Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 15 Finance and Fiscal Policy...

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 15

Finance and Fiscal Policy for Development

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-2

The Role of Financial System

• Providing payment services

• Matching savers and investors

• Generating/distributing information

• Allocating credit efficiently

• Pricing, pooling, and trading risks

• Increasing asset liquidity


Macroeconomic Stabilization Policy

Fiscal policy:

• Taxation and spending actions of the government to affect employment and output

• Expansionary: lower the income tax rate and/or increase public spending to create jobs and income


Macroeconomic Stabilization Policy

Monetary policy:

• Changing the supply of money to affect interest rate, investment demand, employment and output

• Expansionary: increase the money supply to reduce interest rate, increase investment demand, create jobs and income


Requirements of Monetary Policy

• An independent central banking authority

• Well organized financial market with banks and saving and loan institutions

• Strong link between interest rate and investment demand

• A floating exchange rate


Role of Central Bank

• Issue currency

• Banker to the government

• Banker to domestic banks

• Regulator of domestic financial institutions

• Operator of monetary policy


LDC Financial Market

• No central bank or a government-owned and managed central bank

• Financial dualism– Formal market: organized, but dependent financial

institution, consisting of foreign and domestic banks

– Informal market: unorganized, fragmented financial institutions, consisting of landowners and money lenders


LDC Financial Market

• Weak or ineffective link between interest rate and investment demand

• Structural inflation due to import substitution strategy

• Fixed or pegged foreign exchange rate, giving rise to a “currency substitution” problem


LDC Central Banking Problems

• Public agency issuing money to cover government deficit or finance the development plan

• Foreign-owned commercial banks

• Informal financial markets

• Colonial heritage

• A money supply difficult to measure

• A fixed or pegged exchange rate

• Unskilled central bankers


Emergence of Development Banks

• Specialized public and private financial institutions providing medium- and long-term loans for the creation and expansion of industrial enterprises

• Receive bilateral and multilateral loans from international lending agencies

• Receive loans from domestic government


Criticism of Development Banks

• Excessive concentration on large-scale loans

• Excessive concentration on financing urban-industrial development

• Neglect of small business expansion and rural-agricultural development


Need for Financial Liberalization

• Many LDCs suffer from “financial repression” since their central banks control the rate of interest, causing

– A shortage of loanable funds

– Higher interest rate charged by the informal financiers


Financial Repression

Loanable funds

S

r1

D

L1 L2

r3

r2

Credit shortage = L1L2

r1 = Market rater2 = Controlled rater3 = Black market rate

Interest rate


Requirements of Fiscal Policy

• Reasonable tax rates

• Effective tax collection agency

• Honest tax-collectors and tax-payers

• Balanced-budget requirement

• Independent central bank


LDC Fiscal Problems

• Low level of per capita income

• High degree of income inequality

• Low and non-progressive individual and corporate income tax rates

• Low property tax rate

• Excessive foreign trade tax rates

• High excise tax rates


LDC Fiscal Problems

• Ineffective tax collection agency

• Corrupt tax collectors

• Deficit-financing growth policy

• Inflationary-financing growth policy

• Mounting public debt and external debt

• Reliance of foreign aid and foreign direct investment


Comparative Average Levels of Tax Revenue, 1985–1997, as % of GDP


Comparative Composition of Tax Revenue, 1985–1997, as % of GDP


Public Administration Problems

• Fragmented society due to ethnicity, religion, political affiliation, and economic class

• Employment rather than efficiency criterion

• Shortage of skilled administrators

• Low salaries and inadequate benefits

• Lack of trust and prevalence of corruption


State-Owned Enterprises

• Large capital investment

• Public utilities, transportation and communication systems, financial institutions, services, natural resources, agriculture, and manufacturing

• Contributing an average of 7-10 percent to GDP

• Employ 30-40 percent of the labor force


Problems of SOEs

• Inefficiency: employment rather than profit maximization

• Monopoly power

• Higher wages inducing R-U migration

• Import-intensive ISI strategy

• Lack of trust and prevalence of corruption


Solution to SOCs

• Efficiency criterion: adopt a bottom-line focus in managing public enterprises

• Privatization: sell ownership of public enterprises to private investors

• The Latin American and East Asian NICs have been active in the privatization of SOCs


Military Spending and Development

• MDCs’ military spending is significantly higher than that of the LDCs (i.e., $527 vs. $200 billion)

• LDCs’ military spending share of world military spending has risen from 8.3 percent in 1960 to 27.5 percent in 2000


Trends in Global Military Spending, 1960–2000 (billions of U.S. dollars)


Military and Social Expenditures


Countries with Highest and Lowest Expenditures on Military, 2002 (% of GDP)


Countries with Highest and Lowest Expenditures on the Military, 2002 (% of GDP)


Military Spending and Development

• Countries in the Middle East, Latin America, and Africa are big military spenders and major armament importers

– Iran, Syria, Oman, Saudi Arabia, UAE

– Nicaragua, Bolivia

– Somalia, Ethiopia


Effect of Military Spending

Military spending causes economic growth

• Build the basic infrastructure

• Transfer technology

• Create jobs and income

• Spend money on supplies



Military spending hinders economic growth

• Infrastructure is mainly used by the military itself

• Military technology won’t spillover into private sector production

• Resources are diverted from industrial and agricultural production to military spending



Military spending hinders economic growth

• Military imports deteriorate the balance of payment

• Governments use the armament to suppress both internal and external conflict

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 15 Finance and Fiscal Policy...

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