Macroeconomic Policy Analysis

in Low Income Countries

Lectures 8:
Policy Framework

By Dr. Mark Ellyne

 Goals of the Lecture

Review process of creating a no-policy-

change scenario that is consistent across
sectors
Understand different policy frameworks
between fixed and floating exchange rates
Be familiar with some policy strategies for
certain common shocks

Dr. M Ellyne – Macro Policy Analysis 2

 No-Policy-Change Scenario

Assume no change in policies, but current

trends may continue;
Therefore: assume the RER is constant in the
future, and RIR is constant
Incorporate assumptions for rest of the world
from IMF WEO (e.g. Oil price, partner country
growth, etc,)
Incorporate all known information about the
future, including future resource developments
(What to do about oil discoveries?);

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 Key Issues
for the Medium Term
1) Growth and Inflation projection
2) No change in RER
3) What are results for:
a. Fiscal deficit
b. Current account deficit
c. Sufficiency of foreign reserves
d. Public and external Debt

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 1-Real Sector Issues

Establish contributions to Real GDP growth

What sectors are producing the growth?
Contributions to GDP Growth from primary,
secondary and tertiary sectors; or from C, I, X
and M.

= ++

Dr. M Ellyne – Macro Policy Analysis 5

 Contributions to GDP Growth

Where is the growth coming from?

Contribution to GDP Growth 2013 2014 2015 2016 2017 2018 2019 2020 2021
GDP Growth 6.7 4.7 2.9 3.4 5.5 5.7 6.0 6.3 6.4
Primary sector -0.3 -0.3 -1.22 0.9 1.4 1.5 1.6 1.7 1.8
Secondary sector 3.4 3.1 2.3 1.4 2.2 2.2 2.2 2.2 2.2
Tertiary sector 3.5 1.9 1.8 1.1 1.9 2.1 2.2 2.4 2.4

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 GDP = C + I + (X - IM)

Calculate the Investment/GDP ratio from

the ICOR?
Exports and imports (gnfs) come from
BOP
Consumption is residual
What is happening to consumption per
capita (C$/pop)?

Dr. M Ellyne – Macro Policy Analysis 7

 2-What’s Happening to the
Nominal Exchange Rate
Plot Nominal and Real exchange rates
Why do they diverge?
Take care in establishing base for
projecting NER

RER = NER* [CPI_Zam/CPI_US]

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 3-Balance of Payments—
Current Account
Check path of import and export shares of
GDP—what is happening?
What could it be telling you about RER,
foreign demand, …?

Dr. M Ellyne – Macro Policy Analysis 9

 BOP Issues – Overall

What is happening to foreign reserves (in

months of imports)?
What could it mean about the real
exchange rate?
Overvalued – reserves decline a lot
Undervalued – reserves increase a lot

Dr. M Ellyne – Macro Policy Analysis 10

What’s Happening to the BOP?

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 BOP – Capital Account Issues

What is happening to capital account

relative to current account: both +/-,
mixed?
What’s happening to FDI
Is official foreign borrowing consistent with
government borrowing?

Dr. M Ellyne – Macro Policy Analysis 12

 4-Fiscal Issues

 Plot (Fiscal balance)/GDP,

 Revenue/GDP and expenditure/GDP
 What is driving the deficit?
 How does the revenue/GDP ratio compare with
other countries?
 What elements of government revenue are
strongest and weakest?
 Are public sector wages too high or growing
excessively?
 What’s happening with capex?
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 Aid Dependence

In Fiscal accounts, what share of

expenditures are covered by donor aid?
Check Grants/GDP + Gov. borrowing/GDP
or
Grants/Gov Expenditure + Gov.
borrowing/Gov Expenditure

as measures of aid dependence.

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Aid Dependence

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 Domestic Interest Rate

Plot the nominal interest rate (T-Bill rate)

and inflation – what does the difference
represent?
How large is the real interest rate; is it
trending in any direction?

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Real Interest Rate to Turn Positive

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 5-Public Debt Sustainability

Plot internal and external debt (separately)

as shares of GDP.
Are they growing too fast or at dangerous
levels?

Dr. M Ellyne – Macro Policy Analysis 18

Debt Remain Under Control

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External Debt Consistency Checks

Remember that:
Foreign financed Investment Spending
≈ Foreign Grants + loan disbursements,
and must be shown in BOP
Foreign Debtt+1= Debtt – Amortizationt +
new disbursementst

Dr. M Ellyne – Macro Policy Analysis 20

 6: S – I Balance

S = CAB - I
Plot CAB/GDP and I/GDP: what does the
difference tell us about Savings and
Consumption?
Separate I into Ig and Ip – how?
Identify (S-I)g and (S-I)p

Dr. M Ellyne – Macro Policy Analysis 21

 Internal – External Balance

CAB/GDP= Fisc Bal/GDP + Pvt Bal/GDP

Identify the S-I balances (as shares of
GDP) for the public sector and private
sector
Who is saving, who is investing? i.e.,
government or private sector.
Is CAB sustainable?

Dr. M Ellyne – Macro Policy Analysis 22

 Most S and I done by Private Sector

(In percent of GNI)

Current Account Balance 3.7 0.0 2.2 -3.5 -3.7 -1.5 -3.5 -5.2 -6.2
Investment 24.0 24.2 21.2 21.7 21.7 20.4 21.5 22.6 23.6
Government 6.5 6.7 5.4 5.0 5.9 6.5 6.6 6.4 6.2
Private 17.5 18.3 15.8 16.7 15.8 13.9 14.9 16.2 17.5
S=CAB+I 27.7 24.2 23.4 18.2 17.9 18.9 18.0 17.4 17.4
Gross national savings = Y-C 27.7 24.2 23.4 18.2 17.9 18.9 18.0 17.4 17.4
Sgov=Rev+Gr-C 2.9 -0.4 0.0 -1.5 -0.8 1.6 1.7 2.1 2.9
Igov 6.5 6.7 5.4 5.0 5.9 6.5 6.6 6.4 6.2
(S-I)gov [= fiscal deficit] -2.9 -6.7 -5.4 -6.5 -6.6 -5.0 -4.9 -4.3 -3.3
Spvt 24.8 24.6 23.4 19.6 18.7 17.3 16.3 15.3 14.5
Ipvt 17.5 18.3 15.8 16.7 15.8 13.9 14.9 16.2 17.5
(S-I)pvt 7.3 6.3 7.6 3.0 2.9 3.4 1.4 -1.0 -3.0

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 7-Monetary Policy

What is the monetary policy? (monetary

targeting, inflation target, fixed exchange
rate?)
What are the contributions to broad money?
Calculate:
 ΔNFA/M2t0
 ΔNCG/M2t0
 ΔNCP/M2t0

Dr. M Ellyne – Macro Policy Analysis 24

 Monetary Policy

How do the sectoral demands for money

(bottom up approach) compare to the QTM
approach (top down)? Speculate on what
the divergences mean?
Which sector do you think requires a policy
change?

Dr. M Ellyne – Macro Policy Analysis 25

 Check Money and Inflation

Is inflation projection consistent with

money growth?
%∆P = %∆M+%∆v-%∆Y
If not, need to assess what are the
implications for policy

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 How Monetised is the Economy

Can check M2/GDP or NCG/GDP as a

measure of financial depth, compared to
other economies.

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 8-Structural Issues

Are there any institutional issues that need

to be addressed?
• State owned enterprises?
• Functioning of financial markets?
• Trade policy
Other impediments:
• Governance (corruption)
• Excess regulation

Dr. M Ellyne – Macro Policy Analysis 28

Macroeconomic Accounts
Consistency Check
National Accounts
Y(GNDI) = C + I + X - M + Tr + FI
Government Sector
Rev+Tr - Cg - Ig = NFBg + NCGb + NCGnb

Balance of Payments
CAB = X - M + Tr + FI
CAB + CFA + dRes = 0
Monetary
M = NFA + NCG + NCP +OIN
NFA = -dRes

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 Consistency Between Accounts
GENERAL GOVERNMENT
REAL SECTOR
Fiscal Accounts (local currency,
flows)
National Accounts (local currency, flows) Revenues
Grants
Private consumption
Government consumption Expenditures
(Wages+Goods and services) Current
Capital
Private investment Overall balance
Government investment Financing
Domestic financing (net)
Exports of goods and nonfactor Banking system
services Nonbanking sector
Imports of goods and nonfactor External financing (net)
services
MONETARY SECTOR
EXTERNAL SECTOR Monetary Authorities (local currency, stocks
Balance of Payments (US Dollars, flows) Net foreign assets

Net domestic assets:

CURRENT ACCOUNT Net credit to governemnt sector
Exports of goods and nonfactor Credit to banks
services Other items (net)
Imports of goods and nonfactor
services Reserve money
Income (net) Currency
Current Transfers (net) Banks reserves
Official
Private
CAPITAL AND FINANCIAL ACCOUNT Deposit Money Banks (stocks)
Capital account Net foreign assets
o/w Capital transfers Banks' reserves
Direct investment
Medium/long-term capital (net) Net domestic assets:
Private sector (o/w banks) Net credit to government sector
Credit to nongovernment sector
Centr. Government Other items (net)
Short-term capital (net)
Private sector (o/w banks) Liabilities to monetary
Centr. Government authorities
Overall balance Private sector deposits
Reserves (Change in net foreign assets)
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 Check Consistency

Fiscal:
 Grants and disbursement from BOP
BOP:
 Must be done in US$
National Accounts:
 X, IM, Transfers, Net Income from BOP
Monetary:
 Must be consistent with each sector

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Part 2 - Conventional Policy Wisdom

The traditional macroeconomic policy

wisdom was called the “Washington
Consensus,” but we have moved forward
to understand the importance of other
factors, like good goverance, strong
institutions, and ownership, in the “Post-
Washington Consensus”

Dr. M Ellyne – Macro Policy Analysis 32

 Lessons from
the Washington Consensus
1. Fiscal discipline – Fiscal policy should be counter-
cyclical. Composition of spending matters; Don’t let total
debt get too high, and domestic financing is preferable
to foreign financing.
2. Public expenditure priorities should be health,
education and infrastructure; with a focus on providing
public sector. Don’t let government Consumption get
out of control.
3. Tax reform - broaden the base and target the
revenue/GDP ratio.

Dr. M Ellyne – Macro Policy Analysis 33

 Lessons from
the Washington Consensus
4. Maintain a unified exchange rate, and
allow the market to determine its value.
 What does a parallel exchange market
mean?
 See what’s happening to the real exchange
rate?

Dr. M Ellyne – Macro Policy Analysis 34

 Lessons from
the Washington Consensus
7. Trade liberalization is usually good for
growth and consumer welfare.
8. Privatization of state-owned commercial
enterprises can raise the efficiency of
investment. Check social cost vs social
benefit.
9. Try to eliminate barriers to FDI – to
encourage investment and foreign inflows.

Dr. M Ellyne – Macro Policy Analysis 35

 Lessons from
the Washington Consensus
10.Liberalize the financial sector – at the appropriate
pace. Positive real interest rates are generally good
for proper allocation of resources. Encourage bank
competition to deepen the financial sector.

A developed financial sector, accessible to the entire private

sector, improves growth.
Positive real interest rates encourage savings and efficient
use of capital;

Williamson (1993)

Dr. M Ellyne – Macro Policy Analysis 36

 Lessons from
the Post-Washington Consensus
11. Maintain macroeconomic stability,
including effective monetary and fiscal
policies to stabilize inflation and encourage
growth.
• Inflation is bad; it hurts growth, it erodes savings, and
stimulates capital flight (into other assets);
• Limit domestic credit expansion to reduce inflationary
pressures
12. Good governance (no corruption,
government ownership,…) is important
13. Institutional development is essential
Dr. M Ellyne – Macro Policy Analysis 37
 Lessons from
the Washington Consensus
Structural Issues:
5. Are institutional structure sufficiently
strong, like property rights, education, …
6. Is the economy overly regulated? Are
there price controls and subsidies? How
large is the SOE sector?

Dr. M Ellyne – Macro Policy Analysis 38

 Part 3 - Dealing with Common
Shocks/Issues

Commodity shocks and Dutch disease

Inflation
Deflation

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 Oil Price Supply Shock

An oil price reduction shock reduces inflation

and can raise output in an oil-dependent
country
Reduces the current account deficit;
uncertain effect on fiscal balance, although
probably increases fiscal balance
Government response depends if it is
considered permanent or temporary?
 Temporary – save more
 Permanent – Adjust and spend more
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Effect on Oil Producer Depends on:

Who owns the oil – government or private

sector?
How much of oil revenue stays in the
country?
 Wages
 Operating expenses
 Taxes and royalties

Dr. M Ellyne – Macro Policy Analysis 42

Positive Oil Shock – What Happens

A rise in the oil price for an oil producer

may lead to appreciation of the exchange
rate and/or to inflation.
CAB+CFA = ΔNFA
i. Increasing reserves (without offsetting
sterilization) => money => inflation
ii. No increase in reserves =>
Appreciation => inflation down
Dr. M Ellyne – Macro Policy Analysis 43
 What is the Dutch Disease?

When a newly developed exportable good is

abundant and cheap to produce, such that it
dominates exports; it appreciates the
exchange rate and make traditionally
exported goods uncompetitive.
The appreciated real exchange rate and
corresponding income effect usually makes
the prices of non-tradables more expensive
than tradables.
Dr. M Ellyne – Macro Policy Analysis 44
How to Address a Resource Boom

Revenue from oil and other commodities

can be treated according to the Permanent
Income Hypothesis (PIH)
Natural resources are a gift to a nation and
intended to benefit future generations.
Treat oil revenue like personal income.
Smoothing consumption by saving part of
large income increases in order to ensure
higher consumption for future generations.
Dr. M Ellyne – Macro Policy Analysis 45
Permanent Income Hypothesis (PIH)

A permanent wealth approach:

Consider that all the country’s oil was sold at
once and transformed into a financial asset.
This would represent the PV of its oil wealth.
If invested at a given real interest rate, it
would produce a defined income stream for
the future that could cover a fiscal deficit and
therefore set the level of expenditure.

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Permanent Income Hypothesis (PIH)

That income stream should be used to

finance the non-mineral fiscal deficit, so
the value of the oil assets would be
preserved for future generations. Fixing
that deficit to the income stream would be
an anchor for fiscal policy.

Dr. M Ellyne – Macro Policy Analysis 47

Permanent Income Hypothesis (PIH)

Numerous variations of the above theme

exist:
Only spend the interest generated from oil
savings to cover the non-oil deficit;
Fix spending based on a permanent
expenditure at a constant real per capita
level.

Dr. M Ellyne – Macro Policy Analysis 48

 Sovereign Wealth Fund

Many oil producing countries have

created a “sovereign wealth fund”
so that future generations are
guaranteed to share in the benefits
of its sale of natural resources.
The SWF operates as part of a
fiscal rule

Dr. M Ellyne – Macro Policy Analysis 49

 Sovereign Wealth Fund Rules

Think of as performing 2 tasks:

 Stabilising government spending
 Saving for the future (to maintain spending)
How much to save each year – based on
a baseline P and Q
How much to transfer to the budget to
spend each year

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 Country Study

Length: 3000-5000 words excluding tables, graphs, appendices.

Tables: The appendix should contain the following basic tables with 2 or 3 years of
history and 5 years of projections:
 national income accounts (by sector or expenditure);
 balance of payments;
 government budget;
 monetary survey; and
 Summary table of economic indicators like one below.

Small tables within the report can be used to emphasize developments.

Charts: Use charts and graphs within the paper to highlight the points you make.

3-10-2012
57
 Country Study

1-Background
Briefly cover historical issues that enable the reader to put the current
economic situation into context. This would include important social,
political and economic developments, such as: change of government,
political unrest, major economic shocks or important policy changes.

2-Recent Economic Developments

Describe where the economy is at, in respect of the current business cycle
or since the 2009 international financial crisis.
You want to focus on the main economic challenges they have been
having, for example: weak exports, high government spending, inflation,
etc. You probably want to touch all of the sectors (real, fiscal, external and
money) but want to highlight key issues.
Any other important structural issues (bank failures, corruption scandals,
etc.)

3-10-2012 58
 Country Study

3-Medium Term Outlook

Real Sector – Where is growth coming from and what is the
outlook for inflation
Balance of Payments – Evaluate PPP and project the NER.
Which accounts are in surplus or deficit and why. Whats
happening to foreign reserves?
Fiscal Sector – Discuss elements as ratios to GDP. What is
causing the fiscal deficit and what is happening to debt.
Monetary – Do the bottom-up calculation for money and the
top-down calculation, compare and assess.

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 Country Study

3-Policy Issues and Risks

Based on any discrepancy in the monetary analysis, explain
the implications and what policies should be changed.
Evaluate the foreign reserve situation and the public debt
situation.
Highlight any potential sectoral imbalances and discuss the
elements that appear to be driving the imbalances.
What are the main risks to this scenario?

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 Country Presentations

Plan a 20 minute presentation and allow 10

minutes for discussion
Briefly describe the background of the country
including any relevant politics
Identify key issues facing the country recently
Show history and forecast graphically for each
sector
Summarize policy issues and risks.
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 Macroeconomic Policy Analysis in Low-Income Countries
Project Assessment
Student
Country
Report Sections
Executive Assessment of Recommenda
Medium-Term Tables and Weight
Qualities Summary and Historical tions and Score
Projections Appendices (%)
Background Developments Risks
I Quality of writing -
1. General presentation
Clear structure of paper, <--------------> <--------------> <-------------> <-------------> 20%
Clarity of thoughts
Used charts and tables appropriately
II Economic argumentation and logic
1. Arguments
Supported argument with data vs supposition
Consistent economic logic <--------------> <-------------> <-------------> <------------> 25%
2. Focus
Touched on all sectors
Identified key problems/issues
III Technical proficiency
1. Quality of forecasts Real <------------->
Forecasts and key ratios made sense BOP <------------->
Forecasting consistency Fiscal <--------------> <-------------> <------------> 25%
2. Use of analytical tools Money <------------->
Use of econometrics, trends and ratios
IV Data management & excel spreadsheet <--------------> <--------------> <--------------> 25%
V Miscellaneous/discretionary 5%

Weight 15.0% 27.5% 27.5% 15.0% 15% 100% 0

Score 0 0

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