Monetary Policy ERG

8/11/2019 Monetary Policy ERG

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Monetary Policy and Stabilisation

Trap in Selected Asian Countries

Implications for Poverty Reduction

Anis ChowdhuryProfessor of Economics

University of Western Sydney, Australia


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Introduction

deficit financing can lead to a very

unsustainable economy. Bolivia in the

1980s is an extreme example: its

deficit rose to 28% of GNPleadingto hyperinflation and serious economi

crisis. So, each country should aim at

roughly balancing its budget

(Human Development Report, 1991, p. 42) Generalisation from extreme cases le

to the policy package of IMF/World

Bank in the 1980s & 1990s


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Single digit Inflation and growth stagnation

Country

Inflation Rate Growth Rate

1965-80 1980-89 1965-80 1980-89

Bangladesh 14.8 10.6 2.5 3.5

Ethiopia 3.4 2.0 2.7 1.9

Burundi 5.0 3.7 7.1 3.3

Mali 9.0 3.6 4.2 3.8

Niger 7.5 3.4 0.3 -1.6

Rwanda 12.5 4.0 4.9 1.5

Pakistan 10.3 6.7 5.2 6.4

Indonesia 35.5 8.3 7.0 5.3

Cote dIvorie 9.4 3.1 6.8 1.2

Peru 8.1 5.6 4.1 2.1

Congo 6.8 0.3 6.2 3.9

Cameron 9.0 6.6 5.1 3.2

Panama 5.4 2.5 5.5 0.5

Gabon 12.8 -1.0 9.5 1.2

Trinidad & Tobago 14.1 5.8 5.0 -5.5


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Poverty in the 1990s

Country $1 a day $2 a day

Bangladesh 29.1 77.8

Ethiopia 31.3 76.4

Burundi

Mali 72.8 90.6

Niger 61.4 85.3

Rwanda 35.7 84.6

Pakistan 31.0 84.7

Indonesia 7.7 55.3

Cote dIvorie 12.3 49.4

Peru 15.5 41.4

Congo

Cameron

Panama 10.3 25.1

Gabon

Trinidad & Tobago


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Argentina in the 1980s hyper-inflationthe average annual inflation rate

around 391% and average annual economic growthrate around 1%

1990s orthodox IMF stabilisation package succeeded;

average annual inflation rate 1.5%, and the economygrew by an average annual rate of 6.7% during 1991-1997

However

the continuation of severe restrictive macroeconomicpolicies forced the economy into a deflationary spiral

the inflation rate dropped to0.9% and1.3% in2000 and 2001 respectively

economy contracted by3.4% in 1999 and by2.1% in2000

unemployment rate rose from 6.5% in 1991 to 17.5% in

1996 consequently, the poverty rate (head-count ratio) rose

from 21.8% in 1993 to 34.3% in 2002, and the Ginicoefficient from 0.45 to 0.49


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Asian Experience While lower inflationis a positive indicatora near-zero inflation rate

may be symptomatic of demand deficiency leading to capacityunderutilizationTargeting for a too-low inflation ratecan sometimesresult in overkill. .. Yet another problem with pushing inflation too low isthat it will make it difficult to bring about the large relative price changesthat the structural adjustment policies aim at. (Bangladesh Report, p. 38

The point is not that the authority has to fight inflation at any price and toonly value deflationary policy. Rather, it has to face the tough question ohow far to go with fighting inflation, knowing that with ongoing deflation aeconomy might face greater risk of entering into the chain of risingunemployment, falling demand, and reduction in the level of nationalincomeThis restricted policy should not be seen as the only way out,without flexibility. The inflation ratehas remained low since 1995 Buthe targeted inflation of about 4 per centseems to be low if the aim is tcreate employment and economic growth. (Cambodia Report, pp. 48, 6061).

In the current context, one of Chinas important challenges appears to liin counteracting deflationary pressures and sustaining rapid economicgrowth rather than combating inflation...Persistent deflation may haveserious adverse effects on Chinas economic growth and povertyreduction prospects. (China Report, p. 72).

Policymakers continue to adhere to tight IMF-prescribed fiscal and

monetary targets in order to achieve single-digit inflationratesMeanwhile, domestic consumption, not private investment, issupporting growth. But clearly this is not sustainableHigh interest rate[needed for a low inflation target] are an impediment to growth incircumstances such as Indonesias, where the corporate sector is heaviindebted. (Indonesia Report, pp. 15, 19)

Bank Indonesia highlighted Indonesias monetary policy dilemma:

if the policy is tightly directed at attaining inflation targetit is feareto disturb the current economic recovery.

If Bank Indonesia is still persistent in achieving the base money

target, extremely high increase in interest rate will be required,whichcould harm the economic recovery prospects

This sentiment was echoed by the Chairman of the Indonesian Chambeof Commerce of Industry: Bank Indonesia has been keeping interestrates high to ease pressure on the rupiah and stall inflation however,[this] discouraged industries from making new investments that wouldotherwise have helped create new jobs


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Realisation at Last!

Wolfensohn, if we take a closer look,

we see something elsesomething

alarming. In developing countries,

excluding China, at least 100 million morepeople are living in poverty today than a

decade ago. And the gap between rich

and poor yawns wider.

World Bank (2005, p. xiii), there is no

unique universal set of rules [W]e needto get away from formulae and the search

for elusive best practices.

Easterly (2001) called the 1980s and

1990s the lost decades.


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Monetary Policy and Povertytheoriesand evidence

The channels through which monetary policy canaffect poverty are:

long-run economic growth

short-run output stabilisation and

income distribution.

Since monetary growth and inflation are positivellinked, moneys role in poverty reduction will bexamined by looking at the:

inflation-growth inflation

short-run trade off between output and pricestabilisation and

inflation-inequality relationship.

We shall also examine the question of centralbank independence.


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Money in the Long-runDoes InflationHarm Economic Growth?

In theory, the answer is bo th Yes and No

What is the empir ical evidence? Extensive empirical research indicates that the

negative relationship between inflation and

economic or productivity growth is influenced byextreme values or outlying countries having anexceptionally high inflation rates (see Figure 2).

In the words of Bruno and Easterly (1998), thecorrelation loses significance with the omission ofsingle observationNicaragua, which had hyper-inflation and negative growth in the 1980s Mor

generally, significance and sign of the cross-section correlation depends on the inclusion of thcountries with high inflation crisesthe above40% episodes.

They also observed, the significance of thenegative growth during 20-40% inflation vanishesif a singleextreme annual observation is omitted

Iran in 1980. Easterly (2003) reported similar findings and

regarded inflation rates below 35% as moderate


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Figure 2a: Inflation-Growth (1980-1990)

-10

-5

0

5

10

15

-100 0 100 200 300 400 500

Inflation

G

rowth


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Figure 2c: Inflation-Growth (1980-1998)

-10

-5

0

5

10

15

-200 0 200 400 600 80

Inflation

G

rowth


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Figure 3: Average GDP Growth & Inflation Rates

(1960-2000)

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

Between 0

& 5%

Between 5

& 10%

Between 10

& 15%

Over 15%

Average Inflation Rate

AverageG

DPGrowthRate(%)

1960-1979

1980-2000

Source: Islam, 2003


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Figure 3 plots average inflation and growth ratesover four decades (1960-2000) for 141

countries. Two interesting features emerge.

The inflation-growth relationship was negativein the period 1960-1979. But it seems to havebecome non-linearfirst positive and then

negative in the later period of 1980-2000. Thisconfirms the uncertain nature of the inflation-growth relationship.

The variation in growth rate between the twotime periods is much larger at both low andhigh inflation. That is, both high and low

inflation rates can be destabilising, and henceharmful for the poor.


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Thus, one may conclude that while policy makers shouldguard against high inflation, a country may needmoderate inflation to sustain economic growth. Thisunderstanding is essential when there is excess capacity

and persistent high unemployment or underemployment The over-fixation with a single digit inflation target canno

be justified based on the fear of inflation going out ofcontrol once it is allowed to go beyond, say 10% level.

Dornbusch and Fischer (1993) found that inflation rate inthe moderate range of 15-30% does not usuallyaccelerate to extreme levels.

Bruno and Easterly (1998) found that the thresholdinflation rate of 40% at which the probability of inflationrate accelerating rises significantly.

Furthermore, only in a handful of cases inflation rate didaccelerate and output stagnated or declined in the past,and these cases could be attributed to unusualcircumstances (e.g Iran or Nicaragua in the 1980sfollowing dramatic fall of the regimes).

Cross-country scatter diagram (Figure 5) shows, the claiof the orthodox school that inflation harms the poor breadown when one considers inflation rate in the range of 520%. Consistent with the aggregate inflation-growthrelationship, the negative relationship between inflationand the income of the poor is based on few cases ofextreme inflation.

Therefore, contrary to the orthodox view, poverty-reduction strategy requires moderately expansionarymonetary policy, and fear of excesses cannot be a basfor sound public policy.


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Money in the Short-run: Is there anyOutput Stabilisation Role?

Demand Shock: Monetary policys role instabilizing output depends on two questions:

To what extent a country is prone to demandshocks

To what extent prices (product prices,exchange rate & interest rate) and wages

flexible

The components of aggregate demand are lessstable in developing countries due to:

Narrow export base

Poverty and the role of current income Liquidity constraint for both households & smafirms

Among key prices

Exchange rate is quasi fixed

Wages are sluggish downwardsmainlybecause real wage is already too low.


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Therefore, regardless of whether the

adjustment happens through output or

prices, falling aggregate demand will have

serious implications for the poor.

If the adjustment happens through cuts inoutput and employment, the first to lose

job is unskilled and unorganised labour.

If the adjustment happens through

declines in wages, again the unorganised

and unskilled workers would be forced to

accept lower wages.


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S

Po

P1

Do

D1

Y2 Y1 Yo

Figure 6: Adjustments to Demand Shocks


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Thus, the poor unorganised workers areforced to choose between jobs and lower

real wages. In either case, the averageincome of the poor is likely to drop whennominal GDP growth drops from its trendCross- country (Figure 7) evidence showsthat average income of the poor is

negatively related to aggregate demandvariability.

This negative relationship does notbreakdown even when the outliers are

omitted. Therefore, from the point of view of

protecting the poor, monetary policy needto stabilise output in the face of adversedemand shocks.


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Supply Shock: It is generally accepted thatthe developing countries are more prone

to supply shocks than demand shocks.

This is due to their heavy dependence onagriculture and imported raw materials,and energy (oil).

While alternating floods and drought arealmost regular phenomena affectingagriculture, declining terms of trade due torising prices of imported raw materials anenergy adversely affects the industrial

sector. The choice between output and price

stabilisation becomes starker in the caseof a supply shock. This can be showndiagrammatically:


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Figure 8: Adjustment to Supply Shocks

D1 S1 S1

Do So Do So

D1

P2

P1 P1

Po Po

Y1 Yo Y2 Y1 Yo


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In panel A, the response to an advers

supply shock is an expansionarymonetary policy to stabilise output atQ0.

In panel B, the response is acontractionary monetary policy to

stabilise the price level at P0. When the response is an

expansionary policy, the price levelrises further to P2, causing higher

inflation. When the objective is price

stabilisation with a contractionarymonetary policy, output declinesfurther to Q2.


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Inflation and Income Distribution

Inflation can disproportionately hurt the poor throughtwo channels:

Wage rise lags behind price rises

Poor mostly save in money and inflation reducesthe value of their savings.

Counter arguments: If real wage declines due to inflation then

employment should rise. Therefore, the employmeffect of inflation can outweigh the real wage effeon poverty.

The gain from expansionary monetary policy will

be temporary if the inflation rate remainsmoderate. This is evident from the positiverelationship between moderate inflation andeconomic growth as demonstrated earlier.

The poor are largely net financial debtors. Thus,inflation can benefit the poor by reducing the realvalue of their net debt. On the other hand, lower

inflation not only increases the real value of finandebt, the high interest rate policy aimed at bringininflation down increases the debt servicing cost oindebted poor. This makes them, doublydisadvantaged.


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Evidence

Studies have found that income distributionnarrows during the expansionary phase andwidens during the contractionary phase of abusiness cycle.

Figure 9 presents the scatter plots of averageinflation and inequality (measured by Ginicoefficient). Once again, we find that the claimof adverse distributional effect of inflation isbased on extreme inflationary cases.

There seems to be no relation betweeninequality and inflation when the inflation rate

ranges between 5 and 15%. On the other handinequality rises with the variability of nominalGDP growth (Figure 10).

The evidence presented in Figures 9 & 10vindicates the need for output stabilisingmonetary policy that allows for moderate

inflation.


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Central Bank Independence and Inflation-

targeting

The empirical evidence on the performance ofindependent central banks is still mixed.

The conditions required for the success of aninflation-targeting approach include the lack of fiscal dominance and

the absence of any other objectives.

None of these conditions appears to hold inmost developing countries. The revenue base of these countries is very low

and their capital market is underdeveloped. Thisforces most developing countries to borrow from

the central bank. These countries also have some sort of quasi-fixe

exchange rate systems needed to preventimported inflation and to attract short-term portfolforeign capital.

Thus money supply responds to developments ingovernment finance and the balance of payments


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Leaving aside the technical argument, there isbroader issue of democratic governance antechnocratic insulation of institutions.

It is pertinent at this juncture to quote MiltonFriedman who is on record for voicing theconcern ' money is too important to be lefto the central bankers'. His concerns areelaborated in the following quote:

The political objections are perhaps moreobvious than the economic ones. Is it reallytolerable in a democracy to have so muchpower concentrated in a body free from anydirect political control? One economic

defect of an independent central bank isthat it almost invariably involves dispersal ofresponsibility Another defect is theextent to which policy is made highlydependent on personalities A thirdtechnical defect is that an independent

central bank will almost invariably give unduemphasis to the point of view of bankersThe defects I have outlined constitute astrong technical argument against anindependent central bank.


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Stern and Stiglitz (1996) have made thepoint more succinctly:

The degree of independence of thecentral bank is an issue of the balance ofpower in a democratic society. Thevariables controlled by the central bank

are of great importance and thus requiredemocratic accountability. At the sametime the central bank can act as a checkon government irresponsibility. The mostsuccessful economies have developedinstitutional arrangements that afford thecentral bank considerable autonomy; butin which there is a check provided bypublic oversight, an oversight that ensurethe broader national interest is taken intoaccount in the final decisions.


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In this respect, it is worth highlighting the distinctionbetween "goal independence" and "instrumentindependence".

The former refers to central bank's ability to set thinflation target independently of the government.

The later is its independence in the choice ofinstruments and hence relates to central bank'sday to operations.

No central bank can be entirely independent of ademocratic government while it can be entirelyfree in choosing its instruments.

Most developing countries are new democracies.In such a situation, a central bank with both goaland instrument independence may choose a verylow inflation target which can undermine a nascen

democracy by delaying economic recovery. Furthermore, the very argument that an electedgovernment cannot be trusted with theresponsibility of managing the economy goesagainst the very principle of representativedemocracy.


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It is rather strange that under the provision

of the current legislation of BIindependence, neither the president northe parliament can remove the governor oBI before the expiry of his/her tenure.

This led to the much publicised stand-offwhen President Wahid wanted to removethe Governor after he was indicted in acorruption case.

The Governor refused to resign even

when he was convicted following a guiltyverdict.


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In sum, inflation targeting and central bank

independence are not merely technicalmatters, as the orthodoxy tends to believe

It is pertinent at this juncture to point to thobservation made by a central bankinsider, Guy Debelle (1996: 1).

An increase in the inflation aversion ofthe central bank, while always reducinginflation rate, may reduce welfare becausof its adverse effects on output and

government spending. The net welfareeffect is shown to depend on the weightsin the welfare functions of the fiscalauthority and society. Thus, increasing thcentral bank's inflation aversion is notnecessarily a free lunch.


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Thus, the essence of inflation targeting isembedded in the so-called social welfarefunction that includes both inflation and

economic growth.

High unemployment that is required to bringinflation rate to a single digit level or to keepinflation rate in the range of 3-5% hassignificant and systematically regressive effecton the distribution of income.

The poor fare worse when unemployment riseand persists, especially when there is noadequate safety-net or social security system.

At the same time the real value of their net debrises with falling inflation.

Hence the poor have reasons to be moreaverse to unemployment and less averse toinflation than the elite in society.

As the poor lack voice and representation, thechoice of weights for inflation andunemployment in the social welfare functionraises an important issue of conflicts and

political economy of public policy.


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Develop directed credit programs toemployment-intensive small and mediumenterprises, agriculture and rural industries.

This is essential because they are moredependent on bank credits than largerenterprises that have better access to capitalmarkets. Therefore, even when over-all creditgrowth needs to be restrained, directed creditto SMEs and rural-agricultural sectors must bemaintained to avoid asymmetric adverse impaon employment. This will protect the income ofthe poor and offset likely adverse impacts ofcyclical downturn on inequality.

Central banks should be given autonomy tochoose and implement the instruments of

monetary policy within the over-all economicobjectives dictated by the poverty reductionstrategy of the government. This means aparticipatory policy making process so that thetrade-off parameter between inflation andunemployment reflects the concerns of the

poor, and not of the elite or multilateralagencies.


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Given that there is no evidence of atrade-off between employment

creation and moderate inflation, theconflict between goals andinstruments is not as stark.

Yet for two targets the monetaryauthorities can have twoinstruments:

Traditional instrument of interest rate(or such instruments as reserverequirements) assigned to keep

inflation at a moderate level. Specialised credit regulation directed

to employment creation.


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Asset based reserve requirements are aneffective tool for creating incentives forbanks to invest in socially productive

assets. For example:

Based on well-research findings of employmentelasticities, the central banks would list a set ofemployment generating investment, and a lowerreserve requirement would apply for the depositsinvested in these activities than the deposits investedin speculation or Treasury Bills.

The central banks can also take steps to createliquidity and risk sharing institutions for loans tosmall businesses which have promise to generateemployment, but do not have adequate access to thecredit market. For example, the central banks canprovide financial and administrative support for assetbacked securities which would take loans to smallbusinesses and other employment intensive activities,

bundle these investments and sell them as securitieson the open market.

Finally, the central banks can open a special discountwindow facility to offer credit, guarantee or discountfacilities to institutions that are on-lending to firmsand co-operatives engaged in employment intensiveactivities.


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To achieve the RER target, thecentral banks should intervene inthe exchange market.

That is; the nominal exchange rateshould move to hold RER at astable and competitive level foran extended period of time.

There are basically three options:

1. interest rate manipulation

2. sterilised intervention

3. capital controls.


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To support the developmental role of

exchange rate, monetary policy mustmaintain stable and low real interestrates. By boosting exports this willcomplement the employment targetof monetary policy.

Will low interest rates set offinflationary nominal depreciation(under speculative exchange ratedynamics)?

Targeting RER can help central banksavoid this problem.


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Finally central banks need to havesome controls on capital flows.This will give central bankscontrols over monetary

aggregates and hence monetarypolicy independence to keep realinterest rates low, stabiliseemployment and keep inflation ata moderate level, while the

exchange rate policy aims tomaintain internationalcompetitiveness.


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There are, of course, many critics ofcapital controls. However, they mustaccept that the Mundell-Fleming

model conceived of capital flows aslargely money-market flows or atmost money and bond marketsflows.

An important development in theworld economy in the late 1990s wasthe shift of international capital flowsfrom the fixed income marketbothmoney and bond flowsto theequity marketboth portfolio equity

flows and FDI.


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A decline in policy interest rates canraise expected corporate earnings. Thiscan lead equity prices to rise and attractforeign investors with extrapolative

expectations to buy more equities.Therefore, equity effect of lower interestrates can be larger than the money-bondmarket effects to overturn standardMundell-Flemming results.

Thus, capital account openness shouldnot be viewed as an all-or-nothingproposition. The increased importance ofequity flows has increased the effectivescope of a capital account policy of semi-openness. A capital account can be open

to equity flowsboth portfolio and FDI,but closed to money and bond flows.

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Monetary Policy ERG