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Finance Chapter and Fiscal Policy for Development
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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
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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
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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
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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
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Role of Central Bank
Issue currency Banker to the government Banker to domestic banks Regulator of domestic financial institutions Operator of monetary policy
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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
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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
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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
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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
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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
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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
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Financial Repression
Interest rate
r1 = Market rate r2 = Controlled rate r3 = Black market rate
r3 r1 r2 S L1 L2
Credit shortage = L1L2
D Loanable funds
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Requirements of Fiscal Policy
Reasonable tax rates Effective tax collection agency Honest tax-collectors and tax-payers Balanced-budget requirement Independent central bank
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LDC Fiscal Problems
Low level of per capita income High degree of income inequality Low and non-progressive individual corporate and income tax rates Low property tax rate Excessive foreign trade tax rates High excise tax rates
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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
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Comparative Average Levels of Tax Revenue, 19851997, as % of GDP
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Comparative Composition of Tax Revenue, 19851997, as % of GDP
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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
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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
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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
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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
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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
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Trends in Global Military Spe...