Gillis, M., et.a!. Economics ofDevelopment, 3rd Edition
w. W. Norton, New York
Appendix:
Adjustment in a
Small, Open
Economy
In Chapter 5 we identified macroeconomic stabilization and structural
adjustment as essential reforms for a large number of countries trying to
resume economic development in the 1990s. Many economies became
unbalanced because of unstable world market conditions, including: sharp
rises in oil prices during the 1970s, then equally precipitate declines in the
mid-1980s; rising world inflation during the 1970s, followed by tight money,
rising interest rates, and the ensuing world recession in the early 1980s;
and wide swings in the major exchange rates throughout the two decades.
Some governments managed their economies shrewdly enough to overcome-and even to benefit from-these changing conditions. But a larger
number of developing countries were unable to cope and several governments made the situation worse by running unsustainable deficits in their
budgets, allowing the balance of trade and current payments to deteriorate,
accumulating unserviceable debt, expanding the money supply to accommodate rising inflation, and intervening in markets to counteract the effects
of profligate macroeconomic management. Stabilization programs, funded
by the IMF, are intended to reduce the macroeconomic imbalances and
580
APPENDIX:
ADJUSTMENT IN
ASMAll, OPEN
ECONOMY
curb the inflation that resulted from poor economic policies. Structural
adjustment programs, supported by the World Bank, are designed to free
markets from controls and adjust relative prices to reflect economic scarcities.
This appendix treats the problems of adjustment from two complementary perspectives.) We first employ the tools of trade theory-production
frontiers and community indifference curves, utilized in Part 4-to show
how both macroeconomic stabilization and relative price adjustments are
inextricably linked in achieving a balanced economy. We then adopt a
Keynesian perspective-introduced in Chapter 6 and used in Part 3-to
explore the approaches that can be used to reduce macroeconomic imbalances and curb inflation.
ADJUSTMENT IN THE AUSTRALIAN MODEL
Developing economies have two features that are central to understanding
how macroeconomic imbalances occur and can be corrected. First, they
are open economies, in that trade or capital flows across their borders in
sufficient quantity to influence the domestic economy, particularly prices
and the money supply. Most economies are open in this sense, though
openness is a matter of degree. Some countries-China in the 1970s, the
Soviet Union until recently, Cuba, Burma, and Albania-have been so
heavily protected and regulated that they might not qualify as open.
Second, these are small economies, meaning that neither their supply of
exports nor their demand for imports has a noticeable impact on the world
prices of these commodities and services. Economists call these countries
price takers in world markets. Though a number of developing countries
can exert some influence over the price of one or two primary exports in
world markets, they almost never affect the price of goods they import and
for macroeconomic purposes it is usually adequat~ to model even these
countries as price takers.
These two qualities-smallness and openness-are the basis for the Australian or dependent economy model of an economy. 2 In Chapters 15 and 16
we used general equilibrium models to describe comparative advantage
(Figure 15-1) and economic growth through import substitution (Figures
16-5 to 16-7). In those models the two goods were importables and exportabies. The Australian model lumps importables and exportables together
as tradables and distinguishes these from aU other goods and services, called
nontradables. We used this specification in Chapter IS's discussion of Dutch
disease.
I. For this appendix. "adjustment" refers to both stabilization and structural adjustment.
although only some elements of each are considered here.
2. It is called the "Australian" model because it was developed by Australian economists
including W. E. O. Salter, "Internal Balance and External Balance: The Role of Price and
Expenditure Effects." Economic Record. 635. no. 71 (August 1959): 226-238; Trevor W.
Swan. "Economic Control in a Dependent Economy," Economic Record 36. no. 73 (March
1960): 51-66; and W. Max Corden, Inflation, Exchange Rates and the World Economy (Chicago: University of Chicago Press. 1977). Australia is considered a small. open economy.
Tradable goods and services are those whose prices within the country 581
IN
are determined by supply and demand on world markets. Under the small- ADJUSTMENT
THE
economy assumption, these world market prices cannot be influenced by AUSTRALIAN
MODEL
anything that happens within the country and so are exogenous to the model
(determined outside the model). Nontradables are goods and services, such "
as transportation, construction, retail trade, and household services, that
are not easily or conventionally bought or sold outside the country, usually
because the cost of transporting them from one country to another is prohibitive or because local custom inhibits trade. Prices of nontradables are
therefore determined by market forces within the economy. Nontradable
prices are thus endogenous to the model (determined within the model).
Tradables and traded goods or services are not necessarily the same thing.
All exported goods are tradables because domestic producers must sell
them at world prices. Goods that are imported, even if they bear tariffs,
are also tradables. But, paradoxically, imports become nontradables if their
supply is limited by import quotas or other nontariff barriers, so the price
of imports on the domestic market is set by domestic supply and demand
instead of the world price (see Figure 16-2 for one demonstration of this).
Similarly, a good that might be imported under most circumstances, say
clothing or steel, could be rendered nontradable if tariffs were so high that
no imports actually entered the country and domestic market forces controlled prices. It is even possible for a nontraded good to be treated as a
tradable, if government (or a private monopolist) controls the price at world
market levels. In Indonesia, for example, rice is only occasionaIly imported
or exported, but the official domestic price tracks the world price, averaged
over several years. In all cases where goods that are or might be traded are
instead treated as nontradable, or where nontraded goods are treated as
tradable, the cause is some policy intervention that inhibits price-setting
market mechanisms.
Figure A-I depicts equilibrium under the Australian model. 3 The vertical axis represents nontradables (N); the horizontal axis takes both the
exportables and the importables of previous diagrams (Figures 15-1 and
16-5 to 16-7) and treats them together as tradables (1). The production
frontier shows the menu of possible outputs of the two kinds of goods, N
and T. The community indifference curves show consumer preferences
between consumption of tradables and nontradables. Equilibrium is at point
A, the tangency of a consumer indifference curve and the production possibility frontier. This tangency determines the relative price of tradables in
terms of nontradables; P=PtIPn . The slope of the relative price line PI
gives this price in Figure A-I. (Recall that in previous diagrams, with
exportables and importables, the relative price was the world terms of trade.)
The value of income (GNP) or expenditure is Ya , the intersection of price
line PI from point A to the X-axis. 4
3. The presentation in this section follows the more complete treatment of the Australian
model in Richard E. Caves, Jeffrey A. Frankel, and Ronald W. Jones. World Trade and
Payments: An Introduction (Glenview, Ill.: Scott, Foresman I Little, Brown, 1990), Chap. 19.
For a more advanced presentation based on algebra and phase diagrams, see Rudiger Dornbusch, Open Economy Macroeconomics, 2nd ed. (New York: Basic Books, 1989), Chap. 6.
4. The quantity of T-goods is valued at To. The quantity of N-goods is No, which can be
582
APPENDIX:
ADJUSTMENT IN
ASMAll. OPEN
ECONOMY
Vi
o
§
I
relative price line
(slope = P1)
Z
Na
--------
community
- - - indifference
curves
T-GOODS
FIGURE A-l Equilibrium in the Australian Model. With equilibrium at point A, the tangency
of the production frontier and a community indifference curve, the country produces and con·
sumes Ta of tradables and N a of nontradables. The relative price P is an alternative and potentially useful measure of the real exchange rate (see text). National income measured in tradable
prices is Ya•
The relative price P is an alternative measure of the real exchange rate
and is one of the important innovations of the Australian model. In Chapters 15 and 17 we defined the real exchange rate index as RER=RiPw/Pd ),
a composite index of prices that measures the incentives for exporters (or
import substituters) given by the nominal exchange rate and the rates of
world and domestic 'inflation. In the Australian formulation, the price of
tradables in the home market P, replaces RoPw in the earlier definition, and
the price of nontradables P n replaces the overall domestic price level P d
which incorporated both tradable and nontradable prices. The Australian
formulation of P is a more precise and potentially more useful definition of
the real exchange rate, with similar implications: when P rises, tradables'
become more expensive relative to nontradables, so the incentive to produce tradables increases and the incentive to consume tradables decreases. s
Thus a rise in P is the same as a rise in RER, a depreciation of the real
exchange rate, and should work to improve the balance of trade, which is
defined as:
B, = E - M = production of exportables and importables
- domestic consumption of exportables and importables
valued at N,,(t:J.T/11M = N,,( Y" - T)/N" = Y" - Til" So the value of both goods is T + Y - T = Y
(Note that t:J.N/t:J.T=P 1.)
.
"
"
"
".
5. In the Australian model. P, is the price of tradables on the domestic market, so it incorporates any protective tariffs. taxes. and subsidies on tradables. In the real exchange rate
RER, the term P II , is the price in world markets. excluding domestic taxes. Thus the Australian
version P is more akin to the real effective exchange rate. defined in Equation 17-3.
REER=R"NP,JP". where N. the nominal protection index. accounts for tariffs, taxes, and
subsidies. Note. however. that N also includes the quota premium q",. If imports are subject
to quota. they become nontradable in the terms of the Australian model. as explained above.
B, = production of tradables - domestic consumption of tradables. [A-I]
In Figure A-I, with the economy in equilibrium, consumption of each good
is equal to production, so the balance of trade is zero.
The relative price of tradables to nontradables is potentially more useful
than the RER because it separates out prices (Pn ) that are under the influence of monetary and fiscal policy, as well as market forces, within the
country from prices (P,) that can be changed only by adjustments of the
nominal exchange rate. 6 In practice, however, it is difficult to measure P,
because the division between T and N goods is not always clear. Moreover,
national governments have not begun to collect price series that segregate
tradables and nontradables; this makes it difficult to keep continuous time
series on the relative price P.
As the next step toward understanding adjustment within the open economy model, consider what happens if there is an exogenous increase in
expenditure, which would move the relative price line P outward in Figure
A-2, so that the value of expenditure (measured in T-goods) moves from
Ya to Yb • The rise in expenditure could result from arise in government
expenditure in excess of revenues; expenditure in excess of income (dissaving) by consumers; or a spurt in foreign currency inflows, whether from
overseas borrowing, foreign direct investment, or foreign aid.
583
ADJUSTMENT IN
THE
AUSTRALIAN
MODEL
..
§'"
I
Z
N - N
c
d
Na
relative
price lines
production
frontier - _ _
-----
T-GOODS
FICURE A-2 Rise /n Expend/ture under the Australian Model. An exogenous rise in expenditure causes the price and budget line P, to shift outward to a transitory consumption equilibrium at B. Excess demand for N-goods (Nb-N.) causes an inflationary rise in Pn and hence a
downward rotation of the relative price to P2• Consumers now satisfy their preferences at (,
whereas producers shift along the production frontier to D. The excess demand for N has been
eliminated, but the trade deficit (Tc - Td ) remains large.
6. Trade policy can also influence the price of tradables. A rise in tariffs, for example,
raises the domestic price of importables. This effect is captured by both the relative price of
tradables in the Australian model and by the term N in the real effective exchange rate.
584
APPENDIX:
ADJUSTMENT IN
A SMAll, OPEN
ECONOMY
If the shift in expenditure does not change relative prices, there would
be a shift to a transitory equilibrium at a point such as B, where consumption of tradables Tb and nontradables N b both exceed production, which
remains at Ta and N a' The excess demand for nontradables (N b - N a) cannot be sustained very long. Nontradable goods might be supplied from
inventories for a time, but services cannot be stored. Because demand
exceeds supply, the price of nontradables P n will rise. (Remember PI is
determined in world markets and cannot change in the home country unless
there is an exchange rate adjustment.) As P n rises, the relative price of
tradables P rotates downward to a price Iik~P2 in the diagram, with a new
equilibrium for consumers at point C. (Note that the value of expenditure
Yc remains the same as Yb.) At the same time, producers shift out of tradabies into nontradables along the production frontier, from A to D, in
response to the rise in the relative price of N goods. With consumption at
C and production at D, the inflationary excess demand for N-goods has
been eliminated (N,=Nd). However, the trade gap (Tc - Td) remains large
and gross expenditure (Yc) exceeds gross product (Yd ). A trade gap can be
sustained as long as foreign capital inflows continue to finance it or until
the country's foreign reserves run out.
Dutch disease was first diagnosed by the Australian school, and some
aspects of it can be seen clearly in Figure A-2. Consider the horizontal
axis to represent all tradablesexcept the booming export sector, which is
considered to be an economic enclave and therefore outside this model.
Then the shift in expenditure can be due to an improvement in the price of
exports from the booming sector. Recall from Chapter 15 that, under Dutch
disease, the real exchange rate appreciates when the rising demand for
nontradables causes a rise in their price, precisely what has been shown in
Figure A-2 as the rotation of PI to P 2 • Another symptom of Dutch disease
is the decline in the production of traded goods, caused by the appreciation
of the real exchange rate; in the diagram, the move of production from A
to D, caused by the decline in P, is precisely this. With Dutch disease,
however, there is a trade deficit only because we excluded booming sector
exports from the diagram; when these are counted, there is no trade deficit.
To understand stabilization under this model, let us start from the final
point of equilibrium in Figure A-2, consumption at C and production at D,
which have been translated to Figure A-3. Assume the balance-of-trade
deficit is not sustainable. How can stabilization be achieved? Assume that
policymakers aim first to eliminate the trade deficit by reducing expenditure, the rise of which caused the problem in the first place. (We discuss
how they would do this in the next section.) With prices remaining at P 2 in
the absence of a change in the exchange rate, the economy would have to
settle at a point like E in Figure A-3, where (1) production and consumption of tradables are equal (Td= Te ) and (2) consumer preferences are satisfied by a tangency of P2 and an indifference curve. If consumer tastes are
even approximately homo/he/ie, that is, neither good is strongly'preferred
to the other as incomes change, this tangency cannot take place along the
production frontier. With homothetic preferences, tangencies between
indifference curves and the P2 line take place along a ray from the origin,
585
ADJUSTMENT IN
THE
AUSTRALIAN
MODEL
relative
""i::::~'7 price lines
o
•
Yc
T-GOODS
FIGURE A-3 Adjusbnent under the Australian Model. Reductions in expenditure, in the absence
of any change in relative prices, move the economy from C to E, where trade is balanced and
consumer preferences are satisfied. But there is unemployment of resources because potential
production of N·goods Nd exceeds consumption Ne • Devaluation of the real exchange rate from
P2 back to P, is needed to regain the full-employment tangency at A.
0, to point C. But along the production frontier the same tangency at Dis
above the ray OC. The two conditions are, however, satisfied at a point
like E, which is inside the frontier. But at E, there is unemployment because,
although consumption of tradables is balanced with production, consumption of nontradables (Ne ) is less than potential production (Nd ).
The cost of stabilization is high at E because policymakers used only one
instrument, reduction in expenditure, to achieve balance in both the T- and
N-goods markets; put another way, they used expenditure reduction alone
to balance trade and maintain full employment. If a second policy instrument is used, however, it would be possible to achieve a balance of production and consumption in the markets for both T- and N-goods. Seen
through the lens of the Australian model, the goal is to achieve (or to regain)
a tangency between the production frontier and a community indifference
curve. We know from Figure A-I that this takes place at point A, also
shown in Figure A-3.
To regain point A, it is necessary to shift the relative price from P2 to PI,
the original real exchange rate. This real devaluation of the exchange rate
could be achieved in either of two ways. If the price of N-goods is flexible,
then the excess supply of N-goods (Nd>Ne) would work through market
forces to reduce Pn and thus raise P=P,IPn • Alternatively, if rigidities in
the economy are likely to prevent prices from falling rapidly enough, as is
often the case, then the authorities could devalue the exchange rate; this
will drive up the domestic price of tradables P, and raise the real exchange
rate from P2 back to PI.
The lesson of this model is that, to achieve stabilization and full employ-
586
APPENDIX:
ADJUSTMENT IN
A SMALL, OPEN
ECONOMY
ment, policymakers are likely to need two kinds of policies, reduction in
aggregate expenditure and a change in relative prices. Devaluation of the
currency is the most obvious way to achieve the latter, but changes in taxes
and subsidies, as well as deregulation of markets, could also be part of the
package. Expenditure reduction and devaluation are part of the standard
IMF stabilization package. Devaluation, tax and subsidy policy: and deregulation are part of most World Bank structural adjustment packages, which
aim to move production towards tradable goods (D to A in the figures) and
consumption away from tradables (C to A).
MACROECONOMIC POLICY INSTRUMENTS
The policy issue facing many developing countries during the 1980s was
(and remains) that of escaping macroeconomic instability represented by
points like Band C in Figure A-2: a large trade deficit, frequently (though
not necessarily) accompanied by inflationary demand for nontraded goods.
In the Australian model of Figure A-2, which only represents real variables, there is no way to show monetary phenomena and continuing inflation. Hence within the model the excess demand for nontradables shown
at point B cannot continue; temporary inflation (a rise in P n) realigns supply
and demand for N-goods automatically, and then inflation ceases. But in
actual economies, governments can-and often d~ontinue to increase
the money supply enough so purchasing power exceeds the value of goods
supplied and so perpetuate inflation.
We have shown how a move to stabilize a small, open economy-a move
from B or C to A in Figure A-3-requires both a reduction in expenditure
(from Yc to Ya ) and a change in relative prices (from P2 to PI). There are a
number of ways to shift relative prices, from deregulating markets to using
taxes and subsidies. In small, open economies, devaluation ofthe exchange
rate, discussed in Chapter 13 and in Part 4, is a particularly powerful tool.
Here, we concentrate on measures to reduce expenditure, to drive the
economy from point C to a new position on or within the production frontier.
The policy instruments available to reduce expenditure are implicit in
the national income accounting identity
Y=C+/+E-M,
[A-2J
which was encountered in a slightly different form in Equation 6-8. The
symbols have the same meanings as in Chapter 6: gross national product,
consumption, investment, exports and imports of goods and nonfactor services, respectively. For our purposes, here it is useful to transform this
identity into an equation for the foreign balance Bf :
Bf=E-M= Y-(C+I).
[A-3]
Note that Bf is the surplus on current account, the negative of foreign saving (called F in Chapter 6); for an economy at point C. Bf<O. It is clear
from E-quation A-3 that to reduce its deficit on current account (to raise
Bf), a country must cut back consumption, investment, or both. The other
possibility, raising output (Y), is not likely in the short term for an economy
producing at point D, because it is already producing at full capacity and
new investment takes time to become productive. 7
To find the policy levers implicit in Equation A-3, we need to break out
some of its components:
Bf = Yp+T-(Cp+Cg+lp+Ig).
[A-4]
where T is taxes paid to government, Yp is after~tax income left to the
private sector, and the items in parentheses are the private and government
components of consumption and investment. These components can be
regrouped:
Bf=(Yp-Cp) -Ip + T-(Cg+ I g)
Bf=Sp-Ip+Bg.
[A-51
where Sp is private saving and Bg is government's budget balance, positive
for a surplus. 8 An improvement in the foreign balance requires an increase
in private saving, a decrease in private investment, and/or a decrease in
government's budget deficit.
Policymakers have a variety of instruments to achieve the required cuts
in expenditure. Private saving could be increased by increases in interest
rates and by incomes policies that shift earnings toward groups with higher
marginal saving rates (see Chapter I I). Neither effect is likely to be strong,
however, especially in the short run, and the required incomes policy would
work against lower-income groups. Private investment is more amenable to
interest rate policy and to supporting monetary policies that would slow
the growth of private credit from the banking system (Chapter 13). Freeing
interest rates and permitting them to rise to market-determined levels is
crucial to the capital~deepening strategy discussed in Chapter 13 and is a
central feature of many stabilization and structural adjustment packages.
An important long-run monetary reform is to develop money market instruments that give the central bank greater flexibility in influencing the market
conditions that determine interest rates and hence private saving and
investment.
The government bUdget deficit receives more attention than private saving and investment in both IMF and World Bank packages. It is more readily controlled by government, at least in principle, and has in many cases
been a prime cause of inflation and trade deficits. When foreign borrowing
has been used extensively, much of it often goes into government expenditure. Tax reform, discussed in Chapter 12, is essential to raise tax revenue in many developing countries, but generally it cannot be accomplished
in the few months to a year in which stabilization must take place. Some
increase in tax rates and more effective enforcement may help to reduce
7. In this national income model we have abandoned the distinction between traclables and
nontradables, although these could be broken out if needed: E and M consist mostly of tradabIes. whereas C and lean be divided into their tradable and nontradable components.
8. The government budget balance could be written Bg=Sg -[1/' where SI/ = T- Cli is government saving.
587
MACROECONOMIC
POLICY
INSTRUMENTS
588
APPENDIX:
ADjUSTMENT IN
A SMALL. OPEN
ECONOMY
the deficit, but the.scope for this is often limited. Hence the greater burden
falls on reductions in expenditure, and the issue is where to cut.
The largest expenditures are typically salaries of government employees,
the provision for interest and principal repayments on public debt, and
government investment. Reducing government salaries or, more drastically, government employment are politically dangerous measures; yet a
few governments have managed to do one or the other. Defaulting on debt
is even more drastic, as discussed in Chapter 14. Governments typically
look toward purchases of materials and equipment (e.g., paper, educational
materials, medicines, fuel, vehicles), and especially toward investment
projects, to meet expenditure targets of stabilization programs. These kinds
of reductions tend to make government less efficient in delivering services;
to slow down the long-run development of infrastructure, health, education, and other government services; and, to the increasing concern of policymakers and aid donors, to jeopardize the living standards of the poorest
in society.
A popular target for deficit reduction is the subsidies-explicit and
implicit-paid from government to its state-owned corporations. The swing
toward market-based development has convinced many governments to
privatize their corporations by selling shares, or entire companies, to private owners. Those corporations that remain under government control are
increasingly being denied cash subsidies or subsidized credit, and are thereby
forced to become profitable or go bankrupt. These measures, though they
contribute to stabilization, are more properly considered long-run structural adjustments.
Although fiscal management js crucial to adjusting the economy, stabilization does not necessarily require a balanced budget. It all depends on the
required foreign balance and the balance that can be achieved between
private saving and investment, as can be seen from Equation A-5. If the
aim is to achieve balanced trade, for example, and private investors are
trying to spend more than private savers are willing to finance, then government will have to run a surplus to achieve overall balance. But if private
saving exceeds private investment, government can afford to run a deficit
without destabilizing the economy. The foreign balance need not be zero
for stability, either. For those developing countries that are not heavily
indebted, we expect there to be a sustainable deficit on trade, financed by
foreign aid and investment, as discussed in Chapter 14. Much of this inflow
of foreign saving typically does go into the government budget to finance
deficits, generally deficits caused by government development (investment)
expenditures. For heavily indebted countries, however, the trade balance
has to be positive in order to service debt, and this is likely to require a
surplus in the government budget as well.
Note, also, that any given improvement in the budget balance requires
more in additional taxes than it does in expenditure cuts. This is because
taxes reduce private disposable income (Yp in Equation A-4), which deter.
.
mmes savmg:
[A-6]
Thus part of any tax increase comes out of private saving and does not 589
contribute to the required improvement in the overall balance between sav- MACROECONOMIC
POLICY
INSTRUMENTS
ing and investment.
Behind these approaches to expenditure reduction is monetary policy. In
Chapter 13, we introduced the monetary identity, MO=DC+IR, or
•
f:,.MO = fUR +WC,
[A-7]
where MO is the money supply, IR is international reserves, and DC is
domestic credit. With a foreign deficit, international reserves are likely to
be declining and causing a fall in. the money supply, which helps to correct
any inflationary tendencies in the economy. The trouble comes with domestic
credit, which consists of credit from the commercial banks to the private
sector and to government: 9
[A-8]
The excess demand for goods in either the tradables or nontradables markets causes private agents to seek more credit from the banking system
(WCp>O). To the extent that government funds a deficit and gets the banks
to finance it, WCg > O. Thus a reduction in the government deficit reduces
expenditure directly and simultaneously eases the pressure for monetary
expansion. (Government borrowing from the nonbank private lenders does
not create additional domestic credit, but does switch liquidity from private
lenders to the government; this is sometimes called crowding out of private
investment.) An independent central bank may try to swim against this tide'
by using the various means described in Chapter 13 to contain the growth
in credit and the money supply. But most .central banks in developing countries are under the thumb of the finance ministry and are not able to resist
demands for credit expansion. The IMF makes it clear through the conditions on its stabilization packages that the central bank must restrain growth
of domestic credit or the government will forfeit IMF loans (and any other
finance tied to IMF conditions).
Thus at the core of stabilization packages in developing countries are
three essential components: reduced government deficits to cut back aggregate expenditure, restraint by the central bank in monetary and credit management to control inflation, and devaluation to switch expenditures away
from tradables and to switch production into tradables. Other components
may be helpful, even important to stabilization, but these three form the
irreducible core to most adjustment packages. They work together, complementing and reinforcing one another.
9. Here we use DCp and DC, to avoid confusion with the consumption variables. Cp and
CR'