April 19, 2002
Macroeconomic Management: An Overview
Mohsin S. Khan, Saleh M. Nsouli, and Chorng-Huey Wong
Since its establishment in 1964, the IMF Institute has trained more than 13,000 officials from 183 member countries in Washington and over 8,000 officials overseas. The training focuses on such subjects as financial programming and policies, monetary and exchange operations, public finance, financial sector issues, and macroeconomic statistics. This book includes some of the background material that the IMF Institute uses in the training of country officials. Although IMF Institute courses also cover structural issues—such as banking system, public enterprises, and labor market reform (which are also critical to the achievement of economic policy objectives), this book deals only with macroeconomic issues. Specifically, it addresses some of the key questions policymakers face in managing national economies:
The first part of the book focuses on the broader issues of economic adjustment, growth, program effectiveness, and current account sustainability. In Chapter 2, Chorng-Huey Wong reviews the design of macroeconomic adjustment programs in the context of a framework for determining the mix of monetary, fiscal, and exchange rate policies for restoring economic balance. Wong explains that both internal balance and external balance depend on two fundamental variables--the level of real domestic demand and the real exchange rate. Accordingly, various combinations of internal and external imbalances can be identified, depending on whether an excess or deficient real domestic demand exists and whether the real exchange rate is overly appreciated or depreciated. Each combination of imbalances requires a different combination of corrective measures.
Wong focuses on the mix of policies required to deal with a situation in which excess real domestic demand and an overly appreciated real exchange rate combine to produce domestic inflation and a current account deficit. Although the combination of tight monetary and fiscal policies could be used in this case to restore internal and external balance, the combination could also adversely affect production and unemployment. Another approach would be to induce a nominal depreciation to improve the current account position, but that action could increase domestic inflation, unless it is complemented by demand-restraint monetary and fiscal policies. Wong points out that whether a nominal depreciation is required depends, among other things, on the size of the real exchange rate misalignment. This leads to the discussion of the concept and measurement of the macroeconomic balance real exchange rate, which corresponds to the simultaneous attainment of internal and external balance.
Wong considers the relative effectiveness of monetary and fiscal policies in influencing domestic output and prices and the external sector position, which depend largely on the exchange rate regime adopted. He shows that an appropriate mix of policies, whereby each policy is "assigned" to address the particular imbalance for which it has a comparative advantage, will make adjustment convergent.
In Chapter 3, Nadeem Ul Haque and Mohsin S. Khan focus more narrowly on the empirical evidence for the effects that IMF-supported adjustment programs have on inflation, economic growth, and the external sector. They examine the methodologies used in, and the results obtained by, evaluations of IMF-supported programs, with a view to assessing the effectiveness of past programs and ways of improving future evaluations. They note that assessment results can provide an important input into the design of IMF-supported programs. They emphasize that the proper standard for measuring program effectiveness is to compare the macroeconomic outcomes under a program with the outcomes that would have emerged in the absence of a program, or under a different set of policies--the counterfactual case.
Their study points to two important conclusions. First, the methodology of more recent studies, which applied the counterfactual criteria to evaluating program performance by estimating the policy-reaction functions for program and nonprogram countries, have yielded more reliable results than those from earlier studies. Haque and Khan are critical of the earlier studies, because these studies attempted to gauge program effectiveness by comparing macroeconomic outcomes in program countries with performance before the implementation of the program, or with the observed performance of nonprogram countries. Consequently, they failed to measure the counterfactual properly.
Second, Haque and Khan conclude that IMF-supported programs do improve the current account balance and the overall balance of payments. Although the rate of inflation in most cases falls, the change is generally found not to be statistically significant. With regard to growth, output is depressed in the short run as the demand-reducing elements of a policy package dominate, but, as macroeconomic stability returns, growth recovers. Haque and Khan point out that for future work, even though the counterfactual is the most appropriate way of judging program effects, there are serious difficulties in using this criterion. They see some benefit in conducting case studies, as opposed to large multicountry studies, because case studies permit a deeper analysis of program implementation, but they caution that case studies are useful primarily as a means of supplementing the results from cross-country studies.
Sources of Growth
In Chapter 4, Xavier X. Sala-i-Martin considers the sources of growth in rich countries and the causes of slow growth in countries that have lagged behind. To address these questions, he introduces some of the tools used in analyzing the growth performance of countries. He notes that the central element of the neoclassical theory of economic growth is the neoclassical production function, which assumes that all of the inputs for production can be aggregated into three basic ones: capital, labor, and technology.
In neoclassical theory, the production function exhibits constant returns to scale and diminishing returns to each input. Thus, in a world with neoclassical technology and perfect competition, the main driving source of economic growth is technological progress. But, Sala-i-Martin notes, the neoclassical researchers left unexplained the process by which technological progress occurs, by assuming that technology grows at an exogenous rate. This, he points out, is clearly unsatisfactory from a theoretical standpoint because it is tantamount to saying that the ultimate source of growth is unexplained. Accordingly, since the mid-1980s, a large number of researchers have worked to determine the sources of growth. The resulting studies are known as the "new growth literature." Sala-i-Martin divides the research into three broad categories: human capital, technology, and government, viewed within the context of the legal system, the macroeconomic environment, the imposition of taxes, and government spending. He examines the models for analyzing the effects of these issues on growth and the empirical evidence on its determinants. The evidence shows several variables to be strongly correlated with growth: the quality of government (positive); market distortions (negative); investment (positive); openness (positive); market-type economy (positive); education (positive); and sound macroeconomic policies (positive). Surprisingly, some variables appear unimportant for growth: for example, government spending, financial sophistication, scale effects (measured by total area and total labor force), and ethnolinguistic fractionalization (supposed to capture the level of internal strife among ethnic groups).
Current Account Sustainability
Sala-i-Martin links growth to sound macroeconomic policies, which, as Luis Carranza explains in Chapter 5, are also critical to the achievement of a sustainable external current account position. Carranza defines the current account balance and its determinants and explores the relationship between the current account and the key underlying variables such as investment, saving, and capital flows. He points out that the recent econometric literature on determining current account sustainability focuses on issues of intertemporal solvency and other crucial factors, such as macroeconomic policy (including policy reversals and credibility) and the willingness of international investors to lend to countries with large deficits. Carranza examines the set of leading indicators (structural, macroeconomic, and overborrowing factors) proposed in the literature to help predict external crises and detect whether current account deficits could become unsustainable over the long term. He analyzes the various types of policy responses, concluding with a review of the structural characteristics and macroeconomic policy stances of five countries (Argentina, Canada, Chile, Mexico, and Thailand) that had experienced large current account deficits.
The second half of the book turns more specifically to monetary, fiscal, and exchange rate policies. In Chapter 6, Richard C. Barth describes the general framework for formulating monetary policy. He focuses on the objectives of monetary policy, the instruments available to attain those objectives, the basic elements of the relationship between exchange rate policy and monetary policy, and alternative views of the transmission process of monetary policy.
Monetary policy objectives traditionally include economic growth, employment, and price stability. Depending on the country, monetary policy may assign equal weights to these objectives, or as is more common now, place greater emphasis on the objective of price stability. There are, of course, other objectives, such as the stability of long-term interest rates and financial markets, or the level of economic activity in particular sectors of the economy. Barth distinguishes between intermediate targets and operating targets, as well as direct and indirect monetary policy instruments. He also explains the difference between the money view of the transmission mechanism and the credit view, arguing that, in practice, most central banks that use indirect monetary instruments have been unable to exercise a high degree of control over credit aggregates in the short term, and monetary aggregates have been more popular as intermediate variables. Barth also reviews issues pertaining to the role of the central bank in conducting monetary policy: the inflationary bias of monetary policy, rules versus discretion in monetary policy implementation, and central bank independence. He provides examples of how various countries have operated under several types of monetary regime: exchange rate targeting, monetary targeting, inflation targeting, and discretionary policy with an implicit nominal anchor.
Jodi Scarlata discusses inflation targeting in more detail in Chapter 7. Scarlata explains that the inflation-targeting framework is an operational regime intended to enhance the performance of monetary policy. In this type of regime, price stability is the primary goal of monetary policy, and the central bank has discretion in determining how monetary goals are attained and is accountable for achieving those goals. She notes that the inflation-targeting framework was adopted primarily to resolve conflicts among competing monetary policy objectives.
Many countries adopted the framework to address the problems experienced with previous monetary regimes, such as those that used exchange rate pegs or monetary aggregates as the intermediate target. In a few countries, inflation targeting was used where earlier inflation stabilization efforts consisting of heterodox programs and crawling exchange rate bands had conflicted with efforts to maintain the official exchange rate regime and to control inflation. Scarlata argues that the inflation-targeting framework avoids these conflicts by serving as a clear statement that inflation fighting is the primary goal of monetary policy and by giving the central bank the freedom to conduct monetary policy independently of the influence of political cycles, thus making the central bank accountable for achieving monetary goals. She provides an overview of issues associated with the design of monetary policy rules. She assesses the rationale for, and the theory of, inflation targeting, including the prerequisites for adopting an inflation-targeting framework and the operational steps involved in implementing inflation targeting. Finally, Scarlata attributes the success of Israel, New Zealand, and the United Kingdom in reducing inflation directly to their policy of inflation targeting.
The Role of Fiscal Policy
Turning to the role of fiscal policy in macroeconomic management, Samir El-Khouri in Chapter 8 specifies three main functions of fiscal policy:
The role of fiscal policy in price stabilization in the context of a sustainable balance of payments is the focus of Enzo Croce's discussion in Chapter 9. Croce explains that for successful stabilization to be achieved the public sector finances need to be balanced against the demand for investment and the supply of savings by the private sector and available external financing flows. Countries facing major macroeconomic difficulties are often associated with substantial disequilibria in public finances. Reducing the fiscal imbalance thus becomes a necessary condition for improving the macroeconomic situation in such countries.
In defining the role of fiscal policy in adjustment programs, two key issues arise. First, a correct measure of the fiscal position is needed to calculate the true extent to which the public sector is preempting resources. However, since no single comprehensive and complete measure of the underlying fiscal position exists, policymakers must rely on a series of alternative indicators, each with its advantages and disadvantages. Second, once an operational measure of the fiscal position is set, the size of the needed fiscal adjustment has to be determined.
Croce discusses how the stance of fiscal policy can be defined and estimated and reviews the use of various indicators and how they can provide a basis for assessing the impact of fiscal policy on macroeconomic variables. He explains how government operations interact with other macroeconomic variables within the framework of the intertemporal budget constraint of the public sector. In this context, Croce discusses how specific indicators, mainly associated with the dynamics of the debt-to-GDP ratio, can be useful parameters for targeting a timeline for reducing fiscal deficits. He concludes by examining the criteria for fiscal solvency and sustainability and the framework for determining the amount of fiscal adjustment needed to achieve sustainable domestic and external balances within a set time frame.
Exchange Rate Policy and Issues
In Chapter 10, Graciana del Castillo examines the issues involved in determining nominal exchange rates. Her survey of the econometric literature on the determinants of nominal exchange rates notes that traditional models of exchange rate determination have focused on three types of explanatory variable: national price levels, interest rates, and the balance of payments. She begins with a discussion of the fundamental hypotheses underlying the models—purchasing power parity (PPP) and interest rate parity—and reviews the models' empirical validity. She examines early models of the current account and the asset-pricing equilibrium models of the balance of payments under fixed exchange rates. The latter became the basis for modeling the behavior of flexible exchange rates after the collapse of the Bretton Woods system.
Del Castillo analyzes models of exchange rate dynamics during the transition to flexible regimes and reviews the models that have adopted the modern asset-markets approach to determining exchange rates during transition. She explains the testing of the models under both flexible-price and sticky-price assumptions and argues that the asset-market models offer a more refined portfolio-balance approach to exchange rate determination.
In Chapter 11, Peter J. Montiel turns to a discussion of the theory and measurement of the long-run equilibrium real exchange rate (LRER). He focuses on why it is important to get this particular macroeconomic relative price right and on how the value of the equilibrium real exchange rate can be estimated empirically. These questions have been at the center of macroeconomic policy advice that officials of developing and transition economies have received over the past decade--namely the importance of "getting prices right." The need to get relative prices right, Montiel points out, also has a macroeconomic dimension. The two central macroeconomic relative prices are the price of goods in the present relative to the price of goods in the future (the real interest rate) and the price of domestic goods relative to the price of foreign goods (the real exchange rate). These relative prices guide the broad allocation of production and consumption between today's and tomorrow's goods, as well as between domestic and foreign goods. Montiel explains that identifying conceptually or empirically the right level of these macroeconomic relative prices is not easy.
Montiel reviews the conceptual and empirical issues that arise in defining the actual real exchange rate, as well as the conceptual issues involved in the definition of the appropriate real exchange rate. He concludes that the relevant measure is the LRER and sets out a theoretical model designed to identify the relevant set of fundamental determinants of the LRER. After discussing the theory, Montiel examines the measurement issues and reviews the state of the art in the empirical measurement of the LRER. He concludes that the techniques for estimating the LRER are lagging behind the theory, noting that there is no wide agreement on methodology. Montiel, thus, imparts a clear sense of urgency to further research on identifying and measuring the LRER.
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The concepts and issues discussed in this book are indicative of the complexities involved in macroeconomic policymaking. The chapters reflect some of the most recent advancements in the literature on macroeconomic management, including the identification of the sources of growth, inflation targeting, and the application of time-series methods to estimating the equilibrium real exchange rate. The chapters highlight the theoretical and empirical considerations that need to be considered when designing a macroeconomic adjustment program. They show clearly that there can and should be a variety of policy packages for achieving a country's key economic objectives. But designing an effective macroeconomic adjustment program requires a good understanding of how such policies affect the economy. The chapters in this book are an attempt to aid in the deepening of that understanding.