Ep Bab 15 Ingris-Halaman-3

15 Managing Short-Run
Crises in an Open
Economy
E
conomic development takes place in the long term. Most of the processes dis-
cussed in the previous chapters, whether improving human welfare, increasing
saving, or shifting toward manufactured exports, take years and even decades
to bear significant results. If policy makers in developing countries gaze only
at the far horizon, however, they are unlikely ever to reach it. Much happens in the
short term, within a few months or a couple of years, to throw an economy off bal-
ance and make pursuing long-term strategies difficult and sometimes impossible.
Policy makers need to emulate a ship’s captain, who, always steering toward the port
of destination, nevertheless must deal decisively with any storms at sea.
Among the most dangerous and likely of these storms are changes in world
prices that throw the balance of payments into deficit, excessive spending that fuels
inflation or unsustainable debt, and droughts or other natural disasters that disrupt
production. Unless a government counteracts these economic shocks, they create
greater uncertainty and higher risk for private producers and investors, who take eva-
sive actions that reduce future investment, worsen the crisis, and cause development
efforts to flounder.
During the 1970s and 1980s, the late 1990s, and in Europe in 2010–11, as pointed
out in Chapters 12 and 13, many economies became unbalanced because of unstable
world market conditions and their own macroeconomic mismanagement. In Chap-
ters 5 and 11 through 13, we discussed the consequences of such macroeconomic
instability. Countries with overvalued exchange rates and rapid inflation were
unable to grow rapidly. Stabilization programs, many funded by the International
Monetary Fund (IMF), were intended to correct these macroeconomic imbalances.
545
5 4 6 [ C H . 1 5 ] M A N A G I N G S H O R T- R U N C R I S E S I N A N O P E N E C O N O M Y
In this chapter, we develop a mechanism for analyzing the macroeconomic poli-

cies that a developing country should pursue to stabilize its economy and create a
climate for faster economic growth. The model developed here incorporates the two
main policy approaches for correcting macroeconomic imbalances: changing the
level of domestic expenditures and adjusting relative prices. In many cases, manag-
ing economic crises specifically requires expenditure reduction (by lower govern-
ment budget deficits and slower creation of money) and exchange-rate devaluation.
EQUILIBRIUM IN A SMALL, OPEN ECONOMY
Developing economies1 have two features central to understanding how macroeco-

nomic imbalances occur and can be corrected. First, they are open economies, in
that trade and capital flow across their borders in sufficient quantities to influence
the domestic economy, particularly prices and the money supply. Most economies
are open in this sense, especially because of economic reforms in China beginning in
the late 1970s and in Eastern Europe and the states of the former Soviet Union begin-
ning in the early 1990s. Today only a few economies, such as Cuba, North Korea, and
Burma, are so heavily protected and regulated (and subject to foreign embargoes)
that they might not qualify as open to trade and finance.
Second, these are small economies, meaning that neither their supply of exports
nor their demand for imports has a noticeable impact on the world prices of these
commodities and services. Economists call these countries price takers in world mar-
kets. A number of developing countries can exert some influence over the price of
one or two primary exports in world markets: Brazil in coffee, Saudi Arabia in oil,
Zambia in copper, South Africa in diamonds, for example. But they almost never
affect the price of goods they import, and for macroeconomic purposes, it usually is
adequate to model even these countries as price takers.2
These two qualities, smallness and openness, are the basis for the Australian
model of a developing economy.3 Countries typically trade both importable and
1
In developing this and the next two sections, we acknowledge an intellectual debt to Shantayanan
Devarajan and Dani Rodrik, who wrote an excellent set of notes for their class on macroeconomics
for developing countries at Harvard’s John F. Kennedy School of Government in the late 1980s and to
Richard E. Caves, Jeffrey A. Frankel, and Ronald W. Jones, who develop the open economy model in Chap-
ter 19 of World Trade and Payments: An Introduction (Glenview, IL: Scott, Foresman, Little, Brown, 1990).
2
Among developing countries, China and India are large enough that they could become exceptions to
the small country rule, given continued growth in China and both greater growth and openness in India.
3
So called because it was developed by Australian economists, including W. E. G. Salter, “Internal Bal-
ance and External Balance: The Role of Price and Expenditure Effects,” Economic Record 35 (1959), 226–38;
Trevor W. Swan, “Economic Control in a Dependent Economy,” Economic Record 36 (March 1960), 51–66;
W. Max Corden, Inflation, Exchange Rates and the World Economy (Chicago: University of Chicago Press,
1977). Australia also is a small, open economy.
EQUILIBRIUM IN A SMALL, OPEN ECONOMY 547
exportable goods and services. The Australian model lumps importables and export-
ables together as tradables and distinguishes these from all other goods and services,
called nontradables. (We use this specification again in Chapter 18’s discussion of
Dutch disease.)
Tradable goods and services are those whose prices within the country are deter-
mined by supply and demand on world markets. Under the small economy assump-
tion, these world market prices cannot be influenced by anything that happens within
the country and so are exogenous to the model (determined outside the model). The
domestic (local currency) price of a tradable good is given by Pt = ePt* where e is
the nominal exchange rate in local currency per dollar (pesos per dollar for Mexico
or rupees per dollar for Pakistan) and Pt* is the world price of the tradable in dollars.
Even if the supply of and demand for tradables change within an economy, the local
price will not change because domestic supply and demand have a negligible influ-
ence on the world price. Yet, changes in the nominal exchange rate change the domes-
tic price of tradables commodities. If a country devalues its nominal exchange rate, it
increases the amount of local currency required to purchase a dollar (e increases); if a
country revalues its nominal exchange rate it decreases the amount of local currency
required to purchase a dollar (e decreases). Devaluations thus increase the local cur-
rency price of tradables (all else equal), while revaluations tend to decrease the local
currency price of tradables. Because this model simplifies all tradables into one com-
posite good, the price of tradables Pt is best thought of as an index, a weighted average
of the prices of all tradables, much like a consumer price index.
Tradables include exportables, such as coffee in Kenya and Colombia, rice in
Thailand, beef in Argentina, cattle in West Africa, palm oil in Malaysia and Indone-
sia, copper in Peru and Zambia, oil in the Middle East, and textiles and electronics
in East Asia, and importables, such as rice in West Africa, oil in Brazil or Korea, and
intermediate chemicals and machinery in many developing countries.
Nontradables are goods and services, such as transportation, construction,
retail trade, and household services that are not easily or conventionally bought or
sold outside the country, usually because the costs of transporting them from one
country to another are prohibitive or local custom inhibits trade. Prices of nontrad-
ables, designated Pn, therefore, are determined by market forces within the economy;
any shift in supply or demand changes the price of nontradables. Nontradable prices
thus are endogenous to the model (determined within the model). The term Pn, like
Pt, is a composite or weighted average price incorporating all prices of nontradable
goods and services.
INTERNAL AND EXTERNAL BALANCE

Figure 15–1 depicts equilibrium under the Australian model. The vertical axis repre-
sents nontradables (N); the horizontal axis takes both exportables and importables
and treats them together as tradables (T). The production possibility frontier shows
Production
frontier
Consumer
indifference
curve
Nontradables
1
N1
P = Pt /Pn
T1 Y1 = A 1
Tradables
F I G U R E 15–1 Equilibrium in the Australian Model

With equilibrium at point 1, the tangency of the production frontier and a community
indifference curve, the country produces and consumes T1 of tradables and N1 of
nontradables. The relative price, P, is a measure of the real exchange rate (see text).
Y1, national income measured in tradable prices.
the menu of possible combinations of outputs of the two kinds of goods, N and T. The
community indifference curves show consumer preferences between consumption
of tradables and nontradables.
Equilibrium is at point 1, the tangency of a consumer indifference curve and the
production possibilities frontier. At this point, the production of tradables, deter-
mined by the production frontier at point 1, is T1, equal to the demand for tradables,
determined by the indifference curve at 1, and similarly, for nontradables, supply
equals demand at N1. This is a defining characteristic of equilibrium in the Australian
model: At point 1, the markets for both goods are in balance. Put another way, there
is external balance (EB), because the supply of tradables equals demand, and inter-
nal balance (IB), because the supply of nontradables equals demand.
Point 1 simultaneously indicates the optimal (profit maximizing) combination of
tradables and nontradables for producers, the optimal (utility maximizing) combina-
tion of tradable and nontradables for consumers. For both producers and consum-
ers, this optimum occurs with respect to relative prices—in this case the relative price
of tradables to nontradables. This relative price is indicated by the slope of the price
line in Figure 15–1. This joint equilibrium for producers and consumers is indicated
by the tangency of the indifference curve and the production possibility frontier.
The tangency of the indifference curve and production frontier is jointly determined
with the relative price of tradables in terms of nontradables, P = Pt/Pn. This relative
price, P, is one way to define the real exchange rate (RER), one of the important
innovations of the Australian model.4 (Box 15–1 provides a more detailed explanation
of the real exchange rate.) This formulation separates out prices that are under the
influence of monetary and fiscal policy and domestic market forces, Pn, from prices
that can be changed only by adjustments of the nominal exchange rate, Pt = ePt*.
Note that the slope of the price line that is tangent to the production possibility curve
and the consumer indifference curve is the only real exchange rate consistent with
equilibrium in the model.
If P rises (the price line becomes steeper in the diagram), tradables become
more expensive relative to nontradables. Producers then attempt to switch along
the production frontier away from N goods, toward T goods. Consumers attempt to
switch in the opposite direction, up along the indifference curve to consume fewer T
goods and more N goods. Therefore, a rise in P should increase the surplus of T-good
production over consumption.
If the production of T goods exceeds consumption of T goods, there is an exter-
nal surplus, which is identical to a surplus in the balance of trade. To see this, start
with the definition of the trade balance as
Bt = X - M [15–1]
where X and M are exports and imports. Because exports are the surplus of sup-
ply over demand for exportable goods, while imports are the opposite, a surplus of
demand over supply, we can write the balance of trade as
Bt = value of X-goods supply - value of X-goods demand - (value of M-goods

demand - value of M-goods supply),
= value of X-goods supply + value of M-goods supply - (value of X-goods
demand + value of M-goods demand),
= value of tradables supply - value of tradables demand;
or if we let the supply of tradables be St and demand be Dt ,
Bt = PtSt - PtDt = Pt(St - Dt) [15–2]
In Figure 15–1, with the economy in equilibrium, consumption of tradables is equal

to production, so the balance of trade is 0.
The value of income (GDP) also can be found in Figure 15–1. It is the sum of
the value of output of N goods (N1) and T goods (T1). This value is given by Y1, the
4
Chapters 18 and 19 will define the real exchange rate index as RER = RoPw /Pd. The term Ro is an
index of the nominal exchange rate; in this chapter we use e, the nominal exchange rate itself. The term
Pw is an index of world prices, often the U.S. consumer or wholesale price index and is similar or identical
to P* as measured in practice. But Pd is a domestic consumer or wholesale price index that includes both
tradable and nontradable prices, whereas Pn is an index of nontradable prices only. Thus, the Australian
formulation of the real exchange rate is a more-precise definition than those given in the later chapters.
B O X 15–1 R E A L V E R S U S N O M I N A L E X C H A N G E R ATE S
Most anyone who has traveled outside their home country has experience with
nominal exchange rates. The nominal exchange rate is simply the number of units
of local currency you can buy from the country you visit with one unit of your own
currency. For instance, in August 2010, you could buy just over 46 Indian rupees,
or 12.6 Mexican pesos, for US$1. (Note, this implies that you could also have
bought 3.65 Indian rupees with one Mexican peso.) But when you bring a dollar
into India or Mexico what you really care about is not how many rupees or pesos
you can buy with that dollar but rather the quantity of actual goods and services
that you can buy with that dollar. This depends on the prices of goods and ser-
vices in the host country in addition to the price of its currency. This distinction is
the key idea underlying the concept of the real exchange rate (RER).
In the most general sense, RER is the relative price of foreign goods in
terms of domestic goods. In practice, economists have developed a range of
approaches to quantifying this idea. Economists working on developed econo-
mies typically measure the RER as the relative price of domestic and foreign
goods. In contrast, economists working on developing countries typically mea-
sure the RER as the relative price of tradables and nontradables. Tradable com-
modities are goods that are or could be e traded internationally, in contrast to
nontradable goods (such as housing and many services), which are not traded
internationally. A key practical distinction between these categories of goods
is that there are world market prices for tradable goods, but the prices of non-
tradables are determined purely by local supply and demand conditions in each
country.
The nominal and real exchange rates are linked together by the require-
ment that the relative prices of tradable and nontradable goods in the RER
be expressed in the same currency units. The prices of tradables are typically
expressed in U.S. dollars, whereas the prices of nontradables are expressed in
units of the local currency. Thus we need to use the nominal exchange rate to
convert the dollar-denominated price of tradables into units of the local currency
to calculate the RER.
We can construct this RER as follows. Expressing the nominal exchange
rate, e, in terms of the number of local currency units per dollar, and expressing
the prices of tradables and nontradables as Pt and Pn , respectively, we can con-
struct the RER as
ePt* Pt
RER = =
Pn Pn
In this equation, the asterisk on Pt in the second term indicates that the price of
tradables is expressed in dollars. Multiplying this dollar-denominated price by e,
the nominal exchange rate as defined above, converts the price of tradables into
the same local currency units as the price of nontradables.
It is important to consider several issues related to this concept of the RER. First,
note that the RER is based on price indices rather than actual nominal price lev-
els. The RER is thus expressed relative to a base year, and changes in the relative
price of tradables to nontradables, say from 1 to 1.2, would indicate percentage
changes (in this case, 20 percent) relative to the base year. We refer to an increase
in the RER as a depreciation n of the local currency, and a decrease in the RER as
an appreciation n of the local currency. While this may sound counterintuitive, the
rationale for these terms is that when a currency depreciates in real terms, a given
quantity of foreign goods can be exchanged for a greater quantity of that country’s
domestic goods (and vice versa in the case of an appreciation). It is for this reason
that the RER is often thought of an as an indicator of a country’s international com-
petitiveness: When a country’s currency depreciates in real terms relative to its trad-
ing partners’ currencies, that country’s goods become less expensive to foreigners.
An important practical challenge in constructing an RER lies in the need to
choose price indices for tradables and nontradables. Pt and Pn are indices of the
prices of entire categories of goods. Thus constructing these price indices first
requires deciding which goods (and services) belong in which category. Specific
price data may also be lacking. One short cut for addressing these challenges
may be to use the U.S. consumer price index in place of Pt and a similar indicator
from the home country (with the same base year) in place of Pn .
Although the availability of such price indicators as the consumer price index
makes them convenient, their use in constructing RERs is problematic. Theory
calls for an index of nontradables prices, but the consumer price index (CPI) is
typically constructed to reflect the price of a basket of consumption goods that
includes both tradable and nontradable goods. The larger the share of tradable
goods in that basket, the greater the divergence between what the RER tells
us in theory and what we actually measure if we construct an RER using those
broad price indices. In practice, aggregate price indices purely for nontradables
rarely exist. Similar problems exist in choosing a price index to represent trad-
ables prices (for use in the numerator of the RER for a given country). In this
case, in which the goal is to choose a price index based to the greatest extent
possible on tradables, many authors use the wholesale price index (WPI) from
the United States or from a given country’s trading partners. Yet this approach
too is problematic because (as Lawrence Hinkle and Peter Montiel notea) for-
aLawrence E. Hinkle and Peter Montiel, Exchange rate misalignment: concepts and measurement
for developing countries. (Washington, DC: World Bank, 1999).

eign WPIs may not provide a very close indication of the tradables prices actually
faced by consumers in the home country. There is no perfect match between the
theoretical requirements and practical data availability in constructing empirical
RERs. A common compromise is to use the foreign WPI to represent Pt and the
domestic CPI to represent Pn .
An additional question is whether the relevant RER is purely between two
specific countries (the home country and a single trading partner—that is, the
bilateral RER) or between the home country and multiple trading partner coun-
tries. In general, policy makers in a given country will be more concerned with
how their currency relates in real terms with all of their trading partners. In that
case, it is necessary to take a (trade-weighted) average of all the bilateral RERs
between the home country and its trading partners. This average is called the
real effective exchange rate (REER).
The central challenge for policy makers concerned with their country’s inter-
national competitiveness is whether the level of the REER at any given time
reflects its equilibrium value or whether it is overvalued or undervalued rela-
tive to that equilibrium. Equlibrium in this setting generally refers to the level of
the REER at which a country’s internal market (that is, its supply and demand
for nontrable goods and labor) and its external market (that is, its supply and
demand for tradable goods) are in balance.
intersection of price line P from point 1 to the T axis.5 In national income accounting,
we distinguish two concepts. Gross domestic product, a measure of the value of out-
put, is given by
GDP = C + I + X - M [15–3]
where C and I are consumption and investment by both the government and the pri-
vate sector. Gross domestic expenditure, often called absorption, is
A = C + I = GDP + M - X [15–4]
When, as in Figure 15–1, the economy is in equilibrium, X = M and income equals

absorption. Indeed, this is the other condition for equilibrium in the Australian
model. From equation 15–4, we can also see that A - GDP = M - X, indicating
Along the T axis, Y1 is measured in prices of the T good, so PtY1 = PtT1 + PnN1 or Y1 = T1 + (Pn/Pt)N1.
5
But Pn/Pt = T/N, with N = N1 and T = Y1 - T1, the distance along the T axis from T1 to Y1. Thus
the value of both goods in T prices is T1 + Y1 - T1 = Y1.
that any excess of expenditures over income implies a negative trade balance of equal
amount. (The appendix to this chapter provides a more detailed review of balance of
payments accounting.)
This exploration of the Australian model yields three results. First, macroeco-
nomic equilibrium is defined as a balance between supply and demand in two mar-
kets: nontradable goods (internal balance) and tradable goods (external balance).
Second, to achieve equilibrium in both markets, two conditions must be satisfied:
Expenditure (absorption) must equal income, and the relative price of tradables
(the real exchange rate) must be at a level that equates demand and supply in both
markets (the slope of P in Figure 15–1). Third, this also suggests two remedies for an
economy that is out of balance: A government can achieve equilibrium (stabilize the
economy) by adjusting absorption, the nominal exchange rate, or both. Generally,
both instruments must be used to achieve internal and external balance.
THE PHASE DIAGRAM

Using the perspective of trade theory, we tie the small, open economy model of macro-
economic management to the tools of analysis already used in this text. But the princi-
ples of stabilization can be explored from a more-useful perspective, the phase diagram.
To develop this approach, consider the markets for tradables and nontradables from the
perspective of conventional supply and demand diagrams, as in Figure 15–2.
In these diagrams, we use the real exchange rate, which is the relative price of T
goods in terms of N goods (Pt /Pn), as the price in both markets. For tradable goods,
that gives a conventional supply and demand diagram: As the price rises, supply
increases and demand decreases. But in the nontradables market, a rise in P means a
fall in the relative price of N goods, so supply decreases and demand increases. Note
that, in both markets, any increase in expenditure, or absorption, A, causes an out-
ward shift of the demand curve: At any price, consumers buy more of both goods.
To use these diagrams as a basis for macroeconomic analysis, we need to change
the interpretation of the supply curve for tradables. Until now, we have assumed that
all tradables are produced within the home country. But foreign investment and for-
eign aid can add to the supply of tradables by financing additional imports. There-
fore, the supply curve should not be St, but St + F, where F is the inflow of long-term
foreign capital in the form of aid, commercial loans, and investment.
Figure 15–2 constitutes a simple model of the small, open economy that is based
on two variables: The real exchange rate, P, on the vertical axis and absorption, A,
which determines the position of the demand curves. These, of course, are the con-
ventional variables of microeconomics, price and income. But in this model, they
also are the two main macroeconomic policy tools of government: The exchange rate
and the level of expenditure. Because these two variables are central to macroeco-
nomic management, it would be helpful to develop a diagram that uses them explic-
itly on the axes.
Sn
ΔA > 0 St
Dn 1
2 Dn 2
P2 ΔA > 0
Price (P)
Price (P)
1 1
P1 P1
Dt 2 3
P3
Dt 1
T1 T2 N1 N3
Quantity ( N) Quantity ( N)
(a) (b)
F I G U R E 15–2 Tradables and Nontradables Markets

(a) Tradables market: The demand and supply curves for tradables St and Dt have the
conventional slopes. (b) Nontradables market: The slopes are reversed. Sn falls as P
rises (because the relative price of N is falling) and Dn rises as P rises. In both markets,
demand increases when absorption (expenditure) increases, shown by and outward
shift of Dt and Dn.
S, supply; D, demand; P (price) = Pt /Pn.
Figure 15–3 does this. It puts the real exchange rate, Pt = ePt*/Pn, on the verti-
cal axis and real absorption, A, on the horizontal axis. The diagram also contains two
curves, each representing equilibrium in one of the markets. Along the EB, or exter-
nal balance, curve, the T-goods market is in balance (St = Dt ). Along the IB, or inter-
nal balance, curve, the N-goods market is in balance (Sn = Dn).
The slopes of the two curves, EB and IB, can be derived from Figure 15–2. In the
tradables market, when absorption is A1, equilibrium is at P1, where T1 is produced
and consumed. This equilibrium point 1 also is shown in Figure 15–3a. If absorption
increases to A2 in Figure 15–2a, the demand curve moves outward and shifts equi-
librium to point 2. Note that with higher absorption, A2, the real exchange rate, P2,
must be higher to restore equilibrium in the T-goods market. Increased absorption
raises the demand for T goods. To meet this demand, it is necessary to raise output,
which can be achieved only through a higher relative price of T goods, P2. This higher
price also helps regain balance by reducing the demand for T goods along the new
demand curve. Point 2 is transferred to Figure 15–3a at (P2, A2).
In the nontradables market, when absorption is A1, equilibrium is at P1, where
N1 is produced and consumed. This equilibrium point 1 also is shown in Figure
15–3b. If absorption increases to A3 in Figure 15–2b, the demand curve moves out-
ward and shifts equilibrium to point 3. In the N-goods market, higher absorption, A3,
Infl
2
atio
Une
P2
n
mp
Real exchange rate
Real exchange rate
loy
ΔP > 0
me
nt
1 ΔA > 0
P1 P1
ΔA > 0 1
us ΔP < 0
P3 3
rpl
Su
t
fici
De
A1 A2 A1 A3
Absorption Absorption
(a) (b)
F I G U R E 1 5 – 3 The Phase Diagram

(a) External balance (EB). (b) Internal balance (IB). The axes are the main policy
variables: the real exchange rate, P, and the real absorption, A. The curves show
equilibrium in the T-goods market (EB) and N-goods market (IB).
requires a lower, or appreciated, real exchange rate to restore equilibrium. Increased

absorption raises demand for N goods, met by raising output, which can be achieved
only through a lower relative price of T goods, P3. This lower real exchange rate, or
higher price of N goods, also helps regain balance by reducing the demand for N
goods along the new demand curve. Point 3 is transferred to Figure 15–3b at (P3, A3).
Figure 15–3 also shows the zones of imbalance. In the T-goods market (panel a)
for any given level of absorption, say, A1, any real exchange rate greater than P1
causes external surplus: The production of tradables exceeds the demand for trad-
ables because the relative price, P, is at a more depreciated level than required for
equilibrium. Any real exchange rate below (more appreciated than) P1 causes an
external deficit and the demand exceeds the supply of tradables. Therefore, the zone
of surplus is northwest of EB and the zone of deficit is southeast.
In the N-goods market (Figure 15–3b), inflation is to the right of the IB curve,
where the demand for N goods exceeds the supply. In that region, for any given real
exchange rate, such as P1, absorption is too high, say, A3. To the left is the zone of
unemployment, where there is an excess supply of N goods. In that region, for any
given real exchange rate, say, P3, absorption is too low, say, A1.
The meanings of inflation and unemployment are precise in our model but
not in the real world. It is best to think of inflation as being an increase in prices
faster than is customary in the country in question. That rate would be quite low
in Germany, Japan, or China, probably less than 5 percent a year, but quite high in
Brazil or Argentina. Unemployment implies not only jobless workers but also idle
capital and other factors of production. In other words, there is unemployment
when an economy is inside the production frontier in Figure 15–1. A country may
have high levels of labor unemployment but be unable to increase output because it
is fully utilizing its capital or land.
EQUILIBRIUM AND DISEQUILIBRIUM

The two balance curves are put together in Figure 15–4. All along the external bal-
ance curve, the demand for T goods equals the supply produced at home plus any
net foreign capital inflow. All along the internal balance curve, the demand for N
goods equals the supply of N goods. The only point at which there is both internal
and external balance (equilibrium in both the T- and N-goods markets) is the inter-
section of the two curves. This is sometimes called the bliss point. It is the same as the
tangency of the indifference curve to the production frontier in Figure 15–1 at point 1.
The objective of macroeconomic policy is to adjust the exchange rate and absorption
to keep an economy stable, in both external and internal balance.
Int
ern
al
bal
al
A
ern
anc
Ext
Surplus +
e
e
anc
Inflation
bal
Real exchange rate (P = eP*t/Pn)
D B
Surplus + Deficit +
Unemployment Inflation
C
Deficit +
Unemployment
Absorption (A)
F I G U R E 1 5 – 4 Zones of Imbalance
The economy is in equilibrium only at the intersection of the external
balance (EB) and internal balance (IB) curves. Zones of imbalance are
labeled. For example in zone A, the supply of T goods exceeds demand,
so there is a surplus, and the demand for N goods exceeds supply, so
there is inflation.
Economies spend considerable time in one of the four zones of imbalance shown
in Figure 15–4. Zone A to the north is a region of external surplus and inflation, where
the exchange rate is undervalued. In zone B to the east of equilibrium, the economy
faces inflation and a foreign deficit, due principally to excessive expenditure (absorp-
tion is greater than income). To the south is zone C, where the exchange rate is over-
valued (too appreciated) and there is both unemployment and an external deficit.
And west of the bliss point the economy is in zone D, where, because of insufficient
absorption, there is unemployment of all resources but a foreign surplus.
Once in disequilibrium, economies have built-in tendencies to escape back into
balance. Figure 15–5 describes them separately for external balance (panel a) and
internal balance (panel b). Start with an external surplus, point 1 (Figure 15–5a). The
excess supply of tradables generates two self-correcting tendencies. First, the net
inflow of foreign exchange adds to international reserves. If the central bank takes no
countermeasures, the money supply increases and interest rates fall and induce both
consumers and investors to spend more. The increase in absorption moves the econ-
omy rightward, back toward external balance. Second, the inflow of foreign exchange
creates more demand for the local currency and, if the exchange rate is free to float,
forces an appreciation. This is a move downward in the diagram, also toward the
EB line. The net result of these two tendencies is the resultant, shown as a solid line
in the diagram, heading toward external balance. If, instead, the economy starts in
Inte
al
ern
rna
bala
Ext
nce
l
nce
bala
1 ΔM 2 > 0 ΔPn > 0 3

Real exchange rate
Real exchange rate
Δe < 0 ΔPn > 0
Δe > 0 ΔPn < 0
ΔM 2 < 0 2 4 ΔPn < 0
Absorption Absorption
(a) (b)
F I G U R E 1 5 – 5 Tendencies toward Equilibrium

(a) External balance (EB). If the economy faces an external surplus (point 1),
reserves and the money supply tend to rise while the exchange rate tends to
appreciate; this drives the economy toward EB. (b) Internal balance (IB). For
a deficit, if the economy faces inflation (point 3), the rise in prices leads to real
appreciation of the exchange rate and a reduction in the real value of absorption;
this moves conditions toward IB. Conversely for unemployment at point 4,
but only if prices can fall flexibly.
external deficit at point 2, the tendencies are the opposite but the result is the same,
a tendency to regain external balance.
The tendency to regain internal balance is shown in Figure 15–5b. When there
is inflation (point 3), it affects both the real exchange rate and real absorption. If the
nominal exchange rate remains fixed (or is not allowed to depreciate as fast as infla-
tion), the rise in Pn causes a real appreciation. At the same time, the rise in prices
can cause a fall in the real value of absorption, assuming that the central bank does
not take steps to increase the money supply to compensate for inflation. Under these
assumptions, the economy would move from inflation at point 3 back toward internal
balance. Unemployment (point 4) would be self-correcting also if prices are able to
fall as easily as they rise, but this seldom is the case.
Despite these self-correcting tendencies, in practice, they often fail to work smoothly
or quickly enough because of structural rigidities in the economy. For instance,
exchange-rate changes may take time to affect actual imports and exports, perhaps
as long as two years to have a full impact. In economies like Ghana and Zambia,
dominated by one or two export products such as cocoa, oil, and copper, with long
gestation periods for new investment, supply elasticities for tradables may be espe-
cially low, and foreign deficits can persist for a time despite real devaluations.
Nontradables prices probably rise very quickly when demand exceeds supply,
as in Figure 15–5b. But in many developing economies, inflation, once started, may
resist corrective policies, and prices do not fall so easily when there is unemploy-
ment: Unions strike wage bargains that try to maintain real wages by continually
raising nominal wages; banks use their market power to keep interest rates high; pro-
ducers depend on imports, the prices of which are responsive only to exchange rate
adjustments; and large firms with monopoly or oligopoly power keep prices up to
cover costs that resist downward pressures. Such rigidities have frequently been cited
to explain chronic trade deficits and inflation in Latin America, especially in Argen-
tina and Brazil.
However, arguments about structural rigidities can be overstated. There is some
flexibility in production for most export industries, even in the short term. And many
producer prices are quite flexible, including those of most farm products, those in the
large informal sector, and even those of some modern manufacturing firms. Neverthe-
less, the automatic tendencies toward external and internal balance depicted in Fig-
ure 15–5 are likely to be too slow and politically painful to satisfy most governments.
Not all the barriers to adjustment are structural. Sometimes, policies work against
adjustment. When foreign reserves fall, for example, the money supply also falls
automatically unless the central bank’s policy is to sterilize these shifts by expanding
domestic credit to compensate for the fall in reserves and keep the money supply from
falling. Sterilization prevents the move from points 1 or 2 of Figure 15–5a toward exter-
nal balance. And nominal exchange rates respond to changing market conditions only
if the exchange rate is allowed to float or the government makes frequent adjustments
in the nominal exchange rate to match changing economic conditions.
However, the opposite policy, a fixed nominal exchange rate, is needed if infla-
tion in nontradables prices is to cause a real exchange-rate appreciation, as depicted
at point 3 of Figure 15–5b. This fixed nominal rate is called an exchange rate anchor
because the fixed rate alone can halt the upward drift of prices as the economy
moves due south from point 3. Chile used such an anchor to slow inflation during
the late 1970s (Box 15–2). If government devalues the rate to keep up with inflation,
B O X 15 – 2 P I O N E E R I N G S TA B I L I Z AT I O N :
C H I L E , 1973 – 8 4
In the last year of the Salvadore Allende regime in Chile, when the public sec-
tor deficit soared to 30 percent of the gross domestic product (GDP) and was
financed mostly by printing money, inflation exceeded 500 percent a year. In
1973, General Augusto Pinochet overthrew Allende and established an auto-
cratic regime. An early goal of his government was to stabilize the economy. It
proved to be a difficult task of many years, with important lessons for later stabi-
lizations in Latin America.
Faced by rapid inflation and unsustainable external deficits, the government
imposed a fiscal and monetary shock on the economy. The budget deficit was
cut to 10.6 percent of GDP in 1974 and again to 2.7 percent in 1975. Monetary
policy was tight: From the second quarter of 1975 through the middle of 1976, it
has since been estimated, households and firms were willing to hold more money
than was in circulation. But inflation persisted; consumer prices nearly doubled in
1977.
Despite draconian measures, prices continued to rise for two reasons. First,
the peso was aggressively devalued to improve the foreign balance, the more so
because of the 40 percent fall in copper prices in 1975. In 1977, the peso was
worth about one-80th its 1973 value against the dollar. Second, wages in the
formal sector were determined by rules that permitted adjustments based on the
previous year’s rate of inflation, a rule that helped perpetuate the higher rates of
earlier years. It also was argued by some that the monetary policy was not strin-
gent enough.
In 1978, the government switched gears and began using the exchange rate
as its main anti-inflation weapon. At first a crawling peg was adopted with prean-
nounced rates, the tablita a, that did not fully adjust to domestic inflation. In 1979,
the rate was fixed at 39 pesos to the dollar for three years. The appreciating real
exchange rate, or anchorr, helped control inflation, which was down to 10 percent
by 1982. But it also discouraged export growth and contributed to a growing
current-account deficit. At the same time, Chile liberalized its controls over for-
eign capital flows and attracted large inflows of loans: Net long-term capital rose
from negligible amounts before 1978 to average over $2 billion a year in the fol-
lowing five years, equivalent to 8 percent of GDP in 1980. This inflow not only
financed the growing current deficit but contributed to the real appreciation of
the exchange rate.
Not until after 1984 did Chile finally achieve a semblance of both internal and
external balance. It did so through a large real devaluation, approaching 50 per-
cent, supported by tighter fiscal and monetary policies. After a decade and a half
of falling income per capita, Chilean incomes grew by 5.8 percent a year from
1985 to 1991.
Source: Based on the account by Vittorio Corbo and Andrés Solimano, “Chile’s Experience with
Stabilization Revisited,” in Michael Bruno et al., eds., Lessons of Economic Stabilization and Its After-
math (Cambridge, MA: MIT Press, 1991).
Brazil’s practice for many years, then real appreciation is thwarted and there is no
anchor. Similarly, real absorption falls with inflation only if the government fixes its
expenditure and its deficit in nominal terms and allows inflation to erode the real
value of the expenditure and if the central bank restrains the money supply to grow
more slowly than inflation. More typically, the fiscal authorities adjust the expendi-
ture, while the monetary authorities adjust both the money supply and the nominal
exchange rate, to fully compensate for inflation. In that case, rising prices have no
impact on the real exchange rate or real absorption and an inflationary economy
remains at point 3 in Figure 15–5b.
STABILIZATION POLICIES
Whether the barriers to rapid automatic adjustment are inherent in the economic
structure or created by policy contradictions, in most cases, governments need to
take an active role to stabilize their economies. They have three basic instruments for
doing so: exchange-rate management, fiscal policy, and monetary policy.
Alternative exchange-rate regimes were introduced in Chapter 12. Govern-
ments can vary the exchange rate by having the central bank offer to buy and sell
foreign currency at a predetermined or fixed official exchange rate (e in our nomen-
clature) that nevertheless can be changed from time to time or by allowing the rate to
float in the currency market, although the central bank sometimes may intervene to
influence the price. An intermediate case is the crawling peg, under which the central
bank determines the rate but changes it frequently, as often as daily, to ensure that
the official rate stays in line with domestic and world inflation; this results in a con-
stant or slowly adjusting real exchange rate (P).
Governments have two policies that can influence the level of absorption. Fiscal
policy, adjusting levels of government expenditure and taxation, directly affects the
government’s components of consumption and investment. It also influences pri-
vate expenditure, especially consumption, which depends on disposable income, or
income net of taxes. Monetary policy also affects private expenditure. If the central
bank acts to increase the money supply, as described in Chapter 12, it increases the
liquidity of households and firms, lowers interest rates, and stimulates private con-
sumption and investment.
The power of the phase diagram is that it indicates the necessary directions for
these policies, depending on the state of the economy. Figure 15–6 provides such a
policy map. It shows the same external and internal balance lines as in the previous
diagrams but adds a new element: four policy quadrants, I to IV, within which the
policy prescription always is the same.
Take, for example, point 1, which has been placed on the external balance line
but in the inflationary zone. For many years, Brazil was in this situation, with buoy-
ant exports and balance in foreign payments but chronic inflation running from 40 to
well over 100 percent a year. Because the demand for nontradables exceeds supply,
we know that one necessary correction is a reduction in real absorption, monetary
and fiscal austerity, that would reduce demand and move the economy due west
from point 1. But, if that is the only policy taken, the economy would not reach inter-
nal balance until point 4, in the zone of external surplus. One imbalance is exchanged
for another. To avoid generating a surplus, reduced absorption needs to be accompa-
nied by an appreciation of the exchange rate, a move due south from point 1. The
result would be a move approximately toward the equilibrium or bliss point, 0.
Note three things about this result. First, this combination of policies, austerity
and appreciation, would work from any point within quadrant I to return the econ-
omy to equilibrium. That is, the same combination is needed whether the economy
had inflation with a moderate external surplus or inflation with a moderate deficit,
either just above or just below the EB line. If the economy starts just below external
balance, with a moderate deficit, it may seem strange (counterintuitive) to recom-
mend an appreciation that, on its own, would worsen the deficit. But the reduction
in absorption, needed to reduce inflation, also reduces the deficit because it also low-
ers the demand for tradables. Indeed, it reduces the demand for tradables too much
and throws the economy into surplus; this is the reason an appreciation is needed. Of
course, the relative intensity of each policy is different, depending where in quadrant I
the economy starts. But the basic principle holds: Anywhere in quadrant I, the right
combination of policies is austerity and appreciation, the combination that moves
the economy toward point 0.
IV I
IB EB
4 ΔA > 0 6 ΔA < 0 1
Δe < 0 Δe < 0
Real exchange rate (P = ePt *IPn )
0 5
Δe > 0 Δe > 0
2
3
ΔA < 0
ΔA > 0
III II
Absorption (A)
F I G U R E 15–6 Policy Zones

From any position of disequilibrium, two policy adjustments generally are needed
to restore internal and external balance. In each quadrant (I–IV) a particular
combination of exchange rate and absorption policy is prescribed.
Second, in general, two policy adjustments are required to move toward equi-
librium. This is a simple example of the general rule enunciated by Dutch economist
Jan Tinbergen: To achieve a given number of policy goals, it generally is necessary to
employ the same number of policy instruments. Here we have two goals, internal
and external balance, and need adjustments in both absorption (austerity) and the
real exchange rate (appreciation) to reach them both. It is not always necessary to
use two goals, however. If the economy lies just to the east of equilibrium at point
5, then a reduction in absorption achieves internal and external balance simultane-
ously. And, if the initial situation is point 6, due north of 0, then appreciation alone
does the job.
Third, we could view the policy prescription in either of two ways. Austerity is
needed to reduce inflation (move west) and appreciation is used to avoid surplus
(move south). Or appreciation can be targeted on internal balance (move south toward
point 2) but alone would cause a deficit, so that austerity then is required to restore
external balance. Therefore, no logic in macroeconomics suggests that one particular
policy should be assigned to one particular goal. Economic institutions often do this
anyway. In practice, the central bank might use the exchange rate to achieve external
balance while the finance ministry uses the budget for internal balance. But if these
two approaches are not coordinated, they may well fail to reach equilibrium.
With these principles established for quadrant I, it is fairly routine to go around
the map in Figure 15–6 and see what policy responses are required:
• In quadrant II at a point like 2, with an external deficit but internal balance,

exchange-rate devaluation is needed to restore foreign balance but,
taken alone, would push the economy into inflation. Fiscal and monetary
austerity also are needed to avoid inflation and reach equilibrium. We
could reverse this assignment of policies and use austerity to achieve
external balance and devaluation to stimulate the economy. Many African
countries have been in this situation right up to the present, with low
inflation but an insufficiency of export earnings and foreign investment to
pay for the imports required for economic development.
• In quadrant III at point 3, an expansionary fiscal or monetary policy
eliminates unemployment but at the cost of a foreign deficit, so devaluation
is needed to reach equilibrium. Or devaluation stimulates employment and
so requires expansion to eliminate the resulting surplus. This is the situation
of a mature industrialized economy during a recession, with unemployed
labor and capital, but it is not so common in developing countries.
• In quadrant IV at point 4, exchange-rate appreciation can eliminate the
external surplus while fiscal expansion prevents unemployment. Or fiscal
expansion can end the surplus while appreciation prevents a resulting
inflation. A few countries in Asia, such as Taiwan and Malaysia in the 1980s,
have been in this situation.
So the principles of macroeconomic stabilization are simple: If policy makers

know where to place their economy on this map, they know how to move toward
equilibrium. But how do policy makers know where they are? The answer lies partly
in measurement, partly in art. Regularly available data on the balance of payments,
changes in reserves, and inflation can help locate an economy with respect to the
external and internal balance lines. Data on the nominal and real exchange rates,
the budget deficit, and the money supply can indicate movements from one policy
quadrant to another. Some kinds of data, such as private sector short-term borrowing
abroad, however, may not be readily available to policy makers. Such was the case
in Korea at the beginning of that country’s financial crisis in 1997. In principle, bar-
ring such surprises as an unknown large short-term foreign debt that has to be repaid
immediately, econometric models can locate the economy and indicate the policies
needed to balance it. In practice, especially but not only for developing economies,
such models can be too imprecise and too unstable to be wholly dependable. The art
of stabilization policy comes in knowing just how hard to push on each component
of policy and how long to keep pushing. In this, experience in managing a particular
economy is as important a guide as the models estimated by economists.
APPLICATIONS OF THE AUSTRALIAN MODEL
Throughout this book we refer to different kinds of economic problems that are asso-
ciated with developing countries, including the Dutch disease, debt crises, terms-
of-trade shocks, foreign-exchange shortages, destructive inflation, and droughts or
other natural catastrophes. The Australian model and its phase diagram can be used
to show how these and other shocks affect macroeconomic balance and how they
should be handled.
DUTCH DISEASE
In Chapter 18 we will discuss the strange phenomenon of the Dutch disease, in
which a country that receives higher export prices or a larger inflow of foreign capital
may end up worse off than without the windfall. The Dutch disease was first analyzed
by Australian economists Max Corden and Peter Neary, using a version of the open-
economy model.6 Figure 15–7 traces the impact of a windfall gain using the phase
diagram. (Box 18–1 provides an alternative exposition of Dutch disease.)
An economy in equilibrium at point 1 suddenly begins to receive higher prices
for its major export or is favored by foreign aid donors or foreign investors. All the
oil producers, from Saudi Arabia to Indonesia to Mexico, were in this position in the
1970s, as were coffee (and many other commodities) exporters during the boom of
the mid-1970s. Egypt and Israel were rewarded with large aid programs by the United
States after the Camp David accord of 1978, as was Ghana by the World Bank and
others during its stabilization of the 1980s (Box 15–3). Both Chile in the late 1970s
and Mexico after its stabilization in the late 1980s received large inflows of private
capital, much of it a return of previous flight capital. Foreign exchange windfalls are
more frequent than sometimes is supposed. In some cases, these windfalls result
from new discoveries of natural resources, such as the major offshore oil reserves dis-
covered by Ghana in 2007.
When the windfall occurs, the supply of tradable goods rises at any given price.
This can be shown as a rightward shift in the supply curve in Figure 15–2a. In the
phase diagram of Figure 15–7, there is a rightward shift in the EB curve. At point 1,
for example, which had been in external equilibrium along EB1, the economy now is
in surplus, so the new EB curve must be to the right—for example, at EB2. The econ-
omy cannot remain at point 1 because the inflow of reserves increases the money
supply; this adds to demand and, because the windfall increases private income
and government revenue, leads to greater expenditure. So absorption rises, a move
W. Max Corden and J. Peter Neary, “Booming Sector and Deindustrialisation in a Small Open
6
Economy,” Economic Journal 92 (1982), 825–48.

A P P L I C AT I O N S O F T H E A U S T R A L I A N M O D E L 5 6 5
EB1
IB
EB2
ΔF > 0
Real exchange rate (P = ePt */Pn )
1 Δ Reserves > 0 2
P1
Δ Pn > 0
P3 3
A1 A3
Absorption (A)
F I G U R E 1 5 – 7 The Dutch Disease

An export boom or capital inflow shifts the EB curve rightward and leaves the
economy at point 1 in surplus. As reserves accumulate and the money supply
rises (or as the government and consumers spend the windfall), absorption rises
and the economy moves eastward, into inflation. As nontradable prices rise, the
real exchange appreciates. At the new equilibrium (point 3), because P is lower,
the supply and demand is balanced with less production of T goods and more
output of N goods than before. The loss of tradable output is what makes this a
disease.
from point 1 toward point 2. This moves the economy off its internal balance, into
inflation.7
The resulting rise in Pn has two effects: a reduction in real absorption that par-
tially corrects the initial rise in A and, assuming the official rate is fixed, a real appreci-
ation of the exchange rate. (The real rate also appreciates if the nominal rate is floating
because the greater supply of foreign currency drives down the price of foreign cur-
rency.) Therefore, the economy first moves from point 1 toward point 2 in Figure 15–7,
then begins to head in the general direction of the new equilibrium, point 3. In this
case, market forces are likely to be sufficient to reach the new equilibrium, unless the
7
If the windfall is an inflow of capital, this treatment is precise. In the case of a rise in export prices,
however, the move from point 1 to point 2 is an approximation. Strictly speaking, a rise in export prices
should raise Pt*, a depreciation of the real exchange rate that moves the economy upward from point 1,
after which the economy moves east toward EB2.
B O X 15–3 R E C O V E R I N G F R O M M I S M A N A G E M E N T :
G H A N A, 1 9 8 3 –9 1
In 1983, after a decade of economic mismanagement, Ghana’s gross domestic

product (GDP) was 20 percent below its 1974 peak, investment was only 4 per-
cent of GDP, exports had sunk to 6 percent of GDP, and inflation rocketed to
120 percent for the year. After a decade of economic decline, Ghana’s military
government, headed by Flight Lieutenant Jerry Rawlings, was ready to undertake
drastic measures to stabilize the economy and restart economic development.
Working closely with the International Monetary Fund (IMF), Ghana focused
on three deep-seated problems: exchange-rate reform, fiscal adjustment, and
monetary policy. At first, the government maintained its fixed exchange rate but
drastically devalued the cedi from 2.75 to the dollar in 1983 to 90 to the dollar
by 1986. In 1986, Ghana adopted a restricted floating currency, using periodic
auctions to determine the rate. The official exchange market was broadened in
1988, when many foreign exchange bureaus were authorized to trade currencies
and virtually absorbed the parallel market in currency; by 1990, the banks were
empowered to trade in an interbank currency market. This completed the move
to a floating rate regime. By the end of 1992, the cedi traded at 520 per dollar.
In 1983, with fiscal revenues less than 6 percent of GDP, the urgent need
was to restore revenues and control expenditures. The deficit was cut from 6.2 to
2.7 percent of GDP in the first year of austerity, and by 1985, the government
had begun a major public investment program to stimulate growth. By 1988, the
government had restored total expenditures to 15 percent of GDP, 20 percent
of which was investment, and was running a surplus of nearly 4 percent of GDP.
Throughout the period, the money supply was constrained but inflation
remained stubbornly above 20 percent a year until 1991, when it was reduced to
16 percent and real interest rates finally became positive. Because food prices
play a large role in the consumer price index, investment in food production was
seen as an important component of any long-run attack on inflation.
The aid donors responded handsomely to Ghana’s stabilization and the
accompanying economic reforms: The sum of net official transfers and net long-
term capital rose from just over $100 million in 1983 to $585 million in 1991.
Stabilization helped restore economic growth. From the depression of 1983–91,
GDP grew by 5.1 percent a year and investment rose to 17 percent of GDP. The
improvement, although dramatic in relation to the early 1980s, still left Ghana
with a lot to be done: In 1991, income per capita remained 25 percent below its
1973 level.
Source: This account is based on Ishan Kapur et al., Ghana: Adjustment and Growth, 1983–91
(Washington, DC: International Monetary Fund, 1991).
authorities prevent appreciation and maintain real absorption and so keep the econ-
omy in an inflationary posture like point 2.
What, then, is the problem? The economy is at a new equilibrium, its terms of
trade improved, its currency appreciated and so citizens have more command over
foreign resources, people spending and consuming more without having to work any
harder. There are two flaws in this otherwise idyllic picture. First, such windfalls gen-
erally are temporary. When export prices fall or the capital inflow dries up, the EB
curve shifts back and a costly adjustment is necessary. We analyze that process in the
next section.
The second problem is that, in shifting from the old to the new equilibrium,
adjustments in the economy must be made. The real exchange rate P is lower, so St
has fallen, while Sn has risen. Because the booming export sector does not retrench,
nonboom tradables bear the brunt of the adjustment. Frictions in the labor market
are likely to mean at least temporary unemployment as workers switch from tradable
to nontradable production. If the tradable sector includes modern manufacturing,
then long-term development may be set back because manufacturing is the sector
likely to yield the most rapid productivity growth in the future. And if tradable indus-
tries close, it is more difficult to make the inevitable adjustment back toward point 1
when the windfall is over. This decline in nonboom-tradable production turns a for-
eign exchange windfall into a “disease.”
What can be done to cure the disease? The government could try to move the
economy back toward the old (and probably future) equilibrium at point 1. Its tools
are the official exchange rate, which would have to be devalued against the tenden-
cies of market forces, and expenditure, which would have to be reduced through
restrictive fiscal and monetary policies that also reduce inflation (lower Pn or at least
its growth). The resulting buildup of reserves and bank balances have to be sterilized
through monetary policy so they are held as assets and not spent. It is a neat politi-
cal trick to manage an austere macroeconomic policy in the face of a boom because
all the popular pressures are for more spending. Not too many countries have man-
aged it. Indonesia is among the few that have.
DEBT REPAYMENT CRISIS

When Mexico announced in 1982 that it no longer could service the debt it acquired
during the oil boom of the 1970s, many other developing countries followed Mexi-
co’s lead, and the financial world entered a decade of debt crisis (Chapter 13). Most
Latin American countries largely have overcome their debt problems, but many Afri-
can countries continue to struggle to repay the money they borrowed, mostly from
aid agencies. Although debt service insolvency encroaches gradually on an economy
and can be foreseen, it often appears as a national crisis because economic manage-
ment has been inept.
The formal analysis of a debt crisis is similar to that of another common phenom-
enon, a decline in the terms of trade that leads to a foreign exchange shortage, which
in turn is simply the reverse of the Dutch disease. Therefore, the oil exporters, such
as Indonesia, Nigeria, and Venezuela, faced a similar kind of crisis once oil prices
began falling in the 1980s. We can understand the similarity between a debt crisis
and a decline in the terms of trade more clearly by seeing them in their common con-
text in the balance of payments. A decline in the terms of trade implies deterioration
in the balance of trade (in which the excess of imports over exports increases). All
else equal, a declining trade balance adds directly to the current account deficit. As
detailed in the appendix to this chapter, one of the few ways in which countries can
finance current account deficits is by borrowing abroad.8 Indeed, many developing
countries financed chronic current account deficits by borrowing abroad, in the pro-
cess accumulating enormous stocks of debt (often to levels greater than their GDP).
Debt crises ensue (as discussed in Chapter 13) when current account deficits become
unsustainable and lenders want to be repaid.
Figure 15–8 captures this process. An economy in balance at point 1 needs to find
additional resources to repay its foreign debt or needs to adjust to falling terms of
trade. The supply of tradables therefore shifts to the left in Figure 15–2a; in the phase
diagram, the EB curve also shifts leftward to EB2.9 If the crisis leads to debt relief or
additional foreign aid, the curve moves less far and might settle at EB3.
Now in foreign deficit, the economy begins losing reserves. If the government
has to repay some of the debt or falling export prices cut into its revenues, the govern-
ment needs to reduce its expenditures as well. Both cause a reduction in absorption.
These actions move the economy toward external balance but also into unemploy-
ment. To gain the new equilibrium at point 3, it is also necessary to devalue the cur-
rency. This could be done by the central bank under a fixed rate or by the foreign
exchange market under a floating rate. At the new equilibrium, the country produces
more and consumes fewer tradables because P has risen. This, of course, is a loss of
welfare for the populace. The surplus of St over Dt is used to repay the debt or simply
compensates for reduced export prices.
Debt crises and the hardships they cause are not an inevitable consequence
of borrowing to finance development, as was discussed in Chapter 13. If the bor-
rowed resources are invested productively, they increase the potential output of
both tradables and nontradables. Added production increases income and gener-
ates the capacity to repay the debt out of additional income, without a crisis and
an austerity program. Countries such as Korea and Indonesia have been large
international borrowers, but before the financial crisis of 1997–99, they escaped
debt crises.
8
The only other ways (beyond foreign borrowing) to finance a current account deficit are to attract for-
eign investment and/or to run down the central bank’s stock of foreign reserves. See the appendix to this
chapter for a concise summary of balance of payments accounting.
9
Strictly speaking, we cannot analyze the fall in export prices this way, but it is a reasonable approxima-
tion for many situations. See note 7.
EB 2
EB 3
IB
Debt
relief EB1
Δ Debt service > 0

3
P3
ΔP > 0
P1 1
ΔA < 0
A3 A1
Absorption ( A )
F I G U R E 1 5 – 8 Debt Crisis or Declining Terms of Trade

An economy in equilibrium at point 1 suddenly needs to repay its debt (or faces
falling export prices). External balance shifts from EB1 to EB2, although debt
relief or increased foreign assistance might reshift the balance line back to EB3.
If policies accommodate the fall in reserves and income, absorption declines.
A devaluing exchange rate, via central bank action or market forces, helps the
economy move to its new equilibrium at point 3. With more tradables produced
and less consumed, the surpluses can be used to repay the debt.
STABILIZATION PACKAGE: INFLATION AND A DEFICIT

External shock is not the only way an economy gets into trouble. Reckless or mis-
guided government policies often are to blame. Impatient with sluggish develop-
ment or intent on benefiting its constituencies, a government expands its spending
and incurs a budget deficit. Unable to finance the deficit by borrowing from the pub-
lic, the ministry of finance sells short-term bills to the central bank; this adds to the
money supply. The economy drifts into inflation and a foreign deficit, at a point
like point 1 in Figure 15–9, far from equilibrium at point 2 on the economy’s origi-
nal external balance curve EB1. When economies become unstable in this way, pri-
vate investors get skittish and try to invest in nonproductive assets like land or, more
often, invest abroad; this deepens the external deficit. The government, recognizing
the error of its ways or just hoping for some outside help to avoid painful adjustment,
calls in the IMF.
IB EB1
EB2
IMF
package
4
2
P2
IMF
3 targets Δ e < 0?
P3
ΔA < 0 1
A2 A3
Absorption ( A )
F I G U R E 1 5 – 9 Stabilization from Inflation and a Deficit

An economy at point 1, far from equilibrium at point 2, above all needs to
reduce absorption through austerity: reduced budgetary deficits and slower
growth of the money supply. An International Money Fund (IMF) and
donor package of aid might bring equilibrium closer by shifting the external
balance to EB2, but the aid package is conditional on the austerity program.
Whether any exchange rate action is required depends on the precise initial
position, point 1.
The core IMF stabilization program consists of a reduction in the government’s

budget deficit and programmed targets for domestic credit that, in effect, cap the
growth of the money supply. Together, these measures reduce absorption in the
economy and move it westward from point 1, closer to external and internal balance.
IMF packages frequently include an exchange-rate devaluation as well. Whether this
is needed or not depends on the precise location of the economy (point 1) relative
to equilibrium (point 2). In some cases, the reduction in absorption is sufficient to
reach both internal and external balance. As pictured in Figure 15–9, a small devalua-
tion is needed to reach point 2 and avoid unemployment.
However, IMF programs usually come with substantial aid attached, not only from
the fund, but from the World Bank and bilateral donors. The aid package, by adding
to the economy’s capacity to buy tradables, shifts the EB curve to the right, to EB2 in
the diagram, and moves equilibrium to point 3. Note two things about this aid pack-
age. First, it reduces the need for austerity to some extent, as A3 is greater than A2.
Second, it reduces the need for devaluation of the exchange rate. Indeed, as shown,
there is little or no need to devalue to move from 1 to 3. Donors and the IMF never-
theless frequently insist on devaluation. Sometimes, that may be a requirement just
to reach a point like 3. In other cases, donors and the IMF may have in mind a self-
sustaining stabilization that will be valid even after aid is reduced and the external
balance curve moves back toward EB1. Whatever the motive, it is important to real-
ize that aid itself is a partial substitute for both devaluation and austerity. In essence,
the aid does what higher production of tradables otherwise must do and it finances
expenditures that otherwise must be cut. Ghana’s experience, which fits this descrip-
tion, is discussed in Box 15–3. More recently, Greece has suffered a major debt crisis,
the analysis of which draws on elements of both Figures 15–8 and 15–9 (Box 15–4).
B O X 1 5 – 4 TH E G R E E K D E B T C R I S I S O F 2 0 1 0 – 1 2
Problems of unsustainable debt are not limited to the poorest countries. Start-
ing in 2010, Greece faced a debt crisis so severe as to threaten the stability of
the European Union (EU). As of September 2011, it remained uncertain whether
Greece would be forced to default on its foreign debts or whether other mem-
bers of the EU would provide its second bailout package for Greece in two years.
In May 2010, the EU and the International Monetary Fund (IMF) provided a pack-
age of loans and balance of payments support worth €750 billion (approximately
$938 billion). In return, the government of Greece committed itself to an aus-
terity program that included severe reductions in expenditures and wages, ter-
mination of tens of thousands of government jobs, and extensive tax increases.
This agreement sparked widespread civil unrest in Greece, which contributed to
a lack of confidence in the country’s ability to implement the promised reforms
and service its foreign debts.
Greece’s debt problem accumulated over many years of current account defi-
cits, the magnitude of which ballooned during the late 2000s. Greece’s current
account deficits as a share of GDP began mounting in the mid-1990s. Deficits
on the order of 3 percent of GDP in the late 1990s more than doubled relative
to GDP during 2000–05. By 2005, Greece’s current account deficit was equiva-
lent to 7.5 percent of GDP, a proportion that doubled again to nearly 15 percent
by 2008. Between 2008 and 2010, Greece succeeded in reducing its current
account deficit to 10.5 percent of GDP, mainly by reducing imports. Borrowing by
the Greek government to finance its deficits had also grown rapidly, as the gov-
ernment budget deficit as a share of GDP increased from 5.7 percent in 2006
to 15.4 percent in 2009. The government’s total debt shot up from €183.2 bil-
lion in 2004 (equivalent to 99 percent of GDP, or approximately $228 billion)
to €330.4 billion in 2010 (equivalent to 144 percent of GDP, or approximately

$438 billion). The country’s general economic stagnation was further reflected in
its unemployment rate, which after fluctuating around 10 percent for a decade,
fell to 7.5 percent in May 2008, only to double by March 2011. Greece’s GDP
shrank by 6.6 percent in 2010.
By the fall of 2011, the government of Greece found itself between a rock
and a hard place, as the EU debt relief package was imperiled by a threatened
cutoff in response to Greece’s apparent inability to meet its austerity commit-
ments. Yet daily strikes and mounting political pressure within Greece were
preventing the government (led by a socialist party, with a slim parliamentary
majority) from fully implementing the promised cuts. A disorderly default was a
distinct possibility, along with an exit by Greece from the euro zone.
The Australian model lends itself well to a depiction of the Greek debt cri-
sis. The analysis shown in the figure combines elements of Figures 15–8 and
15–9. By 2005, Greece was suffering from both a balance of payments deficit
and unemployment, conditions indicated by point 1. By 2010, both unemploy-
ment and the balance of payments deficit had substantially worsened, moving
Greece toward point 2 (farther from both internal and external balance and far
from equilibrium at point 3). It seems straightforward, based on the phase dia-
gram, that Greece needed to reduce absorption and depreciate its real exchange
rate, but there’s a catch. As a member of the EU, Greece was a member of the
euro zone and was thus unable to devalue its currency as a means of reducing
its balance of payments deficit. The only way for Greece to induce the neces-
sary real depreciation was to reduce Pn sufficiently. In short, austerity presented
itself as virtually the only tool available to the Greek government. Pushing down
wages—a central element of the Government’s austerity program—would reduce
Pn (because labor can be counted as a key nontradable) and help depreciate
the real exchange rate. Austerity was also critical to restoring external balance
because borrowing to finance the current account deficit was no longer an
option for Greece.
The bailout package offered by EU member states in concert with the IMF
would effectively shift the EB curve out to EB , thus reducing the amount of
both real depreciation and spending cuts required to reach the new equilibrium
at point 4. Herein lay the impasse encountered in the fall of 2011. Greece was
widely seen as incapable of making the cuts necessary to reach equilibrium at
point 3. Without the bailout package, default seemed unavoidable. Yet even the
degree of austerity required to reach the postbailout equilibrium at point 4
was becoming politically impossible for the Greek government. Absent a cred-
ible commitment by the Greek government to impose the necessary spending
and public employment cuts (along with substantial tax increases), the EU was
unwilling to provide the bailout. The brinksmanship between Greece’s govern-

ment and its debtors continued into early 2012. Greece’s next round of debt
repayments were due in on March 20, 2012, and, absent a new bailout agree-
ment, default was inevitable. In late February, just weeks before the prospective
default, EU and Greek negotiators agreed on a second bailout program worth
€130 billion ($169 billion) in return for renewed promises of severe austerity and
greater EU influence over Greek budgets. The deal was intended to keep the
Greek government solvent until 2014. Yet, Greece’s continuing deep recession
and political uncertainty suggested that the crisis was far from over.
IB EB EB'
EU/IMF
bailout
Real exchange rate (P = eP*t /Pn)
3
P3
4
P4
1
Greece in 2005
2
Greece in 2010
A3 A4
Absorption (A)
Another kind of stabilization also can be illustrated with Figure 15–9, rapid infla-
tion (or hyperinflation). In Bolivia’s hyperinflation of the mid-1980s or the chronic
inflations in the past in Brazil and Argentina, external balance is a secondary con-
sideration or not a major problem. Point 4 in the diagram depicts this situation.
Austerity still is required to move toward equilibrium at point 2 or 3 (if there is an
aid package), but devaluation only intensifies inflation. Instead, the currency must
be appreciated, which also dampens inflation. One way to achieve this would be to
fix the nominal rate and let the continuing (if decreasing) inflation in nontradable
prices (Pn) appreciate the real rate P. This is the exchange-rate anchor, a device used
often in Latin America, especially in Chile during the late 1970s, in Bolivia during the
mid-1980s, and in Argentina during the 1990s. It has the disadvantage that a lower
real rate discourages export growth. Yet investment in new exports may be part of a
strategy to open the economy, diversify exports, and move the external balance curve
to the right.
DROUGHT, HURRICANES, AND EARTHQUAKES

The human tragedy of drought, earthquakes, and other natural disasters in places
such as Ethiopia, the West African Sahel, and Haiti in 2010 dwarfs issues of macro-
economic management. But the adept management of an economy racked by natu-
ral disaster is essential to reduce the misery of starving or displaced people. Drought,
for example, reduces a country’s capacity to produce food, export crops, and in some
countries, generate electricity from hydropower. At the same time, income is lower
because farmers and others have less product to sell. Government then needs to pro-
vide social safety nets; this means spending more on the provision of food, transpor-
tation, health services, and sometimes shelter. Foreign governments often provide
financial, food, and technical aid under these situations.
The macroeconomic reflection of a drought or earthquake is depicted in Fig-
ure 15–10. The economy begins in equilibrium at point 1. Drought or earthquake
reduces the economy’s capacity to produce both nontradables (some foods, hydro-
electricity, water supplies) and tradables (export crops, importable foods, some
manufactures). We show this as a leftward shift in both the IB and EB lines: Reduced
output of Sn at any given price means a larger zone in which Dn exceeds Sn; this is
inflationary. Similarly for St , and this enlarges the area of deficit. The new external
balance curve, EB2, may be augmented (shifted back to the right) by foreign aid
to EB3, in which case, the new equilibrium is point 3.
The economy, still at point 1, is inflationary. The fall in incomes creates a ten-
dency for absorption to shrink on its own and move the economy leftward toward
the new equilibrium. At the same time, the government tries to spend more to relieve
hunger, disease, and other problems. The outcome depends on the relative force of
these tendencies. The impact of most natural disasters is temporary, typically lasting
a year, although some African droughts have been much longer, and the Haiti earth-
quake of 2010 is likely to last for several years or more. It is appropriate to try to ride
out such shocks with minimal adjustment, especially if foreign aid can bear much of
the burden. Therefore, for example, even if an exchange-rate adjustment is called for
to reach equilibrium, it is unlikely to work very well during the natural disaster and
probably should be resisted. This could be said for fiscal austerity too, except that the
rise in prices can deepen the suffering of those already hurt by the disaster. If the gov-
ernment is able to shift its expenditures so that a greater portion goes into alleviating
the impact of the disaster, it may be able to relieve the worst suffering while restrict-
ing the rise of total expenditures and containing inflation.
SUMMARY 575
EB2
IB1
Food EB3
aid
EB1
IB2
Real exchange rate ( P = ePt*/Pn )
3 ΔY < 0 1
ΔG > 0
Absorption ( A )
F I G U R E 1 5 – 10 Drought
Drought or another natural disaster reduces the capacity to produce both
nontradables and tradables, so the curves shift to the west. Disaster relief
from abroad augments the external balance curve and shifts it to EB3, with
equilibrium at point 3. Remaining temporarily at point 1, the economy
becomes inflationary. The reduction in output and therefore in income reduces
absorption, but the government’s need to spend more on relief tends to offset
this move toward equilibrium. The outcome could be continued inflation.
SUMMARY
• Open economies may be exposed to a variety of shocks, both positive and

negative, either of which may require policy responses to balance potential
negative effects. In many cases, we have seen that a country’s vulnerability
to external shocks may be increased by its own history of poor policy choices.
• One common problem among developing countries arises from extended
periods of spending more than they earn and financing the resulting
current account deficits with foreign borrowing. For many developing
countries, these persistent current account deficits become unsustainable,
typically requiring both spending reductions and currency devaluation.
• The Australian model provides a convenient and versatile framework

within which to diagnose common macroeconomic imbalances.
Equilibrium in the Australian model requires balance in the markets for
both tradable and nontradable commodities (the relative price of which
is one expression of the real exchange rate). Equilibrium in the tradables
markets is known as external balance; equilibrium in the nontradables
market is known as internal balance.
• Disequilibrium in the tradables market implies either a balance of
payments deficit (in the case of excess demand) or a balance of
payments surplus (in the case of excess supply). Disequilibrium in the
nontradables market implies either a higher rate of inflation (in the
case of excess demand) or higher unemployment (in the case of excess
supply).
• Considered together, these disequilibrium conditions may arise in four
combinations: balance of payments deficit with inflation, balance of
payments deficit with unemployment, balance of payments surplus with
inflation, and balance of payments surplus with unemployment.
• The main policy tools available to regain macroeconomic equilibrium are
fiscal and monetary policy interventions to change the level of domestic
spending (absorption) and changes in nominal exchange rate policy aimed
at altering the real exchange rate.
• Recommendations to use some combination of these policy tools to regain
equilibrium must take account of the economy’s natural tendencies toward
equilibrium. The functionality of these natural tendencies will vary with
each country’s economic and policy circumstances.
APPENDIX TO CHAPTER 15: NATIONAL INCOME AND

THE BALANCE OF PAYMENTS
Many macroeconomic problems and crises in developing countries have their roots
in the balance of payments. Chapter 10 opens the discussion of balance of payments
by describing the role of foreign savings in financing investment. Chapter 13 dis-
cusses debt crises in developing countries, and Chapter 15 provides a model for diag-
nosing and responding to macroeconomic crises—including debt crises. Balance of
payments accounting provides a framework within which to understand many of the
opportunities and risks created by opening economies to trade and financial flows.
A P P E N D I X T O C H A P T E R 15 : N A T I O N A L I N C O M E A N D T H E B A L A N C E O F P A Y M E N T S 5 7 7
This appendix provides a brief overview of some key aspects of balance of payments
accounting.10
We begin by placing the balance of payments in the broader context of national
income accounting. The value added from all goods and services produced domes-
tically sums to Gross Domestic Product (GDP). In a closed economy, this exactly
equals gross national expenditure, which consists of private consumption on final
goods and services (C), government consumption and investment in final goods and
services (G), and private investments to expand the country’s capital stock (I). That
is, GDP = C + I + G in a closed economy. In Chapter 15, we refer to gross national
expenditure as absorption (A), or A = C + I + G. Adopting this notation, we can
say that in a closed economy, GDP = A. In addition, in a closed economy all of gross
national expenditures (or absorption) is paid to domestic entities, so GDP also equals
gross national income (GNI).
When we allow for trade with other countries, it is no longer required that gross
domestic product exactly equals absorption or gross national income. This is where
the balance of payments comes in. Balance of payments accounting records all of the
(home) country’s transactions with the rest of the world, including both trade and
financial flows. The main components of the balance of payments are the current
account, the financial account, and the capital account.
We begin by incorporating the current account into national income. The cur-
rent account records all foreign trade in goods (the trade balance) and services
(net factor income from abroad), along with net unilateral transfers (such as for-
eign aid or remittances from residents working abroad). The current account
also includes interest payments on foreign debts (debt service payments, but
not repayment of principal on the debt). In an open economy, part of absorption
may be spent on imports (M), and must be subtracted from A; conversely, some
domestic production may be exported abroad (X), and the resulting payments
to domestic firms are added to A. In this case, we can write the national income
accounting identity as
GDP = C + I + G + X - M [A15–1]
Substituting absorption (A) in for gross national expenditure, we can re-write equa-
tion A15–1 as
GDP = A + X - M [A15–2]
10
This discussion draws on Robert C. Feenstra and Alan M. Taylor, International Macroeconomics,
2nd edition (New York: Worth Publishers, 2012), Chapter 5 (to which the reader is referred for a more
detailed treatment), as well as the IMF’s Balance of Payments and International Investment Position
Manual, 6th edition (Washington, DC: International Monetary Fund, 2011).
That is, gross domestic product equals domestic expenditure plus net exports. Rear-
ranging the terms of equation A15–2, we can see that A - GDP = M - X. In other
words, if domestic spending exceeds GDP, then our imports exceed our exports and
we run a negative trade balance. The trade balance is typically the major component
of the current account. As noted above, net factor income from abroad (NFIA), or
income from the net export of services (e.g., wages paid to a home country resident
working abroad for a foreign firm), is also part of the current account and is included
in gross national income (GNI). Thus, GNI = GDP + NFIA. The difference between
gross national income (GNI) and gross national disposable income (Y) is that the lat-
ter also includes the final component of the current account, net unilateral transfers
(NUT). Putting these steps together, we can write
Y = A + (X - M) + NFIA + NUT = A + CA [A15–3]
where CA is the current account, which equals the sum of net exports, net factor
income from abroad, and net unilateral transfers. Equation A15–3 is important. It
implies that if the home country’s total expenditures exceed its total receipts, the dif-
ference must be provided by running a deficit on the current account. From equa-
tion A15–3, we can see that A - Y = -CA. The current account balance thus serves
as an indicator of whether a country’s spending exceeds its income.
As discussed in Chapter 10, we can also approach the current account from the
perspective of national savings. National savings is what is left over from total receipts
net of private and government consumption, or S = Y - C - G. If we expand A in
equation A15–3 to write Y = C + I + G + CA and subtract C + G from both sides,
we arrive at the current account identity,
S = I + CA [A15–4]
which says that we can only save more than we invest if there is a CA surplus, and we
can only invest more than we save if there is a CA deficit.
Domestic savings has two components—private savings (Sp) and government
savings (Sg). Income in the private sector must be consumed, saved, or paid to the
government as taxes. Thus,
Sp = Y - C - T [A15–5]
Similarly, government savings is the difference between the tax revenue collected by
the government (T) and its expenditures (G), or
Sg = T - G [A15–6]
which is the government’s fiscal surplus (or deficit, if G 7 T). The sum of these two
equations equals our previous observation that S = Y - C - G = Sp + Sg , or total
national savings is the sum of private savings and government savings. Substituting
this idea into equation A15–4 and rearranging, we can see that
CA = Sp + Sg - I [A15–7]
A P P E N D I X T O C H A P T E R 15 : N A T I O N A L I N C O M E A N D T H E B A L A N C E O F P A Y M E N T S 5 7 9
Stated slightly differently, if investment is to exceed national savings, the difference

must be financed from abroad, and that difference equals the current account deficit.
In this sense, we can think of the current account as foreign savings. In addition, if we
substitute equation A15–6 into equation A15–7, we see that
CA = (Sp - I) + (T - G) [A15–8]
which tells us that if investment exceeds private savings and/or the government runs
a fiscal deficit, the current account must be in deficit by an equivalent amount.
The rest of the balance of payments story is about how the current account is
financed. As noted above, in addition to the current account, the balance of pay-
ments includes the financial account (FA) and the capital account (KA). The financial
account records foreign transactions involving financial assets such as stocks, bonds,
and real estate ownership. The major components of the financial account (using
the IMF definition) are foreign direct investment, portfolio investment, and (impor-
tantly) reserve assets (which is the stock of foreign currency—usually U.S. dollars,
euros, or yen) held by the central bank. The capital account refers to the transfer of
assets such as gifts to and from abroad.11
A fundamental principle of balance of payments accounting is that bills must be
paid. This implies that the balance of payments must sum to zero, or
CA + FA + KA = 0 [A15–9]
This is the balance of payments identity. It implies that there are only three ways in
which a country can finance a current account deficit: 1) it can borrow from abroad
(from foreign governments, banks, or international lending bodies), 2) it can attract
capital inflows (in the form of direct or portfolio investment), or 3) it can run down its
stock of foreign reserves. If the current account is in deficit, then it must be balanced
by a surplus in the financial and capital accounts (which potentially includes running
down the country’s stock of foreign reserves). If the balance of payments must also
equal zero, what is meant when we hear about a “balance of payments deficit?” In
common use, a balance of payments deficit refers to a situation in which a CA deficit
is not fully balanced by a surplus in FA + KA where FA is defined narrowly to exclude
the foreign reserve assets of the central bank. In such a case, the total balance of pay-
ments must be brought to zero by a change in foreign reserves (running them down,
in this instance, to finance the remaining CA deficit).
Running a surplus in the (non-reserve) financial and capital accounts means
that the home country is either borrowing from abroad or selling domestic assets
to foreigners. In either case, the home country is increasing the claims by foreigners
11
This narrow definition of the capital account (and broad definition of the financial account) is in
accordance with the approach now taken by the IMF, along with OECD and the UN System of National
Accounts. Previously, the accepted tradition was to define the capital account broadly enough to include
everything that the IMF now assigns to the financial account, with the exception of the reserve assets of the
central bank.
on domestic residents. Conversely, if the home country is running a current account

surplus, it must also be running a deficit on the financial and capital accounts, thus
increasing the claims by residents on foreigners. Since the home country’s stock of
net foreign assets equals the difference between claims by residents of the home
country on foreigners and claims by foreigners on home country residents, the cur-
rent account equals the change in net foreign assets.

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15 Managing Short-Run

In this chapter, we develop a mechanism for analyzing the macroeconomic poli-

EQUILIBRIUM IN A SMALL, OPEN ECONOMY

Developing economies1 have two features central to understanding how macroeco-

INTERNAL AND EXTERNAL BALANCE

F I G U R E 15–1 Equilibrium in the Australian Model

Bt = value of X-goods supply - value of X-goods demand - (value of M-goods

or if we let the supply of tradables be St and demand be Dt ,

Bt = PtSt - PtDt = Pt(St - Dt) [15–2]

In Figure 15–1, with the economy in equilibrium, consumption of tradables is equal

for developing countries. (Washington, DC: World Bank, 1999).

When, as in Figure 15–1, the economy is in equilibrium, X = M and income equals

THE PHASE DIAGRAM

F I G U R E 15–2 Tradables and Nontradables Markets

Real exchange rate

F I G U R E 1 5 – 3 The Phase Diagram

requires a lower, or appreciated, real exchange rate to restore equilibrium. Increased

EQUILIBRIUM AND DISEQUILIBRIUM

1 ΔM 2 > 0 ΔPn > 0 3

Real exchange rate

Δe < 0 ΔPn > 0

Δe > 0 ΔPn < 0

ΔM 2 < 0 2 4 ΔPn < 0

F I G U R E 1 5 – 5 Tendencies toward Equilibrium

F I G U R E 15–6 Policy Zones

• In quadrant II at a point like 2, with an external deficit but internal balance,

So the principles of macroeconomic stabilization are simple: If policy makers

APPLICATIONS OF THE AUSTRALIAN MODEL

Economy,” Economic Journal 92 (1982), 825–48.

F I G U R E 1 5 – 7 The Dutch Disease

In 1983, after a decade of economic mismanagement, Ghana’s gross domestic

DEBT REPAYMENT CRISIS

Δ Debt service > 0

F I G U R E 1 5 – 8 Debt Crisis or Declining Terms of Trade

STABILIZATION PACKAGE: INFLATION AND A DEFICIT

F I G U R E 1 5 – 9 Stabilization from Inflation and a Deficit

The core IMF stabilization program consists of a reduction in the government’s

to €330.4 billion in 2010 (equivalent to 144 percent of GDP, or approximately

unwilling to provide the bailout. The brinksmanship between Greece’s govern-

DROUGHT, HURRICANES, AND EARTHQUAKES

• Open economies may be exposed to a variety of shocks, both positive and

• The Australian model provides a convenient and versatile framework

APPENDIX TO CHAPTER 15: NATIONAL INCOME AND

Y = A + (X - M) + NFIA + NUT = A + CA [A15–3]

Stated slightly differently, if investment is to exceed national savings, the difference

on domestic residents. Conversely, if the home country is running a current account

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