Macro-Micro Linkages

The impact of macroeconomic policy on microeconomic incentives is represented by two main linkages. The first is the impact of fiscal policy on the macro prices. Changes in these prices create changes in the prices of inputs and outputs and thus influence agricultural profitability. The second interaction is direct manipulation of the macro prices through government macro policy. Such action intentionally distorts factor prices or exchange rates, usually in the pursuit of nonefficiency objectives.

Fiscal Policy Linkages

Fiscal policy is of principal interest when the government budget balance is considered to be unsustainable. If budget balances fluctuate between surpluses and deficits but equal zero on average, macroeconomic policies represent stabilizing actions, such as the accumulation or distribution of government reserves. But if the budget balance is chronically in surplus or deficit, consumers and producers are affected directly.

The relationship between the government and the private sector can be demonstrated with the aid of the national income accounting identity. In the long run, the aggregate output available (the supply of goods and services) must equal aggregate expenditures (the demand for goods and services), as shown in the following identity:

Equation 2 summarizes the necessary interaction between the budget balance G - T and the rest of the economy. Positive values of G - T correspond to a government budget deficit. In this circumstance, the economy must experience a surplus of domestic savings over domestic investment, a surplus of imports over exports, or some combination of the two. Because this case characterizes fiscal policy in most developing countries, the subsequent discussion will focus exclusively on fiscal deficits.

Several macroeconomic policy alternatives are available to generate the necessary balance in government resource use. Eventually, the government must alter budgetary policy and reduce expenditures (causing G to decrease) or increase taxation and transfer expenditures from the private to the public sector (causing T to increase). But this alternative is often limited in the short run because of political constraints. Increased tax collections may also be difficult to administer.

Alternatively, the government can try to borrow domestically, either by increasing the interest rate to decrease private consumption and private investment in favor of saving or by imposing limits on private investment. In both circumstances, S - I will increase. Figure 5.2 illustrates the effect of this macroeconomic policy on both the capital market and a typical commodity market. The financial-capital market is portrayed in Figure 5.2a. Initially, all borrowing is done by the private sector; investment is I, the interest rate is i, the intersection between the supply of savings, S, and the demand for investment, D, If the government decides to finance the budget deficit by borrowing, a government demand for capital, D_g, is introduced. Demand is perfectly inelastic at the amount of financial capital needed to meet the deficit (G - T). The new market demand curve is now D', equal to D_g plus the private sector demand curve (DP). The interest rate rises from i to i', and the private sector investment declines from I to I' - (G - T) . Government policy has raised the cost of capital and the rate of return in the private sector. The effect on the commodity market is captured on the supply side, because rising interest rates cause the supply curve to shift upward, from S to S'. Production declines from Q to Q.

Another policy option is to finance the public debt by borrowing on foreign capital markets, thereby increasing foreign capital inflows (permitting F°°` - F'" to rise). This option is governed by the country's ability to service foreign debt, itself a function of past foreign borrowing and future development prospects

Figure 5.3 more elaborately portrays the foreign-exchange market by recognizing foreign capital flows as well as trade in goods and services. The diagram for foreign capital flows, Figure 5.3b, is presented in terms of relative rates of return and amounts of foreign exchange. The supply curve for foreign exchange in the domestic economy, S_K, is upward sloping. Increased inflows result as the domestic rate of return rises relative to the foreign rate of return. The demand curve, D_K, slopes downward, because as the domestic rate of return falls, investors want more foreign exchange (to use in foreign rather than domestic investments).

Initial equilibrium is represented by exchange rate e" and interest rate i_°'. Next a government deficit of G - T is introduced, financed by the borrowing of foreign exchange. Now the offsetting surplus appears in the foreign capital accounts. Foreigners supply more capital, and domestic capital formerly destined for foreign countries is diverted to domestic markets. For the balance of payments to be maintained, foreign trade flows must generate a deficit to offset the surplus in the foreign capital account. This result is achieved by an appreciation of the exchange rate; the price of foreign exchange falls from e* to e'. Commodity producers are affected in two ways. If the foreign capital market is linked with the domestic capital market, interest rates will increase and

cause the costs of production to increase, shifting the supply curve from S to S' and reducing output from Q₁ to Q_2. Moreover, the decline in the exchange rate will cause the domestic currency value of output to decline from P-(e* x P*), where P* is the foreign currency price of the commodity, to _{PW' (e'} x P*). The output effect of this price change is represented by the movement from Q₂ toQ_3.

In many developing countries, foreign capital flows are tightly controlled and isolated from domestic capital markets. Interest-rate effects on the domestic capital market thus could be absent. However, the exchange-rate effects remain. The government deficit still augments total foreign-exchange supplies, and therefore the domestic currency price of foreign exchange is lower than it would be without the fiscal deficit.

The final option for financing deficits involves the use of monetary policy. This policy action usually entails borrowing from the country's central bank, which finances the government debt by increasing the money supply. If the country has unemployed resources that can be mixed together in proportions fitting existing technologies and management, the increase in the money supply can result in the growth of production of goods and services (Q will rise). Taxes and savings increase, and the deficit is financed. But most developing countries face binding resource constraints that cannot be broken simply by increased public expenditure. What is adjusted is the average level of prices (P inflates).

A deficit financed by monetary policy thus causes demand-pull inflation. As equation 2 shows, this policy cannot successfully finance the deficit unless savings increase relative to investment or net foreign inflows increase. In general, therefore, monetary policy actions must be accompanied by one or more of the options just described. The only other way for monetary policy to work involves money illusion; private consumption is reduced in real terms, allowing public consumption (financed by the increase in the money supply) to expand. Without money illusion, monetary expansion will cause inflation. Private consumers alter the prices of their services to maintain their real consumption levels; governments must borrow increasing (nominal) amounts of money to finance the increased (nominal) costs of the public sector demand for goods and services entailed in the budget deficit. Governments also attempt to manipulate macro prices as an explicit objective of policy. Attention here focuses on the remaining macro price, the foreign-exchange rate. When exchange rates are fixed, distortions may be present even without fiscal imbalance. Figure 5.4 illustrates the case of an overvalued exchange rate, e'. The gap between the demand for and the supply of foreign exchange can be sustained as long as the government can borrow abroad or draw down its reserves of foreign exchange. But after these opportunities are exhausted, the country can continue to consume more tradables than it produces only if its trading partners agree to hold its currency, an unlikely occurrence for most developing countries.

If the government wishes to sustain a rate of e', it can try to induce shifts in the demand and supply curves. Curves D' and S' represent shifts that would enable the exchange rate e' to be sustained. These shifts could be attained in several ways. First, foreign income growth affects domestic commodity export opportunities as well as the financial-capital account. Second, shifts in demand and supply conditions in particular commodity markets could increase the world prices of exportables or decrease the prices of importables. Technology provides a third source of change in the foreign-exchange market. Widespread technological changes decrease production costs in the domestic economy, shifting outward the supply of exports and shifting backward the demand for imports. By raising domestic rates of return, domestic technological change also affects the foreign capital account. Inflows of foreign funds are encouraged, and outflows of domestic funds are discouraged.

Two of the adjustment options-foreign income growth and changes in world prices-are beyond the control of the government. Furthermore, changes in world prices would have to be widespread or involve commodities with prominent roles in the domestic country's foreign trade to have a substantial impact on the current-account position. Technological change, a more attractive option, generally requires substantial periods of time and amounts of investment. In most situations, therefore, the overvalued exchange rate must be complemented by additional distorting policies. These policies include rationing-direct allocations of foreign exchange (amount Q) to particular import usesand protection of import-competing industries so that the demand curve for foreign exchange shifts leftward (intersecting S at e' and Q').

Because protection and rationing are not provided uniformly to import-competing industries, some sectors benefit from this combination of policies and others lose. Consequently, interest groups are likely to play a major role in determining the incidence of such protection. The degree of political power of various groups differs among countries. But a plausible generalization is that large-scale industrialists, whether local or foreign, have better access to political privileges than do agricultural producers. Like farmers and small-scale firms in developing countries, most large-scale industries produce goods that are tradable internationally. The production of manufactured goods would be taxed by macroeconomic policy that creates an overvalued exchange rate. If so, the owners, managers, and employees of large-scale urban industries could be expected to support devaluation. In this sense, their political and economic interests would be aligned with those of farmers and artisans who produce tradable goods in rural areas. All of these groups would wish to rid themselves of the exchange-rate tax caused by overvaluation.

Nevertheless, this political alignment of rural and urban producers rarely occurs. Instead, the politically well-organized urban producer interest groups are able to protect themselves by convincing the government to enact commodity policies that offset the taxing effects of the overvalued exchange rate. In the choice of a particular instrument to provide protection, there is an important difference between a tariff and a quantitative restriction. A tariff provides a one-time increase in the domestic price, since the tariff is calculated as a percentage of the cif import price. This world price (in domestic currency) is held constant by a fixed exchange rate. If the exchange rate becomes more distorted over time (the degree of overvaluation increases), the tariff will have to be increased accordingly to continue to offset the taxing effect of macro price policy. But a quantitative restriction provides continuing protection automatically. In this circumstance, the prices of tradable goods protected by quantitative restrictions respond fully to domestic inflation. Since only a limited amount of imports are permitted by the quota, the prices of quota-protected tradables are set by domestic demand and supply conditions.

It is thus no coincidence that special interest groups lobby to receive quantitative restrictions to offset overvaluation. In many developing countries, import quotas on favored goods are set at zero, providing complete protection to local industry. Once protected by import quotas, the benefactors are no longer indifferent to the issue of macroeconomic reform. They then have a strong incentive to oppose devaluation in order to keep the prices of tradable inputs from rising. The combination of quantitative restrictions and an overvalued currency thus shifts the politics of macroeconomic reform by moving urban industrialists from the supporting to the opposing side. Industrial entrepreneurs seek principally to insulate their firms from overvaluation and to receive special policy favors rather than to minimize production costs. Rural producers and macroeconomic reformers then face the imposing task of overturning these entrenched interests.