Chapter 15 Finance and Fiscal Policy for Development Copyright © 2009 Pearson Addison-Wesley All rights reserved 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-2 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-3 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-4 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-5 Role of Central Bank • Issue currency • Banker to the government • Banker to domestic banks • Regulator of domestic financial institutions • Operator of monetary policy Copyright © 2009 Pearson AddisonWesley All rights reserved 15-6 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-7 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-8 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 •Copyright Unskilled central © 2009 Pearson bankers AddisonWesley All rights reserved 15-9 Emergence of Development Banks • Specialized public and private financial institutions providing medium- and longterm loans for the creation and expansion of industrial enterprises • Receive bilateral and multilateral loans from international lending agencies • Receive loans from domestic government Copyright © 2009 Pearson AddisonWesley All rights reserved 15-10 Comparative Composition of Tax Revenue, 1985–1997, as % of GDP Copyright © 2009 Pearson AddisonWesley All rights reserved 15-18 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-19 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 Copyright © 2009 Pearson Addison• Employ 30-40 percent of the labor force Wesley All rights reserved 15-20 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-21 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-22 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-23 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-24 Trends in Global Military Spending, 1960–2000 (billions of U.S dollars) Copyright © 2009 Pearson AddisonWesley All rights reserved 15-25 Military and Social Expenditures Copyright © 2009 Pearson AddisonWesley All rights reserved 15-26 Countries with Highest and Lowest Expenditures on Military, 2002 (% of GDP) Copyright © 2009 Pearson AddisonWesley All rights reserved 15-27 Countries with Highest and Lowest Expenditures on the Military, 2002 (% of GDP) Copyright © 2009 Pearson AddisonWesley All rights reserved 15-28 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-29 Effect of Military Spending Military spending causes economic growth • Build the basic infrastructure • Transfer technology • Create jobs and income • Spend money on supplies Copyright © 2009 Pearson AddisonWesley All rights reserved 15-30 Effect of Military Spending 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 15-31 Effect of 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 AddisonWesley All rights reserved 15-32 ... 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... liquidity Copyright © 2009 Pearson AddisonWesley All rights reserved 15- 2 Macroeconomic Stabilization Policy Fiscal policy: • Taxation and spending actions of the government to affect employment and. .. AddisonWesley All rights reserved 15- 22 Copyright © 2009 Pearson AddisonWesley All rights reserved 15- 23 Military Spending and Development • MDCs’ military spending is significantly higher than