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

2. 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

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-3 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

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-4 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

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-5 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

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-6 Role of Central Bank Issue currency Banker to the government Banker to domestic banks Regulator of domestic financial institutions Operator of monetary policy

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-7 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

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-8 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

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-9 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

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-10 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

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-11 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

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-12 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

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-13 Financial Repression Loanable funds S r1r1 D L1L1 L2L2 r3r3 r2r2 Credit shortage = L 1 L 2 r 1 = Market rate r 2 = Controlled rate r 3 = Black market rate Interest rate

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-14 Requirements of Fiscal Policy Reasonable tax rates Effective tax collection agency Honest tax-collectors and tax-payers Balanced-budget requirement Independent central bank

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

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-16 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

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-17 Comparative Average Levels of Tax Revenue, 1985–1997, as % of GDP

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-18 Comparative Composition of Tax Revenue, 1985–1997, as % of GDP

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-19 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

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-20 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

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-21 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

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-22 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

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-23

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-24 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

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-25 Trends in Global Military Spending, 1960–2000 (billions of U.S. dollars)

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-26 Military and Social Expenditures

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-27 Countries with Highest and Lowest Expenditures on Military, 2002 (% of GDP)

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-28 Countries with Highest and Lowest Expenditures on the Military, 2002 (% of GDP)

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-29 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

30. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-30 Effect of Military Spending Military spending causes economic growth Build the basic infrastructure Transfer technology Create jobs and income Spend money on supplies

31. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-31 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

32. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-32 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