PRESUPUESTOS 2012

It is tempting for the LDCs to resort to inflation as a major ‘tax’ to finance their public expenditure to promote economic development, particularly when the tax revenue as a proportion of GNP is low and tax elasticity with respect to income is not always greater than unity. Given certain demand for money assumptions, inflation can raise revenues. Second, by increasing profitability of industries, inflation can provide incentives to investment. Third, the government will be less obliged to depend upon foreign resources if it can raise more revenue at home. Fourth, it has been argued that inflationary financing could promote the growth of banks and other financial institutions. These agencies may induce the public to hold financial rather than physical assets and thus release real resources for economic growth (Thirlwall 1974).

This, however, is a rather dubious argument because, at times of high inflation, people may be induced to hold more physical rather than financial assets.

On the debit side, inflation could easily distort the efficient allocation of resources and reduce real growth. Second, a high level of inflation will reduce a country’s competitive power in the export market and it may eventually price itself out. The LDCs which suffer from a chronic balance of payments deficit, therefore, should exercise greater caution in the use of inflationary policies. Third, inflation may make the distribution of income more unequal. Many LDCs experience significant inequalities in the distribution of income and, as such, inflationary financing, which often tends to redistribute income in favour of profits rather than wages, may arouse public hostility. However, it may be argued that, even if inflation promotes more inequality, it tends to raise profit share and thereby the saving ratio in national income and this could have a beneficial effect on growth. Critics argue that consumption could also have a favourable effect on growth in the LDCs (Mirrlees 1975; Foxley 1976; Bliss and Stern 1976). Fourth, a high level of inflation could easily shake people’s confidence in the currency and this could induce greater holding of physical

rather than financial assets with detrimental effects on growth. Finally, hyperinflation could only have disastrous consequences on the currency and financial system without conferring much significant benefit on the real growth of a country.

On balance, the weight of the arguments seem to be in favour of a mild degree of inflation for promoting growth (Ghatak 1995). The mechanism has been illustrated by Mundell (1965) and his model will be analysed next.

Mundell’s model of inflation and growth

Mundell starts off with the basic quantity theory equation to show the relationship between inflation and economic growth (Mundell 1965). Thus, we have

MV=PQ (5.1)

where M is money supply, P is price level, V is velocity and Q is total output.

If we differentiate (5.1) with respect to time t we have

(5.2) where p is the rate of growth of prices, i.e. (1/p) dP/dt; g is the rate of growth of quantity, i.e. (1/Q) dQ/dt;

and m is the rate of growth of the money supply, i.e. (1/M) dM/dt.

Let us assume that

Q=βK (5.3)

where β is the output-capital ratio or productivity of capital and K is the total stock of capital. It is implicitly assumed that labour is in ‘surplus’ because output Q simply depends on capital K. Differentiating (5.3) with respect to t we obtain

(5.4)

Let us assume that all public investments are financed by the banks and the true value of public investment is

(5.5) where G is public investment and B is bank reserves.

The association between B and M is given by

B=rM (5.6)

where r is the fractional reserve ratio. Differentiating (5.6) with respect to time we have (5.7) Substituting into (5.5), we have

(5.8) Making necessary substitution between (5.8) and (5.4), we obtain

(5.9) Dividing (5.9) by Q, we have

(5.10)

Equation (5.10) gives the relationship between the rate of output growth and the growth of money supply.

Recalling (5.2), we can now write

(5.11) If V is constant, we can rewrite (5.2) as

P=m-g (5.12)

Substituting into (5.11), we have

(5.13) or

(5.14)

Equations (5.13) and (5.14) show the relationship between p, m and g which could be promoted by deficit financing.

Note that 1/V is the planned money-income ratio. If the government decides to spend r units on investment goods and if prices are stable, then such spending would raise output by rβ. However, if output rises by one unit and money demand rises by 1/V, a rise in output of rβ would raise money demand by rβ/V units, while money supply rises by one unit. Thus whether or not deficit financing is inflationary or deflationary will depend upon

V̄ rβ

Deficit financing could be inflationary since in general both r and β are less than 1 but V>1.

To find out more about the actual working of the model, let us assume that V=4, β=0.33 and r=0.4.

Solving equation (5.14) we find that

p=29.303g

Thus a 29 per cent inflation is necessary to increase growth rate by 1 per cent. Note that given the capital-output ratio, i.e. 1/β or 3.03, a rise of about 10 per cent (i.e. 29.303/3.03) in prices is necessary to raise savings by 1 per cent.

It may be argued that V would not remain constant if inflation tends to be excessive; rather it should rise with inflation. More formally,

V=V(P) (5.15)

and

Imagine that the relationship between V and P is linear. Thus,

V=V₀+αP (5.16)

where V₀ is the velocity with no inflation. This equation is coupled with the equation

(5.17) to obtain

(5.18)

It is clear from equation (5.18) that P/g rises with a rise in g. At the limit inflation would be infinite and the growth rate can no longer be promoted by inflation. The optimal credit-financed rate of growth (g*) is then

(5.19) Using equation (5.14) and assuming with Mundell that V₀=3,

and if α=0, P=19g, i.e. prices should rise by 19 per cent per annum to increase growth by 1 per cent per annum. If a=10, then

i.e. a 1.5 per cent growth per annum would be related to infinite inflation.

Thus, to raise growth rate g by 1 per cent per annum the necessary rate of price increase would be 57 per cent per annum.

Some of the limitations of the Mundell model may now be mentioned. First, Mundell’s assumption that the output-capital ratio, or β, would remain fixed during the process of economic development is questionable when the whole structure of the economy could undergo important changes. Indeed, if credit-financing can increase capacity utilization, the output-capital ratio will rise.

Second, should the credit-financed public investment displace private investment rather than consumption, the rate of growth may be adversely affected.

Third, the model is closed; but if the role of foreign trade is included, then output-capital ratios could be raised by importing capital by creditfinanced government investment (Thirlwall 1974).

Fourth, if inflation is high, velocity is likely to change. This would imply that, for achieving a certain growth rate, a much higher rate of inflation will be needed. From the standpoint of policy formulation, it is almost preposterous to assume that a government would allow prices to rise by 57 per cent per annum to increase the growth rate by 1 per cent per annum.

Fifth, it is argued that the value of r should depend upon the proportion of money holdings supported by government securities rather than the ratio of bank reserves to money supply, as implied by Mundell. A proportion of the expansion of bank deposits will reflect the purchase of government securities, and to this extent the need for borrowing from the central bank for any given expenditure requirement is reduced (Thirlwall 1974:139). The former is generally higher than the latter (0.5 as against 0.3 in LDCs).

Sixth, to the extent that growth in the LDCs is constrained by a lack of demand (Bottomley 1971), credit-financed investment, particularly in projects where the fruition lags are small, could have a favourable impact on growth without seriously disturbing price stability.

Empirical evidence for LDCs shows that, although inflation has a positive effect on saving, such impact, in most cases, is statistically insignificant. The relationship between inflation and investment appears to be positive and significant. This could partly be explained by the impact of inflation on a higher level of

imports of investment goods. However, inflation beyond a certain rate (an ‘optimal rate’) is bound to affect adversely not only investment but also the rate of exchange, balance of payments and the level of unemployment. Existing information also supports this intuitive judgement (Thirlwall 1974).

Further evidence suggests that an inflation tax is feasible in the case of many LDCs. But inflation may have an important adverse impact on allocation of resources in LDCs in particular with fixed foreign exchange and interest rates (Newlyn 1977). Whether inflation as a deliberate policy is desirable or not depends on whether the effect of inflation on resource mobilization is greater than its impact on efficiency.

‘A full assessment would require one to compare the costs involved with the costs associated with distortions introduced by other taxes which would be needed to replace the revenue lost from the inflation tax’ (Ayre 1977). Among other costs of inflation note that it distorts the real rates of return between the different sectors and between the different types of financial assets since in many LDCs, while inflation goes on, nominal interest and exchange rates are kept constant and ‘financial repression’ occurs (McKinnon 1973; Shaw 1973; Ghatak 1995), resulting in reduction in the demand for real balances. A change in the financial structure in the LDCs is thus regarded as an important factor in promoting economic growth (Galbis 1977; McKinnon 1973; Shaw 1973). The development policies in many LDCs are supposed to have resulted in ‘shallow finance’ rather than ‘deepening’ finance or financial ‘liberalization’ which, inter alia,

‘matters’ in promoting economic growth (Shaw 1973). If inflation takes place, although nominal finance rises, real finance does not rise by the same proportion since it is taxed away by inflation and this state is considered as shallow finance. If finance is shallow as a proportion of income, the real rates of return tend to be very low or even negative. When finance is deepening (one index of which is an increase of liquidity reserves; other indices include an increase in the accumulation of average balances of liquid assets—which would prevent waste of resources in barter transactions—in all markets, an increase in the proportion of financial assets in income or wealth, and greater diversification of financial assets), government tends to be less dependent on taxes and foreign savings, capital flight is reversed, velocity falls, and real savings grow in financial rather than physical assets and pave the way for a greater integration between the organized and unorganized money market. As the real size of the monetary system grows, the differences between the interest rates in the organized and unorganized money markets tend to diminish and real rates of interest tend to rise, reflecting more accurately the opportunity cost of capital (as capital is generally the scarcer input in relation to labour in LDCs). Higher real rates are likely to raise real savings and real growth. An increase in real rates would also help for choosing a more appropriate technology (usually labour intensive in this case) with a higher level of employment and a more egalitarian system of income distribution. It is argued that as long as an interventionist policy keeps the nominal interest rates and foreign exchange rates fixed and a state of ‘financial repression’ prevails, ‘the costs in both inefficiency and corruption are high’

(Shaw 1973:12; Ghatak 1995).

Evidence suggests that between 1963 and 1968, while Uruguay experienced a rise in nominal money supply (which included the time and savings deposits) of 710 per cent its real value actually fell by 55 per cent. During the same period in Ghana, the index of nominal money supply (as defined above) rose from 1.

00 to 1.63 while the index of real value remained almost constant. Real output and real consumption fell sharply in Uruguay with severe repercussions upon its financial system and exchange rates. The economy of Ghana also received a considerable setback. On the other hand, in Iran and Thailand where a process of financial deepening took place, i.e. growth in nominal money supply almost matched the increase in real finance, in the same period a rise in both real income and consumption was observed (Shaw 1973:5).

The complexity of this discussion is now clear. A realistic policy of financial reform is called for to promote real saving and growth and employment in the LDCs. Rates of interest should be raised to reflect more correctly the relative scarcity of capital and this would have beneficial effects upon the choice of

technology, employment and income distribution. Although the attraction of an inflation tax is obvious in situations where the real values of revenues from other taxes are falling with rising prices (see Bird (1977) who shows how the real revenue from land tax in Japan was much less than its nominal value in the late nineteenth century) and when ‘inflation is a taxation without representation’, which even the weakest government could enforce upon its people (Keynes 1930), it could be used only in moderate amounts to mobilize resources (say, not more than 10–15 per cent depending upon the country) and great caution is needed to handle it before it gets out of hand.

5.5

OBJECTIVES OF FISCAL POLICY IN LESS-DEVELOPED COUNTRIES