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Elements of Macroeconomic Policy

Macroeconomic policy has its most direct influence on agricultural profitability through decisions to collect and spend government budgetary resources. For agricultural systems, the implications of agriculture's share of government spending are clear. The indirect effects on agriculture of central government decisions to finance spending programs are more complicated. But an understanding of the relationships among fiscal policy, inflationary pressure, exchange-rate options, and agricultural profitability is critical. That set of relationships underlies the indirect imposition of a tax on most agricultural producers.

Budgetary Policy

Budgetary policy deals with the allocation of total revenue, both between recurrent and capital expenditures and among sectors of the economy. The link between budgetary policy and agricultural policy is straightforward; budgetary decisions constrain the levels of government resources available for agricultural programs, such as public investment or recurrent subsidization of agricultural production or marketing. The agricultural sector is only one of many recipients of government funds and, in most developing countries, absorbs only a minor share of such funds. Other categories of expenditure-military and defense, welfare programs for disadvantaged consumers, education and health investments, public sector industries, and public sector employment-account for much larger shares of the budget. Like agriculture, these categories of expenditure are also represented by interest groups with sets of objectives and desires for policies. These objectives often require budgetary support, and budgetary allocations thus serve as indicators of policy-makers' priorities among the competing sectors. But because some objectives can be served by policy instruments that impose little burden on the budget, the expenditure pattern reveals only part of the preference structure of policy-makers.

Fiscal Policy

Fiscal policy is the set of decisions that determine how much revenue the government collects. Ultimately, the government collects as much revenue as it requires for budgetary policy. But for analytical purposes, categorization of sources of revenue allows the identification of budgets that are deficit, surplus, or balanced. Recurrent revenues come from government income taxes, the profits of public sector industry, and borrowings to finance productive investment. When these revenues are compared to recurrent budgetary expenditures, the difference is the budget surplus (revenues exceeding expenditures) or deficit (revenues less than expenditures). Such calculations have analytical importance because they reveal the accommodating policy actions that governments take to resolve budget imbalances. If the budget is in deficit, some form of additional borrowing must occur. This borrowing can be from domestic or foreign lenders, government reserves, or the government's central bank. If the budget is in surplus, the government has to dispose of the surplus. Options include increases in lending to domestic or foreign borrowers, increases in government reserves, or retirement of debts to the central bank or foreign lenders.

Calculation of the budget balance between recurrent revenues and expenditures is complicated by the distinction between productive and unproductive public investments and variations over time in economic activity and in public sector investment. Only rarely will the budget be exactly balanced. In a dynamic, growing economy, the government can maintain a policy of deficit spending that involves growth over time in total indebtedness. If the economy and the government's tax revenue are expected to grow in the future, the government can borrow in the present against that expected future income. When the expected future income gains are realized, the government repays the debt. In an economy that is growing continuously, this exercise is repeated regularly, allowing the government to operate with a deficit in every year. But unless substantial growth in tax revenues is foreseen, the magnitude of allowable deficits will be small. The concept of balanced budgets thus remains a useful (though approximate) basis for evaluation of macroeconomic policy.

Exchange-Rate Policy

A government can choose among three alternatives in establishing its regime to manage the exchange rate (units of domestic currency per unit of foreign currency). The alternatives differ mainly according to the degree of government intervention in the foreign-exchange market. This market exists because local export suppliers and foreign investors have foreign currency that they wish to exchange for domestic currency and local consumers desiring to buy imports or to invest abroad want to make the opposite currency trade. In the absence of government intervention, a market-clearing price for the exchange rate would be determined at a level that would balance the national supply of foreign exchange with the total demand for it.

The first type of exchange-rate regime is termed floating, or freely fluctuating. Since mid-1974, most Western industrialized countries have had floating exchange rates (although governments often intervene in the foreign-exchange markets by buying or selling on government account, a process that has led to the term dirty floats). When a government permits the foreign-exchange market to determine the exchange rate, this market-determined price fluctuates in line with underlying shifts in the supply or demand of foreign exchange. Therefore, a floating exchange rate forces adjustments in levels of imports, exports, and international capital movements.

The second kind of exchange-rate regime encompasses a maximal degree of government intervention in the foreign-exchange market. Governments of most developing and centrally planned economies use fixed (pegged) exchange-rate regimes, in which they determine the nominal value of their exchange rates. A fixed exchange rate is intended to shield the economy from market-induced fluctuations and to permit greater domestic use of macroeconomic policy. To establish a fixed exchange rate, a, government first has to decide how to tie (or peg) its currency. It can tie either to one foreign currency, typically the one in which most of its foreign-exchange transactions take place, or to a basket of currencies, often weighted according to the importance of the included foreign currencies in the country's international transactions. Because the United States has a large role in world trade and capital flows, and because the transactions in some commodity markets (notably crude petroleum) are carried out entirely in U.S. dollars, the dollar is the currency most often chosen as the reference point for fixed-rate regimes. The dollar also weighs heavily in most currency baskets for countries that select this method of fixing their exchange rates.

A fixed-exchange-rate regime does not totally insulate the country's economy from market forces. If particular fixed exchange rates do not correspond to a balance of demand and supply for foreign exchange, additional government actions are required to address the imbalance. Rationing of foreign exchange, multiple exchange-rate regimes, and restrictions on certain categories of imports are common responses to an imbalance of foreign exchange. Tradable commodities subject to exchange rationing become nontraded; their price is determined entirely by domestic demand and supply conditions and will only by chance be as low as world prices. World prices remain relevant only for high-priority imports not subject to rationing.

One policy adjustment to exchange imbalance is revaluation. Under conditions of excess supplies of foreign exchange, revaluation decreases the amount of domestic currency needed to purchase a unit of foreign currency. This adjustment is an upward valuation of the domestic currency, so that it appreciates relative to the foreign currency. The effects of appreciation are illustrated in Figure 5.1a. For convenience, foreign transactions are assumed to be limited to exports or imports of commodities. The supply curve of foreign exchange, S, represents the amount of foreign currency earned from sales of exports. That curve is upward sloping; as the price of foreign exchange (the exchange rate) rises, domestic producers of exportables find foreign market opportunities increasingly attractive. The demand curve, D, represents the amount of foreign exchange used to buy

imports. The curve is downward sloping; because importables become cheaper in domestic prices as the exchange rate declines, consumers demand increasing amounts of importables.

At the initial exchange rate, e', the economy experiences a surplus of foreign exchange. Domestic producers earn Q1 dollars, but domestic consumers spend only Q2 dollars. The difference is absorbed by the government in the form of increased foreign-exchange reserves. This happens if the government needs to rebuild depleted reserves or to retire foreign debt. Eventually, the needs are satisfied, and continued accumulations are no longer desired. Appreciation of the currency, from e' to e*, is one way to prevent continued accumulation of these reserves. Consumers increase their demand for dollars to Q3; producers reduce their supplies of dollar-generating exports to the same amount. The exchange rate is now in equilibrium.

Excess demand is a more common condition in the foreign-exchange markets of developing countries. In these circumstances, a devaluation can address the imbalance. A devaluation is a policy decision to change a fixed exchange rate so that the domestic currency depreciates relative to foreign currencies (that is, more local currency is needed to purchase a unit of foreign currency). For example, if a fixed rate of 50 pesos per dollar is changed to 75 pesos per dollar, the devaluation of the peso results in a 50 percent depreciation of the peso: (75/50 - 1) x 100 percent. Devaluations in fixed-exchange-rate regimes are usually catch-up actions. In effect, they are discrete changes that offset the cumulated effects of postponing gradual adjustment in the exchange rate.

The effects of carrying out a devaluation are shown in Figure 5.1 b. At e", excess demand for foreign exchange exists. Demand for imports is equal to Q4 dollars, whereas exports are providing only Q5 dollars. The government could meet the excess demand by reducing its reserves of foreign exchange. Otherwise, it would have to impose a rationing scheme. Following the devaluation, the world prices in domestic currency are raised by the percentage that the currency is depreciated. Local producers respond to the increased prices by expanding their output of importables and exportables, and local consumers react to the higher prices by reducing demand for these commodities. Import expenditures decline, from Q4 to Q3, and export earnings rise, from Q5 to Q3. Equilibrium in the balance of payments is restored.

Under freely floating rates, the adjustments described in Figure 5.1 occur automatically. Under fixed-exchange-rate regimes, adjustments take place only at the discretion of the government. A third type of regime for exchange-rate policy-a crawling-peg (adjustable-peg) reime-is intermediate between the first two and incorporates features of both. This regime is an attempt to match the control features of the fixed-rate regime with the market determination of the floating-rate regime. The crawling peg is a fixed-rate system in which the government announces in advance a schedule of weekly or monthly changes in the rate. These changes are meant to track the expected movements in the market-those that would have resulted if the rate had been allowed to float. Design issues in a successful crawling-peg regime include proper definition of a basket of currencies, usually trade-weighted, that reflects the country's main international transactions and appropriate choice of the schedule to change the rate (to approximate the movements in market-determined levels). Well-designed crawling-peg regimes provide developing countries with the policy and anti-fluctuation controls inherent in the fixed-rate system and the market-clearing adjustments provided automatically in the floating-rate system.


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