fiscal deficits, inflation and interest...

THE WORLD BANK

Internal Discussion Paper

LATIN AmRICA AND THE CARIBBEAN REGION

Report No. IDP-0055

Fiscal Deficits, Inflation andInterest Rates

Rui Coutinho

June, 1989

Country Operations Division Country Department I

Discussion Papers are not formal publications of the World Bank. They present preliminary and unpolished results of country analysis or research thatis circulated to encourage discussion and comment; citation and the use of such a paper should take account of its provisional character The findings,Iaterpselations, and nclusions expressed in this paper are entirely those of theauthor(s) and should not be attributed in any manner to the World Bank,to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent

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LAC DISCUSSION PAPER SERIES

Report No. Title. Author and Date

IDP-3 "An Analysis of the Sources of Earnings Variation Among Brazilian Males" by Marcelo Dabos and GeorgePsacharopoulos, December 1987

IDP-4 "The Efficiency and Effectiveness of Export Credit and Export Credit Insurance Programs" by Bruce Fitzgeraldand Terry Monson (Consultant), December 1987

IDP-9 "Export Processing Zones: The Economics of Offshore Manufacturing" by Peter 0. Warr (Consultant), August1987

IDP-10 "Dumping, Anti-dumping and Efficiency" by Bruce Yandle and Elizabeth M. Young (Consultants), August 1987

IDP-11 "The Regulation of the Quality of Traded Commodities and Services" by Simon Rottenberg and Bruce Yandle(Consultants), June 1987

IDP-12 "Argentina: Problems for Achieving Macro Stability" by F. Desmond McCarthy and Alfredo E. Thome, Januaryi988

IDP-13 "Argentina: Towards the Year 2000" by F. Desmond McCarthy, June 1987

IDP-14 "Trade Liberalization: The Lessons of Experience", Papers presented in the conference "Toward a New TradePolicy for Brazil', Sao Paulo, April 11 and 12, 1988

IDP-16 "Aspects of Privatization: The Case of Argentina 1978-81" by R. Luders (consultant), April 1988

IDP-17 "Aspects of Privatization: The Case of Chile 1974-85", by D. Hachette (consultant), April 1988

IDP-18 "Privatization in Argentina and Chile: Lessons from a Comparison" D. Hachette and R. Luders (consultants),April 1988

IDP-19 "Principles of Water Supply Pricing in Developing Countries" by Mohan Munasinghe, June 1988

IDP-20 "The Status of Energy Economics: Theory and Application" by Mohan Munasinghe, June 1988

IDP-21 "What are the Prospects for Land Reform?" by Hans Binswanger and Miranda Elgin (consultant), August 1988

IDP-24 "Managing Argentina's Extemal Debt: The Contribution of Debt Swaps", Carlos Alfredo Rodriguez (consultant),January 1989

IDP-29 "Managing Mexico's External Debt: The Contribution of Debt Reduction Schemes", Allen Sangin6s(consultant), January 1989

IDP-30 "Debt Reduction Schemes and the Management of Chilean Debt", Felipe Larrafn (consultant), March 1989

IDP-31 "Managing Brazil's External Debt: The Contribution of Debt Reduction Schemes", Dionislo D. Carneiro andRogerio LF. Wemeck (consultants), January 1989

IDP-32 "Leading Economic Indicators for Brazil: At Attempt at Forecasting Turning Points", Antonio Estache, February1989

IDP-33 "Recovering Growth with Equity, World Bank Poverty Alleviation Activities in Latin America", GeorgePsacharopoulos, April 1989

IDP-34 "Brazil - External Debt Development and Prospects", Silvina Vatnick, December 1988

IDP-40 "Cash Debt Buy Backs and the Insurance Value of Reserves", Sweder van Wijnbergen, June 1989

IDP-41 "Growth, External Debt and the Real Exchange Rate in Mexico, Sweder van Wijnbergen, May 1989

IDP-43 "The Macroeconomics of Social Security in Brazil: Fiscal and Financial Issues", Douglas Puffert (Consultant)and Emmanual Y. Jimenez, June 1989

IDP-49 "Feeding Latin America's Children", Human Resources Division, Technical Department, October 1989

IDP-50 "Marginal Effective Tax Rates on Capital Income in Argentina", 1uca Barbone and Michael McKee (Consultant),August 1989

IDP-53 "A Bibliography on Poverty and Income Distribution In Latin America", Human Resources Division, TechnicalDepartment, November 1989

IDP-54 "Ecuador Development Issues and Options for the Amazon Region", Country Department IV, December, 1989

FISCAL DEFICITS, INFLATION AND INTEREST RATES

Table of Contents

Page No.

1. Intgoduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. Fiscal Deficits and Credit to the Private Sector . . . . . . . . . 2

II.1 The Model . . . . . . . . . . . . .............. 211.2 Credit and Economic Activity . . . . . . . . . . . . . . . . 311.3 Demand for Honey . . . . . . . . . . . . . . . ... . . . . . 611.4 Demand for Bonds . . . . . . . . . . . . . . . . . . . . . . 811.5 Public Sector Borrowing . #.. .. . . . . . . . .. ... . . 811.6 Simulations for 1988 . . . . . . . . . . . . . . . . . . . . 18

III. Fiscal Deficits and*Inflation. . . . . . .. .. .. . .. . * . . 23

1II.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 23111.2 Financeable Deficit . . . ..... .... . . . . . . . 24111.3 The Inflation Adjusted Deficit . . . . . . . . . . . . . . . 25111 4 Some Additional Issues . . . . . . . . . . . . . . . . . . . 30111.5 Estimatiov of the Financeable Deficit . . . . . . . . . . . 32111.6 The Into ^.Debt Ratio . . . . . . . . . . . . . . . . . . 34111.7 Finance -. Deficits and Consistency of Macro targets . . . 37111.8 Debt, Investment and the Internal/External Transfer . . . . 40

IV. Fiscal Deficits, Interest Rates and Inflation . . . . . . . . . . . 42

IV.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 42IV.2 The Demand for Money . . . . . . . . . . . . . . . . . . . . 43IV.3 The Inflation Equation . . . . . . . . . . . . . . . . . . . 44IV.4 Impact on Inflation . . . . . . . . . . . . . . . . . . . . . 45IV.5 Impact on Interest Rates .. . . . . . . . .0. . . . .. . . 45IV.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

V. Summiny Up . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

V.1 Overview.. .. .. . .. . ... .. . .. .. ... .. . .. 50V.2 Sectoral Disaggregation . . . . . . . . . . . . . . . . . . . . 52V.3 Deficits and the Central Bank . . . . . . . . . . . . . . . . . 54

t

List of Tables

Table No. Page No.

1 Credit to Private and Publ;c Sectors (1980-1987) . . . . . 5

2 Demand for Money Equations . . . . . . . . . . . . . . . . 9

3 Long Run Income and Interest Elasticities . . . . . . . . 10

4 Demand for Bonds Equation . . . . . . . . . . . . . . . . i1

5 Public Sector Domestic Debt . . . . . . . . . . . . . . . 16'

6 Public Sector Domestic Debt Stocks, December 1987 . . . . 17

7 Assumptions Underlying the Three Main Scenarios . . . . . 18

8 Projected Reil Growth Rates of Main Financial Assets, 1988 20

9 Public Sector, Domestic Debt (Net) . . . . . . . . . . . . 21

10 Projected Growth of Domestic Credit . . . . . . . . . . . 22

11 Evolution of Public Sector Indebtedness: AlternativeConcepts, 1980-87 . . . . . . . . . . . . . . . . . . . . 36

12 Consistency Checks Between Inflation Targets and MaximumFinanceable Fiscal Deficit (1988) . . . . . . . . . . . . 38

13 Public Sector Operational Deficit (Z of GDP), 1980-87 . . 39

14 Monetary Financing - Inflation Impact . . . . . . . . . . 46

15 Bond Financing - Interest Rate Impact . . . . . . . . . . 48

FISCAL DEFICITS, INFLATION AND INTEREST RATES

Rui Coutinho

June 1989

1. Introduction

1. This paper describes the methodology used in a recent World Bankreport on Brazil to evaluate the consistency of macroeconomic objectives andto obtain short term projections for Brazil.1 Two models were used. Thefirst is a short-term model that links the balance of payments flows, with thefinancing of the fiscal deficit, the demand for money and credit from thebanking system. This framework, which will be discussed in Section II, issimilar to the financial programming analysis, and evaluates the consistencybetween expected savings and investment targets. Particular attention isgiven to the consistency between public sector borrowing, derived from theexpected deficit, and the available financing, including domestic credit. Themain question posed is: given the available external credit and domesticsavings, does the financing of the public sector 44.1icit imply an absorptionof domestic savings that will crowd out domestic private investment?

2. To answer this question it is necessary to estimate the not (afterdeficit is financed) private, domestic and external savings and evaluate iftheir magnitude is consistent with the investment flows necessary to supportthe domestic growth target. The incluion of a banking system allows for theanalysis of the investment/savings links from the point of the borrowing andlending activities. Because the agents that generate savings are notnecessarily the same that undertake investments, financial intermediariesfacilitate the exchange of resources between savers and investors, providingthe former with a menu of assets that satisfy their portfolio preferences andthe latter with desired credit resources. The estimated trend of creditavailable to the private sector is a good indicator of potential crowding outpressures.

3. A second model is presented in Section III. It consists of afinanceable deficit framework that yields the fiscal deficit consistent in themedium term with a given inflation and growth targets, and a preferred debtstrategy. In essence, the exercise implies a projection of the seignoragerevenues and domestic finance (excluding money creation) that can be obtainedwithout exceeding the inflation target or crowding out the private sector.

IThis paper is a revised version of Annex VII of the World Bank report,'Brazil-An Assessment of the Current Macroeconomic Situation, Report No.7540-BR, December 1988. The methodology described in this paper is based on theframework used in the Macro Assessment Report of December 1987, modified toincorporate suggestions made during a workshop held in the World Bank inFebruary 1988.

*2*

The projected and financeable deficit are then comparedi if the projecteddeficit is larger than the financeable limits, monetary expansion and/or bondfinancing will exceed the financeable amounts, raising inflation and interestrates. The latter could lead to crowding out of the private sector. InSection IV, the framework is used to evaluate the effects that the financingof a deficit larger than the financeable limits may have on inflation andinterest rates. A summary is presented in Section V.

II. Fiscal Deficits and Credit to the Private Sector

11.1 The Model

4. The approach used to link the financing of the fiscal deficits andcredit to the private sector integrates monetary, credit and balance ofpayments flows. The starting point is the consolidated balance of the bankingsystem, an accounting identity that shows that the change in the money stock(the liabilities of the banking system) is equal to the sum of the changes innet domestic and foreign assets of the banking system. In a compact form thisrelationship can be presented ass

* * *p + e** +MUp+ Lg + e(R -Lx ) Z (1)

5. The left hand side of equation (1) measures the changes in domesticliabilities of the banking system, M, that include currency, demand, time andsavings deposits. In the following notation a dot (*) over a variableindicates a change in the value of the variable. The right hand sidedescribes the change in total assets of the banking system. These include (a)credit to the private sector ; (b) not credit to the public sector, L ,defined as credit to the publi sector minus deposits held in the bankigsystem; (c) net external assets defined as reserves, R*, minus externalborrowing, L, (e is the exchange rate); and (d) net other assets, 2.2

6. The projected change in domestic credit is derived from the balancesheet identity after obtaining projections for the balance of payments flowsand the demand for money. The change in net foreign assets was projected onthe basis of the balance of payments flows. The procedures used to projectthe demand for money and public sector borrowing are discussed in detail

2 The effects of credit policies on the balance of payments can beanalyzed using Equation (1). Neglecting the residual component of t"e abovebalance sheet, 2, the balance of payments will improve (or deteriorate) if thechange in the money supply exceeds (or falls short of) the change in domestic-redit. In a nutshell, this is the reasoning underlying the monetary approachto the balance of payments.

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below. After calculating the share of government borrowing that is financedby the banking system, credit to the private sector is obtained as thedifierence between total credit availability and public sector borrowing fromthe banking system. A broad consistency check is to evaluate if the rate ofexpansion of credit to the private sector is consisterst with the level ofeconomic expansion.

11.2 Credit and Economic Activity

7. An obvious question is why the focus on credit? Credit policiesaffect the level of economic activity (as well as future growth) through thelink between credit, investment, and future production levels. Because whenmaking investment decisions firms take into account both the availability aadthe price of credit, a decline in the availability of medium-term funds willhave a negative effect on investment. The full impact on investment willdepend on whether external borrowing, and equity financing can replacedomestic credit as a source of funds. Changes in the availability of creditto finance working capital will have an effect on the level of economicactivity. During the production process firms need resources ti finance thepurchase of inputs and to maintain an adequate level of inventories (in theform of raw materials and semi-finished goods). Constraints on credit tofinance working capital may result in bottlenecks in the production processthat will limit the firms' ability to respond to short term changes in demand.Constraints on short term credit, may disrupt the production schedule.

8. Credit rationing can have a powerful influence on aggregate demandand supply. Through its effects on investment, credit rationing will reducecapital accumulation and, consequently, the long run potential output. Also,limited availability of short-term funds for working capital and/orconsumption credit, will reduce output and employment. In the case of creditrationing it is the supply rather than demand for credit that is beingobserved. Because the latter is not specified in this framework, it isdifficult to estimate the amount of credit (e.g., consumption, working capitaland investment credit) needed to support a give growth path. In thisanalysis, a rate of expansion of real credit equal to the real GDP growth ratewill be taken as a reference point for the required credit growth path.

9. Credit market segmentation has been an important feature of theBrazilian financial system. Such segmentation resulted from governmentpolicies that favored specific economic activities or regions of the country.Policies such as minimum portfolio requirements, direct credit policies, andcredit at negative real interest rates have raised interest rates in therelatively free segments of the credit markets and distorted resourceallocation. By establishing interest ceilings and by setting (particularly in1983) monetary correction below the inflation rate, the authorities inducedlarge internal income transfers. Because the federal government has bornesome of the costs of these policies, the final effects were higher fiscaldeficits and inflation. In Brazil, the federal government controls the flowof a large share private sector credit. The government's role in channeling

resources to specific economic sectors or regions of the country increasedduring the 1980's. It is estimated that the share of outstanding financialsystem liabilities that was directly or indirectly controlled by thegovernment increased from about 50-602 in 1980 to about 802 in 1987.

10. Credit market segmentation resulted in a wide range of lendingrates. Large differences across lending rates is equivalent to imposing a taxon those sectors that have no access to government directed credit andgranting a subsidy to sectors that receive such funds. Moreover, as theiradministration has not been always transparent and the rationale for theirexistence not always clear, directed credit programs have reduced resourceallocation efficiency. As a result of their constantly changing complexregulations, credit programs increase financial institutions operational costsand lead to higher spreads between lending and borrowing rates in therelatively free segments of the credit markets.

11. During the 1980-87 period two main features characterized thebehavior of Brazil's credit aggregates: (1) the decline in the stock ofcredit's value measured at constant prices, and (2) the strong increase in thepublic sector's share of credit at the expense of the private sector (Table1). Between 1980-87 the banking system's stock of credit (excluding CentralBank) declined 10 in real terms (end of period values). Even more remarkableis the 261 decline in the ratio of total credit to GDP during the same period.

12. The decline in real terms of the stock of loans was accompanied by aremarkable composition shift in favor of public sector credit. Between 1980and 1987 the public sector's share of total credit increased from 13.6% to30.12 (Table 1). Either measured at constant prices or 4s a ratio of GDP, thestock of public sector credit increased substantially during the 1980s.Between 1980-87, credit to the private sector declined in real terms by 27.4%and by 402 compared to GDP (fourth quarter values). These results suggestthat in the 1980s significant crowding out of the private sector has takenplace.

13. In sum, price as well as the quantity of credit are important todetermine the effects of credit policies. The interest rate represents therelative price (on an intertemporal sense) between consumption and saving andallocates resources among borrowers. The importance of bank credit as asource of financing depends on the ability of firms to finance production orinvestment with retained profits or external borrowing. Even if firms have asignificant amount of retained profits, high interest rates (caused, forexample, by public borrowing or an uncertain economic and politicalenvironment) may render investment opportunities unattractive compared tofinancial market instruments. The availability of private sector credit alsodepends on public sector financing needs that can preempt resources to theprivate sector (financial crowding). In the long run, for the private sectorto absorb a larger share of government debt, the interest rate would have toincrease. If the private sector views government debt and capital assubstitutes, the required rate of return on capital will increase therebyhaving a negative effect on investment. So, credit availability at areasonable price is an important ingredient in a medium-term growth strategy.

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Table 1t BRAZIL - CREDIT TO PRIVATE AND PUBLIC SECTORS (1980-1987)

(quarterly values)

Index of Real Credit/a Share of Total Credit to GDP Index/k(1980-100) Credit (M) (1980=100)

Private Public Total Private Public Private Public Total

1980.4 90.0 92.8 90.3 86.6 13.4 90.4 93.3 90.71981.4 88.5 143.8 95.6 80.2 19.8 95.9 155.8 103.61982.4 86.7 178.2 98.5 76.5 23.5 91.1 187.0 103.51983.4 63.8 162.1 76.6 73.2 26.8 72.2 176.8 85.71984.4 63.1 159.4 75.6 72.6 27.4 61.1 154.7 73.11985.4 66.9 187.3 82.5 70.5 29.5 59.4 166.4 73.3

1986.1 60.8 178.1 76.0 69.5 30.5 55.9 163.5 69.81986.2 71.4 186.9 86.3 71.8 28.2 60.4 158.1 73.01986.3 79.1 186.8 93.0 73.9 26.1 64.4 152.2 75.81986.4 88.7 181.4 100.6 76.6 23.4 73.2 149.8 83.1

1987.1 76.9 190.3 91.6 73.0 27.0 65.9 163.2 78.51987.2 61.6 189.0 78.1 68.5 31.5 49.0 150.2 62.11987.3 69.6 197.0 86.4 70.3 29.7 56.9 160.2 70.21987.4 65.3 187.9 81.2 69.9 30.1 54.1 155.8 67.3

/a End of period stock of loans by the banking system (excluding CentralBank) deflated by IGP-DI.

/b Credit at constant prices divided by quarterly GDP.

Sources Central Bank (credit data), IBGE (quarterly GDP).

11.3 Demand for Money

14. The demand for money plays a critical role in this framework. Toforecast the trends in domestic credit it is important that the differentitems of equation (1) can be accurately forecasted. Specifically, it isimportant that the demand for money can be accurately forecasted on the basisof small set of variables such as income, interest rates and inflation. As aresult of changes in the opportunity cost of money, financial marketsinnovation aad other factors, there has been a shift in the demand for moneythat diminished the reliability of the forecasts.3

15. From the standpoint of the consolidated banking system theappropriate monetary aggregate is M3 . The Brazilian definition of M3 includescurrency in the hands of the public, demand deposits and time and savingsdeposits.4 The long run demand for money is specified ass

A

me* a t, rt # t) (2)

wheres mt is the desired demand for real balances

yt is real GDP

rt is the interest rate, and

A

pt is the inflation rate.

3Available econometric evidence suggest that there has been a downwardshift in the demand for money (Hi) in the 1980's. For details see Rossi, J.W., OThe Demand for Money in Brazil Revisited,' IPEA Textos Para DiscussaoInterna No. 96, October 1986, and Coutinho, R., *The Demand for Money inBrazil 1966-86 - An Econometric Analysis.* mimeo World Bank, June 1987.

4The interdependence between credit policies and the demand for money isa factor that will not be taken into account in this analysis. For example,changes in the availability of credit to the private sector will have arelikely to have an effect on interest rates and the demand for money. In theabsence of a full macroeconomic model the feedback effects between creditpolicy, interest rates and the demand for money could be analyzed byconducting several iterations until convergence is attained.

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16. The short run demand for real balances is obtained combiningequation (1), with a partial adjustment mechenism specified in real terms ass

mt- mt*1 - d.(at * - t.,43

17. Equation (3) indicates that following a change in its desired demandfor real balances the private sector will not adjust immediately its holdingsto the new desired level. The coefficient d, whose value is expected to liebetween zero and one, represents the share of the difference between actualand desired real money balances by which money balances will be adjusted in agiven period. Combining equations (2) and (3), and defining all variables inlogarithmic terms we obtain the demand equation to be estimated ass

log m *ao+ al.log yt+ a2.log rt + a3.1og t + a4.1og at(4)

18. Because all variables enter in logarithmic form, the coefficients ofequation (4) represent the short-run elasticities of the demand for money.The coefficient of the lagged money variable, a4, is equal to one minus theadjustment coefficient (d). The demand for M3 was projected on the basis ofeconometrically estimated relationships for currency, sight deposits and timeand savings deposits. On the basis of the results of in-sample and out-sampleforescasts, the disaggregated procedure was preferred over a single equationfor M3. The use of sepa7ate regressions to forecast the components of M3increases the flexibility of the specification. For example, when the demandfor M3 is est!mated on the basis of a single equation the speed of adjustmentbetween actual and desired holdings is restricted to be the same for allassets that included in the aggregate. By allowing for different speeds ofadjustmenc a disaggregated procedure increases the flexibility of theprecedure to project M3.

19. It is likely that the different motives explain private sectorholdings of each of the assets included in M3. In the case of demand depositsand currency, the transactions motive is expected to dominate. For theseassets, income as a proxy for the volume of transactions appears to be a goodscale variable. However, in the case of interest bearing assets, such s timeand savings deposits, the main determinant of demand is likely to be a storeof value rather than transactions motive. Because monetary correction largelyinsulated the real value of these deposits from inflation, they graduallybecame a main financial asset for savers. The incentive to shift to theseinterest bearing deposits increased with the reduction of their requiredminimum holding period. Consequently, in the case of time and savingsdeposits wealth rather than income would appear to be the more appropriatescale variable. Nevertheless, in the absence of data on total wealth, incomewill be used as the scale variable in the econometric estimation of the demandequations.

20. Equation (4) was estimated for three assetst currency, sightdeposits and time and savings deposits. By combining time and savingsdeposits in a single aggregate it is implicitly assumed that these assets areperfect substitutes. The resulti of the OLS estimation are shown in Table 2.The estimated equations have a good fit, the coefficients of all variableshave the expected signs and, with the exception of the income coefficient inthe time and savings equation, they are statistically significant. Thisresult suggests that income may not be the appropriate scale variable toexplain the demand for interest bearing assets. Seasonal duumy variables weretested, but only the fourth quarter variable turned out to be statisticallysignificant and thus included in the final set of equations.

21. The incomplete adjustment hypothesis is strongly supported. Thecoefficients of the lagged dependent variable are statistically significantbut their values appear too large. Because these regressions were estimatedwith quarterly data, p vriori a much faster adjustment speed should beexpected. The large values of the coefficients of the lagged dependentvariable may be the result of errors in the measurement of variables.5 Thedemand for currency is more responsive to changes in inflation than the demandfor sight deposits while the opposite is true for interest rates. Theavailability in Brazil of interest bearing assets with high liquidity andthat are close substitutes to demand deposits explains the larger interestelasticity of the sight deposits equation. The long run income and interestelasticities are presented in Table 3. The estimated income elasticity forcurrency is 1.3 and for demand deposits is 0.8. The estimated incomeelasticity for savings and time deposits, 0.2, appears to be on the low side.

11.4 Demand for Bonds

22. The demand for bonds was also estimated using the specification ofequation (2) and a partial adjustment mechanism. The values of the OLSestimated coefficients are presented in Table 4. All the coefficients havethe expected signs and are statistically significant. The implied long runincome and interest rate elasticities are 1.9 and 0.232, respectively. Thelong run income elasticity appears to be on the high side. The estimated bondequation will be used to project the increase in private sector holdings ofpublic debt in several scenarios to be discussed below.

11.5 Public Sector Borrowing

23. In Brazil, e-post the fiscal deficit is measured *below the line'by the public sector borrowing requirements (PSBR). Two main concepts are

5See Goodfriend, M., *Reinterpreting Money Demand Regressions. CarnegieRochester Conference Series on Public Policy, 1985.

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Table 2: BRAZIL - DEDAND FOR MONEY EQUATIONS

Demand Time & SavingsCurrency Deposits Deposits

Variable Coefficients

Constant 0.736 2.429 0.646(2.04) (3.93) (3.45)

Lagged Endogenous 0.717 0.618 0.914Variable (24.44) (16.39) (21.72)

Interest Rate -0.060 -0.140 0.057(3.36) (6.07) (3.71)

Inflation -0.105 -0.085 -0.056(6.23) (3.73) (4.32)

Tncome 0.365 0.311 0.017(5.64) (3.07) (0.22)

Seasonal Dummy 0.130 0.070 ---Variable la (7.75) (4.11)

R2 0.978 0.983 0.988

D.W. 2.01 1.89 2.26

h 0.035 0.394 .964

Rho 0.058 0.350 ---(0.37) (1.95)

Sample period: 1976.1 - 1988.2

la Fourth quarter seasonal dummy variable.

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Table 3s BRAZIL - LONG RUN INCOME AND INTEREST ELASTICITIES

Demand Time and SavingsCurrency Deposits Deposits

Income 1.29 0.81 0.20

InterestRate -0.21 -0.37 0.66

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Table 4: BRAZIL - DEMAND FOR BONDS EQUATION

Variable Coefficients

Constant -0.304(0.39)

Lagged Endogenous 0.768Variable (6.53)

Interest Rate 0.069(2.27)

Inflation -0.052(1.96)

Income 0.443(2.66)

R2 0.965

D.W. 1.97

h 0.196

Rho 0.674(3.97)

Sample period: 1976.1 - 1988.2

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used, the operational and the nominal deficit. The difference between the.operational and the nominal deficit is that the latter includes the accruedmonetary correction on the stock of debt.

24. Nominal and Operational Deficits. For economic policy purposes thefiscal deficit, particularly when supplemented by additional economicanalysis, may be used (i) to provide a crude indicator of the impact offiscalpolicy, (ii) to compare fiscal performance over time and (iii) toassess the extent, if any, of the required fiscal adjustment. Duringinflationary periods the deficit as a share of GDP becomes a biased indicatorof the fiscal stance.6 Although inflation influences in different ways theindividual budget items, nowhere is its impact more visible than in theinterest payments category. If public debt has been issued at variableinterest rates, a rise in inflation would increase nominal interest rates,int:,rest payments and the deficit as a ratio of GDP. The impact on thedeficit of a rise in inflation will be larger the higher is the debt to GDPratio and the higher the share of variable interest rate debt.

25. In a conventionally measured deficit, interest payments are includedas an expenditure item but amortization payments are excluded from governmentoutlays. A rise in inflation increases interest payments, and at the sametime reduces the real value of the outstanding stock of debt, representing afaster amortization schedule. Whether the higher interest payments should beviewed as additional income or as a compensation for the decline in real valueof wealth depends on bond holders's degree of money illusion.

26. The concept of operational or inflation adjusted deficit takes into.account the impact of inflation. In this concept, which underlies thefinanceable deficit analysis, interest payments are evaluated at real ratherthan at nominal interest rates. The inflation adjusted deficit, assumes thateconomic agents do not suffer from money illusion and that their behavior isdetermined by real rather than nominal variables. Economic agents respond toan inflation induced decline in their real wealth by fully restoring the value

6This point has been argued vigorously by R. Eisner. For details see thefollowing: Eisner., R., "How Real is the Federal Deficit, The Free Press,New York, 1986; Eisner, R., and Pieper, P., 'A new view of the Federal Debtand Budget,' American Economic Review, March 1984; Eisner, R., and Pieper, P.,'Measurement and Effects of Government Debt and Deficits,' mimeo, September1986; and Eisner, R., and Pieper, P., ODeficits. Monetary Policy and RealEcouomic Activity,* mimeo, June 1986. Another study of the impact ofinflation on the deficit is Cukierman, A., and Mortensen, J., 'Monetary Assetsand Inflation Induced Distortion of the National Accounts; Conceptual issuesand correction of sectoral income flows in 5 EEC countries,* Economic Papers,No 15, June 1983, Commission of the European Communities Directorate Generalfor Economic and Financial Affairs. See also Jump, G., *Interest Rates,Inflation Expectations and Spurious Elements in Measured Real Income andSaving,' American Economic Review, December 1980; Siegel J., "InflationInduced Distortions in Government And Private Savings Statistics,' The Reviewof Economics and Statistics, February 1979.

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of their portfolio of assets. If the change in the nominal interest ratefully captures the higher inflation rates, the increase in the debt holdersnominal income (the result of higher interest payments) will offset thedecline in the real value of their holdings of government debt.7

27. There will be no change in private sector claims on the publicsector if the additional income is used to purchase additional debt, such thatthe share of public debt in private wealth remains constant. Because realincome (properly defined), real interest rates and real wealth will remainconstant and given that these variables are the main determinants of privatespending, investment and consumption will not be affected.8 Governmentborrowing to finance the inflation component of interest payments does notincrease public sector absorption of private savings and it is consistent witha constant degree of financial crowding out pressure. In sum, when bondholders are free from money illusion the inflation adjusted or operationaldeficit is a more relevant indicator of the fiscal stance and its effects oneconomic activity.

28. Although the discussion so far has been focused on deficits measured*above the line*, these arguments are also relevant to such cases as that ofBrazil's in which, ex-post, the deficit is measured by the increase in publicdebt, and the government interest bearing liabilities are inflation indexed.In this case, the inflation induced increase in debt, i.e., the monetarycorrection, should be subtracted from the total change in public debt toobtain an estimate of the inflation-adjusted deficit.

29. When bond holders experience money illusion, the inflation adjustedconcept does not appropriately measure the impact of the fiscal deficit.Because bond holders consider monetary correction as income, they willincrease their consumption following an inflation induced increase in monetarycorrection. However, because monsty illusion is unlikely to persist in

7The relevant rate for portfolio decisions is the ex-ante real interestrate. However, given the problems associated its estimation, for empiricalpurposes the adjustment of the debt stocks is done with ex-post inflationrates.

8The concept of disposable income, from which the perceived losses on thereal value of private sector net claims on the government are deducted, turnsout to be equal to the rate at which the society can expect to continue toconsume while maintaining real wealth intact. This is similar to the Haig-Simon concept of income or Friedman's permanent income. The inflationadjusted deficit links changes in real wealth and savings and it is needed toestablish a wealth accounting in roal terms. Because changes in real wealthaffect current and future demand, from the point of view of aggregate demandthe more relevant deficit concept is the one that measures the increase inthe real net debt of the public sector. This is consistent with the lifecycle theory of consumption. For details see Modigliani, F., *Life Cycle,Individual Thrift and the Wealth of Nations,8 American Economic Review, June1986.

- 14 *

economies such as Brazil's that experience sustained high inflation rates thenominal concept would overestimate the impact of the deficit. In actualsituations it is more likely that the behavior of the atypical" bond holderwould lie somewhere in between the two extremes, although closer to the *nomoney illusion' case. In this intermediate case the inflation adjustedconcept would underestimate the impact of the deficit.9

30. Credit to Public Sector. The starting point of these projections isthe ex-ante operational deficit obtained consolidating the budgets ofcomponents of the public sector. In Brazil these aret the CentralAdministration, State and Local Governments, public enterprises, SocialSecurity and Decentralized Agencies. From the point of view of the Equation(1) the relevant variable is the change in nominal stocks or in other words,the nominal borrowing of the public sector. In brief, the procedure used toproject public sector nominal borrowing is the followings first, theoperational deficit (DEFO) is estimated on a monthly basis for each of thecomponents of the public sector; secondly, the nominal deficit (DEFN) iscalculated as the increase in the public sector's stock of net debt andconsists of two parts, the monetary correction and the operational flow. Thenominal deficit is:

DEFNt - Dt - Dtl (5)

where Dt is the stock of public debt in period t and it is equal tot

Dt - Dt_l .mct + DEFOt (6)

where: mct is the monetary correction for period t and DEFOt is theoperational deficit in period t. Monetary correction is calculated on thegross stock of debt that is subject to monetary correction rather than on thenet stock.

91n general, an inflation caused increase in interest payments may havereal effects if inflation is a new phenomenon, was not fully anticipated, orsome segments of the private sector are liquidity constrained. Moreover, ifas a result of the acceleration of inflation and the continued accumulation ofpublic debt the government is forced to pay a risk premium in its new debtissues, the real interest rate will increase. Through its effects on interestsensitive expenditures the issue of additional debt necessary to finance theinflation component of the interest payments will have an impact on theprivate sector. In this case the inflation adjusted deficit wouldunderestimate the effects of the financing of the deficit on financialmarkets. For a further discussion of inflation and its impact on the deficitsee Blejer, Mario "The Measurement of the Budget Deficit and the MonetaryImplications of Fiscal Policies,* mimeo, June 1987, and Tanzi, V., Blejer, M.,and Teijeiro, M., *Inflation and the Measurement of Fiscal Deficits,9 IMPStaff Papers, December 1987.

- 15 -

31. The nominal deficit is estimated on a monthly basis to account forthe effect of monetary correction on the stock of debt. For a givenoperational deficit, the nominal deficit depends on (a) the monthlydistribution of the operational deficit (the nominal deficit will be largerthe more concentrated is the operational deficit in the early part of theyear) and (b) the rate of inflation (higher rates of inflation will raise thenominal deficit for a given value of the operational deficit). The overalloperational deficit is the sum of the inflation adjusted deficits for all thecomponents of the public sector.

DEFOt = E DEFOi t(7)

where DEFOi is the operational deficit of the ith component of thepublic sector, for example public enterprises.

32. Tutal domestic public debt, Dt, consists of debt held by thenonfinancial private sector, Dp, and debt held by the banking system Db.

Dp + Db D (8)

33. The bulk of the public debt held by the private sector consists ofgovernment bonds while the debt to the banking system includes loans as wellas bonds (Tables 5 and 6). On the basis of the assumptions of the scenariosdescribed below and the bond equation, end of period bond holdings andconsequently the real growth rate of bond debt can be obtained. It is assumedthat private sector holdings of government debt would increase at the aboverate. Therefore, banking system credit to the private sector is obtained asthe difference between credit availability and public sector borrowing fromthe banking system. The latter is equal to public sector domestic borrowingminus the nominal increase in private sector holdings of government debt.

34. .External Borrowing. The amount of external borrowing is obtainedfrom a set of balance of payments projections. These projections wereprepared using a modified version of the Bank's standard model (RMSM). Forsimplicity, it is assumed that all short medium and long term borrowing isundertaken by the Central Bank. Furthermore, it is assumed that the CentralBank also holds all the country's foreign assets.10

10For a description of the World Bank model and how it relates tofinancial programing see Kahn, M. S., P. Montiel, P., and Hague, N. V.,"Adjustment with Growths Relating the Analytical Approaches of the World Bankand the IMF,* World Bank Discussion Paper, October 1986.

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Table 5s BRAZIL - PUBLIC SECTOR DOMESTIC DEBT(DECEMBER 1987)

By Agent Cz$ billions

Central Government 4152.6

Federal Debt 6733.1Central Bank -426.4Commercial Banks -2152.3Non-monetary Financial Institutions -1.8

State and Municipal Governments 1172.1

State and Municipal Debt 398.9Commercial Banks 435.5Non-monetary Financial Institutions 337.7

Public Enterprises 2118.4

Federal Debt -153.8Commercial Banks 1687.0Non-monetary Financial Institutions 560.3Floating Debt of Public Enterprises 25.0

Decentralized Agencies 96.1

Commercial Banks 33.8Non-monetary Financial Institutions 62.3

Social Security -101.4

Federal Debt -96.1Commercial Banks -5.3

TOTAL 7437.8

Source: Central Bank of Brazil

- 17 -

Table 6t BRAZIL - PUBLIC SECTOR DOMESTIC DEBT STOCKS

DECEMBER 1987

(Cz$ billions)

By Source Cz$ billions 2

Net Credit from Financial System 6319 85.0

Central Bank 4127 55.5

Commercial Banks 966 12.7

Non-monetary Financial Institutions 1248 16.8

Non-financial Private SectorHoldings of Public Debt 1096 16.7

Federal Debt 713 9.6

State and Municipal Debt 381 5.1

Floating Debt of Public Enterprises 25 .3

TOTAL 1438 100.0

Source: Central Bank of Brazil

* 18 -

11.6 Simulations for 1988

35. The Scenarios. Given the uncertainty surrounding the short-termtrends of some key variables such as inflation, two main scenarios are usedfor 1988. These scenarios, hereafter designated as Cases B and C, defineanupper and lower bounds of a range of possible outcomes for inflation, GDPgrowth, and the fiscal deficit. Moreover, a baseline scenario is presented(Case A) containing the main assumptions of the June's 1988 Governmenteconomic program and it will be used mainly as a reference point. Table 7summarizes the main assumptions underlying the three scenarios. Scenario Bduplicates the assumptions of the Government Base Case scenario but allowingfor a higher rate of inflation in the second half of the year. The lastscenario, Case C, illustrates an outcome in which in the latter part of 1988inflation rises to about 251 per month. Furthermore, the fiscal deficitexceeds the government targets reaching 52 of GDP. These scenarios, define arange of possible outcomes within which actual economic performance shouldfall. The simulations presented in the second half of this paper, will bealso prepared in the context of the above scenarios.

Table 7: BRAZIL - ASSUMPTIONS UNDERLYING THE THREE MAIN SCENARIOS

Case A Case B Case C

Inflation(Annual Rate 2) 600.0 800.0 1000.0

Operational Deficit(2 of GDP) 4.0 4.0 5.0

GDP Growth (Z) 2.0 2.0 0.0

Real Interest Rates(Annual Rate) 12.0 12.0 15.0

36. The Projections. Equation (1) has four main componentes the changein the demand for money, the change in net foreign assets, the change indomestic credit, and the change in other assets, (2). In the consolidatedbalance sheet of the banking system, the latter Lategory includes anheterogeneous group of assets and liabilities such as official and privatecapital, net interbank float, not credit to the rest of the financial system,social security funds, deposits on foreign loans and valuations losses. Whenfor specific items, such as foreign currency deposits, official flowprojections were available these forecasts were used. For items for which noofficial forecast was available, the rate of inflation was used to project end

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of period stocks. In the past, this rule of thumb yielded, on an aggregatelevel, reasonable results.

37. As a result of high inflation and interest rates, economic agentsare expected to continue to hold low levels of non-interest bearing assets,Le, currency and sight deposits. Table 8 shows the projected growth rates ofthe monetary aggregates under the different inflation and growth scenarios.The overall outlook is for the continuation of a shift in the composition ofprivate sector's portfolio towards indexed assets, a shift that will bestronger in Case C where inflation and interest rates are the highest. Thedecline in the demand for currency and bank reserves, the latter the result oflower demand for sight deposits, is projected to result in a large decline inreal terms of the monetary base (a detailed discussion will be presentedbelow). In these simulations the broader financial aggregate, M4, whichincludes government bonds outside the Central Bank, is projected to remainconstant in real terms.

38. The projections for public domestic debt with a higher inflationrate and a higher operational deficit, scenarios B and C, were obtained byfirst, calculating GDP at current prices and second, estimating theoperational deficit as the assumed share of GDP. Then, the operationaldeficit was distributed monthly, taking into account, as far as possible, theseasonality pattern implicit in the original projections. Table 9 shows theprojected nominal deficit and the growth rates of domestic debt for thedifferent scenarios. The overall conclusion is that the borrowing needs ofthe public sector will continue to absorb a significant share of availablecredit. As the projections in Table 9 show, the nominal deficit andconsequently, the nominal borrowing, are largely determined by the rate ofinflation. Given its total borrowing requirements, banking system credit tothe public sector is expected to increase significantly in real termscontinuing the trend of 1980's (Table 10).

39. The decline in the real growth rate of credit to the public sectorwhen the operational deficit increases to 5.0% of GDP may appear counterintuitive. Two factors explain this decline. The first is that the higherinterest rate assumed in Case C, which is consistent with an increase in thedebt to GDP ratio, raises the demand for bonds and allows a larger share ofthe deficit to be financed outside the banking system. The second factor hasto do with the relationship between period average and end of periodinflation. Because the deficit is defined as a share of GDP, a flowcalculated at average prices, an acceleration in the rate of inflation duringthe second half of the year results in a lower real growth rate of the stockof debt, measured at end of year prices.

40. On the basis of these projections, credit to the private sector isexpected to decline significantly as a result of the combination of (a) largepublic sector borrowing needs; (b) a small decrease in the demand for money(real terms); and (c) negative net external borrowing, the result of theaccumulation of reserves and reduced external financing. The present trendsare clearly inconsistent with a recovery of private investment and renewedgrowth. A basic condition for a recovery of investment, a recovery which will

- 20 -

Table 8: BRAZIL - PROJECTED REAL GROWTH RATESOF HAIN FINANCIAL ASSETS, 1988

(Z)


Currency -35.9 -44.3 -52.2

Demand Deposits -32.8 -43.7 -54.0HI -33.5 -43.8 -53.6

Time and Savings Deposits 3.6 3.5 5.5M3 -5.5 -8.2 -9.1

Federal Securities 15.8 15.4 16.0M4 2.1 .5 0.0

Monetary Base -31.8 -38.2 -44.3

Assumptions

Inflation(annual rate) (M) 600.0 800.0 1000.0

Real Interest Rate(annual rate) (2) 12.0 12.0 15.0

GDP Gro"th (2) 2.0 2.0 0.0

Notes Deflator IGP/DI

- 21 -

Table 9: BRAZIL - PUBLIC SECTOR, DOMESTIC DEBT (NET)1988 PROJECTION


Operational Deficit(a of GDP) 4.0 4.0 5.0

Nominal Deficit 36.0 40.9 49.2(2 of GDP)

Growth Rate ofNet Domestic Debt (I)

Nominal growth 743.0 980.0 1220.0Real growth 20.4 20.0 20.0

Domestic Debt toGDP Ratio

End of Period 0.765 0.866 0.994Period Average 0.357 0.356 0.369

Assumptionst

GDP Growth (%) 2.0 2.0 0.0

Annual Real InterestRate (2) 12.0 12.0 15.0

Annual Inflation Rate(IGP/DI) 3 600.0 800.0 1000.0

- 22 -

Table 10: BRAZIL - PROJECTED GROWTH OF DOMESTIC CREDIT

(Consolidated BankinS System)


Real Growth Rates (2)

Credit to Private Sector -16.7 -22.9 -22.4

Credit to Public Sector (net) 9.2 8.9 8.3

Assumptions

Inflation (2) 600.0 800.0 1000.0

Operational Deficit(I of GDP) 4.0 4.0 5.0

GDP Growth (2) 2.0 2.0 0.0

Real Interest Rate(Annual rate 2) 12.0 12.0 15.0?

- 23 -

induce an increase in the demand for credit, is the improvement in theeconomic outlook. Such improvement can only be achieved with a strong fiscaladjustment and a reduction in inflation. Those constitute the prerequisitesfor an increase in the availability of credit to the private sector.

III. Fiscal Deficits and Inflation

111.1 Overview

41. As it is well known, inflation cannot persist without monetaryaccommodation. There are basically two views of the causes of high inflation,or alternatively, of the factors that explain the continuous expansion of themoney supply. One view relates high inflation to fiscal deficits and theother to balance of payments causes namely the exchange rate. In brief terms,the fiscal view argues that fiscal deficits are the cause for the continuousgrowth of the money supply. The balance of payments view argues that adversedevelopments in the external accounts create the need for a devaluation of thedomestic currency raising inflation and the fiscal deficit. A devaluationofthe domestic currency and higher inflation, would result in higher interestpayments on external debt and a decline in real tax revenues (Tansi effect)leading to higher fiscal deficits.

42. In indexed economies the feedback between changes in prices, thefiscal deficit and the rate of depreciation of the nominal exchange rateblursthe distinction between these two views. They are more relevant to theanalysis of the shocks that initiate periods of sustained high inflation. Buttheir main message is that in the event of an inflationary shock, such as aLiscal expansion or a devaluation of the domestic currency, in the absence ofa nominal anchor the shock is accommodated and its inflationary effects areincorporated in the price level. In the limit, the absence of a nominalanchor will make the rate of inflation to behave as a random walk.

43. It can be shown in the context of a Cagan type demand for moneyfunction (a semilog money demand function in which real balances are afunction of expected inflation), that two inflation equilibria exist when thedeficit is financed through monetary expansion. When inflation rises as aresult of the fiscal induced monetary expansion, seignorage initiallyincreases and then declines yielding a Laffer curve for the revenues frommoney creation. Assuming that the operational deficit is a constant share ofGDP, the dual equilibria implies that the economy may be trapped at a higherthan necessary inflation rate. The Government could finance the same deficitat a lower inflation rate.

44. Which of the two equilibria is stable is likely to depend on howexpectations are formed. It can be shown in the context of a simplified modelthat in the case of adaptive expectations or a lagged adjustment of moneybalances the high inflation equilibria will be unstable and the low equilibria

- 24 -

stable. The reverse occurs in the case of rational expectations.11 When thegovernment can finance the deficit by issuing bonds as well as money, theinflation outcome is likely to depend on the operational rule followed by theCentral Bank. When the monetary authority either sets a nominal growth ratefor the money supply or the nominal interest rate there is only oneequilibria. When the Central Bank sets the real interest rate two equilibriamay occur. The dual equilibria is the result of the failure to adopt anominal anchor for the economy. In an open economy, the dual equilibria willoccur if the authorities peg the real exchange rate. Ultimately, theinflation rate will depend on the size of the fiscal deficit, (as a share ofGDP), that determines the expansion of the money supply.

45. The above analysis neglects the effects of inflation on the primarydeficit. Empirically, these effects are likely to be important as high ratesof inflation diminish government's real tax revenues (Tanzi effect). Realrevenue losses resulting from collection lags may more than compensate for anyreal gains that may be obtained from a less than full adjustment of income taxtvackets. On the expenditure side inflation will also affect fiscal outlaysbut the extent of the effect is difficult to evaluate without an item by itemanalysis. Finally, high and variable inflation rates may induce private bondholders to set a risk premia on interest rates raising real rates and thefiscal deficit. In net terms the above factors should increase the fiscaldeficit.

111.2 Financeable Deficit

46. The financing of public deficits can be obtained from three sourcessexternal financing, monetary financing and by issuing domestic interestbearing debt. The authorities macroeconomic targets, e.g., GDP growth,inflation, to mention only a few, establish a set of restrictions on thefinancing that can be obtained from each of these sources. The financeabledeficit represents the upper limit of a fiscal stance that is consistent witha given domestic and external debt strategy and the inflation and growthtargets. When the expected deficit exceeds the above ceiling it is likelythat, at least in the medium term, the fiscal stance will be inconsistent withthe remaining targets. Thus, either one of the non-fiscal targets will have

11For details see Michael Bruno and Stanley Fisher uSeignorage, operatingrules and the high inflation trap* NBER Working Paper, No. 2413 October 1987.

* 25 -

to be adjusted or, alternatively, the fiscal deficit will have to be reducedto insure the overall consistency of the macro economic targets.12

47. The financeable deficit is determined from the financing side, i.e.,"below the line,' as the resources that can be obtained domestically andexternally consiatent with the inflation and growth targets as well as aparticular debt strategy. Such strategy can be represented by a desired valuefor the debt-to-GDP ratio. A convenient starting point is to assume thatgovernment borrowing will maintain the ratios of external and internal debt toGDP constant. Because no optimization criteria are associated with the choiceof a particular debt-output ratio, the assumption of constant debt-to-GDPratios represents only an initial working hypothesis. In the short run, anddepending on specific economic circumstances, policies that result in changesin the value of the above ratios may be desirable.

48. To complete the estimation of the financeable deficit it isnecessary to project the expansion of the monetary base that is consistentwith the inflation and growth objectives. The financeable deficit is thedeficit that can be financed through the sum of: i) the domestic and externalborrowing that will maintain the respective ratios of debt stocks to GDPconstant and ii) an expansion of the monetary base consistent with the desiredinflation rate and expected output growth. In the simulations, when theexpected external financing is below the level that would maintain the debtoutput ratio constant, the financeable deficit will be revised downward totake into account the constraint on external borrowing.

111.3 The Inflation Adjusted Deficit

49. The public sector deficit, Def, is the sum of the primary deficit,X, defined as the difference between non-interest expenditures and receipts,and net interest payments on domestic and external debt. The deficit can befinanced by issuing high powered money (base money), H, issuing domestic debtsuch as bonds, B, or borrowing abroad, eB*. In nominal terms the deficitidentity ist

12A discussion of the main relationships underlying the concept offinanceable deficit can be found in Buiter V., 'Measurement of the PublicSector Deficit and its Implications for Policy Evaluation and Design', IMFStaff Papers December 1983. See also Buiter, 'A Guide to Public Sector Debtand Deficits," Economic Policy, 1985. For an earlier application of thismethodology to Brazil, see Knight P., et. al., *Brazil A MacroeconomicEvaluation of the Cruzado Plan,' A World Bank Country Study, Washington, D.C.,1987. For an application to Turkey, see Anand, R., and Wijnbergen, S.,OInflation and the Financing of Government Expenditure in Turkeys AnIntroductory Analysis,9 unpublished, World Bank, October 1987. See alsoCoutinho, R., 'Public Deficit, Financeable Deficits and Stabilization,* mimeo,World Bank, February, 1988.

* 26 -

Def - X + LB + i*.e.B** * ** (10)W H + 1 + e.P

where3

i is the nominal interest rate on domestic debt;i is the nominal interest rate on external debtseB*.is the value of the stock of external debt converted into domestic

currency at an average exchange rate, e, defined as units of domesticcurrency per unit of foreign currency, for example the US dollar.'

50. Defining h, b, and b* as the ratios to nominal GDP, Y, of the itocksof money, domestic debt and external debt, respectivelyt

h - H/Y, b - BlY, b* eB*lY (11)

differtntiating (11) logarithmically and rearranging terms we obtains

* A A A

h - H.h - p.h - y.h (12)

* A A A

b = B.b - p.b - y.b (12b)

* A A A A

b* =B .b - p.b - y.b' + e.b* (12c)

A

where p and y represent the domestic inflation rate and real GDP,respectively. A dot, (0), over a variable represents a change in the variablewhile a caret, (^), represents the variable growth rate. Dividing the budgetidentity, equation (10), by nominal GDP and substituting (12a) to (12c) weobtain:

x + i.b + i*.b* =H/Y + 8/Y + e.B /Y

* A A A A

- h + ( p + y ).h + b + ( p + y ).b +

p + e ).b* (13)

51. Equations (10) and (13), represent the government budget constraintexpressed in nominal and real terms respectively. Their left hand side showthe deficit measured *above the line", the sum of the primary deficit and theinterest payments on domestic and external debt. Their right hand side, oftenreferred to as the deficit measured 'below the line,' represents the change ingovernment net external and domestic liabilities, the net governmentborrowing. The real exchange rate, q, is:

q = e.p *p (14)

* 27 -

or in terms of rates of growth:

A A A

q + p p (15)

A A

where p and p* are the domestic and the external price levels and p and p* arethe domestic and external rates of inflation, respectively. Real and nominalinterest rates are linked through the Fisher equations

A A

i = p + r and i* = p + r (16)

where r and r* are the domestic and external real interest rates,respectively. The inflation adjusted deficit is obtained substituting (15)and (16) into (13) and rearranging termst

a A A A

x + r.b + r* .b* h + ( y + p ).h + b + y.b

A A

+ b*.( y - q ) + b* (17)

52. Equation (17) represents the deficit evaluated at real interestrates, and it is equivalent to the nominal deficit with the interest paymentsadjusted by the inflation premium. The inflation adjusted budget constraintshows that the primary deficit plus the inflation adjusted interest paymentson domestic plus external debt are financed through changes in the real valueof domestic and external debt and changes in monetary base, all expressed asGDP ratios.

53. The choice of a debt strategy will be reflected in the desired valueof the debt output ratio. The initial working hypothesis was to maintainthe debt output ratios constant, b b* - 0. In this case the financeabledeficit, FDEF, becomes:

A A A A A

FDEP - h + ( y + p ).h + y.b + b*.( y - q ) (18)

54. In the medium term, as inflation and interest rated stabilize, themoney output ratio should remain con ant. Consequently, money velocity, theinverse of h, will be constant. However, in the short run, as the economicagents adjust the composition of their assets to a lower inflation (as in theearly phase of the Cruzado Plan), velocity will decline (1 > 0) raising the

- 28 -

revenue from money creation. But this will be a one time gain. In a steadystate the money base to GDP ratio is constant and the monetary base is growingat the same rate of nominal GDP. The ( 9 + 0).h term in equation (18)measures the revenue obtained from the expansion of the money supply. Thefirst component, Y.h, is the revenue obtained as consumers raise their moneyholdings as GDP increases. This term will be called the seignorage gain.13The other term, O.h, measures the revenue obtained as consumers attempt tomaintain real balances constant in the face of inflation. This term will bedesignated as the inflation tax.14

55. A higher rate of output growth raises the financeable deficit byincreasing the revenue from money creation - seignorage - and by allowing formore debt accumulation in the context of a constant debt ratio. A realdepreciation of the domestic currency raises the external debt output ratio.Following a real depreciation, a reduction in external borrowing will berequired to bring the debt ratio to its original value. As equation (18)shows, when the real depreciation is equal to the GDP growth rate no roomexists for external borrowing if the debt GDP ratio is to remain consistent.The primary deficit will have to be reduced to be consistent with the lower

13There is no uniformity in the literature regarding the meaning of theseignorage gain. The term seignorage has been used to described the totalrevenue from money creation as well as either of its two components. From anhistorical perspective seignorage refers to the feudal privilege of Kings orPrinces to coin money and to levy a tax in the process, often in addition to afee - brassage. Frequent recoinage created pressures for free coinage, and in1666 seignorage was abolished in England.

14This source of revenue can be considered a tax in the sense that tocompensate for the erosion of the value of their real balances due toinflation, consumers will have to reduce their consumption to add to theirnominal balances. Thus, like a tax, there is a flow of resources to thegovernment and a decline in private consumption, see M. Friedman, *Discussionof the inflationary gap, American Economic Review, June 1942. For adiscussion of alternative concepts of the inflation tax see A. Drazen, 9Ageneral measure of inflation tax revenues,' Economic Letters, 1985. Drazensuggests a broader measure of the revenues associated with money creation toinclude both the current flow as well as revenue obtained from assetspurchased with revenue from past money issue.

- 29 -

financeable deficit. If the external financing is expected to be lower5thanb .y, the financeable deficit should be revised downward, accordingly.

56. When there is a limit on how much debt the private sector is willingto absorb, whenever this upper bound is reached monetary expansion will becomethe main source of financing with the consequent inflationary implications.This deficit-inflation link, which characterizes the fiscal view of inflation,has been forcefully underlined by Sargent and Wallace.16 Their argument isthat when the fiscal stance is unsustainable, a shift from money to debtfinancing will have an ultimate inflationary impact. Once the limit of thereal per capita public debt is reached the financing of the deficit can only

15A more complete analysis of the long run consistency of fiscal policyrequires an inter-temporal framework. Taking into account the budgetsconstraints for both the government and household sector, the effects ofgovernment policies are more adequately discussed in the context of itseffects on lifetime budget constraints of future and current generations.This extension would require, among others, an estimation of the present valueof all future revenues and expenditures. This framework would permit theevaluation of the consistency of fiscal policy in an inter-temporal context.For example, the effects of fiscal policies that may result in large futuredeficits, may not be reflected in today's deficit. But their effects would bereflected in an inter-temporal budget constraint. If financial markets arewell developed and forward looking, the expected deficits would increase longterm interest rates, adversely affecting the present level of economicactivity. This is an example of negative fiscal multipliers. Given the levelof spending the relevant issue for fiscal policy is to chose the optimalcombination of taxes and borrowing to finance this level of spending. For ananalysis of these issues in an overlapping generations framework seeBlanchard, 0., *Deficits And Finite Horizons,$ Journal of Political Economy,1985. See also Buiter (1985) for a discussion of public exhaustive spendingand the solvency constraint. For a recent attempt to model the effects offiscal policy in an inter-temporal context see Auerbach A. and Kotlikoff,Dynamic Fiscal Policy,' Cambridge University Press, 1987.

16Sargent, T., and Wallace, N., 'Some Unpleasant Monetarist Arithmetic,'Federal Reserve Bank of Minneapolis Quarterly Review, 1982.

- 30 -

be accomplished through monetary expansion. The endogenity of the moneysupply establishes the link between deficit financing and inflation.

17

111.4 Some Additional Issues

57. The previous analysis did not distinguish between current andcapital expenditures or revenues. Although the dividing line between currentand capital outlays is not always clear, total spending can be divided intoconsumption and investment expenditures in a manner analogous to household andenterprise accounting. Capital expenditures should be separated from currentoutlays to estimate the evolution of Government owned capital and net worth.Moreover, the separation between capital and current outlays may provide someinsight into the costs of some government programs. Capital expenditures,however, should not be viewed as an indicator of the government contributionto growth or the amount that can be borrowed. Several current expendituresmay be essential to the proper functioning of the economy and their impact ongrowth should not be disregarded. Because the size and composition ofgovernment programs as well as the financing mix have Important macroeconomiceffects, the deficit issue should be viewed in the context of its macroeconomic implications.18

58. In the above analysis it was assumed that government debt was acomponent of net wealth. Deficit financing displaces other assets in privateportfolios and to the extent that horizons are finite, debt burdens can beshifted to future generations and substitution of debt for taxes have real

17The government obtains revenues from two sources, taxes and revenuesfrom printing money. Because lump-sum taxes are not usually available and themarginal social cost of raising revenues increase with the tax rate, thesmoothing of taxes over time should be the optimal fiscal policy. Inflationacting as a tax on holdings of money balances is one form of taxation. Inaddition of the well known deadweight losses there are other social costsassociated with inflation as described in Fisher S. and Modigliani F.,"Towards an Understanding of the Real Effects and Costs of Inflation," inFisher S., Indexing, Inflation and Economic Policy, 1986. Because ofdeadweight losses, optimally, the government would choose a combination of thetwo instruments that minimizes the present value of those losses. This choicelinks the government budget and the money supply process.

1 8 Crowding out of capital formation refers to private rather than totalinvestment. Direct crowding out can occur if private and public investmentare close substitutes. Alternatively, if the two types of expenditures arecomplementary an increase in public Investment will raise private investment.The impact of direct crowding out on growth will depend on the differencebetween the marginal productivity of private and public capital. The largerthe difference between the marginal productivity of private and public capitalthe larger will be the impact of direct crowding out on long term growth.

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effects. An alternative view expressed by Barro is that government deficitsdo not reduce private savings and private sector's demand for capital.19

Barro's contribution was to show that if individuals are driven by altruisticmotives or they care about the utility of their heirs they have effectivelyinfinite horizons. The inter-generational link would not make debt netwealth.20

59. The 'Ricardian doctrine' does not deny that government expenditureshave effects on the level of economic activity. It only states that theeffects will be the same whether these expenditures are financed by borrowingor taxes. Deficit financing does not crowd out capital formation. Severalconditions are required to ensure the validity of the Ricardian proposition.Among those are (i) consumers are rational and farsighted, (ii) capitalmarkets are perfect, (iii) the successive generations are connected bytransfers altruistically motivated and (iv) taxes are not distortionary anddon't lead to redistribution of income within generations.2 1 This Ricardianview has been subject to considerable debate. Because its conclusions depend

19Barro R., 'Are Government Bonds net Wealth?," Journal of PoliticalEconomy, 1974.

201n Barro's approach the burden of the government expenditures is fullymeasured by their size and does not depend on how they are financed. If anincrease in government expenditures is financed through taxation, consumptionwill decrease. Alternatively, if expenditures are financed by issuinginterest bearing debt, the private sector (knowing that taxes will be leviedin the future to pay for the interest in the new debt) will increase savingsand reduce consumption enough to purchase the new securities. The reductionin consumption is equivalent to the present value of future taxes discountedat the interest rate on government securities. In this case fiscal deficitsonly postpone taxes and the timing of the taxes is unimportant. Consumers areindifferent between paying the taxes now or, if the budget deficit is financedthrough borrowing, paying the taxes plus interest latter. If the additionalgovernment expenditures are financed by issuing money, the resulting increasein prices will reduce the real money balances to the level prior to themonetary expansion.

21As discussed in detail in Bernhelm, *Ricardian Equivalences AnEvaluation of Theory and Evidence' in NBER, Macro Economics Annual, 1987, theavailable empirical evidence does not appear to support the Ricardianproposition. For a discussion of Barro's view see Tobin J., *AssetAccumulation and Economic Activity,' and Tobin J. and W. Buiter, "Fiscal andMonetary Policies, Capital Formation and Economic Activity,* in Furstenberg,(Ed.), The Government and Capital Formation, 1979.

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on a very restrictive set of assumptionL. the empirical relevance of the'Ricardian view* appears quite limited.22

111.5 Estimation of the Financeable Deficit

60. To estimate the financeable deficit for 1988 it is necessary toproject the increases in base money, domestic and external debt that areconsistent with the inflation and growth targets. In the case of Brazil, giventhe recent shifts in the demand for money, and the uncertainties surroundingthe future trends of inflation and interest rates, any forecast of the demandfor a given monetary aggregate becomes an hazardous exercise.23

61. The demand for base money originates from two sourcess the nonbankprivate sector and the banking system. The monetary base, H, is the sum ofcurrency in the hands of the public, C, and banking reserves, RR, thatfinancial institutions hold in the form of deposit liabilities at the CentralBank. These reserves are calculated as a fraction, k, of the bank depositliabilities. Although banks usually hold small amounts of currency, 'vaultcash," in the following analysis currency will be defined as the amount heldby the non-bank public and vault cash will be counted as a part of reserves.None of the analytical conclusions would be altered if financialintermediaries cash holdings were included in currency. The monetary base is:

H = C + RR (19)

62. Banking system reserves consist mainly of required reserves, butbanks also may hold a variable amount of excess reserves. Alternatively,total reserves can be decomposed into borrowed and unborrowed reserves. For a

22A major draw back is the assumption of perfect capital markets. In theshort run, changes in the debt/tax financing mix may have important impact onconsumption if the marginal propensity to consume is sensitive to restrictionson borrowing prevailing in the economy. For details see Hubbard, R., andJudd, K., 'Finite Lifetimes, Borrowing Constraints and Short Run FiscalPolicy,' NBER Working Paper No 2150, February 1987. For a survey of theimpact of liquidity constraints see Hayashi, F., 'Tests for LiquidityConstraints: A Critical Survey,' NBER Working Paper No 1720, October 1985.

231n a sense, the values of the parameters (elasticities) of the demandfor money are a function of government policies. The demand function can beviewed as a reduced form relationship of a structural model. If theparameters determining agents decision rules are a function of expectations offuture government policies, for example a stabilization program, to evaluatethe consequences of the policies on the demand for money it would be necessaryto have information on how government actions affect expectations and howthese in turn impact on the decision rules. For details see Lucas R.,'Econometric Policy Evaluations A Critique," in Lucas, Studies in BusinessCycle Theory. MIT Press, 1981.

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given financial institution reserves are obtained on the basis of depositliabilities and their respective reserve requirements ratio(s).24 To simplifythe analysis it is assumed that only demand deposits, DD, are subject toreserve requirements. Reserves, RR, are then equal tot

RR - k.DD (20)

63. Equation (20) assumes that banks maintain reserves against depositson a contemporaneous basis. In many cases the Central Bank follows a two week*lagged" rather than a contemporaneous reserve accounting policy.25 Becausethe money demand functions were estimated using quarterly data, reserveaccounting procedures are less relevant to explain fluctuations in themonetary base than if monthly data had been used.26

64. The computation of a reserve ratio for Brazil poses significantproblems. The Brazilian financial sector, a highly developed and diversifiedsystem that combines private and publicly owned financial intermediaries, ischaracterized by widespread market segmentation and multiple reserverequirements that depend on the type of deposit and the financial institution.Reserve policies are not only directed to the control of the money supply butare also targeted to objectives that are not directly related to the conductof monetary policy resulting in diverse and frequently changed reserverequirements.

65. The average reserve ratio needed to project the monetary base wascalculated on the basis of the average bank reserves for the period January toJune 1988. The reserve ratio is defined as the ratio of bank reserves,including vault cash, to demand deposits. For the projection period a valueof k-0.38 was chosen.

24When given the market interest rate, commercial banks are required tohold more government bonds than the desired amount, there is in effect a taxthat can be viewed as another form of seignorage. The value of the tax can beestimated as the product of the difference between the bond and the marketinterest rates and half of the excess bond holdings.

25The existence of lagged reserve requirements may have important effectson short term monetary control, particularly when the reserve aggregate isused by the monetary authority as the main operating instrument. For adiscussion, see McCallum B., 0On the Consequences and Criticisms of MonetaryControl* Journal of Money Credit and Banking, November 1975.

26Although this is a very simplified representation of the bankingsystem, (private sector expectations and behavioral lags have not beenmodelled), this framework includes the essential link between money supply anddemand, describing how the money stock is determined simultaneously by theCentral Bank, banking system and private sector actions.

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111.6 The Internal Debt Ratio

66. To analyze the financeable deficit it is necessary to estimate theinitial value of the debt GDP ratio. This value will be taken as a referencepoint to determine the financeable increases in domestic debt. As mentionedpreviously, no optimization criteria is associated with the choice of aparticular debt ratio and consequently with the choice of the debt strategy.From the macroeconomic point of view the composition of the debt stock is animportant issue. Until 1986, federal public debt in Brazil was comprised oftwo types of securitiess Treasury bills (LTNs) and indexed government bonds(ORTNs). Over the 1986-87 period, two short term debt instruments werecreated, Central Bank Bills (LBCs - Letras do Banco Central) and TreasuryFinancing Bills (LFTs - Letras Financeiras do Tesouro). Created in May 1986,the LBCs are floating rate instruments, with up to one year maturity whoseyield reflects the average overnight rate and that were originally exemptedfrom income tax withholding. The LFTs, created in late 1987, are financialinstruments that are issued by the Treasury up to limit set in the budget andtheir features resemble those of the LBCs which th y replaced. After thecreation of the LFTs the Central Bank lost the power to issue public debt. Asof the end of 1987, OTNs represented about 31.52 of the stock of federal debtand LFTs accounted for 68.52.

67. A main feature of the Brazilian federal debt is that a large portionof the stock has been held by highly leveraged intermediaries that financetheir holdings on a short-term basis, mostly overnight, on the basis of 24-hour sale and repurchase or resale agreements. Because it is estimated thatabout 752 of the stock of federal debt is held on an overnight basis, anyincrease in short-term rates will have a strong Impact on the fiscal deficit.Given that the stock of debt is equivalent to about 10.3% of GDP (1987 data),a one percentage point increase in real interest rates will raise the cost ofthe debt held in the overnight market by 0.11 of GDP. Bowever, when intereston bank loans is included, the cost for the consolidated public sector of onepercentage point increase in real interest rates is about 0.152 of GDP.

68. Brazil's internal debt has grown rapidly over the last few years.The combination of low external financing and large fiscal deficits forced theauthorities to relying on domestic finances sources. Moreover, the transferof foreign debt obligations from the private to the public sector increasedthe debt service obligations of the latter and constrained the scope forfiscal adjustment. Between 1980 and 1987, the stock of public securities,excluding the portfolios of the Central Bank, Social Security and publicenterprises but including State and Municipal debt, increased in real terms ata 16.92 average annual rate. This rate would have higher except for thedecline in 1983 and 1986 of the stock of domestic debt. In 1983, as monetarycorrection was set below inflation the real stock of debt declined by about17.72 and in 1986, the remonetization process in the initial months of theCruzado Plan, led to a substitution of monetary debt for interest bearingdebt.

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69. Because it includes the financial assets and liabilities of theconsolidated public sector, from a macroeconomic point of view net public debtis a preferable measure of domestic indebtedness. In the case of Brazil, inaddition to bonds, net public domestic debt includes loans from the bankingsystem, net of deposits and other domestic assets of the public sector.Because the Central Bank is included in the public sector, its assets andliabilities towards the private sector are also incorporated. Between 1981and 1985, net domestic public debt increased in real terms at 15.32 per year.Although the 1983 and the 1986 policies slowed its growth, as a percentage ofGDP the net domestic debt of the public sector more than tripled tetween 1981and 1987 (Table 11).

70. The debt to GDP ratio at current prices depends on the inflationrate. In periods of high and variable inflation the debt to GDP ratio isusually biased, depending on whether the monthly inflation rate shows adownward or upward trend. Because the stock of debt is measured at year endprices and the GDP is measured at average period prices, an acceleration ininflation will increase the debt GDP ratio. To obtain a more accurateestimate of the value of those ratios the debt stocks were evaluated ataverage period prices. The IGP/DI was used as the deflator. Between 1981 and1987 the inflation adjusted ratio increased from 11.4% to 21.42, or from 8.5%to 19.3% if the monetary base is excluded.27 On the basis of the deflatedratios, for the financeable deficit analysis a value of .19 was chosen for thedomestic debt ratio.

71. Two observations with respect to the public sector net debt concept.The first refers to the missing items, capital and net worth, which have beenexcluded for lack of data. Although for empirical purposes net debt isrestricted to financial assets and liabilities, nevertheless operationsconcerning the missing items should be carefully treated. For example, a saleof Government assets does not change net debt and should not be considered asrevenue. The second point refers to concept of monetary base. The inflationtax falls on net non-interest bearing private sector claims. Using the Gurleyand Shaw terminology, the inflation tax falls only on goutsidel money.2 8

Thus, non-interest private sector assets and liabilities at the Central Bank

2 7The debt to GDP ratios were obtained as followes

[D(t)/Pe(t) . Pa(t)/Pgdp(t)] /GDP80(t)

Where D(t) is the stock of debt at time t; Pe(t) is the end ofperaod t price index; Pa(t) is the average price index for period t; Pgdp(t)is the implicit price deflator for period t; and GDP8O(t) is GDP in period tat 1980 prices. The IGP/DI was used to deflate the debt stocks.

28john, G., and Shaw, E., 'Money in a Theory of Finance,' 1960,Brookings Institution, Washington D.C.

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Table 11: BRAZIL - EVOLUTION OF PUBLIC SECTOR INDEBTEDNESStALTERNATIVE CONCEPTS, 1980-87

TREASURY SECURITIES Treasury NET PUBLIC SECTOROUTSTANDING securities DOMESTIC DEBT

outstandingexcl.

IC.B., socialIsec. & State I

excl. excl. I plus State excl.C.B. C.B., social I & Municipal Monetary

Total portfolio sec. & State I Debt I Total Base(1) (2) (3) (4) 1 (5) (6)

|-----------------2 growth rates* ***------------- --1 growth rates-I II II

1981 86.1 79.5 79.6 71.4 n.a. n.a.1982 27.8 10.8 9.3 I 12.0 27.9 37.31983 3.9 -37.9 -38.7 --34.6 13.1 27.01984 9.6 80.3 85.4 j 64.4 18.7 19.41985 33.1 44.3 42.4 | 38.8 16.8 17.91986 66.6 -15.8 -22.2 1 -18.2 2.7 -10.61987 -1.5 22.4 28.1 | 27.7 14.6 29.6

II|------------------Z of GDP ---------------------- of GDP---- I

I1980 6.7 4.8 4.6 5.8 n.a. n.a.1981 12.6 8.7 8.3 10.0 15.5 11.51982 16.1 9.7 9.1 11.2 19.8 15.81983 21.4 7.7 7.1 9.3 28.6 25.71984 23.1 13.7 13.0 15.2 33.5 30.31985 28.4 18.2 17.1 19.5 36.1 32.91986 28.9 9.4 8.1 9.7 22.7 18.01987 44.0 17.7 16.1 19.2 40.0 36.0

|------------------% of GDP-l---- I----I of GDP 1/-I IIII

1980 4.83 3.48 3.30 j 4.16 n.a. n.a.1981 9.28 6.45 6.12 j 7.36 11.4 8.491982 11.73 7.07 6.61 j 8.16 14.4 11.531983 12.54 4.52 4.17 | 5.49 16.8 15.071984 13.01 7.70 7.32 8.55 18.9 17.031985 15.98 10.26 9.62 10.9s 20.3 18.531986 24.64 7.99 0.92 8.29 19.3 15.341987 23.58 9.50 8.62 10.29 21.4 19.32

1/ End-of-period stocks converted at period average prices.

Notess

(1) - Total Treasury securities outstanding.(2) - Treasury securities outstanding excluding the Central Bank portfolio.(3) - (2) minus securities held by state enterprises and the social security system.(4) = 3 + State and municipal securities.(5) - Central Bank included in the public sector. Net domestic debt includes the

monetary base plus net credit from the banking system.

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should be deducted from the monetary base to obtain a true measure of'outside* money. Nevertheless, to make it comparable with available Braziliandata the conventional concept of monetary base will be used in this analysis.

III.7 Financeable Deficits and Consistency of Macro targets

72. On the basis of the results obtained in the previous section it ispossible to estimate the financeable deficit. The ultimate objective is toevaluate the consistency between the fiscal stance and the other macrotargets.29

73. Table 12 shows the maximum financeable deficit consistent withdifferent inflation targets. These results strongly suggest that anoperational deficit equivalent to 4Z of GDP exceeds the financeable limits,thereby requiring additional monetary or bond financing. The governmentprogram implicitly assumed that domestic borrowing would take the burden ofdeficit financing, thus accepting an increase in real iaterest rates. Theincrease in real terms of the net domestic credit to the public sectordiscussed before is consistent with such result.

291n the following discussion some important conditions necessary for asuccessful implementation of a stabilization program are not covered.Assuming that the *fundamental" variables have been adjusted, the success of astabilization program may require some degree of over-adjustment in the shortrun. The overshooting of the real variables may be necessary to create atemporary situation of excess supply, to break inflationary expectations andto reinforce the credibility of the authorities commitment to the success ofthe stabilization program. Moreover, high real interest rates may benecessary to control aggregate demand, preventing a speculative accumulationof inventories and temporarily increasing domestic supply, to reduce theburden on administrative controls and to avoid a possible spillover of excessdemand into imports. The adjustment in the fiscal deficit should create roomfor the increase in interest payments brought about by the tight monetarypolicy. For details see Blejer, M., and Liviantan, N., OFightingHyperinflation; Stabilization Strategies in Argentina and Israel 1985-1986,2IMF Staff Papers, September 1987. Lack of credibility of policy announcementsmay affect price setting behavior of forward looking firms perpetuatinginflation inertia. See Wijnbergen, S., 'Monopolistic competition credibilityand the output cost of disinflation programs An Analysis of Price Controls,'NBER Working Paper No. 2302, June 1987.

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Table 12t BRAZIL - CONSISTENCY CHECKS BETWEEN INFLATION TARGETSAND MAXIMUM FINANCEABLE FISCAL DEFICIT (1988)

MaximumInflation Targets Increases in Financeable Deficit

(Annual Rates Money Base as (Operational)Dec to Dec) Percentage of GDP (U of GDP)

Case A 600? 2.3 1.9/a

Case B 800% 2.3 1.1/b

Case C 1000% 2.1 0.5/c

Ua Net external financing of -.82 of GDP (trade surplus US$1? billion,and US$2.9 billion in debt conversions); GDP growth at 22.

/b Net external financing of -1.6% of GDP (trade surplus US$16 billionand US$2.9 billion in debt conversions); GDP growth at 2%.

/c Same as /b but GDP growth at 0%.

74. Two points need to be emphasized. First, given the output andinflation targets, the financeable deficit represents the maximum deficitconsistent with a desired demand for money, constant debt to output ratiosand, consequently, an unchanged degree of crowding out pressure. In the shortrun a lower deficit target would be desirable to increase the flexibility ofmonetary and fiscal policies, to reduce the debt ratios, to diminish thepressure on interest rates and to reduce the future burden of interestpayments. Thus, a deficit below the financeable limit would be important toenhance the probability of success of a stabilization program.

75. Secondly, there are important differences between the operationaldeficit, as measured in Brazil, and the inflation adjusted deficit or "true,operational deficit. First, the inflation adjustment is calculated using theofficially determined monetary correction, that may differ from actualinflation as well as from the relevant inflation rate for bond holders.Second, non-interest bearing assets or liabilities are not adjusted forinflation losses or gains. The use of a "restrictedu deficit represents ashort cut in the face of (i) the difficulties in estimating, ex-ante, theinflation adjusted deficit and (ii) the need to use a common concept forcomparing our deficit estimates with the Brazilian figures. For the period1980 to 1987, Table 13 shows the estimated operational and primary deficitsfor Brazil.

®0Тф е® 1Э: еАеавва. - w� .ac аЕст� А п аwы. об� саТ � � � ', а �� .

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. 1 р р !1 ае®о о.в в.о � .в п.е а.о п.о р -л.л р в.в рр аю а .- о.в е.о -g.a в.п в.s п.в р -в.л р в.в р wр а8вп -®.в в.� -е.о ss в.в п.® р -о.л р s. в g �

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аф i одв8 � дl, д дф еь, eBw � ф tia s а0вбдlф г��Оf од В , ®А3ф ед , � � � 11е � е4� гiд м вD®дs1 � о.

� � ггвдбr веооr дгв sa � 1 � s 8s вqваl io sDee ор®nвбтавl � iel в Ое� � ОЪе � евог В �.

� ® д®г. ба®Ад.гпа®� .11 � г�: Мв8твlvo тв8wо 6 дsies вo т дигрОде.

.8, тт�геок садt га0 8 � д1с

40

76. As a result of the significant changes in Brazil's budgetaryprocedures, the estimated 1988 operational deficit is not directly comparablewith the estimates for previous years. Until 19870 Brazil's monetaryauthorities consisted of the Central Bank and Bank of Brazil that shared theexecution of the quasi fiscal of the Central Administration through the*monetary budget'. This budget included it9cal outlays such as severalsubsidies, official lending to some sectors notably agriculture and exportssectors, and expenditures related to marketing of agricultural products.During the 1986-87 period, some of these expenditures were Included in theCentral Administration budget but it was only in 1988 that the budgetunification process was completed with the inclusion of the Government netlending operations in a credit component of the Treasury budget.

'il. Prior to 1988, the operational deficit included the parafiscaloperations of the monetary budget but, given the accounting procedures used bythe Central Bank it was difficult to estimate the interest payments on theBank's portfolio of go7ernment securities. The redefinition of functionsbetween the Treasury and the Central Bank that included the transfer ofresponsibility from the Central Bank to the Treasury for the issuing ofsecurities, and a change in accounting procedures increased significantly thetransparency of the links i atween the fiscal and monetary authorities. Since1988, the operational deficit included the interest payments on governmentbonds. including those in the Central Bank portfolio, a payment that had acounterpart in the Bank's profits. The nominal profits of the Central Bankreflect largely monetary correction received on domestic assets minus monetarycorrection paid an the Bank's liabilities.

78. In addition, some changes were made in the balance sheet of theCentral Bank. First, the Central Bank portfolio of government securities,which had been valued at historical prices was brought up to current values;and second, in a two part operation the Central Bank transferred to theTreasury claim that as a result of previous para-fiscal operations it held onBanco of Brazil. To restore its capital position, the Central Bank received aspecial issue of government securities. Thus, beginning in 1988, the nominaldeficit (PSBR) included nominal interest payments on the revalued stock ofgovernment bonds, the Central Bank profit and lose accounts and the assetsacquired by the Treasury through lending operations. Although it is difficultto ascertain the full extent of the above modifications on the estimateddeficit, the Impact on the operational results of the consolidated publicsector appears to be rather small.

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111.8 Debt. Investment and the Internal/External Transfer

79. From Equation (13) the increase in domestic debt as a ratio of GDPcan be written as:

b + b(r + b*(r* - y + q) - h - (p + y) h - b* (21)

80. The path of the domestic debt to GDP ratio is determined by severalfactors. Maintaining everything else constant, equation (21) shows thats

A

(a) An increase in the GDP growth rate (higher y), or a reductionin the primary deficit (lower x) slows down the increase inthe debt ratio.

A

(b) A real depreciation of the domestic currency (q > 0) willraise the real domestic cost of servicing the external debt,increase domestic borrowing and the debt ratio. A devaluationof the domestic currency poses a trade off for the debtorcountry. On one hand, it will increase the price oftradeables versus nontradeables goods and result in the highertrade surplus necessary to service the foreign debt. On theother hand, a real depreciation of the domestic currencyincreases the real burden of the external debt contributing toraising the fiscal deficit.

(c) An increase in revenue from money creation will diminish theneed for domestic borrowing and will reduce debt to GDP ratio.Assuming that the supply and demand for money are equal, therevenue from monetary expansion is the sum of two components:the expansion of the demand for money keeping velocityconstant and the change in the demand for money as a result ofthe change in velocity. When these two elements move Indifferent directions it is possible that the net effect willbe a decline in the revenues from money creation. In thiscase the economy will be in the downward side of the Laffercurve.

0

(d) Lower external borrowing, (smaller b*), will increase domesticborrowing and the domestic debt to GDP ratio. For a givenfiscal deficit the replacement of external by domesticfinancing will not increase the total indebtedness of thepublic sector. However, increased reliance on domesticborrowing will have important implications for domesticfinancial markets.

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81. Financing fiscal deficits domestically at interest rates higher thanthe growth rate of domestic output is unsustainable and raises the question ofpublic sector solvency. The solvency question can be analyzed by looking atthe public sector budget constraint from an intertemporal point of view. Thesolvency condition can be formulated to show that the sum of the present valueof all future primary deficits and the future resources that can be obtainedby printing money should be equal to the value of the net outstanding publicdebt. This condition illustrates the importance of the inclusion in thefiscal adjustment program of a sustainable change in the primary deficit toincrease the credibility of the overall program.30

82. In the medium term there are important links between the path of thedebt to GDP ratio and investment. The desired stock of capital depends on,among other factors, the user cost of capital, determined by a combination ofthe real interest rate and tax factors such as accelerated depreciation rules,investment tax credits and income taxes. If in the long run the wealth outputratio remains constant, an unchanged debt to GDP ratio would imply a constantshare of government liabilities in private wealth. Thus, a debt strategy thatresults in a constant debt output ratio would maintain a constant realinterest rate and an unchanged degree of crowding out per until of output.Alternatively, an increase in the long run of the share of government debt inprivate wealth will require a higher real interest rates so as to divert a!irger amount of private savings towards the financing of public deficits.Thus, the user cost of capital will increase, adversely affecting investmentand resulting in a lower stock of capital and output per capita in the longrun.

83. A decline in external financing raises the burden on domesticfinancial markets. The externallinternal transfer problem can be discussedwith the help of equation (21). For simplicity we*can start from a positionin which net transfers from abroad are zero (b (r -1) - 8 ) and the realexchange rate is constant (4 - 0). Domestic borrowing is needed to financethe excess of the primary deficit and domestic interest payments over therevenue from money creation. Unless there is a primary surplus, domestic debtwill grow faster than domestic income if the net (after tax) real interestrate on the debt exceeds the growth rate of the economy.

84. For a given primary deficit, when net transfers from abroad becomenegative, domestic borrowing will have to increase to raise the resources tofinance the external debt service. From a dynamic perspective thesubstitution of domestic for external debt has several important effects.When the domestic interest rate is higher than the external rate thereplacement of external debt by domestic debt raises the public sector'sinterest bill and deteriorates the fiscal position. Moreover, as the debtoutput ratio increases, the absorption of a higher share of domestic savingsto finance the fiscal deficit will raise the domestic interest rate, further

30por a discussion see Buiter, V., "Some Thoughts on the Role of FiscalPolicy in Stabilization and Structural Adjustment in Developing Countries.'KBER Working Paper, April 1988.

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augmenting the government's interest bill and the fiscal deficit. In thiscontext monetary expansion becomes a cheaper and attractive alternative sourceof deficit financing. The obvious shortcoming of this alternative is theincrease in inflation.

85. When the private sector cannot borrow abroad, a likely possibilityin the case of Brazil, since the government faces a constrain in its externalindebtedness, the increase in domestic government borrowing will crowd outprivate investment either by raising interest rate or by reducing theavailability of credit to the private sector - credit rationing. The higherinterest rate will be necessary to raise private savings or to decreaseinvestment to the extent necessary to compensate for the switch of governmentborrowing from external to internal financial markets.

IV. Fiscal Deficits, Interest Rates and Inflation

IV.1 Overview

86. The approach used in the first set of simulations was to start frominflation and growth targets to derive the revenues from money creationconsistent with these targets. On the basis of the amounts that can beborrowed domestically and externally, a path for the operational deficit canbe derived consistent with the initial debt strategy. However, aninconsistency between the projected and the financeable deficit will have aneffect on domestic financial markets. Unless the primary deficit is reducedto make public sector borrowing needs consistent with the available financing,some of the targets will have to be abandoned. In the following discussion itis assumed that no additional external borrowing can be obtained and that theforeign exchange reserve target will remain unchanged. Consequently,additional financing will be obtained either through monetary expansion ordomestic borrowing.

87. The effect on interest rates and inflation of a deficit that exceedsits financeable limits will depend on how much burden will put on domesticborrowing versus monetary financing. To evaluate the different impact ofthese financing alternatives and assuming a constant level of externalfinancing, two sets of simulations were conducted. In the first, it wasassumed that the expansion of the monetary base will be consistent with thedesired inflation rate. The question being asked is what will be the impacton the real interest rate if the remainder financing is obtained throughdomestic borrowing? The second simulation assumes a constant interest rateand estimates the amount of domestic borrowing that is consistent with thatlevel of interest rater. The question being asked iss what will be theimpact on inflation if the remainder deficit financing is obtained byexpanding the monetary base?

88. These two simulations illustrate two extreme financing alternatives,or alternatively, two different rules of conduct of monetary policy. One is

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to maintain the expansion of the base consistent with the inflation target andallowing interest rates to increase as a result of additional governmentborrowing. The other is to maintain a constant real interest rate andallowing the monetary base to expand by the arount necessary to finance thefiscal deficit. Although the initial inflation and interest rate targets maybe consistent with each other, whenever the fiscal deficit exceeds thefinanceable limits Imposed by these targets, the additional domestic borrowingand monetary expansion will make at least one target unattainable.

89. To analyze the link between monetary expansion and inflation asimple framework was used in which inflation is a function of the excesssupply of base money, inertial inflation and exogenous shocks. Because in aneconomy like Brazil's, in addition to the excess supply of money the rate ofinflation is affected by many other factors this framework is necessarilyincomplete. The objective is to illustrate the linkages between deficitfinancing, monetary expansion and inflation, rather than to accuratelyforecast inflation.

IV.2 The Demand for Money

90. In this framework the demand for money is a Cagan type demandfunction, a semi-log function with the income elasticity constrained to beequal to one. The demand for money balances (monetary base) as a ratio ofGDP, h, is a function of expected inflation. It is assumed that economicagents have perfect foresight. These relationships are shown below inequations (22) and (23).

log hd - a, + a2 .pe (22)

A A

pe = p (23)

91. The demand equation was estimated by OLS with a correction for autocorrelation, including three seasonal dummy variables, and using quarterlydata for the period 1975.3-1987.4. The estimated equation is presented below.

A

log h -2.187 - 0.929 p

(-3.967) (-7.319)

Sample periods 1975.3 - 1987.4

R2 a .96

* 45 -

DW =1.15 (23A)

92. For the log linear demand function there is a unique finite long runseignorage maximising inflation rate. This rate is -1/&2 . When actualinflation exceeds this value there is a decline in inflation tax revenues. Inaddition to other costs associated with inflation, to push the rate ofinflation to such a level becomes an extremely inefficient procedure to obtaininflation tax revenues. The Laffer curve indicates that the same amount ofrevenue could be obtained at a lower rate of inflation. The estimatedcoefficient of the inflation variable suggest that in the case of Brazil themaximum inflation rate could be about 27.52 per month.

IV.3 The Inflation Equation

93. In this framework inflation is a functlon of the lagged inflaticn,the excess supply of money and exogenous shocks. Indexation introduces astrong inertia in the inflation path which is being captured by the laggedinflation variable. Monetary shocks, represented by an excess supply ofmoney, and other shocks will raise the inflation above the inertial trend.The inflation equation iss

p = bl. p (-1) + b2 . (hs - hd ) + x (24)

A

where p is the inflation rate, x is a variable representing exogenous shocks,and h. and hd are, respectively, the supply and demand for the monetary base,both expressed as a ratio of GDP. The above equation suggests that when thereare no exogenous shocks and the supply of money balances equals the desiredholdings, the rate of inflation will depend only on past inflation. We wouldexpect that b, - 1 and b2 >0. Excess supply of money was obtained as thedifference between actual and projected money balances, the latter calculatedas the in sample forecast of the demand for base money using equation (23A)presented above.

94. Equation (24) was estimated using quarterly data for the period1975.3 1987.4. Dummy variables were included for the second quarter of 1986(Cruzado Plan) and the thArd quarter of 1987 (Bresser Plan). The results ofthe estimation were*

A A

p - .003 + 1.035.p (-1) + 0.189.(hg - hd )

(.233) (15.738) (2.260)

R2 - .95

DV = 1.91 (25)

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95. Equation (25) represents a rough approximation of the variables thatdetermine inflationary trends. Econometric problems aside, the equationignores the effects of cost pressures, exchange rate changes and policyannouncements. It is not forward looking particularly with respect to theinflationary effects of future fiscal deficits. In spite of theseshortcomings the estimated coefficients appear reasonable. The constant termis not statistically significant and the coefficient of the lagged inflationterm is close to one. However, the coefficient of the excess supply of moneyvariable appears to be on the low side. On the basis of the results obtainedabove, the inflation framework consisting of equations (23a) and (25) wascalibrated for the last quarter of 1987 and the first two quarters of 1988.

IV.4 Impact on Inflation

96. When the financing of the deficit is completed through additionalmonetary expansion (hs will increase) the impact on inflation will besubstantial (Table 14). In our baseline case an expansion of the monetarybase equivalent to 2.3% of GDP will be consistent with an average inflationrate in the last quarter of 1988 of 20% per month. A higher expansion of thebase, for example equivalent to 42 of GDP would raise inflation to the 251range in the last quarter. This rate of inflation does not represent acomplete adjustment to the larger money supply. In 1989, the inflation ratewould continue to increase until actual and desired money holdings converge.Therefore, the full inflationary impact of this financing alternative willdepend on the conduct of monetary policy in 1989. The inflationary pressureswould depend on whether or not the Central Bank absorbs the excess liquidity.In any event, the hyperinflationary risks of this alternative are very high.

97. The simulations presented in Table 14 illustrate the potentialimpact of large amounts of debt conversions. The conversions have an impacton financial markets that does not constitute deficit financing. For example,given the amount of real balances the private sector is willing to hold forthe different inflation and interest rates, conversions financed by monetaryexpansion will leave less room for non-inflationary deficit financing.

IV.5 Impact on Interest Rates

98. Another deficit financing alternative is to maintain the expansionof the monetary base at a rate consistent with the inflation rate target andto finance the fiscal deficit by issuing bonds. The amount of the bond issueswould be determined by the fiscal deficit and the need to sterilize themonetary impact of external operations so as to maintain the expansion of thebase compatible with the inflation target. The interest rate would have toincrease to induce the economic agents to hold the additional bonds. Forgiven inflation and growth targets, the demand for bonds estimated in SectionII was used to obtain the interest rate compatible with the larger supply of

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Table 14: MONETARY FINANCING - INFLATION IMPACT

(monthly averages - last quarter of 1988)

Operational Deficit4X 5.01

Increase in the Increase in theMonetary Base Monetary Base

(Z of GDP) Inflation/e (Z of GDP) Inflation

Baseline Case 2 .3/a 20Z 2 .1/b 25Z

ExcludingDebt Conversions/d 3.1/c 232 4 .2 /c 29Z

IncludingDebt Conversions 4.0/c 25% 5.1/c 31%

If Increase in the monetary base consistent with an inflation rate of 202per month, a growth rate of GDP of 22 and a real interest rate of 122per year.

/b Increase in the monetary base consistent with an inflation rate of 252per month, a growth rate of GDP of 02 and real interest rate of 152 peryear.

Ic Increase in the monetary base necessary to complete the deficitfinancing.

Id Excludes debt conversions of US$ 2.9 billion for 1988.

If Monthly average for the last quarter of 1988.

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bonds. The results of these simulations (Table 15) suggest that a substantialincrease in real interest rates would be necessary to place the additionalbonds.

99. These results represent only a first approximation. If the bondfinancing strategy is pursued, the subsequent increase in real rates couldhave an adverse effect on the level of economic activity and reduce the demandfor money thus requiring additional bond borrowing. Moreover, to maintainthe same operational deficit in the face of higher interest rates and a lowerlevel of economic activity, cuts in the primary deficit either through highertaxation or lower spending could become necessary. Because the effects on thefiscal deficit of higher interest rates, higher taxes or lower spending werenot considered, the above results should*be seen as a first orderapproximation. Nevertheless, the omitted effects are likely to reinforce theconclusion that the interest rate would have to sharply increase if thedeficit is financed by issuing bonds and the sterilization of external flowsis undertaken.

IV. 6 LIMM

100. The results shown in Tables 14 and 15 represent two alternativepossibilities of deficit financing. Given the effect that an exclusivereliance on one source of financing would have on financial markets, inpractice it is more likely that the deficit would be financed through acombination of domestic borrowing and monetary expansion. For example, theauthorities may expand the monetary base in order to reduce the Impact that anincrer%e in real interest rates will have on (i) the fiscal deficit, through ahigher interest bill, (ii) the stability of financial markets, bydivertingfunds from time and savings deposits into the overnight market, and(iii) the level of economic activity. On the other hand, exclusively relianceon monetary finance would move the economy into hyperinflation.

101. The combination of large trade surpluses, other flows related to theexternal accounts, and the financing of large fiscal deficits could exertsignificant pressures on financial markets. The range of policy choicesavailable to the authorities vary from (a) a total sterilization of themonetary impact of the external operations through open market operations,financing the deficit largely through domestic borrowing, and accepting theeffects of high real interest rates on the level of economic activity and thefiscal deficit, and (b) allowing the monetary base to expand accepting thesubsequent inflationary pressures. Both alternatives have significant costs.In the short run, the increase in real interest rates will have a negativeeconomic Impact. But these costs may be necessary to prevent the economy fromentering a hyparinflationary path. The solution is the reduction of thefiscal deficit. A lower fiscal deficit and a careful anagement of themonetary impact of the trade surpluses and other external flows, for example,through a less restrictive import policy favoring capital goods, could reducethe burden on monetary policy.

Table 15s BOND FINANCING - INTEREST RATE IMPACT

(monthly averages - last quarter of 1988)

Operational Dficit

42/b S.0%/b

Baseline Case 0.95 1.2

Excluding Debt Conversions 1.33 6.72

Including Debt Conversions 4.00 9.50

/a Assumes a GDP growth rate of 2% for 1988 and an average inflation rateof 20% per month for the last quarter of 1988.

/b Assumes a GDP growth rate of 0.0? for 1988 and an average inflationrate of 25? per month for the last quarter of 1988.

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V. SuMMina U

V.1 Overview

102. This paper presents two frameworks that can be used to evaluate theconsistency of a particular economic program. The first approach, describedin Section II, follows closely the financial programming methodology; thesecond approach, presented in Section III, is centered on the concept of thefinanceable deficit and looks at the financing needs of the public sector andtheir compatibility with the targets of the government's economic program. Inthe following discussion the two approaches will be designated as thefinancial programming and the financeable deficit, respectively. 31 Thissection presents a brief comparison of the two frameworks.

103. As indicated earlier, the questions that these frameworks are bestsuited to answer are slightly different. The financeable deficit looks at thedeficit that is consistent with a given borrowing strategy, and a set ofinflation and growth targets. By focusing on the sources of financing, thefinanceable deficit provides an upper limit of the fiscal stance that, ifmaintained over the medium-term, will likely be compatible with theauthorities's growth and inflation targets. This approach underlines the linkbetween inflation and deficit financing, and consequently, the need for aconsistency between fiscal and monetary policies and inflation targets. Thefinancial programming integrates monetary and credit factors with balance ofpayments flows to obtain a relationship between changes in foreign reservesand changes in the money supply and credit. The two approaches can be viewedas consistency frameworks with a minimal behavioral content that are suitableto be used in cases where data constraints severely limit the scope forestimating an econometric model.

104. The financial programming framework looks at the expansion incredit to the private sector that, for a given inflation rate, balance ofpayments outlook and output growth, it is consistent with the projectedincrease in the demand for money and public sector borrowing from thefinancial system. The relationship between credit, money and external flows,can be obtained integrating the consolidated balance sheet of the bankingsystem and the balance of payments flows. It can be shown that, given thechange in net foreign assets, a decline in the demand for money or an increase

31 The paper illustrates the use of these frameworks employing, as areference, a set of scenarios defining a range of possible outcomes. Althoughthese projections cover only one year, the two frameworks can be easily extendedto cover several periods.

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in public sector borrowing will result in a decline in credit available to theprivate sector. 32

105. The financeable deficit brings forward the link between the fiscaldeficit, its financing and the medium term sustainability of a particularfiscal stance. The financeable deficit is defined as the deficit of theconsolidated public sector, including the Central Bank, that is consistentwith a given inflation target and the maintenance of constant domestic andexternal debt to GDP ratios. 33 The deficit concept used is the operational orthe inflation adjusted deficit, in which interest payments are adjusted totake into account the effects of inflation on the nominal interest rate. Thestarting point is the government budget constraint establishing how thedeficit will be financed through monetary expansion and domestic and externalborrowing. Given a set of targets for inflation and GDP growth, thefinanceable deficit estimates the value of the fiscal deficit that isconsistent with forecasts of external financing, net of changes in reserves,and levels of domestic financing that will be compatible with the initialtargets.

106. The main point is that when the deficit exceeds the financeablelimits, and further external financing is not available, the additional money

32 The demand for money is a key behavioral relationship. In order topredict the effects that changes in domestic credit will have on the balance ofpayments, the demand for money must be a stable function of a well defined setof variables such as income and variables representing the opportunity cost ofholding money balances. An expansion in domestic credit creates a discrepancybetween the demand and supply of money. Because at the pre-expansion level ofincome and prices the public would not be willing to hold the excess money,prices and output would have to change to restore money market equilibriumleading to a deterioration in the balance of payments. In the case of Brazil,the volatility of the demand for money in the 1980's, implies that the forecastsof the demand for money presented in this paper should be regarded as onlyindicative of broad trends.

33 The implications of this borrowing strategy, that only represents areference point, are clearer when the steady state growth path is analyzed. Ina steady state, the rate of inflation and the shares of the different assets inprivate portfolios remain constant. Thus, if the deficit is financed by anamount of borrowing that would keep the debt to GDP ratio unchanged, the domesticreal interest rate would remain constant maintaining the degree of crowding outper unit of output. It is in this context that a deficit financed by a borrowingstrategy that maintains the debt GDP ratio constant may be seen as a referencepoint to evaluate the fiscal stance. In the medium-term it may be desirable topursue a fiscal policy that results in a decline of the debt GDP ratio, thuscrowding in private investment.

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creation and domestic borrowing necessary to finance the deficit may renderthe Government's targets inconsistent. When domestic financial markets arethin, the scope for financing the deficit domestically through borrowingbecomes limited. In such a case a tighter link way exist between fiscaldeficits and external borrowing. In the absence of other sources, thegovernment may have to expand the monetary base to finance the deficitcreating a link between budget deficits and inflation.

107. The financeable deficit provides a tool to analyze the dynamics andsustainability of the deficits. Such a sustainability is particularlydependent on the relationship between the real interest rate and the realgrowth rate of domestic output. As discussed in Section 111.8, when thegovernment runs a primary deficit that exceeds the revenue that can beobtained from money creation and the GDP growth rate is lower than the realinterest rate, the debt to GDP ratio will increase. If such a fiscal stanceis maintained, the continuous increase in the debt to GDP ratio will becomeunsustainable in the long term. As private sector recognizes suchinconsistency, the attractiveness of government securities declines exertingan upward pressure on real interest rates.

108. When the fiscal deficit exceeds the financeable limits, from an economicpolicy point of view it is important to evaluate the economic impact of itsfinancing. In Section IV the financeable deficit approach is extended toevaluate the effects of alternative financing strategies. In brief, twoquestions are asked: (i) What will be the impact on inflation if theauthorities peg the real interest rate and finance the remaining fiscaldeficit through monetary expansion? (ii) What will be the impact on the realinterest rate if the expansion of the monetary base is maintained at a levelconsistent with a given inflation target and the remaining domestic financingis obtained by issuing interest bearing debt?. 3

V.2 Sectoral Disaggregation

109. The two methodologies differ with respect to their sectoraldisaggregation. In the financial programming case, the economy is dividedinto four sectorst external, Government, banking and private sectors. A moreaggregated decomposition is used in the financeable deficit approach in whichthe economy is divided into the external sector, the government sectorincluding the Central Bank, and the private sector. The Central Bank isshifted from the banking system to the Government sector while the rest of thebanking system is included in the private sector. In both methodologies, the

34 The role of exchange rate policy should not be neglected. To simplifythe presentation, it was assumed that the nominal exchange rate was adjusted soas to maintain the real exchange rate constant. However, if an adjustment inthe real exchanger is considered to be necessary, the impact of such anadjustment on the balance of payments, credit worthiness indicators, inflationand fiscal deficit should be taken into account.

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public enterprises are included in the government sector and the variablesincluded in the private sector budget constraint are residually determined.The degree of sectoral aggregation has implications for the choice of theappropriate concepts of money and domestic debt. In the financeable deficitthe monetary base becomes the relevant monetary aggregate. To calculate theinflation tax, however, the monetary base should be adjusted to account forCentral Bank holdings of non-interest bearing private liabilities. In thecase of financial programming the money supply includes the banking systemdeposit liabilities to the private sector.

110. The degree of disaggregation determines the number of budgetconstraints to be considered. In the financial programing framework thereare four budget constraints showing for each sector the relevant inflows andoutflows. These flows can be divided in two groups: those that result fromproduction decisions and those that result from financial decisions. Acomplete set of transactions shows that for a given sector, saving (ordissaving) must finance, or be financed by, an equivalent dissaving (orsaving) by other sectors. For the whole economy spending in excess of incomeit is only possible when financed by external net savings. A consolidationof these budget constraints shows the change in the country's wealth, itsnational savings that by definition are identical to investment. A similarconsolidation can be done in the case of the financeable deficit.

ill. To a large extent, both methodologies are focused on monetary flows.Monetary variables contain important macroeconomic information, and that inmany countries, including Brazil, monetary data are relatively more accurateand can be obtained more timely than data on real variables. Moreover, it ispossible that the relationships describing the trends of monetary variables,such as the demand for a broad monetary aggregate, are more stable than thosedescribing the behavior of real variables. The difficulties in estimatingbehavioral functions such as the consumption equations, largely due to theabsence of reliable data, do not permit an in depth analysis of the relativestability of these relationships, a discussion that figured prominently in theliterature describing the controversy between monetarists and keynesians. 35

112. In sum, these two consistency frameworks describe the major economicrelationships through a set of budget constraints, one of which can be droppedusing Valras law. Which one should be dropped will depend on the details ofthe case that is going to be studied, e.g., data availability, set of issuesto be addressed. In its simplest form, the financial programming focus on therelationship between balance of payments outcomes and domestic creditpolicies. The financeable deficit focus on the implications of the deficitfinancing. The objective is to find out how much deficit financing can beobtained through increases in public debt that are allowed by the increase indemand for debt and an inflation rate that is compatible with a stable

35 This point is raised in Auernheimer L. * Approaches to theMacroeconomic Framework' mmeo, World Bank, September 1989.

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economic environment. In a medium term context, the financeable deficitrepresents a useful short-cut that can be used to establish targets levels forthe fiscal deficit by analyzing the amount of financing that can be obtainedcompatible with a set of targets for growth, interest rates and inflation.

V.3 Deficits and the Central Bank

113. A last point refers to the analytical implications of the inclusionof the Central Bank in the public sector. Several arguments can be advancedin favor of such inclusion such as the lack of Central Bank autonomy vis a visthe Treasury and the need to include the inflation tax as a source of revenue.From an accounting point of view if Central Bank profits (or losses) arecorrectly calculated and, after allowing for reserve build up, transferred tothe Treasury, the impact of Central Bank on the fiscal accounts vill beaccurately presented. However, when the Central Bank undertakes activities ofa fiscal nature that may result in losses that are not adequately covered bytransfers from the Treasury, the fiscal deficit will be underestimated. Inthis case it may be useful to calculate the net domestic debt of the publicsector, including the Central Bank, estimating the consolidated deficit of thepublic sector as the increase in net debt. Such a consolidation highlightsthe constraints Imposed on the deficit financing.

114. When the Central Bank undertakes quasi-fiscal activities, fiscaldata may provide an incomplete description of the fiscal policy. The type ofactivities undertaken by a Central Bank can be divided in two main categories:*normal* activities that involve the conduct of monetary policy, and otherquasi fiscal activities that are not directly related to the conduct ofmonetary policy.36 The traditional functions of the Central Bank include thecontrol of the issue of currency, lender of last resort, banking supervisionand regulation, custody and management of the country foreign currencyreserves, settling and clearing balances among commercial banks. Some ofthese activities, such as the clearing function, could be exercised by aprivate bank.

36 A distinction should be made between the Central Bank balance sheet,showing the composition of the institution's assets and liabilities and theBank's profit and loss accounts, showing the Bank's current revenues andexpenditures and its surplus. The two sets of accounts are related in a flow-stock sense, as Central Bank profits will increase the institution's net worth.The creation of base money provides the Central Bank with a main source ofrevenue. The monetary authority may purchase government or private interestbearing securities that provide a large part of the Bank'a income and financethe purchase by issuing base money. The Central Bank also obtains revenues fromrediscount activities, by using the proceeds from compulsory reserves held byother financial Institutions to purchase Treasury securities, and in some casesby operating a multiple exchange rate system.

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115. Central Bank quasi-fiscal expenditures may include subsidizedcredit, expenditures resulting from bailing out ailing institutions, exchangerate subsidies among others. The dividing line between traditional and quasi-fiscal activities is not always clear. Items such as exchange rate guaranteesmay remain off the Central Bank balance sheet and losses may be reflected inan overvaluation of the institution's assets rather than in a decline inprofits. Although they may eventually do so, exchange guarantees do notnecessarily result in immediate losses. A relevant issue is the extent towhich reserves should be held against contingent liabilities when the latterare likely to become realized. Although a detailed discussion of this pointis beyond the scope of this paper, if the objective in estimating the deficitis to measure the financing needs of the monetary authority, accrued capitalgains or losses could be excluded from the estimation of the Central Bankprofits.

116. The transparency issue becomes rather relevant when subsidiesgranted to a particular sector are channelled through the Central Bank ratherthan the Treasury. An example is subsidized credit. When the Central Bankfavors a particular sector by providing lines of credit at below market rates,the loan assets held by the Bank yield a rate of return lower than the marketrate. The Central Bank can compensate for the asset valuation by transferringto a reserve account part of its profits, thereby maintaining its net worthposition. Assuming that the appropriate reserve policy is being pursued andthe Central Bank remaining profits are transferred to the Treasury, the fiscalimpact of Central Bank quasi-fiscal activities is being taken into account.However, an issue may arise when as a result of quasi-fiscal activities, theCentral Bank experiences losses. The fiscal deficit is underestimated whenthe Central Bank losses are not covered by a transfer from the Treasury andare financed by printing money. In this case the inclusion of the Central Bankin the public sector and measuring the deficit as the increase in net debt ofthe consolidated public sector, may offer a more accurate estimate of thefiscal deficit.

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