Essay Title - Monetary Policy Macroeconomic
Choose One macroeconomic policy area [inflation, monetary, fiscal, or exchange rate policies] To discuss the theoretical and empirical factors limiting The applicability of standard macroeconomic models to developing countries.
Introduction
It is generally argued that the role of monetary policy should be to maintain price stability rather than output stabilization though the consensus in the past was that the primary objective of monetary policy in developing countries has been to promote economic growth through inflationary means, interest rate ceilings and directed credit programmes (Hossain and Chowdhury, 1998).
There is an emerging consensus though that price stability is an essential goal for competitiveness, business confidence, reduced uncertainty and the maintenance of positive interest rates (Sikorski, 1996). These are key ingredients essential to support the development process of developing countries.
Chang and Grabel (2004) define monetary policy as government actions that influence the money supply and market interest rates. Governments control money supply and market interest rates through a number of instruments such as open market operations, discount rates and reserve requirements. Money supply is basically made up of domestic credit and net foreign assets and domestic credit is composed of central bank credit to government and commercial bank credit to the public (Hossain and Chowdhury, 1998).
In order to assess the effectiveness of monetary policy, open economy macroeconomic models are used. These models attempt to incorporate the balance of payments, the exchange rate and the terms of trade in a general framework where they interact with income levels (both foreign and domestic), money supply, interest rates (domestic and foreign) and the price level (domestic and foreign) (Hossain and Chowdhury, 1998).
Hossain and Chowdhury (1998) has listed a number of macroeconomic models that have been designed to analyse issues confronted by open economies and their policy options and they include: the absorption approach to the balance of payments; the Mundell-Fleming (MF) model; and the Swan-Salter-Corded (SC) model. This paper has used the Mundell-Fleming model in reviewing the factors that limit the applicability of standard macroeconomic models to developing countries.
Although there is disagreement on the goal of monetary policy, there is consensus that developing countries are constrained by various factors in the implementation of monetary policy and these affect the effectiveness of monetary policy in stimulating output. These factors further limit the applicability of the macroeconomic models to developing countries.
Developing countries are generally characterised with dual monetary systems, low elasticity of investment to interest rates, non-monetised transactions, undeveloped financial systems and lack of transparency and creditworthiness, institutional weaknesses and market failures (Sikorski, 1996; Ghatak, 1995; and Rodrik, 2007). These characteristics are elaborated in greater detail in the latter part of the essay.
The major focus of the essay is to review theoretical and empirical factors that limit the application of the standard macroeconomic models to developing countries and in answering the question, the paper is divided into four sections namely: Introduction; Monetary policy and the standard macroeconomic model theoretical prepositions; Factors limiting the applicability of the standard macroeconomic models and then conclusion.
Key words-Monetary Policy, Mundell-Fleming Model, Money Supply, Aggregate Demand, Output, Capital Mobility and Exchange Rate.
Monetary policy and the standard macroeconomic model theoretical prepositions
Monetary policy views
The objectives of monetary policies in developing countries are usually related to money and credit control, price stabilisation and economic growth and many consider price stability as the most important objective of monetary policies in the developing countries since they are supposed to suffer from inflation than the developed countries (Ghatak, 1995).
The rationale behind the reasoning is that monetary policies are more effective than fiscal policies in dealing with inflation. Hossain and Chowdhury (1998) point out that there exists a relationship between money supply growth and inflation and therefore it's on this basis that Monetarists argue that the aim of monetary policy should be to maintain price stability rather than output stabilization.
Keynesians and Structuralists on the other hand argue that the role of monetary policy in developing countries should be beyond mere maintenance of price stability but should include increasing the amount of loanable funds, reducing interest rates to stimulate investment and raise aggregate demand which in turn would lead to employment creation and increase in output*.
The Structuralists argue that tight monetary policies lead to expensive credit, pushing firms into the unofficial money market, driving up unofficial money market interest rates and leading to an increase in input costs and that the effect of mark-up pricing stimulates inflation while at the same reduces output below that obtained from the demand-reducing effects of constraints (Sikorski, 1996).
There is however wide theoretical and empirical support in favour of a strong relationship between money supply growth and inflation. Hossain and Chowdhury (1998) confirm this view and find a strong relationship between money supply growth and inflation and that this relationship is much more pronounced in developing countries. Governments in developing countries should therefore control money supply in order to control inflation and maintain price stability.
Sikorski (1996) argues that if price stability is not maintained, cost-push effects that may occur through wage indexation mechanisms may likely take-over and erode any growth. Price stability as Sikorski (1996) concludes is essential for any country to maintain its competitiveness, business confidence and positive interest rates.
There are also other additional roles that monetary policies can play in an economy. Ghatak (1995) argue that monetary policies are also regarded as useful for achieving equilibrium in the balance of payments and stabilise the exchange rates in the developing countries because a country with a balance payment surplus would reduce interest rates whereas developing countries which suffer from balance of payments deficits would raise the interest rates to encourage the inflow of foreign funds.
Assumptions used in constructing the standard macroeconomic model
Hossain and Chowdhury (1998) claim that the Mundell-Fleming (MF) model is the best-known and mostly widely used macro model of an open economy. This paper has used the MF model because of its widely usage. The model is an extension of the standard IS-LM model, it's Keynesian in spirit and has been extended to include aggregate supply considerations and allows the exchange rate to influence the domestic price level (Hossain and Chowdhury, 1998). The MF model is based on the following assumptions:
Hossain and Chowdhury (1998) point out that the assumption of fixed money wages and prices is the key Keynesian feature of the model which implies a perfectly elastic aggregate supply (AS) curve where output is determined by the position of the aggregate demand (AD) curve. However in the MF model, the degree of capital mobility that is determined by the sensitivity to interest rate differentials plays a crucial role (Hossain and Chowdhury, 1998)*.
Effectiveness of the policy
The Mundell-Fleming model describes the effectiveness of monetary policy in stimulating output. The effectiveness of the monetary policy depends on the country's exchange rate regime and degree of capital mobility. Hossain and Chowdhury (1998) argue that the relative effectiveness of monetary and fiscal policies in an open economy described by the MF model depends on the degree of capital mobility and the exchange rate regime-with or without sterilization.
Most developing countries do not attract much capital despite a surge in capital mobility in the recent past. This implies that the balance of payment (BP) curve will be steeper than the LM curve reflecting a limited degree of capital mobility in developing countries. Hossain and Chowdhury (1998) claim that interest rate does not play a major role in the demand for money in most developing countries with a large non-monetised sector and this implies that the LM curve is relatively steep.
The option for developing countries is to either follow fixed exchange rate regime or some variants of it or opt for flexible/floating exchange rate system. Most developing countries however are increasing opting not to use fixed exchange rate regime because doing so would imply that they would have to use their foreign exchange reserves to increase money supply, thereby reducing the country's foreign exchange reserves and assets.
Hossain and Chowdhury (1998) outline three reasons why developing countries have had to switch from fixed to flexible exchange rate arrangements which include: firstly, developing countries allowed their currencies to depreciate to restore external competitiveness; secondly, switch meant to minimise the adverse effects of fluctuations in the exchange rates of major currencies; and lastly, move was politically convenient for developing countries.
However, with a floating exchange rate regime, developing countries are able to attract investments through reduction of interest rates, which stimulates output. Figures one and two at annex 1 illustrate the effectiveness of monetary policy in both fixed exchange rate and floating exchange rate regimes but with limited capital mobility. The two graphs show a situation where the BP curve is steeper than the LM curve respectively.
There is however no impact of either an expansionary or contractionary monetary policy on output and employment under a fixed exchange rate regime (unsterilized) as in the longer run, output falls back to original level. While under floating exchange regime the expansionary monetary policy is effective in stimulating output, however, the effectiveness is much higher in a high capital mobility environment. The effectiveness of the monetary policy in developing countries depends on the marginal propensities to save and import and the price elasticities of exports and imports of a particular country.
Usefulness of the model
Open economy macroeconomic models particularly the Mundell-Fleming model is useful in analysing the effectiveness of both monetary and fiscal policies in stimulating output in an economy. The model has been extended to include aggregate supply considerations and allows the exchange rate to influence the domestic price level (Hossain and Chowdhury, 1998).
The model can further be extended to incorporate some of the assumptions regarding developing countries, such as the low elasticity of investment to interest rates and allowing wages and prices to vary. Wages and prices are allowed to vary by adding the labour market to the model.
Hossain and Chowdhury (1998) point out that by adding the labour market to the model, the aggregate supply (AS) curve is no longer perfectly elastic but is upward sloping, under reasonable assumptions about wage-price flexibility.
Factors limiting the applicability of standard macroeconomic models
It is difficult to apply standard macroeconomic models to developing countries because the models omit a number of factors, which are important in developing countries. These factors which limit the applicability of standard macroeconomic models in developing countries can be summarised into two broad groups namely: theoretical and empirical factors.
Theoretical factors
Ghatak (1995) claims that it has been generally acknowledged that monetary policy can play only a limited role in developing countries. Several reasons are advanced to explain such a limited role and these are discussed as follows:
Firstly, the existence of dual monetary system in developing countries clearly limit the applicability of standard macroeconomic models and act as an impediment to the success of a monetary policy. Fischer and Reisen (1993) argue that domestic financial markets in developing countries can be stylised as follows: credit markets are segmented; competition among banks is weak; joint ownership between the corporate sector and financial institutions predominates; asset quality in banks' balance sheets is low; and institutional arrangements for prudential supervision and regulation are inadequate.
The factors alluded to by Fischer and Reisen (1993) have led to dual segmentation of the developing countries' monetary system into a small formal financial market and a very large and fragmented informal market. The informal money market, it has been argued tends to be more efficient than the official formal markets (Sikorski, 1996).
However, in the formal market, one expects the speculative demand for money to vary with interest rates while in the disorganised informal market which as Ghatak (1995) argues is dominated by shopkeepers, moneylenders, landlords, merchants or a combination of some of them, the interest rates are expected to change with the risks and returns on real assets and money supply may not affect the rates of interests significantly, hence, the Keynesian theory may not be applicable to developing countries.
Secondly, the existence of a large, non-monetised sector in developing countries coupled with the narrow size of the money and capital market, the presence of a limited array of financial stocks and assets hinder the effectiveness of monetary policy and limit the application of standard macroeconomic models to developing countries (Ghatak, 1995).
Financial markets are underdeveloped in developing countries and therefore a lot of transactions that take place occur outside the mainstream formal monetary system that are out of control of central banks rendering it difficult for central banks to control money supply*.
Thirdly, in most developing countries, currencies comprise a major proportion of total money supply, which implies the relative insignificance of bank money in the aggregate supply of money. However, in developing countries, currency substitution is very prevalent and this reduces the demand for domestic money and hence central banks find it difficult to measure and control money supply.
Ghatak (1995) argue that the ratio of currency to money supply is significantly influenced by the demand for money by the public, whereas, the effects of the changes in the central bank's monetary policies will mostly be on bank credit.
Further, Hossain and Chowdhury (1998) point out that most developing countries have a low elasticity of investment to interest rates. Empirical studies, such as Blejer and Khan (1984), Greene and Villanueva (1991), Khan and Reinhart (1990), Sundararajan and Thakur (1980) and Tun Wai and Wong (1980), as cited in Hossain and Chowdhury (1998) suggest that the real interest rate, the inflation rate and economic growth are the primary determinants of private investment in developing countries though the rate of responsiveness of investment is very low.
Finally, developing countries' economies are characterised by structural bottlenecks which Kirkpatrick and Nixson (1976) outline as being factor immobility, market imperfection and rigidities and disequilibria between demand and supply in different sectors of the economy.
Kirkpatrick and Nixson (1976) argue that substantial underutilisation of resources in some sectors coexists with shortages in other sectors of the economy in most developing countries, and market imperfections (and technological constraints) prevent the movement of resources in response to market signals.
Other authors such as Thorp and Whitehead (1987), and Killick (1984) cited in Fitzgerald and Vos (1989) suggest that the problem with the neoclassical theories is not just that they are undesirable, but that such policies cannot succeed due to the nature of the external sector in developing countries (Inelastic exports, exogenous prices, producer goods imports and so on) and that exchange rate devaluations are ineffective because the endogenous money supply allows them to 'pass through' without contracting effective demand.
Kirkpatrick and Nixson (1976) point out that for a number of reasons, the price elasticity of demand for both imports and exports in developing countries is likely to be low and that the elasticity of demand for imports is likely to be low where imports consist largely of raw materials, capital and intermediate goods, the volume of which will be unresponsive to relative price changes, while supply within the developing countries may be unresponsive to changes in relative prices too.
Developing countries also face declining terms of trade and Hossain and Chowdhury (1998) claim that most developing countries being net importers of oil, faced serious terms of trade shocks in the 1970s following two sharp oil price rises and therefore are more prone to demand shocks from the external source as they are mostly primary commodity exporters with fluctuating and mostly declining prices and importers of industrial machinery and oil.
These structural bottlenecks namely; the low price elasticity of supply (market failures), low price elasticity of exports and imports, and declining terms of trade faced by developing countries limit the application of standard macroeconomic models to developing countries as the models are based on the neoclassical theory of price-clearing mechanism as optimal mechanisms of resource allocation.
Empirical factors
Analytical models such as the Mundell-Fleming model are founded on the neo-classical premise that goods and assets markets tend to stable adjustment under a freely operating price-clearing mechanism. Fitzgerald and Vos (1989) point out that the central element in the analytical models is a faith in 'undistorted' markets as the principal mechanism that will lead to macroeconomic stability, but also to renewed investment, growth, and increased living standards.
However, both the exponents of the neo-classical theories and Structuralists acknowledge that markets in developing countries are far from being neo-classically perfect and that their adjustment is mediated by institutional and technological factors.
Nevertheless, the neo-classical theory assumes that these distortions are created by (excessive) developing countries' governmental interventions in the form of subsidies, tariffs and controls and that food shortages, trade deficits and inefficient industries are commonly explained as being the result of the failure of governments to induce the 'correct' price incentives (Fitzgerald and Vos, 1989).
Despite the debate on the causality of factors affecting developing countries, there is sufficient empirical evidence that developing countries are constrained by structural bottlenecks which are institutional weaknesses and market failures and these are generally taken to be: the inelastic supply of foodstuffs; the foreign exchange bottleneck; and the financial constraint (Rodrik, 2007; Kirkpatrick and Nixson, 1976).
Authors such as Thorp and Whitehead (1979) and Cline and Weintraub (1981) cited in Fitzgerald and Vos (1989) attribute the failure of market solutions to the importance of structural and institutional factors (like asset distribution and group interests) in explaining observed immobility of resources in the face of price signals.
Fitzgerald and Vos (1989) conclude that indeed a freely functioning market may produce perverse effects on stability even if price signals are 'correct' (that is, reflecting world prices), especially if accompanied by suspension of controls over capital flows and attempts to drastically reduce government expenditure. Most of these conditions are prevalent in developing countries.
An empirical test of the 'structuralist' carried out by Edel (1969) cited in Kirkpatrick and Nixson (1976) on the alleged food supply bottlenecks in eight Latin American countries (Mexico, Brazil, Venezuela, Chile, Columbia, Peru, Uruguay, and Argentina) finds inadequacy of production trends in Chile, Columbia, Peru, Uruguay, and Argentina and inelasticity of supply as a factor in Peru, Uruguay, and Argentina.
Much more recently, the experiences of other developing countries such as Ghana and Zambia, which have been on the International Monetary Fund/World Bank's macro-adjustment, stabilization programmes (Poverty Reduction and Growth Facility programme) confirm the existence of theoretical factors discussed earlier, which are somewhat similar with the findings of Edel (1969) in Latin American countries.
A study undertaken by Epstein and Heintz (2006) on Ghana finds that the country is faced with structural barriers that impact on the effectiveness of monetary policy in influencing economic outcomes such as improving employment opportunities. The study finds the following structural barriers, which are found in other developing countries:
Firstly, Ghana's financial institutions, dominated by the banking system are not currently structured to mobilize resources for investment and employment creation and that productive sectors have limited access to affordable credit;
Secondly, the existence of duality in Ghana's monetary system into narrow formal and large informal financial institutions and that informal enterprises and small-scale businesses that can not access formal credit markets often rely on informal sources of credit; and
Finally, the real, short-term interest rate has had no discernable impact on investment on Ghana. Furthermore, the level of domestic credit supplied to the public sector had no significant impact on investments. Ndikumana (2000) cited in Epstein and Heintz (2006) claims that other research into investment behaviour in Sub-Saharan Africa support these conclusions that public borrowing has been associated with less fixed investment if other factors remain the same.
Zambia too is faced with similar structural constraints, which affects the effectiveness of the monetary policy in stimulating output. Kalyalya (2007) states that Zambia's monetary policy challenges are; underdeveloped financial market; the underdeveloped nature of the secondary market for government debt coupled with the inflexibility in the use of government securities to regulate money supply growth; external shocks (Oil prices and fluctuations in copper prices); global integration leading to short-term capital flows and fiscal slippages and fragility which have tended to undermine the effectiveness of monetary policy.
The existence of empirical factors in developing countries have confirmed the existence of theoretical factors discussed earlier which limit the effectiveness of monetary policy and application of the macroeconomic models in developing countries.
Conclusion
There is sufficient empirical evidence to support theoretical prepositions on the existence of institutional structural bottlenecks and market failures in developing countries, which certainly impact on the effectiveness of monetary policy and application of standard macroeconomic models.
These factors can be summarised as being: Undeveloped financial system characterised by dual monetary system; low elasticity of investment to interest rates; low price elasticity of demand for both imports and exports, and supply within developing countries may be unresponsive to changes in relative prices; and deterioration in the external terms of trade (Kirkpatrick and Nixson, 1976; Hossain and Chowdhury, 1998).
The macroeconomic model (Mundell-Fleming model) used in this paper is effective in assessing the effectiveness of monetary policy in developing countries, though limited in application by the factors discussed, but can be extended to include some of these factors such as the low elasticity of investment to interest rates and allowing wages and prices to vary.
The best policy strategy for developing countries could have been if it was practical to eliminate institutional and market failures but as Rodrik (2007) notes, this would be tantamount to telling them that the way to get rich is to get rich. The developing countries therefore should be advised to adopt monetary policies that would focus on employment creation and economic growth rather than inflation targeting (Chang and Grabel, 2004).
This view is shared by Epstein and Heintz (2006) who recommend for Ghana's transition from an inflation-targeting monetary policy regime to a monetary policy regime that supports growth and employment and coordinate with reforms of the country's financial sector.
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*Extension of ECM62 2007 Lecture Notes
