits (all proxie derikand deposits in our model) as a reliable method of increasing the SuppiY of bank zedit and loosening the working capital bottleneck. As the s4ution bellow indicatfes, however, there is no guarantee that interest rate pol.icFi* alone
1 do the job.
/#& :=&($‘/&,$ + sdJZ/8i&, the credit-share weighted average of semiof d,emand for demand deposits and curb maekat loans with in id expands the sup& of bank credit but does not the total supply af loanable funds. When & is raised, from the curb market, foreign bonb9 and currency sits. Portiolio shifts out of foreign bonds and currency gate loan supply. But, because of tlhe reserve ratio every &&r switched from the curb market to demand deposits te loan supply by a factor of k. if curb loans constitute a large ble funds and are relatively good substitutes with demand supply of credit in the economy can contract. The limited ble suggests that this is not an unlikely outcome. ‘ahesize of Ihe curb market at several times that of banking system (see footnote 2). Such estimates are itent with the very large currency-M2 ratios (0.5475) and reeluired ‘e ratios (O.HM) observed in many high.ly inflationary, financially SIEs. Taking the normal currency442 rati. in a non-financially SIE to be approxiinately 0.25, a value close to thart found in the ted States in the Iate 1870s [see Cagan (1958)], these hi@ ratios imply t SJ& will generally be in the two to four range. For financial hation to succeed, demand deposits must be much biter substitutes th currency and foreign bonds than with curb loans. Van Wijnbergen’s fur South Korea, however, show just the opposite to be true: it is its and mib loans that are relatively good s.ubstitutes.8 at finan.cial liberalization is an exceedingly &ion+ But lest opponents of fmancial Ijiberalizajtionmake too ults, it should be stressed that they depend &criticallyupon k
the household sector alloclites its wealth between time deposits ts plus currency held by the public:). in terms of our as D and Ml as CU,. %nce the required rmmve ratio MI toward TD increase aggregate loan supply while
it. VanWijnbergen’sestimates rshowtime dep0sit.sto be faar with MI. In f&t, the demand for A41is completely rate. Fittiqg this result into OUPmodel, it says that auppk falls on subsliitution aut of foreign bonds. will often be far above csod substitutes and S a.?! ex
portfblio shift out of
E.F. h&k, Finmcial repression and stddization policy
.I13
the short-run time frame of the analysis. Mctinnon and Shaw assume that increases in id will signif&antly raise the savings rate [McKinnon (1973, pp. 15, 67), Shaw, (1973, pp. 73, 237)], As we shall see in section 4, a stro:ag savings response may, in the long run, increase the stock of wealth enough to offset the unfavorable substitution effects tending to contract aggregate lam supply. In the time frame assumed in conventional short-run macro models, however, savings flows cannot atyect asset stocks. The results here argue f,or the desirability of linking increases in the interest deporit rate with inc:reares in the money stock or decreases in the marginal reserve ratio as safeguards against unexpected short-run effects.g 3.3, Beoaluation Devaluation has long been a favorite whipping boy of structural&s, bcth old and new. ‘The rather vague, old structural% arguments have now been supplemented by the new structuralist claim that devaluation creates stagflationary pre ssure3 by reducing real loan supply and raising interest costs.
WCle devaluation may be stagflationary for any number of reasons [(Krugman and Taylor (1978)], the solutions below cast some Coubt on the new structural% critique. 2, H&+-g) -= 6 di, -= t?
+(I -gM A
(1 -OJ(g-&)+a(1
A(l+i,)-’
+ Ql
-g)(l
614)
9
-h,BJ
-9
(23
I
where At =eF/PA, the share of foreign bonds in total financial wealth. From (14) it may be seen that devaluation operates on totd real labor cost, W(1+ i&/P, through two distinct channels. First, deva.luation lowers the product wage, W/P, if there is not full feedback from prices onto wages.. This favorable effect appears in the second term of the numerator, which is positive if g< 1. Second, devaluation influences ‘both the dem;and fcr anA supply of loanable funds. This shows up in the first bracketed expxssion. For a dven level of employment, devaluation raises ICEUIdemand bj, gtl. On 9McKinnon (1980, p, 119) advocates combining the freeing of intere:it rates with a decrease in the required reserve ratio, but for a daerent reason. In a compeGve banking syseem, every increase in the real interest deposit: rate raises the real bank ICGXA rate by a factor of Ql --a) - I. ‘4 decrease in k is required following financial liberalization if real Iozn rates are not to rise to heights chokialg off economic growth. Increases in the real t;ank loan rate are meiev,ant in our model since the real curb rate is’ the critical interest rate (at least until full integration of financial markets is achieved).
tfrtr;increase in the domestic currejncy value. of foreign bonds’ joan Supply by A+? and this must bch&mccd aghwt the i.n losn demand. Corttntryto the new structuralist critique, we find uation’s favorable neoclassical effect may be reinforced by in M markets. This occurs when the..-&me of’-indexed & w& ,(here0 ,R,).,*;eyg&; It&# &$v -af wage. ,”
()‘...
.,
. .‘., ,. :
.:
,
:
L
at least say something :abo.ut M&h. one : or the other- view .&Imoru3:likey to be qualitative effect of ::‘devaluationup~a empkqment t d tk ela&city of substitution (a).fO The crit.~til pirrameter out to be g, the degree of wage indexation. If t&e is a of real wage rigidity, one should def& to the new not, it is best to remain in the orthodox camp. Setting to mu, the crutial, borderline value of g that makes one’s aver is found to be are
ambigrrous,
we
can
is h, and the larger is A,, the greater the degree of real wage to preserve the orthodox conclusion that devalua;tion is Large values for A, result in the emergence of strong excess loan market and a small value for h, means that the excess tes into a sharp increase in iC.Since normally A,< 1, nominal not necessary,Ii but the real wage must fall to a certain tent to offset rising iMerest costs.
g
analysis dealt with the short run, or impact, eff!
of We would also like to know how the economy will evolve to these pohcies. Analysis of the adjustment process 2 of iC_WIN&~or not
fiinciai market repercussic!ns are favorable to My on the sign of Af -g. Large values ‘of CTfai.vsr increases. in i, skngs in labor demand. For example, eva when g < 4, if Q is large, strongly enough that ultimately ic rises. This means that in ic will not tell one whether the financial market repercussions or diminished labor demand required if impoa’ced inputs are sign&ant. Whether the devaluation are favorable or not then depends upon the sign of the shares of labor and imported inputs in total variable i,canrise,A~inthenominalwa~mayBcnaededto labor demand of both rising interest costs and a decrease in the ned input demand.
E.F. Bugle, Finmlcial repression und stabilization policy
315
particularly important in an economy of the type modeled here bec;!use as the payments deficit alters the stock of 15nancial wealth then: are feedback effects through financial markets to the real side of the economy. As we shall see, the adjustment process may be unstable, and even with a stable adjustment process, impact and long-run multipliers may differ in sign. In egs, (16) and (17) below we state the budget constraint for households and a pair of identities for the stock of high-powered mone,y. The second part of (17) follows afte substituting for CUc and kD from the balance sheet constraints (see table 1) for firms and commercial banks. An olrerdot denotes a time derivative and a tilde that a variable has been deflate11 by the price level. CN is real consumption.
M=kD+CUf+CU,=C-tD+CU;.
(17)
High-powered money is held either as cunency (C&J or demand deposits by households, or used to make loans to firms in the curb mr rket. Chans:s in the desired stocks of these assets tand the desired stock of foreign bonds constitute increases in the desired stock of real financial wealth. We take the latter to depend positively upon all interest rates as well as real income a,nd assume a standard, Metzler-type saving:; function. Substituting (17) in: / (16), setting P* = 1 by choice of units so th;,t P=e, and moving CN to thie lefthand side we have
B=k=A[i$j,
ic)Y-A],
a,VI, V&O,
where B is the current account deficit measured in domestic prices (or foreign exchange since P = e),’ 2 V is the Desired ratio of wealth to income (the dependence on the constant foreign interest rate has been suppressed) and II is a parameter measuring the speed with which the gap between the actu.al and the (desired stock of wealth is closed. (18) is the familiar specie-flcbw mechanism emphasized by the monetary approach to the balance of payments: individuals save or dissave when the aggregate stock of finaiat:!,.al wealth is not at its d - Cxd level and wealth accumulation/decumulation tak.es place through the4L:lirrent account. ,.--
“With the foreign interest rate set equal to zero, there are no interest flows to worry abcut. Neglecting the it;teres? se:,+x account does not affect any of the results qualitatively. With a posr tive foreign intere: r’ate, both BB and CC become flatter in slope. BB becomes flar ter because an increase in i, reduces foreign bond hoidings and thus worsens the interest service account. CC becomes flatter because the decrease in interest income on foreign bonds reduces total income and total loan supply, assuming h, ~0. As the effects involved are relatively small and do not, (2 priori, enhance OF lessen the ‘likelihood ;;f Lstability, we retain the simplifying assumption thlat the foreign interest rate is equal to zero.
‘-interest elastic&y of demand for f?&anciaIwe&h t J. BB’s slope is indetegninatc. A larger stock of i savhgk and wors&s the balance of”&~en&. An uces iS reduce84Output but lower!3&+enditu,re as weIl if in&&MS thir holdings of curb market loans. The s&&s efM the paymenti balanti but the output effect worsens it if the propens& to save is positive. Provided the savings rate is not rily sensitive to iC and G is not negligible, the output effect will and BB’s slope wilf be negative.
E.F. Bugle, Financial reprmsion and stabilization policy
317
With instantaneous clearing in the loan market, the economy is always on the CC sqhedule, .T’a the left of BB there is a payments surplus and i, is falling ,.whiletwits right ,:there is % de&it and & is rising. Stability requires that J3I3~if negatively sloped, cut CC from above. Comparing (19) and (20), it is seen that, inst&ility rem&s when ~(l+ii3(1-83+1-h,B,
A Fig.
2
perspective alters a number of our earlier conclusions. tigid real wage, devaluation is neutral in th.c long run, As .l,.a devitluation reduces the stockof real-&ancia& wealth .from : wcount & &, j-p :.froa”.; $$ .&. ikr;-A ‘ wgi@s s:g$::&#,ggea$ gq~~~y
bhgs
the mnamy
b&
$0
point.
&i
0,&&j&Y,
,Qg.
I-
without m&&&ion to a reduction in the stack of high-powered muney which lowers total real financial wealth by E$. Even in this new udkt modeL then, the monetary app&&h to the balanceof payments I ~~~ a a loag-run theory. Devaluation and contracticurs in the stock of which -~ventuNy mtore flcioneygquxate~:payments sucplu~s The new structur8list eonttibution.. ,comes in uilibrium, the transition. path be@een equilibrium states i, and are everywhere higher than in the initial equrlibrium, uation can ,achieve a permanent cut in the real wage, it- is ilwa &at in the long run, empioyrnent :must .increase and that reperc~~ions always augznent -4qbor.demand, For in the full stocHlow equilibrium is a&ieved and an x”/, devaluation luan supply by an equal tslmount.Ac .in (14) and (15) is by one in detamining the..long-run effects upon 1, and 5,. 1 +&)A then represents the additional positiv;;: sjoost to ng from excess supply in the loan market at the initial l3 Ail of this, of course, applies only to the long run. 7%e economy may still have to contend with short- and medium-run in in unemployment before it reaps the long-run reward. with devaluation, a long-run perspective makes a critical difference to r u&&ate ver& on the McKinnon-Shaw policy of raising the interest te: the impact and long-run multipliers may be opposite in sign. a and Shaw maintain that anincrease in the real interest deposit Fwrate a poweM savings response. This shifts the BB schedule tight in fig. 3. If the horizontal shift of BB exceeds that of CC (PI > , ic fdfes in tb long run Initially iCrises for reasons analyzed earlier ia 3. Brett,cwer time, the powerful savings effect comes into play and a *on ,of current account surpluses eventually raises the real stock of enough to overcome the adverse substitution effects tending to gate loan supply.” ~%oug policies analyzed earlier, only contractions in the stock of or iower in the new equilibrium depends on the sign of (15) when f -g). ic falls if crx( f -Q/(1 - h,8,). Though the long-run financial always fAvorable to fabor demand, i, may, for reasons discussed in m new equilibrium_ sible. If the substitution effects are strong relative to the ~ceed that of BB and the adverse short-run by a series of payments Micits lowering lthe
E.F. Buflc, Financial repression and stabilizationp&y
Fig. 3
319
-7,
bank credit retclin like signed short- and long-run multipkrs. An increase in k sh.fts CC upward while leaving the BB schedu1.e in place in fig. 4. If BB is negatively sloped (the most plausible case), there is an immediate payments defic 3 and .,de long-run eflects upon i, and employment are even more harmful than in the short run. A cumulative payment:!; surplus: results if 3B is positively sloped. This mitigates, but only partly, the adverse short-run effects. Finally, the IMF package of devaluation-cum-credit and money stock contraction can be represented by simuhaneous upward sl&fts of BB and CC and a leftward displacement from point S. If the package relies too heavily upon credit contraction, a deficit will result as in fig. 4,. Si.nce i, increases strongly, for this policy to have a.ny chance of success it must be accompanied by severe wage repression.
5. Conclusions In their first efforts to develop macro models appropriate for SIEs and LDCs, development economists have made some significant departures from standard macroeconomic analysis. The usual assumption that reduction is point-input-point-output has been drllpped in favor of the old Austrian view: inputs affect output with a lag s,.nd capital ifiers from other inputs only in being more ‘roundabout’. Labor lis characterizeld as working capital
a
with the result that real interest costs are a significant determinant of employment. In variants of the McICinnon-Shaw model of financial rewessian and the models of the view structuralists, the Austrian mode of production has been integrated with. analysis of a heavily regulated financial system in which commercial banks are the predominant source of firm finance. The model developed in this -paper conforms to this broad outline but difhxs crucially in certGn de&. The commercial banking &stem is as an important source of finance, but it is the curb maiket that votal role as the margina’. supplier of funds. This sets the model agirrt from those of financial rzpres?don theorists, who have neglected the arket altogether, and from the new structuralists, who, using ad /WC cations, have assumed the relevant interest rate to be some weighted of the commercial bank aud c:~b market rates. The di&rex~ in specification turns out to be of considerable importacce in certain cases- Once we allow for repercussions in the curb market, al liber&zation becomes a p&lous undertaking. Devaluation has effects but is not in%-ariably contractionary as the new claim. If there is substantial real wage rigidity, the new correct, but, if not, devaluation will actually be trument than in conventional models,
E.F. B@e, Financial repression and slabiliza;ion policy
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Extending the time frame to the long run also makes a significant difference. Short- and long-run multipliers can QiEer in sign if the policy in questbn #enerates current account surpluses (deficits) that offset initial adverse (beneficial) effects in financial markets. Thus, devaluation: in the presence of a rigid real wage and variations in the stock of high-powered money are neutral in the long run, though harmful in the short run. And if real wages can be cut at all, devaluation must ultimately increase employment and real output. The short-run contractionary effects of reductions in the stock of bank credit, however, are likely to be exacerbated in the long run by a series of current account deficits, This may also be the fate of financial liberalization if the savings rate does not respond much to an increase in id, but a sufficiently powerful savings response eventually eliminates any difIiculties that arise in the short run. Our main concern was to develop a rigorous treatment of the interaction between the financial sector and the real side of the economy. In order to bring this interaction into sharp relief, we abstracted from demand factors by assuming a small, totally open econo,my. To test the robustness of the results in this paper and to cast the model in a form suitable for empirical testing or policy prescription, further work integrating the analysis presented here with a detailed treatment of the demand side of the economy is needed. References Basant, ICqxur L, 1976, Alternative stabilization policies for less developed economies, Journal of Political Economy w, no. 4, Aug., 777-795. Bruno, Michael, 1979, Stabilization and stagflation in a semi-mdustrialized economy, in: Rudiger Dornbusch and Jacob A. F’renkel, eds., International economic policy (Johns Hopkins University Press, Baltimore, MD, Londo=t). Cagan, Phillip, 19S8, The demand for currency relative to the total money supply, Journal of . Political Economy 66, no. 4, Aug., 303-328. Chandavarkar, Anand G., 1971, Some aspects of interest rate policies in less developed economies: The experience of selected Asian countries, Imemational Monetary Fund Staff Papers 18, no. 1, March, 48-112. Diaz-Alejaadro, Carlos F., 1981, Southern cone stabilization plans, in: William R. Cline and Sidney Weintraub, eds., Economic stabilization in developing countries (The Brookmgs Institution, Washington, DC). Foxley, Alejandro, 1981, Stabilization wlicies and their effects o:l employment and income distribution: A Latin American pers,f-stive, in: William R. C!ine and Sidney Weintraub, eds., Economic stabilization in developing countries (The Brookings Institut;on, Washington, DC). Keller, Peter M., 1980, Implications of credit policies for output anu the balance af payments, International Monetary Fund Staff Papers 27, no. 3, Sept., 45 t-478 ‘I(rugman, Paul and knee Taylor, 1978, Contractionary effects G: devaluation, Journal of International Eco-;_;tics 8, no. 3, Aug., 445-456. Mathieson, Donald J., 1979, Financial reforms and capital flows in a develcpiq econom. International Monet;tiy Fund Staff Papers 26, no. 3, Sept ,450-489. McKinnon, Ronald I., 1973, Money and capital in economic development (The Brooking Institutron, Washington, DC). GRinnon, Ronald I., 1986, Financial policies, in: John Cody, l-lelen Hughes alid David Wall, eds., Policies for industrial progress in developing countries (Oxford University. Press, London).
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