Transcript 14. Monetary, Fiscal, and Incomes Policy, and Inflation

Chapter 14
Monetary, Fiscal
& Income Policies
and Inflation
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Monetary & Fiscal Policies
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Limitations of monetary policy in LDCs.
Low tax rates in LDCs.
Tax policy goals.
Political constraints on tax policies.
.Limits of spending to stabilize income & prices.
Explanations for inflation, its benefits & costs, &
relationship between inflation & growth..
Banking & financial repression & liberalization.
Capital market & financial system & instability.
Islamic banking.
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Monetary, Fiscal & Incomes Policy
and Inflation
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Monetary policy affects the supply of
money & the rate of interest.
Fiscal policy includes the rate of taxation
& level of government spending.
Incomes policy consists of anti-inflation
measures that depend on income & price
limitations, such as moderated wage
increases.
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Inflation
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LDC governments have even less capability
than DCs to use monetary & fiscal policies to
attain macroeconomic goals of output and
employment goals and price stability.
Look at tools: monetary, fiscal & incomes
policies to moderate high inflation (5.9%
monthly or 100% yearly price increases).
High inflation in Argentina (1980-91), Brazil
(1980-93), Poland (1982, 1990), Mexico (1983,
1986, 1994), Russia (1992-94, 1998), 1920s’
postwar Germany, Austria, Hungary, Russia &
Poland; Yugoslavia (late 1980s & early 1990s).
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Limitations of monetary policy
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Many LDC commercial banks branches of
large private DC banks, with external
orientation.
Many LDC governments lack control of
money supply to multiple of foreign
currency held by central bank.
Not much influence on amount of bank
deposits: few loans by central bank to
commercial banks & central bank usually
buys & sells few bonds on open market.
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Limitations of monetary policy
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Commercial banks generally restrict loans
to large & medium enterprises in modern
sector. LDC banks less influence than DCs
on interest rate, investment, & GDP.
Checking accounts usually less than half
total money supply.
Links between interest rate, investment &
GDP questionable because of supply
limitations& many money lenders outside
banks.
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Tax Ratios & GNP per Capita
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Taxes/GNP in LDCs less than in DCs.
Increase in taxes/GNP with increased GNP per
capita (Table 14-1).
Demand for social goods relatively greater
(Wagner’s Law).
Capacity to levy taxes increases, especially
direct taxes, primarily property, wealth,
inheritance, & personal & corporate income
taxes (Table 14-2).
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Goals of Tax Policy
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Mobilization of resources for public
expenditure.
Stability of income & prices.
Improved income distribution.
Efficiency of resource allocation.
Increase capital & enterprise.
Administrative feasibility.
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Bottom line: administrative feasibility
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Where monetary sector small, literacy low, few
accounting records, little voluntary taxpayer
compliance, & not an honest & efficient
administration, many taxes that are good in
theory can’t be administered.
Value added tax (VAT on difference between
sales of firm & purchases from other firms) is
simple, uniform, & can generate buoyant
revenues if country has administrative capacity.
If VAT not feasible, LDC may have to rely on
less than ideal taxes such as international trade,
excise, or sales taxes.
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Political constraints to tax policy
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Rich & influential taxpayer may
be able to prevent tax reform.
Legal tax avoidance & illegal
evasion widespread in LDCs.
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Inflation from the 1970s
to the present
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Acceleration from 1960s through early 1990s.
Drop in inflation rates from the early 1990s to
the present (globalization ?).
Before 1960s, economists viewed inflation as
phenomenon affecting countries in isolation.
Since then, instability in international
economy is considered a contributor to an
individual country’s inflation.
For inflation, 1960-2003, see Table 14-4.
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Types of inflation
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Demand-pull: demand in excess of
economy’s capacity to produce.
 Cost-push: supply side pressure from
prices increasing because of higher
costs.
 Ratchet: with aggregate demand
constant, prices rise with increased
demand but stay constant when
demand falls.
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Types of inflation: structural
inflation in Latin America
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Structural rigidities such as unstable
growth of foreign currency earnings &
inelasticity of agricultural goods.
Deterioration in terms of trade, cost of
import substitution, devaluation, & rise
in agricultural prices.
Orthodox demand-reduction policies
won’t work, structuralists argue.
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Types of inflation: structural
inflation in Latin America
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Orthodox economists say overvalued
domestic relative to foreign currency
contributes to inflation.
Moreover, food supply growth & terms
of trade changes not particularly bad in
Latin America.
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Types of inflation
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Expectational: inflationary expectations
cause workers, managers & consumers to
behave to make inflation a self-fulfilling
prophesy.
 Political: Government gives into efforts by
country’s major economic interests to make
excessive money demands that can only be
worked out with inflation.
 Monetary: Excess demand for money
(relevant during periods of high inflation).
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Incomes policies &
external stabilization
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Should LDCs temporarily fix the price
of foreign exchange & undergo wage &
price freezes?
Subsequent crawling exchange-rate peg.
Foreign exchange rate fixidity can
reduce competitiveness.
Wage-price controls can be
circumvented.
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Benefits of inflation
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Bid resources away from low-priority
uses.
Redistribute income from wage earners
to capitalists who save more.
Reduce real interest rate & debt burden
for expanding business.
Inflationary pressures could more fully
utilize labor & other resources.
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Costs of inflation
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Government redistribution to high
savers works only in early inflationary
stages. In later stages, actors find ways
to protect against inflation.
Tax on holders of money. People evade
this tax by holding onto goods.
Distortion of business behavior,
undermining rational calculation of
profits.
cont
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Costs of inflation
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Weakens creation of credit & capital
markets.
LDC instruments too weak to slow
inflation without sacrificing real income
& social welfare.
Little evidence that redistribution to
high-income groups increases savings.
Reduces international balance of
merchandise trade.
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Empirical evidence
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Mundell: inflation can increase real
economic growth.
Thirlwall et al. find growth declines
when annual inflation exceeds 10%.
Fischer: high inflation (>40% p.a.) not
consistent with sustained growth.
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Empirical evidence
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Improved proficiency of LDC monetary
management.
Bruno & Easterly: no negative
correlation between inflation & growth
for inflation < 40% per annum.
Stiglitz: IMF preoccupation with
contractionary financial policies below
40% inflationary misconceived.
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Financial Repression &
Liberalization
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Repression: distortions of interest rate &
foreign exchange rates reduce growth &
size of financial sector.
Reducing nonprice rationing of loans &
repressed foreign exchange markets can
increase efficiency (see pre-1990s’ India,
pp. 491-492).
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Liberalization still requires
banking & financial regulation
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As an LDC moves toward a liberalized
economy, it needs to limit spending &
restrain “wildcat” bank lending.
Indeed Japan, South Korea, & Taiwan
used mild financial repression to spur
rapid growth during much of the postWorld War II period.
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Capital market & financial system
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Banks are intermediaries between savers
& investors.
Bank provide discipline to market,
providing loans to higher quality
borrowers & charging premium to lower
quality borrowers.
Banks can monitor borrowers & force
them to restructure.
Banks need to be supervised.
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Causes of financial instability
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Adverse selection - Asymmetric
information resulting in poor loans by the
financial system, which lacks the capability
of making judgments about investment
opportunities.
This asymmetry is characterized by lenders
having poor information about potential
returns of and risks associated with
investment projects and potential bad credit
risks being most eager to borrow.
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Causes of financial instability
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Moral hazard: The risk associated with a loan
in which the borrower has incentives to invest
in projects with high risk where the borrower
does well if the project succeeds but the lender
bears most of the loss if the project fails.
The prospect of “bail out” of failed projects by,
for example, the International Monetary Fund
and the international community means that
borrowers are more likely to shirk or use funds
for personal use or power.
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Islamic banking
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Interest-free banking can improve
efficiency, since profit shares are free
from interest rate controls.
Khan: shocks to economy are absorbed
by changes in the values of deposits held
by public.
Kuran: Islamic banks match returns of
conventional banks.
Profit sharing problematic where
business hide profits for tax evasion.
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