StudySpace: Economics in Development, 6th Edition

Worked Example: A Sad Tale of Macroeconomic Populism

To grasp the analysis of macroeconomic imbalances, a good starting point is to look at how the imbalances may originate. The simplest tool to use for this purpose is the graph of supply and demand in the markets for tradables (T) and nontradables (N), as shown in Figure 21–1.

Notice that the vertical axis measures the price of tradables relative to the price of nontradables, P = P_T /P_N . In the Australian model, P defines the real exchange rate, which is the key determinant of the allocation of consumption and production between T and N. In panel A, the real exchange rate is a natural measure of the price of tradables. But P is an inverse measure of the price of nontradables. A higher P indicates a fall in the relative price of nontradables; a lower P indicates a rise in the relative price of N. Since the price measure in panel B is inverted, so are the supply and demand curves. It may look odd for the curves in panel B to be drawn with the “wrong” slopes, but they reflect the ordinary market meaning a rise in P, as defined—causes a decline in the quantity supplied and a rise in the quantity demanded. As usual.

The starting point in each panel is point 1. Both markets are at equilibrium. In the market for tradables, the quantity demanded (T₁ ) is consistent with the quantity supplied, which is determined by exports (X_T ) plus net inflows of foreign financing (F). In the market for nontradables, the equilibrium quantity (N₁ ) is consistent with the economy’s noninflationary production capacity. (Line X_N shows that nontradables output still could rise but not without pushing up prices and shifting resources out of tradables.) The situation is one of external and internal balance.

FIGURE 21–1

What can go wrong? One common source of trouble is imprudent macroeconomic management—macroeconomic populism. The government spends more than it can afford on nifty programs like subsidies, roads, bailouts for mismanaged parastatal (state-owned) companies, and military equipment; the deficit is financed by inflationary credit from the central bank. These loose fiscal and monetary policies cause absorption to rise, and this leads to rightward shifts in the demand curves in both markets, to DT ′and D′N. The outcome in panel A is a balance-of-trade deficit (distance T₁ T₂ ) that is not supported by sustainable foreign financing; in panel B, the excess demand for nontradables (distance N₁ N₂ ) provokes inflation. In this particular case, the cure is simply to reverse absorption and shift the demand curves back to their initial positions by tightening fiscal and monetary policies.

Keep in mind that tightening means cutting the budget for subsidies, roads, bailouts, and military equipment. Stabilization is not popular. That is why governments often try to avoid the adjustments and paper over the imbalances. For example, the external imbalance can be covered by drawing down foreign exchange reserves, building up unsustainable foreign debt, defaulting on debt-service payments, or imposing foreign exchange controls. Domestic inflationary pressures can be suppressed with price controls or accommodated with indexing arrangements. These expedients only delay the day of reckoning; meanwhile they create distortions and imbalances that make the adjustment more costly when it comes. Eventually, the economy has to restore a balance between supply and demand in each market, without suppressing the competitive market forces that drive long-run growth.

External shocks may serve as the trigger for adjustments. A cutoff of foreign financing or an adverse movement in the terms of trade, for example, would shift the supply curve in panel A leftward, to (X_T + F)′. (The external shocks may also affect P and DN, but we limit attention to the main impact.) This accentuates the external imbalance (distance T₃ T₂ ). To deal with the crisis, the government asks the IMF for support in the form of financing to increase F; but support is available only on the condition that steps are taken to redress the underlying imbalances.

Must the government take action? The market’s self-correcting mechanisms may not work quickly or smoothly, and they can be thwarted by government policies. For example, excess demand for nontradables increases PN, this lowers the real exchange rate, and this stimulates supply and demand responses that move the N market toward equilibrium, perhaps slowly. But a drop in P worsens the external imbalance, as you can see in panel A. If the external imbalance is covered by having the central bank sell foreign exchange reserves, this will reduce the money supply and dampen absorption, and this helps to restore balance in both markets. But the monetary contraction is easily offset by the government’s profligate spending.

The whole analysis is neatly displayed in the phase diagram in Figure 21 –2. By increasing absorption, loose macroeconomic policy pushes the economy from point 1 to point 2, in the deficit-plus-inflation zone. A cutoff of foreign aid shifts EB to the left, to EB′, worsening the external imbalance. With the economy at point 2, a drop in the real exchange rate due to rising domestic prices moves the economy closer to line IB, but then we are farther than ever from external balance. The solution is to reduce absorption. Foreign financing can alleviate the crisis by shifting EB′back toward its initial position.

FIGURE 21-2

Exercises

1. Before tackling applications of the Australian model, it is a good idea to practice the mechanics. All the questions in this exercise refer to the immediate impacts and exclude subsequent adjustments that may occur due to self-correcting tendencies of the market.

a. Figure 21–3 reproduces the supply and demand curves for tradables (T) and nontradables (N). As pointed out in the Worked Example, notice that in panel B the vertical axis is an inverse measure of the price of nontradables, so the demand curve for N slopes up and the supply curve for N slopes down.

FIGURE 21–3a

(i) Starting at point 1 in panel A, how does each of the events listed below affect the market for tradables? Each answer should cover the following points: Does either curve shift? If so, which way? If not, how does the impact show up in the graph? And what is the nature of the resulting imbalance?

Event 1. A decline in absorption due to tight fiscal and monetary policies.

Event 2. An increase in foreign aid receipts.

Event 3. A killer frost that decimates the harvest of the main export crop.

Event 4. A devaluation of the official exchange rate.

(ii) Starting at point 1 in panel B, how does each event affect the market for nontradables? Answer in the same manner as previously.

FIGURE 21–3b

Event 1: A decline in absorption due to tight fiscal and monetary policies.

Event 2. An increase in foreign aid receipts.

Event 3. A killer frost that decimates the harvest of the main export crop.

Event 4. A devaluation of the official exchange rate.

b. Such events can also occur when the economy is not at equilibrium to start out.

(i) When the real exchange rate is P₂ in panel A of Figure 21–3, what is the nature of the imbalance in the market for tradables?

(ii) In panel B, what is the nature of the imbalance in the market for nontradables?

(iii) Briefly explain how the imbalance in the market for tradables is affected by each of the following events:

Event 1. A rise in absorption due to loosening of fiscal and monetary policies.

Event 2. A cutoff of access to foreign loans.

Event 3. A bountiful harvest of the main export crop.

Event 4. An appreciation of the official exchange rate. (Remember that P_T = e ×PT^*_T .)

(iv) How is the imbalance in the market for nontradables affected by each event?

Event 1. A rise in absorption due to loosening of fiscal and monetary policies.

Event 2. A cutoff of access to foreign loans.

Event 3. A bountiful harvest of the main export crop.

Event 4. An appreciation of the official exchange rate.

c. Figure 21–4 reproduces the basic phase diagram for the model.

FIGURE 21-4

(i) Explain why the EB line slopes upward. Use the following opener as the start for your answer: “The EB line has a positive slope because external balance can be preserved only if a rise in absorption...”

(ii) Explain why the IB line slopes downward. Start your answer with the following opener: “The IB line has a negative slope because internal balance can be preserved only if a rise in absorption...”

d. The economy begins at point 1, with internal and external balance.

(i) Other things held constant, how does each event listed below affect the economy’s external balance? Will the EB curve shift? If so, which way? If not, how does the impact on the external balance show up in the graph? What is the nature of the resulting imbalance?

Event 1. A decline in absorption due to tight fiscal and monetary policies.

Event 2. An increase in foreign aid receipts.

Event 3. A decline in the world price of the main export good.

Event 4. A devaluation of the official exchange rate.

(ii) How does each of the following events affect the economy’s internal balance?

Event 1. A decline in absorption due to tight fiscal and monetary policies.

Event 2. An increase in foreign aid receipts.

Event 3. A decline in the world price of the main export good.

Event 4. A devaluation of the official exchange rate.

e. Similar events can occur when the economy has not initially achieved external and internal balance.

(i) At point 2 in Figure 21–4, what is the nature of the external imbalance?

(ii) At point 2, what is the nature of the internal imbalance?

(iii) Briefly explain how the external imbalance is affected by each of the following events:

Event 1. A rise in absorption due to tight fiscal and monetary policies.

Event 2. A cutoff of access to foreign loans.

Event 3. A rise in the world price of the main export good.

Event 4. An appreciation of the official exchange rate.

(iv) Briefly explain how the internal imbalance is affected by each

Event 1. A rise in absorption due to tight fiscal and monetary policies.

Event 2. A cutoff of access to foreign loans.

Event 3. A rise in the world price of the main export good.

Event 4. An appreciation of the official exchange rate.

2. The Worked Example illustrated one way for a small, open economy to get into and out of trouble in terms of macroeconomic imbalances. It is your turn to consider a different situation. The scene is the tiny Kingdom of Antiquity, which produces one tradable good, elegant pottery for export, and one nontradable, banquet services. Everything else is imported using the proceeds from exports plus foreign loans from a wealthy moneylender in nearby Carthage. The story starts with the economy operating at point 1 in Figure 21–5.

FIGURE 21–5

a. Overnight, pottery from Antiquity becomes a favorite in fashionable homes from Cathay to Gaul. Earnings from pottery exports double.

(i) How will the export boom affect the external-balance line? Why?

(ii) Draw the new external-balance line as a dashed line in Figure 19–5. Label it EB2.

(iii) If absorption (A) and the real exchange rate (P) were to remain unchanged at point 1, describe the nature of the macroeconomic imbalance that arises following the export boom.

(iv) What combination of changes in A and P is needed to restore overall macroeconomic balance? Label the new equilibrium point 2.

(v) Since the fashion boom does not expand the kingdom’s production frontier, how can an increase in absorption—which boosts the demand for nontradables—be accommodated without causing inflation?

(vi) The kingdom’s sacred book prohibits changes in the official exchange rate. How can the real exchange fall to P₂ ?

b. The government of Antiquity successfully manages its macroeconomic policies and achieves point 2 in Figure 21–5. Shortly thereafter, fashionable homeowners grow bored with Antiquarian pots and start buying Greek statues instead. Earnings from exporting pots fall to half the original level.

(i) Draw in the new external-balance line as a dashed line in Figure 21–5; label it EB3.

(ii) If absorption and the real exchange rate remain at point 2, what macroeconomic imbalance will arise following the collapse in the world market for pottery?

(iii) Could external balance be restored by a change in the real exchange rate alone, with absorption fixed? What about overall macroeconomic balance? Explain.

(iv) Could external balance be restored by changing absorption alone, with the real exchange rate fixed? What about overall balance? Explain.

c. The King of Antiquity refuses to take the necessary steps to adjust to the loss of export earnings. As a result, Antiquity’s credit rating is downgraded; the moneylender in Carthage boosts the interest rate on all the kingdom’s external debt.

(i) How does this new external shock affect the position of the curves in Figure 21–5, the macroeconomic imbalances, and the magnitude of the required policy adjustments? (Answer in words; the graph is messy enough.)

(ii) The Samaritan League learns of the Antiquity’s plight. They offer a package of low-interest financial support large enough to cover the increase in market interest rates, plus compensatory financing to offset part of the decline in export earnings. How does this foreign financing affect the position of the EB curve, the macroeconomic imbalance facing Antiquity, and the magnitude of the required policy adjustments?

3. Now try applying the model to more realistic settings.

a. Seven points are marked in Figure 21–6. Each point corresponds to one of the following economic conditions. Match the descriptions of conditions to the appropriate point numbers from the graph.

FIGURE 21-6

(i) Through effective exchange-rate management, Brazil in the early 1990s had a stable balance-of-trade situation despite chronically high inflation: point .

(ii) In the early stages of its adjustment efforts, Chile experienced an unsustainable inflow of foreign savings with high domestic unemployment and falling real incomes: point .

(iii) Several African countries, such as Kenya, had moderate inflation and reasonable output growth along with serious foreign exchange constraints due to excess demand for tradables: point .

(iv) Prior to implementing a very successful adjustment program in 1993, Peru encountered high inflation and a debilitating balance-ofpayments crisis: point .

(v) In the 1980s, Taiwan’s economic management led to stable prices with full employment together with a balance-of-payments surplus that resulted in a large buildup of foreign exchange reserves: point .

(vi) In 1975 Korea nearly tripled its foreign exchange reserves, but the inflation rate reached 25 percent: point .

(vii) During the 1980s, several African countries, like Tanzania, faced severe balance-of-payments constraints despite economic growth so sluggish that per capita income declined: point .

b. Study the position of the seven points in Figure 19–6. As drawn, what combination of changes in the real exchange rate (P) and absorption (A) would be needed to achieve simultaneous internal and external balance in

(i) Brazil?

(ii) Chile?

(iii) Kenya?

(iv) Peru?

(v) Taiwan?

(vi) Korea?

(vii) Tanzania?

c. The country at point 7 starts out with excessive slack in its economy, yet the model indicates that a contraction in absorption is needed to bring absorption to the level consistent with macroeconomic balance. Why is a contraction needed when the economy is weak at the outset?

 

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