Macroeconomic Policy Analysis

in Low Income Countries

THE
MACROECONOMIC
FRAMEWORK and the
THEORY of FINANCIAL
PROGRAMMING

By Dr. Mark Ellyne

 Course will teach you:

How to analyse a country like the IMF does,

using financial programming and the 4-sector
approach to the economy:
Basic forecasting of macro variables
How to build a simple model of an economy
Understand sectoral linkages and Consistency
Policy diagnosis and advice

2
Financial Programming Framework

1) Real Sector - National income accounts

 Output (GDP) and
 Prices
2) External sector - Balance of Payments
 Exchange rate
 Trade and capital flows
 Foreign debt
3) Fiscal - Government Budget
 Fiscal deficit
 Domestic borrowing and Public debt
4) Money and banking – Monetary Survey
 Money and the interest rate
5
 OUTPUT EXTERNAL
REAL ABSORBTION Foreign Inflows
Trade Flows
Output
Foreign Reserves
Prices PRICES Foreign Prices

DEMAND NCP NFA

MONETARY Exchange Rate

Credit to Government PPP IMPORTS,
DONOR
Credit to Economy Interest Rates AID
NFA

DEMAND NCG

FISCAL
Tax Revenue &Grants Expenditure
Foreign Financing Domestic Financing (T-Bills)

6
 National Accounts - GDP
Table 1. Zambia: Baseline Scenario, Gross Domestic Product by Sector of Origin at 2010 Constant Prices

at 2010 constant prices 1994 1995 1996 1997 1998 1999 2000 2001
(In billions of 1994 kwacha)
Primary sector 11,795 13,684 13,719 13,262 12,662 13,095 13,233 13,201
Agriculture, forestry and fishing 8,394 11,120 10,967 10,313 10,335 11,243 11,261 10,798
Mining and quarrying 3,402 2,564 2,753 2,949 2,327 1,853 1,972 2,403
Secondary sector 8,656 8,491 8,253 9,315 9,051 9,290 9,656 10,404
Manufacturing 3,804 3,797 4,018 4,233 4,326 4,463 4,642 4,860
Electricity, gas and water 1,523 1,495 1,406 1,460 1,462 1,491 1,501 1,678
Construction 3,329 3,199 2,828 3,622 3,263 3,335 3,513 3,866
Tertiary sector 17,407 17,546 19,750 20,580 21,388 22,870 23,970 25,491
Wholesale and Retail trade 6,005 5,414 7,282 7,696 8,071 8,558 8,905 9,565
Restaurants, Bars and Hotels 644 676 731 782 809 757 847 1,049
Transport, Storage and Communications 1,116 1,064 1,170 1,196 1,335 1,456 1,543 1,648
Financial Intermediaries and Insurance 3,827 4,536 4,129 4,105 4,080 4,133 4,049 3,986
Real Estate and Business services 1,574 1,623 2,013 2,298 2,629 3,045 3,633 3,845
Community, Social and Personal Services 4,241 4,234 4,426 4,502 4,464 4,921 4,992 5,398
Plus: Financial intermediation services indirectly
-2,496 -2,962 -2,700 -2,688 -2,676 -2,717 -2,753 -2,785
measured 1/
TOTAL GROSS VALUE ADDED 35,362 36,758 39,022 40,468 40,425 42,538 44,105 46,311
Taxes less subsidies on Products 3,212 2,934 3,138 3,300 3,175 3,089 3,300 3,615
TOTAL G.D.P. AT MARKET PRICES 38,574 39,692 42,160 43,768 43,599 45,627 47,405 49,926

7
 Table. Zambia: Baseline Scenario, Central Government Operations, 1994-2008
(in billions of kwacha)

Government
1994 1995 1996 1997 1998 1999

Revenue and grants 665 856 1,058 1,262 1,459 1,862

Budget Revenue
Tax revenue
450
414
595
527
817
729
1,023
936
1,131
1,077
1,324
1,276
Income Tax 129 172 222 296 381 470
Excise taxes 70 85 127 168 211 222
Sales tax/value-added tax (VAT) 76 108 137 184 200 248
Trade taxes & import duties 139 163 243 288 285 336
Nontax revenue 36 68 88 86 55 48
Grants 216 260 242 239 328 538
Total expenditures and net lending 855 1,000 1,214 1,407 1,943 2,193
Current expenditure 625 727 869 1,017 1,318 1,464
Wages and salaries 115 178 221 324 327 402
Goods and services 249 290 326 367 515 519
Interest due 2/ 261 259 322 326 476 543
Other (subsidies+transfers+social benefits) … … … … …
Capital expenditure 230 273 345 390 625 729
Foreign financed … … … …
Domestic financed … … … …
Overall balance (accrual) -189 -144 -155 -145 -484 -179
Overall balance excluding grants -405 -404 -397 -384 (812) -717
Financing 189 144 155 145 484 179
Domestic borrowing (net) 107 196 -152 -72 363 -947
Nonbanks 82 200 -164 -83 139 -982
Banking systems 4/ 25 -4 12 10 224 35
Foreign borrowing (net) 82 -52 307 217 122 1,127
Foreign borrowing (net) -50 -81 -51 10 (67) 385
Debt securities/bonds
Debt relief ( including rescheduling) 132 29 358 207 189 741
Change in arrears (net) 0 0 0 0 - 0
Memorandum items:
GDP (billion of kwacha) 2,448 3,290 4,345 5,656 6,587 8,130
Domestic treasury bill debt (in kwacha bn) 4,171 4,367 4,216 4,143 4,506 3,559
% of GDP 170.4 132.8 97.0 73.3 68.4 43.8
Sources: IMF and Zambian sources, and estimates.
Balance of
Payments
 Monetary Accounts

Table 11. Zambia: Monetary Survey, 1994-2008

(In billions of kwacha; end of period)
1994 1995 1996 1997 1998 1999
Net foreign assets -965.4 -985.2 -1,217.4 -1,129.3 -2,261.3 -2,423.5
Central Bank -1,011.9 -1,092.1 1,934.8 -1,334.7 -2,676.6 -2,893.0
Commercial Banks 46.5 106.9 -3,152.2 205.4 415.3 469.5
Net domestic assets 1,313.6 1,525.9 1,944.4 2,030.7 3,366.4 3,851.6
Net domestic credit 247.9 397.6 541.9 579.2 1,131.7 1,505.3
Net claims on government 1/ 85.4 91.9 112.7 122.3 580.7 693.2
Claims on nongovernment 162.5 305.7 429.2 456.9 551.0 812.1
Other items (net) 1,065.7 1,128.3 1,402.5 1,451.5 2,234.7 2,346.3
Broad money (M3) 348.2 540.7 727.0 901.4 1,105.1 1,428.1
Narrow money (M1) 144.3 228.3 270.1 355.3 397.6 504.0
Currency outside banks 57.1 79.0 106.3 136.7 169.7 212.2
Demand deposits 81.7 140.2 163.1 217.2 226.4 289.9
Quasi money (QM) 203.9 312.4 456.9 546.1 707.5 924.1
Savings deposits 67.0 73.8 114.0 141.5 146.4 189.8
Time deposits 108.6 151.1 182.0 197.2 167.3 200.8
Foreign currency deposits 28.3 87.5 160.9 207.4 393.8 533.5

10
 Question?

How do you know if the economy is in

balance?
How do you know what is a balanced
growth path for the future?

11
 Strategy

Build accounting framework with behavioural

equations where appropriate
Create a “No-Policy-Change” Scenario for
future projections
 Identify future
problems/disequilibria
 Determine what policy
changes are needed to
correct disequilibria
12
Financial Programming Approach

Create sectoral projections for the real

sector, the balance of payments, and the
fiscal deficit. Then check to see if they are
consistent in a monetary context with the
projected macroeconomic growth path.

13
 Financial Programming Model

Money Demand/Supply
M = NFA + NCG + NCP

External Government Private

Net Foreign Net Credit to Net Credit to
Assets Government Private Sector

Monetary sector provides judgement about consistency of sectoral

balances with aggregate macroeconomic performance.

14
 Structure of the Monetary Survey

Assets Liabilities
Net foreign assets (NFA) Broad Money (M3)
Central bank Foreign currency
Comm. Banks deposits
Domestic Credit M2
Net claims on govern. Time & savings deps.
(NCG) M1
Net claims on private Currency in
sector (NCP) circulation
Other items, net (OIN) Demand depos.

15
What is the Correct Money Supply?

The amount of money needed to satisfy

the credit demand for all sectors of
the economy (real, government and
external) while providing a stable
combination of growth and inflation.

16
 Sectoral Linkages of the
Monetary Accounts
Accounting Behavioral determinants

Net foreign BOP ∆NFA = Change in Foreign Reserves

asset
Net domestic Gov Domestic borrowing = Deficit – Foreign
credit to gov. borrowing
Net domestic Real NCP = η GDP – βr
credit to
private
Other items Banks Valuation adjustments, bank capital
net and profits
Broad money Money QTM: Mv=PY

17
 Quantity Theory of Money

Mv = PY
%∆M = %∆P + %∆Y - %∆v

Inflation Growth Velocity

Money supply must be consistent with

the projections for growth and inflation
and economic conditions (velocity).
18
 No-Policy-Change Scenario

Assume that velocity remains constants

Or
On same trajectory

21
 Real:
Y(GDP) = C + I + G + (X-IM)
(X-IM) = (T-Cg-Ig) [Fiscal]
+ ([Y-TI]-Cp-Ip) [Pvt]

BOP:
Fiscal:
(X-IM+TR+FI) + [FDI +
T + TR – Cg – Ig
Port + BORg +BORp] =
= DB + FB
∆RES

Money:
M = NFA + NCG + NCP
%∆M = %∆P + %∆Y - %∆v
23
 Madagascar:
Simplifed Example of
Financial Programming

24
 Finding an Equilibrium Growth Path

 We use the monetary accounts projections to determine

if we have an equilibrium projection for the economy
 ∆M = ∆NFA + ∆NCP + ∆NCG + ∆OIN
 Project nominal GDP to project private sector credit
demand
 Project Fiscal balance to project credit to goverment
 Project BOP current account and change in reserves to
project demand money
 Check if bottom up projection of M is balanced with
macro-economy

25
 1-Real Sector

1-Real Sector Assumptions for 2008:

• Real growth = 7%
• Inflation = 8.8%
2007 GDP = 18,782 bn MGA
How big is nominal GDP in 2008?

 %GDP = (1.07)*1.088) = 1.164 =>16.4%

 GDP 2008 = 1.164*18782= 21,862 bn MGA
26
 2-Domestic fiscal financing

2-Domestic financing is 1.3% of GDP

 How much will government borrowing

contribute to the money supply?

 = .013*21,862 = 284.2 bn MGA

 What is the impact on government debt?

27
 3-Overall Balance of Payments

3-Overall balance (CAB+CFA) is $206 ml

surplus
• What is the BOP contribution to money
demand in 2008?
• Projected Exchange rate based on PPP =
2050 MGA/$
 $206*2050MGA = 422.3 bn MGA money
creation

28
 4-Private Sector Credit Demand

4. Private sector needs sufficient credit to

meet desired nominal GDP growth.
• Target NCP growth =
= (Elasticity of NCP to GDP)*(%GDP)
 Ƞ ~ [0.7 – 1.5]
(Calculate trend in elasticity or assume Ƞ = 1.0)
• What is NCP for 2008 if it was 1827 bn MGA
in 2007?
 ∆NCP = [1.0*(0.164)]*1827 = 299.6 bn MGA
29
5-Calculating Money Demand
from the Bottom Up
+ ΔNFA (422.3 from BOP)
+ ΔNCG (284.2 from budget)
+ ΔNCP (299.6 private sector)

= ΔM3 = 1006.1
M3(2007) = 3915
= 1006.1/3915 = 25.7% growth

31
 Checking Money Demand

How do we know
if our projected money demand
is appropriate?

 Need to check with Top-Down approach

Quantity Theory of Money

32
 6-Money from Top Down

Quantity Theory of Money

Mv = PQ or M = kPQ
%∆M = %∆P + %∆Y - %∆v
Assume %Δv = 0%
%∆M = 8.8% + 7% - (0%)
Approx = 15.8%
Or (1.088)*(1.07)=1.164 => 16.4%
33
 Consistency

Bottom up money projection => 25.7%

growth
Aggregate top down projection=>16.4%

The sectoral calculations indicate 26%

growth in M3 needed, but this is not
consistent with aggregate economic
requirements of 16% growth in money!

34
What Does the Discrepancy Mean?

 Inflation projection is too low for given

scenario; or
 Fiscal deficit is too large, i.e. needs to be
smaller; or
 BoP surplus (overall balance) is too large. If
central bank buys less foreign reserves,
there will be some real appreciation, which
would help reduce inflation.

35
“No-Policy-Change” Scenario

The simulation of the “no-policy-

change” scenario into the future is a
strategy to identify potential problems
or disequilibria.
If there are disequilibria, then
alternative policies have to be
identified.
36
Simulate to Find Equilibrium
Program Objectives (g,
Program Design & Revision

NO-Policy-Change Scenario

Are sectors balanced?

Monetary Survey

Balance of Fiscal
Payments Accounts
37
 Macroeconomic Policy Design

“Having looked at monetary policy from

both sides now, I can testify that central
banking is as much art as science.
Nonetheless, while practicing this dark
art, I have always found the science
quite useful.”
Alan S. Blinder (1997)

(quoted from Clarida, Gali and Gertler)

38
 Structure of the Monetary Survey

Assets Liabilities
Net foreign assets (NFA) Broad Money (M3)
Central bank Foreign currency
Comm. Banks deposits
Domestic Credit M2
Net claims on govern. Time & savings deps.
(NCG) M1
Net claims on private Currency in
sector (NCP) circulation
Other items, net (OIN) Demand depos.

39
Monetary Approach to the BOP

(ΔNFA)
ΔMs – Δcredit demand
= Md = Ms
 ΔMd - ΔDom Credit

 ΔMd >> ΔMs –> ΔNFA Surplus

 ΔMs >> ΔMd –> ΔNFA Deficit Surplus

40
 Monetary Approach to the BOP

At the Central Bank

Money demand = (Credit+OMO+NFA)
Money supply = (cash + dom reserves):
Md = Ms
 [Credit+OMO+NFA] = [Cash+dom Reserves]
 ΔNFA = ΔMs –ΔCredit
ΔNFA = ΔMd –ΔCredit

41
Monetary Approach to the BOP

Md = Ms
 ΔMd - ΔDom Credit

 ΔMd == ΔMs == ΔNFA + ΔDC

 ΔMs >> ΔMd –> ΔNFA Deficit Surplus

42
Monetary Approach to the BOP

ΔNFA =
ΔMs – Δcredit demand
ΔMd - ΔDom Credit
Md = Ms
ΔMd == ΔMs == ΔNFA + ΔDC

 ΔMs >> ΔMd –> ΔNFA Deficit

 ΔMd >> ΔMs –> ΔNFA Surplus

43
 Sectoral Projections

Projections based on “no-policy-change”

scenario
Credit to the private sector = F{GDP}
Credit to Government = F{deficit}
Money creation from ΔNFA = F{ΔForeign
Reserves of Central Bank}

44
 Real Sector

Real GDP = output

 Sectoral composition
 Expenditure composition
Price level
Nominal GDP – Drives fiscal, balance of
payments, and credit

45
 Is Output Exogenous?

What is trend GDPR?

Supply side potential output
 Y = TFP Kα L1-α
Business cycles are a function of shocks
to TFP

46
 Identifying the Price Level

Augmented Philips curve:

π = β(πe) + φ(y- ye)
(Supply) (demand)
Inflation(π) is a function of expected
inflation(πe) and the
output gap (y- ye)
π = ẞ1π-1 + ẞ2 ygap
50
 Nominal vs Real Measures

1. Real factors determine the economic growth

path
2. Nominal factors often determine monetary
movements
3. Calculate the Nominal Value=P*Q
GDP_N = GDP_R * PGDP
(1+%GDP_N) = (1+GDP_R) (1+%PGDP)
%GDP_N ≈ g + π

51
 Other Key Prices

The interest rate and exchange rate are

linked to the domestic Price Level
Nominal and Real interest rate (r)
= nominal rate (i) - inflation (πt)
rt = (it – E{πt})
Nominal and Real Exchange Rate
PPP: RER = NER Pf/P = constant

NER = Nominal exchange in local/Foreign currency, R/$

52
 Why Is The Exchange Rate So
Important:

It affects:
 Prices and inflation;
 Value of external debt;
 Value of foreign assets (wealth);
 Amount of imports and exports.

56
 External Sector

CAB: Goods, Service

X + IM + TRansfers + Factor Income
+
Private
Capital and Financial Account
(FDI + Port + Borrowing)
Govt.
=
0 if float
Change in Official
Reserves
Not 0 if fixed

57
 Determinants
of Foreign Reserves
CAB+CFA = ∆NFA
 With no-policy-change and a constant
real exchange rate, we calculate the CAB
and the CFA to determine the change in
Foreign Reserves
 If the change in foreign reserves is not
stable, then the implication is that the RER
is not correct or another policy needs to
change.
58
 Balance of Payments Accounts
Current Account Capital and Financial Accounts
 Goods  Capital Account
 Imports (-)  Capital transfers
 Exports (+)  Acquisition/disposal of non-
produced nonfinancial assets
 Financial Account
 Services (nonfactor)  Foreign direct investment
 Portfolio investment
 Factor Income  Other investment, net
 Compensation of employees
 loans
 Investment income, dividends, &
debt interest  Trade credit
 Errors & omissions
Change in Reserves
 Current transfers
 Foreign exchange
 Official (Foreign Aid)
 Gold & IMF position
 Private (NGOs)
59
 Question?

If the central bank buys foreign

reserves, what happens to the money
supply?

63
 Fiscal Sector

Tax+Transfers - Gov Spend = Financing

T + TR – Cg – Ig =

= Foreign Borrowing

+ Domestic Borrowing (CB + B + NB)

64
 Summary of Budget

Revenue & Grants Expenditure & Net Lending

 Tax Revenue  Current
 Direct Taxes  Non-interest
Taxes on income Wages & salaries
Taxes on wealth Goods & services
 Indirect Taxes  Transfers
Goods & services Pensions
Imports Subsidies
Other  Interest
 Non-Tax Revenue  Capital Expenditure
 Fees  Foreign financed
 CB profits  Domestic financed
 Grants  Net Lending
-Overall Balance = Financing 65
 Determinants of Fiscal Flows

What drives tax revenues?

What drives wages?

What drives interest cost?

What drives other non-interest costs?

66
 Question?

To finance its deficit, is there a difference if

the government borrows from the central
bank or the private sector?

67
 Domestic Fiscal Financing

Inflation: If the government borrows

money from the Central Bank
(printing money) it is likely to be
inflationary.
Crowding Out: If the government sells
to many treasury bills to the domestic
(private) market they will push up
interest rates.
68
 Financial Programming Model

Money Demand/Supply
M = NFA + NCG + NCP

External Government Private

Net Foreign Net Credit to Net Credit to
Assets Government Private Sector

Monetary sector provides judgement about consistency of sectoral

balances with aggregate macroeconomic performance.

69
 Dealing with Disequilibria

Medium-term (no-policy-change)
projections help identify inconsistencies
among sectors
Inconsistencies lead to policy
recommendations

70
 Course will teach you:

How to do a country economic analyse

How to build a simple model of an economy
with consistent sectoral linkages
Forecast macro variables
Diagnose problems and offer policy advice

71
End of Lecture

Appendix follows

72
 OUTPUT EXTERNAL
REAL ABSORBTION Foreign Inflows
Trade Flows
Output
Foreign Reserves
Prices PRICES Foreign Prices

DEMAND NCP NFA

MONETARY Exchange Rate

Credit to Government PPP IMPORTS,
DONOR
Credit to Economy Interest Rates AID
NFA

DEMAND NCG

FISCAL
Tax Revenue &Grants Expenditure
Foreign Financing Domestic Financing (T-Bills)

73
Output and Price Variable Definitions

Y = domestic demand/output - GDP

Yf = foreign demand/output
P = price level
π = inflation rate
i = nominal interest rate
r = real interest rate = r = (i – πt+1e) ≈ i – π

74
National Account Variable Definitions

C = Consumption
Cg = Consumption by the
government
Cp = Consumption by the private
sector
FI = Factor Income, includes interest
on external debt & worker remittances
G = noninterest Government
expenditure
I = Investment
75
 BOP Variable Definitions

CAB =Current Account Balance

IM = IMports
X = Exports
TR = Foreign Transfer/grants
FI = Factor Income
NER = Nominal exchange rate (generally
local/foreign currency, ie R/$)
RER = Real exchange rate = NER [Pf/P] =
Pf/P in rand
76
 BOP Variable Definitions

CFA = Capital and Financial Account

FDI = Foreign direct investment
FB = Foreign borrowing
Port = Portfolio investment

ΔNFA = Net Foreign Assets

ΔRes = change in international Reserves
(ΔRes = -ΔNFAcb)

77
 Fiscal Variables

Rev = Revenue
T = Tax (and nontax) fiscal revenue
TR = Foreign Transfer/grants
Ex = Expenditure
BORf = Foreign borrowing
BORd = Domestic borrowing

78
 Money Variable Definitions

RM = Reserve Money
M = Money
ΔNDA = Net Domestic Assets of monetary
survey
ΔNCG = Net Credit to Government
by banking sector
ΔNCP = Net Credit to Private sector
ΔOIN = Other Interest Net
79