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

S D

L1 L2 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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