Monetary Policy and Stabilisation

Trap in Selected Asian Countries

Implications for Poverty Reduction


Anis Chowdhury
Professor of Economics
University of Western Sydney, Australia



Introduction
deficit financing can lead to a very
unsustainable economy. Bolivia in the
1980s is an extreme example: its
deficit rose to 28% of GNP leading
to hyperinflation and serious economic
crisis. So, each country should aim at
roughly balancing its budget
(Human Development Report, 1991, p. 42)
Generalisation from extreme cases led
to the policy package of IMF/World
Bank in the 1980s & 1990s
Single digit Inflation and growth stagnation
Sources: World Development Reports, 1991, 2002
Country



Inflation Rate

Growth Rate



1965-80

1980-89

1965-80

1980-89



Bangladesh

14.8

10.6

2.5

3.5



Ethiopia

3.4

2.0

2.7

1.9



Burundi

5.0

3.7

7.1

3.3



Mali

9.0

3.6

4.2

3.8



Niger

7.5

3.4

0.3

-1.6



Rwanda

12.5

4.0

4.9

1.5



Pakistan

10.3

6.7

5.2

6.4



Indonesia

35.5

8.3

7.0

5.3



Cote dIvorie

9.4

3.1

6.8

1.2



Peru

8.1

5.6

4.1

2.1



Congo

6.8

0.3

6.2

3.9



Cameron

9.0

6.6

5.1

3.2



Panama

5.4

2.5

5.5

0.5



Gabon

12.8

-1.0

9.5

1.2



Trinidad & Tobago

14.1

5.8

5.0

-5.5



Sources: World Development Reports, 1991, 2002
Poverty in the 1990s
Sources: World Development Reports, 1991, 2002
Sources: World Development Reports, 1991, 2002
Country

$1 a day

$2 a day

Bangladesh

29.1

77.8

Ethiopia

31.3

76.4

Burundi





Mali

72.8

90.6

Niger

61.4

85.3

Rwanda

35.7

84.6

Pakistan

31.0

84.7

Indonesia

7.7

55.3

Cote dIvorie

12.3

49.4

Peru

15.5

41.4

Congo





Cameron





Panama

10.3

25.1

Gabon





Trinidad & Tobago





Argentina in the 1980s
hyper-inflation the average annual inflation rate
around 391% and average annual economic growth
rate around 1%

1990s
orthodox IMF stabilisation package succeeded;
average annual inflation rate 1.5%, and the economy
grew by an average annual rate of 6.7% during 1991-
1997

However
the continuation of severe restrictive macroeconomic
policies forced the economy into a deflationary spiral
the inflation rate dropped to 0.9% and 1.3% in
2000 and 2001 respectively
economy contracted by 3.4% in 1999 and by 2.1% in
2000
unemployment rate rose from 6.5% in 1991 to 17.5% in
1996
consequently, the poverty rate (head-count ratio) rose
from 21.8% in 1993 to 34.3% in 2002, and the Gini
coefficient from 0.45 to 0.49

Asian Experience
While lower inflationis a positive indicatora near-zero inflation rate
may be symptomatic of demand deficiency leading to capacity
underutilizationTargeting for a too-low inflation ratecan sometimes
result in overkill. .. Yet another problem with pushing inflation too low is
that it will make it difficult to bring about the large relative price changes
that the structural adjustment policies aim at. (Bangladesh Report, p. 38).
The point is not that the authority has to fight inflation at any price and to
only value deflationary policy. Rather, it has to face the tough question of
how far to go with fighting inflation, knowing that with ongoing deflation an
economy might face greater risk of entering into the chain of rising
unemployment, falling demand, and reduction in the level of national
incomeThis restricted policy should not be seen as the only way out,
without flexibility. The inflation ratehas remained low since 1995 But,
the targeted inflation of about 4 per centseems to be low if the aim is to
create employment and economic growth. (Cambodia Report, pp. 48, 60-
61).
In the current context, one of Chinas important challenges appears to lie
in counteracting deflationary pressures and sustaining rapid economic
growth rather than combating inflation...Persistent deflation may have
serious adverse effects on Chinas economic growth and poverty
reduction prospects. (China Report, p. 72).
Policymakers continue to adhere to tight IMF-prescribed fiscal and
monetary targets in order to achieve single-digit inflation
ratesMeanwhile, domestic consumption, not private investment, is
supporting growth. But clearly this is not sustainableHigh interest rates
[needed for a low inflation target] are an impediment to growth in
circumstances such as Indonesias, where the corporate sector is heavily
indebted. (Indonesia Report, pp. 15, 19)
Bank Indonesia highlighted Indonesias monetary policy dilemma:
if the policy is tightly directed at attaining inflation targetit is feared
to disturb the current economic recovery.
If Bank Indonesia is still persistent in achieving the base money
target, extremely high increase in interest rate will be required,
whichcould harm the economic recovery prospects
This sentiment was echoed by the Chairman of the Indonesian Chamber
of Commerce of Industry: Bank Indonesia has been keeping interest
rates high to ease pressure on the rupiah and stall inflation however,
[this] discouraged industries from making new investments that would
otherwise have helped create new jobs
Realisation at Last!
Wolfensohn, if we take a closer look,
we see something else something
alarming. In developing countries,
excluding China, at least 100 million more
people are living in poverty today than a
decade ago. And the gap between rich
and poor yawns wider.
World Bank (2005, p. xiii), there is no
unique universal set of rules [W]e need
to get away from formulae and the search
for elusive best practices.
Easterly (2001) called the 1980s and
1990s the lost decades.
Monetary Policy and Poverty theories
and evidence

The channels through which monetary policy can
affect poverty are:
long-run economic growth
short-run output stabilisation and
income distribution.

Since monetary growth and inflation are positively
linked, moneys role in poverty reduction will be
examined by looking at the:
inflation-growth inflation
short-run trade off between output and price
stabilisation and
inflation-inequality relationship.
We shall also examine the question of central
bank independence.
Money in the Long-run Does Inflation
Harm Economic Growth?

In theory, the answer is both Yes and No.
What is the empirical evidence?
Extensive empirical research indicates that the
negative relationship between inflation and
economic or productivity growth is influenced by
extreme values or outlying countries having an
exceptionally high inflation rates (see Figure 2).
In the words of Bruno and Easterly (1998), the
correlation loses significance with the omission of
single observation Nicaragua, which had hyper-
inflation and negative growth in the 1980s More
generally, significance and sign of the cross-
section correlation depends on the inclusion of the
countries with high inflation crises the above
40% episodes.
They also observed, the significance of the
negative growth during 20-40% inflation vanishes
if a single extreme annual observation is omitted
Iran in 1980.
Easterly (2003) reported similar findings and
regarded inflation rates below 35% as moderate.

Figure 2a: Inflation-Growth (1980-1990)
-10
-5
0
5
10
15
-100 0 100 200 300 400 500
Inflation
G
r
o
w
t
h


Figure 2c: Inflation-Growth (1980-1998)
-10
-5
0
5
10
15
-200 0 200 400 600 800
Inflation
G
r
o
w
t
h

Figure 3: Average GDP Growth & Inflation Rates
(1960-2000)
-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
4
Between 0
& 5%
Between 5
& 10%
Between 10
& 15%
Over 15%
Average Inflation Rate
A
v
e
r
a
g
e

G
D
P

G
r
o
w
t
h

R
a
t
e

(
%
)

1960-1979
1980-2000
Source: Islam, 2003
Figure 3 plots average inflation and growth rates
over four decades (1960-2000) for 141
countries. Two interesting features emerge.

The inflation-growth relationship was negative
in the period 1960-1979. But it seems to have
become non-linear first positive and then
negative in the later period of 1980-2000. This
confirms the uncertain nature of the inflation-
growth relationship.
The variation in growth rate between the two
time periods is much larger at both low and
high inflation. That is, both high and low
inflation rates can be destabilising, and hence
harmful for the poor.
Thus, one may conclude that while policy makers should
guard against high inflation, a country may need
moderate inflation to sustain economic growth. This
understanding is essential when there is excess capacity
and persistent high unemployment or underemployment.
The over-fixation with a single digit inflation target cannot
be justified based on the fear of inflation going out of
control once it is allowed to go beyond, say 10% level.
Dornbusch and Fischer (1993) found that inflation rate in
the moderate range of 15-30% does not usually
accelerate to extreme levels.
Bruno and Easterly (1998) found that the threshold
inflation rate of 40% at which the probability of inflation
rate accelerating rises significantly.
Furthermore, only in a handful of cases inflation rate did
accelerate and output stagnated or declined in the past,
and these cases could be attributed to unusual
circumstances (e.g Iran or Nicaragua in the 1980s
following dramatic fall of the regimes).
Cross-country scatter diagram (Figure 5) shows, the claim
of the orthodox school that inflation harms the poor breaks
down when one considers inflation rate in the range of 5-
20%. Consistent with the aggregate inflation-growth
relationship, the negative relationship between inflation
and the income of the poor is based on few cases of
extreme inflation.
Therefore, contrary to the orthodox view, poverty-
reduction strategy requires moderately expansionary
monetary policy, and fear of excesses cannot be a basis
for sound public policy.
Money in the Short-run: Is there any
Output Stabilisation Role?

Demand Shock: Monetary policys role in
stabilizing output depends on two questions:
To what extent a country is prone to demand
shocks
To what extent prices (product prices,
exchange rate & interest rate) and wages
flexible

The components of aggregate demand are less
stable in developing countries due to:
Narrow export base
Poverty and the role of current income
Liquidity constraint for both households & small
firms

Among key prices
Exchange rate is quasi fixed
Wages are sluggish downwards mainly
because real wage is already too low.
Therefore, regardless of whether the
adjustment happens through output or
prices, falling aggregate demand will have
serious implications for the poor.

If the adjustment happens through cuts in
output and employment, the first to lose
job is unskilled and unorganised labour.
If the adjustment happens through
declines in wages, again the unorganised
and unskilled workers would be forced to
accept lower wages.
S
Po
P1
Do

D1
Y2 Y1 Yo
Figure 6: Adjustments to Demand Shocks
Thus, the poor unorganised workers are
forced to choose between jobs and lower
real wages. In either case, the average
income of the poor is likely to drop when
nominal GDP growth drops from its trend.
Cross- country (Figure 7) evidence shows
that average income of the poor is
negatively related to aggregate demand
variability.

This negative relationship does not
breakdown even when the outliers are
omitted.
Therefore, from the point of view of
protecting the poor, monetary policy needs
to stabilise output in the face of adverse
demand shocks.
Supply Shock: It is generally accepted that
the developing countries are more prone
to supply shocks than demand shocks.

This is due to their heavy dependence on
agriculture and imported raw materials,
and energy (oil).
While alternating floods and drought are
almost regular phenomena affecting
agriculture, declining terms of trade due to
rising prices of imported raw materials and
energy adversely affects the industrial
sector.
The choice between output and price
stabilisation becomes starker in the case
of a supply shock. This can be shown
diagrammatically:
Figure 8: Adjustment to Supply Shocks
D1 S1 S1
Do So Do So
D1
P2
P1 P1
Po Po
Y1 Yo Y2 Y1 Yo
In panel A, the response to an adverse
supply shock is an expansionary
monetary policy to stabilise output at
Q0.
In panel B, the response is a
contractionary monetary policy to
stabilise the price level at P0.
When the response is an
expansionary policy, the price level
rises further to P2, causing higher
inflation.
When the objective is price
stabilisation with a contractionary
monetary policy, output declines
further to Q2.
Inflation and Income Distribution
Inflation can disproportionately hurt the poor through
two channels:
Wage rise lags behind price rises
Poor mostly save in money and inflation reduces
the value of their savings.

Counter arguments:
If real wage declines due to inflation then
employment should rise. Therefore, the employment
effect of inflation can outweigh the real wage effect
on poverty.
The gain from expansionary monetary policy will not
be temporary if the inflation rate remains
moderate. This is evident from the positive
relationship between moderate inflation and
economic growth as demonstrated earlier.
The poor are largely net financial debtors. Thus,
inflation can benefit the poor by reducing the real
value of their net debt. On the other hand, lower
inflation not only increases the real value of financial
debt, the high interest rate policy aimed at bringing
inflation down increases the debt servicing cost of
indebted poor. This makes them, doubly
disadvantaged.

Evidence

Studies have found that income distribution
narrows during the expansionary phase and
widens during the contractionary phase of a
business cycle.
Figure 9 presents the scatter plots of average
inflation and inequality (measured by Gini
coefficient). Once again, we find that the claim
of adverse distributional effect of inflation is
based on extreme inflationary cases.
There seems to be no relation between
inequality and inflation when the inflation rate
ranges between 5 and 15%. On the other hand,
inequality rises with the variability of nominal
GDP growth (Figure 10).
The evidence presented in Figures 9 & 10
vindicates the need for output stabilising
monetary policy that allows for moderate
inflation.

Central Bank Independence and Inflation-
targeting
The empirical evidence on the performance of
independent central banks is still mixed.
The conditions required for the success of an
inflation-targeting approach include
the lack of fiscal dominance and
the absence of any other objectives.
None of these conditions appears to hold in
most developing countries.
The revenue base of these countries is very low
and their capital market is underdeveloped. This
forces most developing countries to borrow from
the central bank.
These countries also have some sort of quasi-fixed
exchange rate systems needed to prevent
imported inflation and to attract short-term portfolio
foreign capital.
Thus money supply responds to developments in
government finance and the balance of payments.

Leaving aside the technical argument, there is a
broader issue of democratic governance and
technocratic insulation of institutions.

It is pertinent at this juncture to quote Milton
Friedman who is on record for voicing the
concern ' money is too important to be left
to the central bankers'. His concerns are
elaborated in the following quote:

The political objections are perhaps more
obvious than the economic ones. Is it really
tolerable in a democracy to have so much
power concentrated in a body free from any
direct political control? One economic
defect of an independent central bank is
that it almost invariably involves dispersal of
responsibility Another defect is the
extent to which policy is made highly
dependent on personalities A third
technical defect is that an independent
central bank will almost invariably give undue
emphasis to the point of view of bankers
The defects I have outlined constitute a
strong technical argument against an
independent central bank.
Stern and Stiglitz (1996) have made the
point more succinctly:

The degree of independence of the
central bank is an issue of the balance of
power in a democratic society. The
variables controlled by the central bank
are of great importance and thus require
democratic accountability. At the same
time the central bank can act as a check
on government irresponsibility. The most
successful economies have developed
institutional arrangements that afford the
central bank considerable autonomy; but
in which there is a check provided by
public oversight, an oversight that ensures
the broader national interest is taken into
account in the final decisions.
In this respect, it is worth highlighting the distinction
between "goal independence" and "instrument
independence".

The former refers to central bank's ability to set the
inflation target independently of the government.
The later is its independence in the choice of
instruments and hence relates to central bank's
day to operations.
No central bank can be entirely independent of a
democratic government while it can be entirely
free in choosing its instruments.
Most developing countries are new democracies.
In such a situation, a central bank with both goal
and instrument independence may choose a very
low inflation target which can undermine a nascent
democracy by delaying economic recovery.
Furthermore, the very argument that an elected
government cannot be trusted with the
responsibility of managing the economy goes
against the very principle of representative
democracy.

The above issues have become more prominent in
Indonesia as the new central bank law (enacted in
1999) grants the Bank Indonesia (BI) both goal and
instrument independence.

This has been responsible for open disputes between
the BI and parliament in a number of occasions on the
appropriateness of monetary policy stance.
The national planning agency (BAPPENAS) has also
expressed concerns about the mismatch between the
monetary policy stance of the BI and fiscal policy.

The Indonesia country report (p. 19) observes:
It is difficult to ease monetary policy and achieve
some consistency between fiscal and monetary
policies when the Bank of Indonesia (BI) remains
relatively autonomous and wedded to tight
monetary policies. While BI should have autonomy in
determining its policy instruments, its objectives
should be subject to public discussion and oversight.
By setting low inflation as its overriding objective, BI
can compromise the achievement of other objectives,
such as growth of income and employment
generation, which most people value highly, in
addition to price stability.
It is rather strange that under the provision
of the current legislation of BI
independence, neither the president nor
the parliament can remove the governor of
BI before the expiry of his/her tenure.

This led to the much publicised stand-off
when President Wahid wanted to remove
the Governor after he was indicted in a
corruption case.
The Governor refused to resign even
when he was convicted following a guilty
verdict.

In sum, inflation targeting and central bank
independence are not merely technical
matters, as the orthodoxy tends to believe.

It is pertinent at this juncture to point to the
observation made by a central bank
insider, Guy Debelle (1996: 1).

An increase in the inflation aversion of
the central bank, while always reducing
inflation rate, may reduce welfare because
of its adverse effects on output and
government spending. The net welfare
effect is shown to depend on the weights
in the welfare functions of the fiscal
authority and society. Thus, increasing the
central bank's inflation aversion is not
necessarily a free lunch.
Thus, the essence of inflation targeting is
embedded in the so-called social welfare
function that includes both inflation and
economic growth.

High unemployment that is required to bring
inflation rate to a single digit level or to keep
inflation rate in the range of 3-5% has
significant and systematically regressive effects
on the distribution of income.
The poor fare worse when unemployment rises
and persists, especially when there is no
adequate safety-net or social security system.
At the same time the real value of their net debt
rises with falling inflation.
Hence the poor have reasons to be more
averse to unemployment and less averse to
inflation than the elite in society.
As the poor lack voice and representation, the
choice of weights for inflation and
unemployment in the social welfare function
raises an important issue of conflicts and
political economy of public policy.

Policy Recommendations
Recognise both price and output stabilisation
roles. That is, avoid both too conservative
and too expansionary monetary policy.
Inflation in the range of 10-20% can be
regarded as safe both from the point of view
of avoiding a stabilisation trap and harmful
affects of expansionary monetary policy.

Achieve consistency with the fiscal policy
stance. Safe expansionary monetary policy
within the above guideline will allow
governments to borrow from the central bank
to finance employment-intensive public
investment programs in infrastructure. This
can create and stabilise employment without
pressure on interest rate. Thus private
investment is unlikely to be crowded out;
rather both domestic and foreign investment
will be encouraged by demand growth and
externality benefits from improved physical
infrastructure.
Develop directed credit programs to
employment-intensive small and medium
enterprises, agriculture and rural industries.
This is essential because they are more
dependent on bank credits than larger
enterprises that have better access to capital
markets. Therefore, even when over-all credit
growth needs to be restrained, directed credit
to SMEs and rural-agricultural sectors must be
maintained to avoid asymmetric adverse impact
on employment. This will protect the income of
the poor and offset likely adverse impacts of
cyclical downturn on inequality.

Central banks should be given autonomy to
choose and implement the instruments of
monetary policy within the over-all economic
objectives dictated by the poverty reduction
strategy of the government. This means a
participatory policy making process so that the
trade-off parameter between inflation and
unemployment reflects the concerns of the
poor, and not of the elite or multilateral
agencies.

Given that there is no evidence of a
trade-off between employment
creation and moderate inflation, the
conflict between goals and
instruments is not as stark.
Yet for two targets the monetary
authorities can have two
instruments:
Traditional instrument of interest rate
(or such instruments as reserve
requirements) assigned to keep
inflation at a moderate level.
Specialised credit regulation directed
to employment creation.

The central banks can consider a
number of options in designing
specialised credit programs:
Follow the Indian example, where all banks
(public and private) are required to lend at
least 40 per cent of their net credit to the
priority sector. If banks fail to meet this
requirement, they are required to lend
money to specific government agencies at
a very low interest as a penalty.
Alternatively, use some carrot and stick
measures by combining the penalty
system with incentive based measures
such as asset based reserve requirements,
support for pooling and underwriting small
loans, utilising the discount window in
support of employment generating
investments
Asset based reserve requirements are an
effective tool for creating incentives for
banks to invest in socially productive
assets. For example:

Based on well-research findings of employment
elasticities, the central banks would list a set of
employment generating investment, and a lower
reserve requirement would apply for the deposits
invested in these activities than the deposits invested
in speculation or Treasury Bills.
The central banks can also take steps to create
liquidity and risk sharing institutions for loans to
small businesses which have promise to generate
employment, but do not have adequate access to the
credit market. For example, the central banks can
provide financial and administrative support for asset
backed securities which would take loans to small
businesses and other employment intensive activities,
bundle these investments and sell them as securities
on the open market.
Finally, the central banks can open a special discount
window facility to offer credit, guarantee or discount
facilities to institutions that are on-lending to firms
and co-operatives engaged in employment intensive
activities.
To achieve the RER target, the
central banks should intervene in
the exchange market.

That is; the nominal exchange rate
should move to hold RER at a
stable and competitive level for
an extended period of time.

There are basically three options:
1. interest rate manipulation
2. sterilised intervention
3. capital controls.


To support the developmental role of
exchange rate, monetary policy must
maintain stable and low real interest
rates. By boosting exports this will
complement the employment target
of monetary policy.

Will low interest rates set off
inflationary nominal depreciation
(under speculative exchange rate
dynamics)?

Targeting RER can help central banks
avoid this problem.
Finally central banks need to have
some controls on capital flows.
This will give central banks
controls over monetary
aggregates and hence monetary
policy independence to keep real
interest rates low, stabilise
employment and keep inflation at
a moderate level, while the
exchange rate policy aims to
maintain international
competitiveness.
There are, of course, many critics of
capital controls. However, they must
accept that the Mundell-Fleming
model conceived of capital flows as
largely money-market flows or at
most money and bond markets
flows.

An important development in the
world economy in the late 1990s was
the shift of international capital flows
from the fixed income market both
money and bond flows to the
equity market both portfolio equity
flows and FDI.

A decline in policy interest rates can
raise expected corporate earnings. This
can lead equity prices to rise and attract
foreign investors with extrapolative
expectations to buy more equities.
Therefore, equity effect of lower interest
rates can be larger than the money-bond
market effects to overturn standard
Mundell-Flemming results.
Thus, capital account openness should
not be viewed as an all-or-nothing
proposition. The increased importance of
equity flows has increased the effective
scope of a capital account policy of semi-
openness. A capital account can be open
to equity flows both portfolio and FDI,
but closed to money and bond flows.