Chapter 15
Finance and
Fiscal Policy for
Development
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The Role of Financial System
• Providing payment services
• Matching savers and investors
• Generating/distributing information
• Allocating credit efficiently
• Pricing, pooling, and trading risks
• Increasing asset liquidity
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Macroeconomic Stabilization Policy
Fiscal policy:
• Taxation and spending actions of the
government to affect employment and output
• Expansionary: lower the income tax rate
and/or increase public spending to create
jobs and income
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Macroeconomic Stabilization Policy
Monetary policy:
• Changing the supply of money to affect
interest rate, investment demand,
employment and output
• Expansionary: increase the money supply
to reduce interest rate, increase investment
demand, create jobs and income
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Requirements of Monetary
Policy
• An independent central banking authority
• Well organized financial market with banks
and saving and loan institutions
• Strong link between interest rate and
investment demand
• A floating exchange rate
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Role of Central Bank
• Issue currency
• Banker to the government
• Banker to domestic banks
• Regulator of domestic financial
institutions
• Operator of monetary policy
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LDC Financial Market
• No central bank or a government-owned and
managed central bank
• Financial dualism
– Formal market: organized, but dependent
financial institution, consisting of foreign and
domestic banks
– Informal market: unorganized, fragmented
financial institutions, consisting of landowners
and money lenders
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LDC Financial Market
• Weak or ineffective link between interest
rate and investment demand
• Structural inflation due to import substitution
strategy
• Fixed or pegged foreign exchange rate,
giving rise to a “currency substitution”
problem
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LDC Central Banking Problems
• Public agency issuing money to cover government
deficit or finance the development plan
• Foreign-owned commercial banks
• Informal financial markets
• Colonial heritage
• A money supply difficult to measure
• A fixed or pegged exchange rate
• Unskilled central bankers
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Emergence of Development Banks
• Specialized public and private financial
institutions providing medium- and long-term
loans for the creation and expansion of
industrial enterprises
• Receive bilateral and multilateral loans from
international lending agencies
• Receive loans from domestic government
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Criticism of Development Banks
• Excessive concentration on large-scale
loans
• Excessive concentration on financing
urban-industrial development
• Neglect of small business expansion and
rural-agricultural development
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Need for Financial Liberalization
• Many LDCs suffer from “financial
repression” since their central banks control
the rate of interest, causing
– A shortage of loanable funds
– Higher interest rate charged by the informal
financiers
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Financial Repression
Interest rate
r1 = Market rate
r2 = Controlled rate
r3 = Black market rate
r3
r1
Credit shortage = L1L2
r2
D
S
L1
L2
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Loanable funds
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Requirements of Fiscal Policy
• Reasonable tax rates
• Effective tax collection agency
• Honest tax-collectors and tax-payers
• Balanced-budget requirement
• Independent central bank
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LDC Fiscal Problems
• Low level of per capita income
• High degree of income inequality
• Low and non-progressive individual and
corporate income tax rates
• Low property tax rate
• Excessive foreign trade tax rates
• High excise tax rates
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LDC Fiscal Problems
• Ineffective tax collection agency
• Corrupt tax collectors
• Deficit-financing growth policy
• Inflationary-financing growth policy
• Mounting public debt and external debt
• Reliance of foreign aid and foreign direct
investment
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Comparative Average Levels of Tax
Revenue, 1985–1997, as % of GDP
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Comparative Composition of Tax
Revenue, 1985–1997, as % of GDP
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Public Administration Problems
• Fragmented society due to ethnicity, religion,
political affiliation, and economic class
• Employment rather than efficiency criterion
• Shortage of skilled administrators
• Low salaries and inadequate benefits
• Lack of trust and prevalence of corruption
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State-Owned Enterprises
• Large capital investment
• Public utilities, transportation and communication
systems, financial institutions, services, natural
resources, agriculture, and manufacturing
• Contributing an average of 7-10 percent to GDP
• Employ 30-40 percent of the labor force
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Problems of SOEs
• Inefficiency: employment rather than profit
maximization
• Monopoly power
• Higher wages inducing R-U migration
• Import-intensive ISI strategy
• Lack of trust and prevalence of corruption
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Solution to SOCs
• Efficiency criterion: adopt a bottom-line focus
in managing public enterprises
• Privatization: sell ownership of public
enterprises to private investors
• The Latin American and East Asian NICs
have been active in the privatization of SOCs
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Military Spending and Development
• MDCs’ military spending is significantly higher
than that of the LDCs (i.e., $527 vs. $200 billion)
• LDCs’ military spending share of world military
spending has risen from 8.3 percent in 1960 to
27.5 percent in 2000
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Trends in Global Military Spending,
1960–2000 (billions of U.S. dollars)
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Military and Social Expenditures
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Countries with Highest and Lowest
Expenditures on Military, 2002
(% of GDP)
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Countries with Highest and Lowest
Expenditures on the Military, 2002
(% of GDP)
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Military Spending and Development
• Countries in the Middle East, Latin
America, and Africa are big military
spenders and major armament importers
– Iran, Syria, Oman, Saudi Arabia, UAE
– Nicaragua, Bolivia
– Somalia, Ethiopia
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Effect of Military Spending
Military spending causes economic growth
• Build the basic infrastructure
• Transfer technology
• Create jobs and income
• Spend money on supplies
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Effect of Military Spending
Military spending hinders economic growth
• Infrastructure is mainly used by the military
itself
• Military technology won’t spillover into private
sector production
• Resources are diverted from industrial and
agricultural production to military spending
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Effect of Military Spending
Military spending hinders economic growth
• Military imports deteriorate the balance of
payment
• Governments use the armament to
suppress both internal and external conflict
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