Journal of Policy Modeling
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Dynamics of Macroeconomic Adjustment With Growth: Some Simulation Results

Sushanta K Mallick*
Department of Economics
University of Warwick
Coventry CV4 7AL, UK


* Thanks are due to Kenneth F. Wallis for his helpful comments on the earlier drafts of this paper. Naturally any error that might yet remain would be of the author alone. Financial support from the Commonwealth Scholarship Commission in the UK is gratefully acknowledged.


This paper examines the impact of several macroeconomic policies, both demand and supply management policies, on economic activity within an small macroeconomic simulation model. The model is based on a standard analytical framework that underlies adjustment policies in developing countries. The standard approach has been to use aggregate government expenditure as an instrument of fiscal policy to shock economic activity in a developing economy, with a negative dynamic response typically observed. In the context of such a small macroeconomic simulation model we decompose government expenditure into consumption and investment expenditure. Simulation exercises with and without model-consistent expectations throw up some contrasting results in the sense that fiscal policy can influence output positively through the effects of public sector investment on private investment in a developing economy such as India.

JEL Classification No.: F43, E62

Key Words: Growth-oriented Adjustment, Public investment, and model-consistent expectations

I    Introduction

Macroeconomic management in developing countries has typically been demand-oriented with little emphasis on supply-side policies in order to achieve short run stabilisation which ignores medium term growth in view of the implicit assumption that productive capacity is exogenous. Such neglect of medium run growth in the adjustment process came under vehement criticism in recent years as persisting external and internal imbalances led to a slackening in growth balance of payments (BP) difficulties and high inflation. The cause of these short run disequilibria can frequently be traced to a situation of government fiscal deficits that end in excessive monetary expansion and feed domestic demand. Stabilisation programmes (whether sponsored by the IMF or otherwise) are typically put into effect to reduce these demand pressures. A financial (or stabilisation) programme is a package of policies designed to eliminate disequilibrium between aggregate demand and supply in the economy which typically focuses on correcting short term imbalances by aiming at a desired BP outcome and a desired rate of inflation.

It has frequently been argued that these adjustment programmes fail to encourage economic growth. Attempts at integrating short run stabilisation and long run growth in the context of developing world have not been able to adequately address the complex dynamic interactions involved in the relationship between stabilisation and growth. However Khan and Knight (1985) [henceforth KK] attempted to show that the adjustment programmes of the IMF type can achieve a viable BP within the context of improved long-term growth performance and price stability.1 While KK's structural model can be understood to be based on standard: financial programming model of the Fund2 and gap model of the World Bank3, the Fund and the Bank models on the contrary rely heavily on accounting identities and thus leave out a substantial amount of economic structure and behaviour.

The model presented in this paper is in essence a variant of the simulation model reported in KK. KK in their simulations show that adjustment programmes often supported by the resources of the Fund do not impose significant economic costs. They indicate how alternative combinations of demand-side and supply-side measures can be expected to influence the rate of growth of output in the short run. Here we show that the composition of government expenditure is a neglected factor in explaining the long-term growth of the economy. Instead of considering aggregate government expenditure as in KK's simulations, a decomposition into consumption and investment expenditure allows public investment expenditure to become a major stimulant to long-term growth. This is important when government expenditure is treated either as a individual policy measure or as part of a complete policy package. A policy package is meaningful because most of the adjustment programmes contain a set of policies to be implemented synchronously. Though KK's model is treated as a medium term model with the specification of the determinants of productive capacity, it is still deficient in terms of its treatment of investment as exogenous.4 Hence, a behavioural private investment equation, influenced by public expenditure, can be introduced as an additional channel through which economic activity could be stimulated. The formation of expectations in KK was modelled in an adaptive fashion, and we consider the sensitivity of their results to this assumption by also implementing a forward-looking treatment. The second section of this paper presents the model. The third section analyses the effects of policy changes on economic growth. The fourth section sums up.


Although no single model can generally cover the whole range of policy measures contained in a typical adjustment programme, one such model that does include the whole gamut of policies involving the control of aggregate demand and supply is the one by Khan and Knight (1985) which is a variant of the econometric model developed by Khan and Knight (1981, 1982). Khan (1990) provides a summary of studies evaluating the effects of Fund-supported adjustment programmes on the leading macroeconomic objectives in the short-run. Overall, these studies yield three conclusions. First, there is frequently an improvement in the balance of payments and the current account, although a number of studies show no effects of such programmes. Secondly, inflation is generally not affected by programmes. Finally, the effects on the growth rate are uncertain, with the studies showing an improvement or no change being balanced by those indicating a deterioration in the first year of a programme. The theoretical core of the KK model can be summarised in what follows.

Structure of the Model

KK's model, a highly aggregated structural dynamic model, which has been found to provide a framework in the sense of being able to handle several policies synchronously, can be taken as a starting point for analysing the dynamic effects of macroeconomic policies. This simulation model was preferred from numerous in the literature on development macroeconomic models for the following reasons:

a. It is an aggregated model with a simple open developing economy structure;
b. It integrates monetary and real sectors of the economy;
c. The model simultaneously determines output growth, inflation, balance of payments, and money supply;
d. It explicitly considers the composition of the balance of payments and more importantly allows capacity output growth to be endogenously determined.

The model consists of six behavioural equations and five identities, as follows:

The first equation is a standard demand for money equation relating the desired stock of real money balances (md) to real income (y), the rate of interest on deposits (r), and the expected rate of inflation which is assumed to follow an adaptive process:

The next two equations describe the behaviour of imports and exports. The desired demand for real imports depends on real income and relative prices:

The actual quantity of imports is assumed to adjust proportionally to the difference between the demand for imports and actual imports in the previous period. This partial adjustment model is specified as

where is the coefficient of adjustment, As is well known, this type of adjustment model introduces a distributed lag process (with geometrically declining weights) into the behaviour of real imports Substituting equation (2a) into (2b) and solving for the level of nominal imports yields

The volume of exports will increase with the productive capacity of the economy (represented by y* ) and with the profitability of producing and selling exports (captured by the ratio of export prices to domestic prices

The domestic rate of inflation (logP) is assumed to be positively related to the excess supply of real money balances and the rate of foreign inflation, which is measured by the rate of growth of import prices (logPm) adjusted by the percentage change in the exchange rate (log): n yields

This formulation ensures that domestic inflation is determined by foreign inflation in the long run and the dynamic coefficients associated with foreign inflation add up to one.

The rate of growth of output (logy) is specified to respond to both monetary and fiscal variables, the deviations of output from capacity output (the output gap), and the rate of growth of real exports:

The rate of growth of capacity output (logy*) is central to analysing supply-side policies, and a simple growth model that starts with an aggregate production function (f) relating output (y) to the capital stock (K) and the labour force (L) has been used:

Converting this equation into rates of growth yields

where the variable dK is defined as equal to the rate of gross real investment (IR), treated as exogenous. A log-linear approximation to equation (6b) would render the capacity output growth equation. that is,


The remaining equations in the model are identities. The supply of money comes from the banking system's balance sheet in the form of domestic credit and international reserves as

The external sector's budget constraint defines the balance of payments, which is equal to the trade balance (X-IM), the net services account (S) and the change in foreign financing to the private sector (FIP) and the public sector (FIG):

Changes in domestic credit (DC) can result from changes in commercial banks' claims on the private sector (DCP) and central bank financing of the government budget deficit (DCG):

Now the fiscal and monetary accounts are linked by assuming that any government deficit (G-T) can be financed only by borrowing from the banking system (DCG) or borrowing abroad (FIG), that is,

where G and T are government expenditures and revenues respectively. Rearranging yields:

Finally, the expectations of inflation were assumed to be generated by an adaptive process in which these expectations are revised proportionally to the difference between the actual rate of inflation in the previous period (logPt-1) and the rate that was expected to prevail (et-1):

where is the coefficient of expectations, 01. In this formulation a value of equal to unity would mean expected rate of inflation is equal to the actual rate of inflation in the previous period: et = logPt-1.

The framework outlined above contains 11 equations, the structure of which has been summarised in Table I (II). KK calibrate it by imposing the values of the parameters, the specific choice of which were broadly consistent with the estimates obtained by empirical studies on various aspects of stabilisation policies in developing countries. They have used it to compare alternative policy packages for the balance of payments, inflation and real output growth. These comprise a package of demand-management policies (that is, a once-for-all reduction in the rates of growth of nominal domestic credit and nominal government expenditures, plus a devaluation) and a combined package of demand-management and structural policies (that is, the above-mentioned demand management policies, plus a set of structural policies that would gradually raise the rate of growth of capacity output). They find that the combined package of demand-management and supply-side policies succeeds in putting the economy on a higher secular growth path. However, the demand-oriented policy package includes a reduction in government expenditure, and the model makes no distinction between government consumption expenditure and government investment expenditure. In a country like India, a cut in govt expenditure in practice falls more on the reduction of capital expenditure, which contributes to long-term growth, relative to consumption expenditure. Hence the composition of the government expenditure is important in gauging their effect on long-term growth.

In itself, KK model is inadequate in achieving the objective of growth-oriented adjustment despite their claims of doing so in the absense of a growth-inducing mechanism in the model that primarily comes through investment which KK treat as exogenous. Hence an alternative way of examining the effect of fiscal policy on output growth should be made through public investment. Though the IMF literature holds the view that government fiscal deficits adversely affect real output due to the crowding-out effect, here we argue that it will be no longer valid it' the deficit is created in generating physical infrastructure in the economy that would induce private investment and thereby growth. Further an increase in public investment can result through the receipt of foreign financing, since most governments in developing countries are fiscally constrained and financing through domestic credit expedites inflation.

We modify the basic KK model in two ways:

i. The supply side is extended by incorporating a detailed investment mechanism;

ii. Agents' expectations are made forward-looking and specifically are formed rationally for the relevant future variable, namely expected inflation in the present model.

The following equations are the three new equations added to the KK model. Expectations of inflation (e) are assumed to be generated in a forward-looking model-consistent manner, suppressing equation (11).

It has invariably been argued by Indian economists that the public investment on infrastructure must not be cut in the transition process of the economy, for it has adverse long-term consequences. In other words, the private sector relies on public investment in most of the infrastructure because this is either a natural or a legal public monopoly. Hence there are potential supplyside relations between public and private investment, and public infrastructure and private investment should be complementary, in that infrastructure deficiencies will hold back both private production and private investment (Joshi and Little, 1994). Thus the real private investment equation has been introduced to depend on real public investment with a lag and real domestic credit extended to the private sector. This specification was found appropriate both in the agricultural sector (Mallick, 1993) and in the industrial sector (see Nayyar, 1995) of the Indian economy:

Total real investment is equal to real public investment and real private investment:

From the demand side, total government expenditure can be disaggregated into government consumption expenditure (GC) and government investment expenditure (IRG):

The above extension of the model has been summarized in Table I (I2).


1Examples of the burgeoning literature on the subject of growth-oriented adjustment can be found in Khan, Montiel and Haque (1990), Blejer and Chu (1989), Bacha and Edwards (1988), and Corbo, Goldstein, and Khan (1987).

2The Fund doctrine has been expounded at length in Polak (1957), which considers only one policy instrument, that is, domestic credit ceilings. After 1973 with the breakdown of the Brettonwoods convention of fixed exchange rates, the exchange rate has been the second major instrument for stabilisation through demand management (IMF, 1977; 1987).

3For an overview of the gap models, see Chenery and Strout (1966), Bacha (1990), and Taylor (1994). The two-gap conception, including the resource gap and the trade gap, is a simple open economy extension of the Harrod-Domar model of long-term growth based on the simple Keynesian system.

4The stylized Fund-Bank model treats investments as determined by the available saving, while the three-gap model derives it residually from saving, foreign exchange availability, or the government budget, depending on which is the binding constraint.

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