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LIKELY CONSEQUENCES OF SHORT-RUN STABILIZATION MEASURES

There are reasons to believe that traditional short-term stabilization will (a) increase income inequalities and (b) affect absolute poverty, measured by some appropriate indicator, such as calorie consumption per capita or weight-per-height in children.

First, we need to be aware of some stylized facts about developing countries that modify the environment in which those traditionally North Atlantic policies are applied and that will necessarily have an effect on the nature of the trade-offs involved. Developing countries are characterized by (a) low levels of per capita income and (b) high inequalities in the distribution of income. When issues of poverty are considered, it is clear that the most vulnerable groups will be found in low-income countries, such as the sub-Saharan African ones, and in those groups that are at the bottom of the distribution of income, such as unskilled workers, landless peasants, urban pedlars, etc. Within those groups, women and children are likely to be the most affected [23, 24]. Since these groups are the most vulnerable, if only be cause of their low level of income, any loss of income resulting from stabilization policies will affect them disproportionately.

On the other hand, most developing nations are characterized by the existence of a large informal sector in urban areas and by economic factors that operate outside the traditional, monetized economy. This is particularly true of the smallholder farm sector. This subsistence sector can be quite large in poor countries. Its existence complicates the analysis of the way adjustments operate precisely because they respond to changes in real income in a "perverse" manner (meaning any behaviour that does not conform to textbook economics!).

The issue of "supply response" is crucial in this respect. Decisions to enter the labour market for given skills are not necessarily made in response to marginal increases in the real wage, and decisions to market additional quantities of crops or livestock do not necessarily respond to higher prices, as the orthodoxy assumes. Not only should the usual behavioural assumptions be modified to analyse such situations; there might also be microeconomic constraints, in addition to macroeconomic ones such as foreign-exchange shortages, that limit the response of those groups in the context of a market economy.

The most important determinants of changes in distribution resulting from short-term policies are as follows [25]:

On the basis of these variables - and before examining stabilization policies one by one and indicating to what adjustments in the economy they are likely to lead - we can anticipate the most important conclusions concerning the likely implications of such policies in the welfare of the poor in the short run:

  1. Stabilization policies are expenditure-reducing in the short run; that is, their goal is to make total absorption fall. The burden of the reduction will affect various groups differently. The poor will be affected through the channel of wages and employment, to the extent that real wages and employment fall. The impact on the poor of expenditure-reducing measures will depend on their share of wage income in total income, and on their share of formal employment in total employment (see 5 below).
  2. Stabilization policies are also expenditures witching in the short run; that is, their goal is to change the composition of expenditures through changes in relative prices. The poor will be affected by those price changes to the extent that the share of tradable goods and services in the price index used to deflate income is high. Expenditure-reducing and expenditure-switching policies affect the poor both through production (employment and wages) and consumption channels and through changes in relative prices and relative quantities.
  3. These distributional effects may be accentuated if, as structuralists claim, the effects of orthodox policies are mainly stagflationary, even though they restore external balance. The compound impact of recession and inflation, added to the direct effects indicated under 1 and 2, cannot be predicted easily.
  4. These effects on the poor may be dampened if cuts in government spending affect current expenditures less than proportionately and if the incidence of marginal reductions in government spending is low for the poor.
  5. These effects also depend on the relative participation of the poor in the formal sector vis-a-vis the informal sector. The "formal" sector of the economy is characterized by high barriers to entry due to size, investment requirements and technology (capital: labor ratio), management style, predominance of wage employment, and size of establishment. The "informal" sector, by contrast, is characterized by virtually free entry, minimal capital and skill requirements, small size, and the prevalence of self-employment, for instance, in petty trade, small shops, etc. If the formal and informal sectors are good substitutes in production and in consumption, so that the informal sector could benefit from a recession in the formal sector, the poor will be less affected. If the two sectors are complementary- for example, in heavy industry- the poor in the formal sector will be affected indirectly to the extent that their inputs originate in the formal sector.
  6. The net impact of stabilization policies on the poor in the short run will depend on (a) the direct and indirect effects of these policies, (b) compensatory mechanisms, such as those already mentioned, which can dampen these direct and indirect effects, and (c) the composition of the particular policy package. Raising the nominal wage during a devaluation will soften the blow for wage-earners, for instance. Conversely, some combination of policies, such as a devaluation together with severe fiscal and monetary measures, can lead to "overkill."

STABILIZATION MECHANISMS

Devaluation of the Exchange Rate

Devaluation (an increase in the nominal price of the dollar in terms of the domestic currency) is often part of a stabilization package because it alters the real exchange rate. The latter is defined as an index of prices of export goods and import substituting goods (together called "traded goods") relative to the price of goods produced domestically that are not traded internationally, such as services, construction, etc. Altering the real exchange rate by devaluation is a powerful instrument to restructure incentives in the domestic economy, that is, to increase the price of non-traded goods and lower the price of traded goods.

Consider the typical case of a country with a trade deficit. Absorption (expenditures) exceeds income. The country is thus an importer of real resources. Without any change in the international terms of trade faced by the country (the relative price of exports compared to imports), the country can finance this trade deficit by a capital inflow, which is consistent with the maintenance of overall balance-of payments equilibrium. Production within the country will not change because prices have not changed, since, by assumption, the terms of trade are constant; and so the situation would be sustainable only if the inflow of capital were permanent.

This conclusion is true only if the assumptions hold. If, for example, the terms of trade facing the country change when the country develops a trade deficit, the conclusion is not valid. Such cases are frequent in middle-income developing countries. If the trade deficit is due to low exports With comparatively high imports, from the point of view of absorption), it is clear that the international price of exports will slowly increase under the pressure of international demand (unless, of course, there is a world-wide recession so that there is a lack of demand in industrialized economies for minerals, agricultural goods, and other primary inputs produced by developing countries). When the country has the ability to influence international prices (as Brazil has for coffee, Thailand for rice, Madagascar for vanilla, the Philippines for coconuts, Bolivia for tin, Chile for copper, etc.), this simple conclusion ceases to be true. What then matters is the extent to which a fall in the price of exports will lead to an increased volume of exports for the developing country. Brazil, for example, managed to generate a huge trade surplus in 1985 because of favourable conditions in the world coffee market. Most countries, however, are small from the point of view of international trade. The vast majority of sub-Saharan African countries, for instance, have no influence on the international price of the commodities they export.

If some goods and/or services produced in the economy are non-traded, it is not true that a capital inflow will not change relative prices and, therefore, production. All countries produce exports, import-substituting goods (domestically produced goods that compete with imports), and non-traded goods. If we lump exports and import-substitutes together in a ''traded" category (which is legitimate as long as we maintain the assumption that the terms of trade between them, i.e., the relative price of exports in terms of import-substitutes, are constant) and analyse the trade deficit in terms of traded and non-traded goods, we will see easily why the real exchange rate is such an important variable.

A trade deficit implies that the absorption of traded goods exceeds their production. In terms of non-traded goods, however, production is always equal to absorption for the simple reason that one cannot import haircuts. The important implication of this fact is that in order to reduce the trade deficit permanently, it is necessary for the relative price of non-traded goods to fall. This will have two effects. Producers will shift their production toward traded goods because their price, in relative terms, has increased. Production of export goods that are also consumed domestically, such as beef in Argentina or Uruguay, or import-substitutes, such as television sets or automobiles in Brazil, will increase, thus increasing incomes. Simultaneously, consumers will shift to non-traded goods (e.g., cassava in Africa) and away from traded goods (e.g., imported rice or maize) because the price of non-traded goods, relatively speaking, has decreased, and this will reduce expenditures. Because of the nominal devaluation, exports will be boosted and imports of foreign goods will fall, reinforcing the process. Combined, these effects will be enough to absorb the excess supply of traded goods that were imported and bring the trade balance back to equilibrium.

The nominal increase in the exchange rate (devaluation) leads to an increase in the real exchange rate through an increase in the price of traded goods, a decrease in the price of non-traded goods, or both. This leads to drastic changes in the patterns of consumption and production, which restore equilibrium in the trade balance. The devaluation will affect the poor through three main channels: (a) wage and employment effects, (b) price effects, and (c) possible stagflationary effects. Even if the money wage stays fixed during devaluation, the real wage will almost certainly decline. It declines first of all because the price of intermediate imports rises, thus squeezing domestic value added, and also because, there is a presumption, non-tradables are highly labour-intensive. It will almost certainly decline in terms of the prices of tradables 126]. By how much is an empirical question, the answer to which depends on the weight of traded goods in the price index.

The switch from non-tradables to tradables is achieved through adjustments caused by internal price movements and without foreign capital flow. Very often, as pointed out by Helleiner [23], this restructuring is little more than a euphemism for reducing wages and employment in the government and in other (formal) service sectors relative to other sectors. Adjustments of a permanent nature (lower levels of expenditures compatible with incomes generated in the economy) have been provoked by the devaluation, with the real exchange rate (the relative price of tradables vis--vis non-tradables) acting as the adjusting variable in the macro-economy.

In reality, there are many marginal cases where the same good can be classified as traded or non-traded. These marginal cases, however, can be crucial for the effect of the devaluation on the poor, depending on their "participation," in production and in consumption in both types of sectors.

Some goods or services are non-traded by nature [27], others because transportation costs would be too high to make international trade worthwhile, such as some services in the construction sector. Other goods are traded or non-traded depending on shifts in relative prices that can be induced by policy. At prevailing prices, if the good is taxed with a very high tariff, it can be considered non-traded, but it would be traded if there were no policy intervention. The purpose of liberalizing foreign trade is precisely to remove those barriers. Cassava is traded internationally by some countries, Thailand for example, and considered non-traded in some others. The ultimate criterion is that the good is considered to be traded if the fluctuations in its domestic price over time are closely correlated with the fluctuations in its international price, and that it is considered non-traded if domestic and international fluctuations are uncorrelated. This requires a good deal of information that is not always available in poor countries. In practice, since it is not possible to make a list of what goods are traded or not, the movements in the real exchange rate are measured by the behaviour of the exchange rate relative to internal price developments adjusted for price changes in major trading partners [28].

Orthodox economists and the IMP claim that devaluation is a necessary measure of "austerity" and that it will have positive effects on the economy through a "restructuring of incentives." They claim that short-run costs implied in terms of income and employment are unavoidable and will be compensated by long-run gains. The country lives "beyond its means" and needs to find a more permanent position of equilibrium in order to grow in a balanced way, according to its comparative advantages in the international economy, without distortions.

To a certain extent, they have a point. When there are indications that the currency of a developing country is excessively overvalued, this indicates that "something is wrong" in the economy. Ghana, for example, devalued its currency in 1984 by 1,000 per cent, from 3.45 cedi per US dollar to 35.3. There were indications, however, that the currency was still overvalued, as indicated by a black market exchange rate of C135 per dollar in 1984. Therefore, in January 1986 the Ghanaian government announced a major devaluation of its currency by one-third of its nominal value, from C60 to C90 to the dollar, to restructure its economy. Simultaneously, it raised the minimum daily wage by 30 per cent. Production of traded goods such as export crops is often discriminated against, so that farmers and manufacturers have little incentive to invest resources in these sectors, and consumption of traded goods increases relative to non-traded goods, leading to a rising import bill and to a trade deficit that is, in the long run, unsustainable. In those cases, a rise in the real exchange rate becomes unavoidable.

Both theory and recent experience indicate that devaluation might not be the best instrument to achieve the goals of restoring external balance and restructuring incentives. First of all, devaluation is a highly sensitive political issue in some countries and can trigger unanticipated reactions. Second, whether the measure will be successful or not depends on a host of conditions. A wide body of theoretical and empirical literature deals with the conditions under which this will be the case. Unfortunately, the conclusions are not very encouraging for developing countries. The consensus is that a devaluation usually succeeds in restoring external balance, but has positive effects internally only under specific conditions that do not usually exist in poor countries. If exports do not increase and intermediate imports necessary for their production cannot decrease, there is a possibility of recession and inflation- reinforcing the effects mentioned above - first pointed out by orthodox critics [29, 30]. Coupled with a devaluation, fiscal and monetary restraining measures can lead to overkill and aggravate the stagflationary impact, with severe consequences for the poor.

Fiscal Restraint

Stabilization policies, because they are primarily concerned with reducing absorption, almost always involve fiscal restraint, achieved by cutting budgetary expenditures or by increasing government revenues. Beveridge and Kelly [31] provide detailed information on the fiscal content of 105 stand-by agreements negotiated in the decade 1969-1978. The majority of these programmes include tax measures to be taken before the start of the programme, efforts to strengthen tax administration, statements on total expenditures, and the contribution of public enterprises. There are also specific statements concerning the reduction of wages of public-sector employees, the reduction of consumer subsidies and transfers to public enterprises, and public pricing policies. In 40 per cent of these programmes the overall budget deficit is made an object of attack, and the ratio of the deficit to the GDP is to be reduced by more than 1 per cent from the level of the previous year. In many cases, these fiscal targets are set too low and have to be revised.

They were revised upward, for instance, in Argentina from 5 to 8.1 per cent of the GDP in 1984, in Brazil from -0.6 to 0.3 per cent also in 1984, and in Mexico from 3.5 to 5.1 per cent in 1985. In spite of these corrections, the projections made by IMP economists were off target, since the actual deficit reached 12.4 per cent in Argentina but -0.2 per cent in Brazil in 1984 [32].

The short-term effect of such fiscal measures on the poor will depend, in the first instance, on whether the government's cutbacks affect current expenditures or investment expenditures. In the former category, the likely candidates are social programmes and employment and wages in the public sector. Helleiner wrote that "the Latin American experience of the past decade, and particularly of the last five years, offers plenty of scope for careful testing of the popular proposition that, whatever the composition of expenditures when they are rising, cutbacks typically impact disproportionately upon social programmes and the poorest" [3].

During the external shock period of 1973-1975 the adjustment process involved mostly cuts in public consumption, but during the second major wave of shocks, in 1979-1983, investment cutbacks accounted for proportionately a much larger share of the aggregate cutbacks than in 1973-1975 13]. These cuts in public investment programmes were made necessary by the political limits to further reduction in consumption. Even then, Mexico cut current expenditures from 38 per cent of GDP in 1982 to 30 per cent in 1984.

In many Latin countries, interest payments on the external debt rose dramatically, thus making it difficult to reduce current expenditures. After 1982, the IDB reports that almost all Latin American countries showed a decline in the ratio of public capital expenditures to GDP, and that, within that category, social infrastructure suffered most [32].

Peltzman noted that government spending on subsidies and transfers has grown faster than other elements of public expenditures [33]. He argued that a decline in income inequality in developed countries and the emergence of a politically articulate middle class have accounted for major growth in government in the past 50 years. More equality has generated a political demand for still more equalization and, hence, a growing demand for subsidy and transfer programmes. He concluded that "there is nothing inexorable about the growth of government, nor is there some arbitrary limiting ratio of government to GNP. Instead, our argument is that the size of government responds to the articulated interests of those who stand to gain or lose from politicization of the allocation of resources. "

Although there may be deliberate exceptions, however, the presumption is that government expenditures are more equitably distributed than private ones [3]. Exceptions can be found, for instance, in societies that discriminate deliberately in government programmes against certain races, ethnic groups, or religious groups. The first example that comes to mind is South Africa, but countries such as Malaysia have similar economic policies [29, 30].

Public-sector cutbacks are therefore more likely to harm the poor than are private expenditure cutbacks of equal size. Another corollary is that the poor will stand to lose from public spending restrictions to the extent that they are not able to articulate their demands politically.

IMPACT OF THE REMOVAL OF FOOD SUBSIDIES

Recently, orthodox policies have involved removing or reducing subsidies on consumer goods- for fiscal as well as other reasons, such as the removal of distortions affecting productivity in the food-crop sector. The official IMP historiographer writes that "by 1978 additional performance criteria [to the usual conditionality] were occasionally used. For example, in some programmes the elimination of subsidies for basic food items was included. Not only was this considered helpful in cutting budgetary expenditures but, by permitting high prices for foodgrains, it was considered a price incentive for farmers to increase production" [10]. We consider the likely impact of such policies under the heading of fiscal restraint, although it is clear that they have broader motives and implications.

Governments almost always intervene in food markets by introducing a wedge between producer prices, import prices, and consumer prices. The goals are to stabilize prices and thus reduce income fluctuations, and to avoid inflation. In poor countries, food constitutes a high share of total production and consumption, and interventions in food markets attempt to maintain or at most marginally alter the status quo between the interest groups involved.

In general, cuts in food subsidies will favourably affect the income of farms that produce food and negatively affect the income of urban workers and rural landless. But the end result of the cut depends on how it will affect the general level of activity, that is, how those changes in nominal income affect demand for non-agricultural goods, prices, and real income. If demand for nonagricultural products is dominated by rural income, the subsidy cut can have a positive effect. Otherwise, there will be an output loss- and possibly inflation due to excess demand- in the nonagricultural sectors, and the overall impact can be contractionary [15].

In Egypt the food subsidy system significantly redistributes income towards the urban and the rural poor [36], and abolishing the system would hurt them. In Thailand, by contrast, increasing the price of rice would have only minimal effects on rural poverty because most of the gains would be realized by large commercial farmers, while the short-run losses would be incurred mostly by the urban poor [37]. In Sri Lanka the change in the rice subsidy system in 1978-1979 had a negative impact on nutrition among the poor [38, 39]. All these changes for attempted changes) were motivated by fiscal reductions.

Cuts in food subsidies lead to an immediate decline in the demand for food products. This induces a decline in food imports and leads to an improvement in the trade balance, which is usually the overriding objective of the policy. Under the 1985-1986 stand-by agreement with Madagascar, for example, imports of rice were required to fall from an all-time high of 350,000 tons in 1982 to 80,000 tons in 1985. At the same time, rice prices were liberalized by the government in 1983, and this led to an average threefold increase in the price of rice in 1985. Food price increases after subsidy cuts or price liberalization are likely to be high because the demand for basic food items is price inelastic. Moreover, the poor devote a large share of their spending (usually 50 to 60 per cent) to food. Subsidy cuts are supposed to lead to substitution in consumption from imported to domestic foodstuffs, and from traded goods such as rice to non-traded goods such as cassava.

Tight Monetary Policy

The dominant view of monetarists is that the most common cause of disequilibrium in developing countries is an overly expansionary domestic demand policy, and therefore calls for ''demand management" policies, usually in the form of credit restrictions. Other situations are characterized by distortions in costs or relative prices requiring a devaluation of the exchange rate, elimination of consumer subsidies and/or of restrictions on trade, and international payments, which also make it necessary to apply a tight monetary policy, since "an inappropriate expansion of credit could nullify the intended changes in relative prices and their effects on the allocation of resources" [40].

The basic assumption of the monetarist model [41] is that there is a stable relationship between financial variables such as money and domestic credit) and non-financial variables (such as real national income and prices), and that the monetary authorities can control some of the financial variables so as to affect the real side of the economy [7].

Financial programming, therefore, starts with the "equation of exchange" of the quantity theory of money, which states that the value of transactions in the economy (prices times quantities) in a given period is equal to the amount of money demanded multiplied by some proportionality factor. This factor is equal to the inverse of the "velocity" of money, which measures the speed at which money is utilized in financing transactions.

If we assume, as monetarists do, (1) that velocity is constant and (2) that the growth rate of output is known from supply (or employment) projections done by the IMP staff, the increase in money demand will depend only on price increases. It is assumed that increases in the price level will be determined in the short run by rises in the costs of labour and of intermediate imported inputs, that is, by the levels of the wage and exchange rate.

On the other hand, the basic accounting identity of the consolidated banking system states that money supply (liabilities in the balance sheet, made of currency of the central bank and deposits at commercial banks) must be balanced by assets. These assets are either loans to the private and public sectors or foreign-reserve holdings. Thus, it is easy to see what could happen if credit is restricted.

Since money demand must equal money supply, restricting the latter in the form of credit ceilings or reductions in the fiscal deficit will put pressure on the price index - from the equation of exchange.

Here an additional monetarist postulate must be introduced, called the "law of one price." It states that the price of traded goods in the country is equal to the world market price times the (effective) exchange rate. The domestic price of the traded good "cannot" exceed its international equivalent, due account being taken of transportation costs and other surcharges. If it did exceed it, say in the case of importables, every customer would buy the foreign substitute.

If there is pressure on the price index to fall but the law of one price applies so that prices of traded goods stay constant, then prices of nontraded goods will decline. There will be expenditure switching. The change in relative prices means that it becomes more profitable to produce more traded good - export more or substitute imports. The surplus of exports over imports will increase, and the trade deficit will be smaller.

If the law of one price does not apply, prices will be determined by international costs and money demand will be given by the equation of exchange. The change in money supply is set equal to the change in money demand. Since money supply is made of bank loans and international reserves, cutting back loans by the banking sector must lead to an increase in reserves. Reserves come from net exports (exports minus imports) plus net capital inflows. If the amount of capital inflow (foreign grants and loans, etc.) is given, an increase in reserves can only lead to an increasing trade surplus - or decreasing trade deficit.

In both cases, whether the law of one price applies or not, the goal of redressing the balance of trade deficit (increasing the amount of foreign reserves) is achieved. No consideration is given to the fact that the policy could be strongly deflationary, with all the social consequences attached to deflation. In the monetarist reasoning, causality runs from money to prices and not the other way around.

The adjustment process can of course fail if the IMP economists do not do their homework properly, that is, if they make incorrect projections of output growth, etc., or if they have been given inaccurate data by local policy-makers during their dialogue to set performance criteria, as sometimes happens. As indicated by Taylor [42] and Helleiner [43], this is frequently the case with African countries, which have not received the level of competence that they deserve from the IMP.

The process can also fail because the assumptions of the model used for financial programming are far-fetched. Output is not strictly determined by supply, velocity is certainly not constant but jumps erratically, the law of one price does not apply or the price index used for the calculations is not the relevant one, etc. The model is too simple. There are too many intervening variables that are simply treated as fixed.

Businesspersons usually dislike "tight money" because it drives interest rates up. In developing countries, most loans to the business sector are made to finance working capital, to pay for imported inputs, or to pay the wage bill, and much less to finance investment. The rise in interest rates will therefore increase costs. The normal response of the businessperson will be to attempt to pass along the increase in the form of higher prices or to cut back on activity. The outcome is that, even if aggregate demand fails because of credit restrictions- which is the purported goal of the policy - aggregate supply can fall even more. There will be an increase in excess demand for goods and services, and this will fuel inflation rather than restrain it. If the "cost-push effect" of tight credit policy is strong enough, the result in the short run is stagflation: inflation and output contraction.

As can be seen, simple causality does not necessarily mean lower prices. But the goal is still achieved: less money improves the trade balance because output contraction reduces demand for intermediate imports [15].

The effects of ''tight money'' and credit restrictions and of "ceilings" on poverty are particularly difficult to analyse. Monetary restraint will affect various groups differently, and especially those who are dependent on credit for their day-to-day operations such as small farmers, small entrepreneurs, etc. It will also affect the poor through its possible inflationary and recessionary impact.

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