Macroeconomic Stability and Economic Resilience:

The Role of Macroeconomic Policies

Lawrence SchembriBank of Canada

Prepared for International Conference on Small States and Economic ResilienceMalta, 23–25 April 2007

This presentation represents the views of the author, not the Bank of Canada.

Motivation: Why are we here?

• Ultimate economic goal of a nation state is economic growth that is high and stable (and therefore sustainable)

→ economic growth contributes to a higher quality of life

• Small states have difficulty achieving this goal – they are “economically vulnerable” (Briguglio); – they are “open” to adverse external shocks

• Our objective is to reduce the probability of an adverse impact by “nurturing” “economic resilience” (Briguglio, Cordina et al.)

Motivation: Why I am here?

Definition “Economic resilience”: – An economy’s ability to recover from, withstand or avoid

adverse economic shocks

Index of Economic Resilience (4 Components)1. Macroeconomic stability – MY TASK2. Microeconomic market efficiency3. Good governance4. Social development

My purpose:1. Discuss how macroeconomic stability contributes to

resilience and 2. Examine how it can be achieved through

macroeconomic policy

Measuring Macroeconomic Stability

• In the Resilience Index, macroeconomic stability is broadly measured by:

1. Unemployment rate + Inflation rate

2. Fiscal deficit (as a ratio of GDP)

3. External debt (as a ratio of GDP)

• Only #1 is a measure of macro stability

• #2 and #3 are more accurately described as measures of effective stewardship of public and external resources

Key Hypotheses

1. Macroeconomic stability and effective stewardship of public and external resources “nurtures” or contributes to economic resilience

2. Macroeconomic stability and effective stewardship of public and external resources can be enhanced by appropriate domestic macroeconomic (& financial) policies

Outline

1. Provide a conceptual framework for these broad measures of macroeconomic stability and their contribution to resilience

2. Discuss how macroeconomic policies (that is, fiscal, monetary and exchange rate policies) contribute to macro stability

3. Analyse the macroeconomic experience of a sample of small states in order to draw useful policy lessons

Conceptual Framework“High Level”

Macroeconomic & Financial Policies

Macro Stability & Effective Stewardship of Public, External & Private Resources

Economic Resilience

Economic Growth

Macroeconomic Stability: “Conceptual Framework”

• Ultimate economic goals: “nurturing” economic resilience and achieving high & stable growth

• Intermediate goals of public policy:1. Internal balance 2. External balance3. Effective stewardship of public resources4. Effective stewardship of external resources5. (Effective stewardship of private resources)

• Each of these intermediate goals fosters economic resilience and high & stable growth

Macroeconomic Stability:Meaning & Contribution to Resilience

1. Internal balance– Output at the full employment level– Low, stable & predictable inflation

2. External balance– A current account position that is roughly equal to a

sustainable level of capital flows – Relative domestic prices that adjust smoothly to any

imbalance

Contribution to Resilience: An economy in internal & external balance can more easily withstand and recover from external shocks. Policies are in place to ensure flexibility & anchor expectations.

Effective Stewardship: Public ResourcesMeaning & Contribution to Resilience

1. Sustainable fiscal deficits & public debt → Debt service costs should be manageable

• Tax rates: low, broadly based and stable→ Preserve incentives to work, save & invest

2. Expenditures on public goods maximize social returns

Contribution to Resilience:Lessen vulnerability to crises with unsustainable debt loads; preserve flexibility to respond to shocks; and maintain internal balance.

Effective Stewardship: External ResourcesMeaning and Contribution to Resilience

1. External debt at sustainable levels→ External debt service costs not too onerous

2. Balanced capital inflows→ FDI and equity are less prone to reversals → FDI facilitates technology/knowledge transfer

3. Easy access to global markets

→ Allows borrowing & lending to smooth shocks and portfolio diversification to reduce risk

Contribution to ResilienceReduce probability of crises due to high debt loads and unstable foreign borrowing and better diversify risks

Effective stewardship: Private resources

• Represented by the “microeconomic market efficiency” measures in the Resilience Index

• Examples: financial and labour markets

• Domestic financial markets should provide efficient intermediation of savings and access to risk diversification

• Labour markets should be flexible; wages should adjust or labour move easily in response to shocks

Fiscal Policy Contribution to Macroeconomic Stability

• Fiscal policy is critical to maintaining macro stability and “nurturing” economic resilience

• From a stabilization (internal balance) perspective:→ Fiscal policy should be countercyclical→ Fiscal policy should be automatic rather than

discretionary

• To ensure that the public debt/GDP ratio is sustainable (& therefore preserve fiscal space to respond to external shocks), governments should commit to a long-run target for this ratio

Exchange Rate & Monetary Policy Contribution to Macroeconomic Stability

• Two policies must be discussed together

• Choice of exchange rate regime has direct implications for the monetary policy regime

1. Common currency → no domestic monetary policy 2. Fixed or heavily managed exchange rate → monetary

policy must maintain the exchange rate3. Flexible exchange rate → monetary policy independence,

but central bank must chose a nominal anchor: inflation or money supply targeting

• Key Consideration: Stable nominal target to anchor expectations and maintain macro stability

Macroeconomic Policy Challenges in Small States

Fiscal Policy

• Large demand for expenditures & transfers (governments play a large role; provide insurance)

• Tax collection inefficient (lack economies of scale; heavy reliance on import taxes)

• Chronic deficits often result that are not easy to finance (require financial institutions to hold debt)

• Monetary financing of deficits undermines exchange rate & monetary policy

Macroeconomic Policy Challenges in Small StatesExchange Rate & Monetary Policy

• Difficult to conduct an independent monetary policy (thin domestic financial markets; low demand for monetary base; fiscal problems)

• Typical policy regimes: Common currencies; currency boards; fixed or heavily managed exchange rate regimes

• Import domestic monetary policy from abroad

• Lose the nominal exchange rate as a flexible adjustment mechanism; must rely on flexible wages and prices to absorb shocks

Country Population (2006)

GDP Billions of USD

GDP per capitaPPP

Exchange rate regime

Monetary Policy Framework

Bahamas 303,770 $6.48 $21,300 Fixed peg to USD Exchange rate anchor

Barbados 279,912 $5.11 $18,200 Fixed peg to USD Exchange rate anchor

Fiji 905,949 $5.50 $6,100 Fixed peg against a basket

Exchange rate anchor

Jamaica 2,758,124 $12.71 $4,600 Float Base moneytarget

Malta 400,214 $8.12 $20,300 Fixed peg to Euro Exchange rate anchor

Mauritius 1,240,827 $16.72 $13,500 Float Inflation targeting

Singapore 492,150 $138.6 $30,900 Managed float against a USD, Euro and JPY.

Exchange rate anchor

Nominal Exchange RateLocal currency per USD

0

1

2

3

4

1973 1978 1983 1988 1993 1998 2003

0

10

20

30

40

50

60

70

Barbados Malta Singapore Fiji The Bahamas Mauritius Jamaica

Misery IndexFixed Exchange Rate

0%

10%

20%

30%

1980 1985 1990 1995 2000Barbados Malta Fiji Bahamas

Misery IndexManaged Floating Exchange Rate

0%

25%

50%

75%

100%

1980 1985 1990 1995 2000

Singapore Mauritius Jamaica

Fiscal Deficit per GDPFixed Exchange Rate

-10%

-5%

0%

5%

1973 1978 1983 1988 1993 1998 2003Barbados Malta Fiji The Bahamas

Fiscal Deficit per GDPManaged Floating Exchange Rate

-20%

-10%

0%

10%

20%

1973 1978 1983 1988 1993 1998 2003

Singapore Mauritius Jamaica

External Debt per GDP

0%

12%

24%

36%

1973 1978 1983 1988 1993 1998 2003Barbados Malta Mauritius Fiji The Bahamas

Output GrowthFixed Exchange Rate

-20%

-10%

0%

10%

20%

30%

1973 1978 1983 1988 1993 1998 2003

Barbados Malta Fiji The Bahamas

Output GrowthManaged Floating Exchange Rate

-10%

20%

50%

80%

1973 1978 1983 1988 1993 1998 2003

Singapore Mauritius Jamaica

0%

CPIFixed Exchange Rate

-5%

5%

15%

25%

35%

45%

1973 1978 1983 1988 1993 1998 2003Barbados Malta Fiji The Bahamas

0%

CPIManaged Floating Exchange Rate

-10%

20%

50%

80%

1973 1978 1983 1988 1993 1998 2003

Singapore Mauritius Jamaica

0%

Coefficient of variation for Output Growth

Country 1973 – 2004 1973 – 1989 1990 - 2004

Bahamas 2.80 2.65 1.88

Barbados 2.08 1.73 2.78

Fiji 1.56 2.21 1.05

Jamaica 5.79 -23.54 1.13

Malta 0.83 0.73 0.71

Mauritius 1.30 1.14 0.19

Singapore 0.53 0.44 0.64

Coefficient of variation for CPI

Country 1973 – 2005 1973 – 1989 1990 - 2005

Bahamas 0.72 0.47 0.76

Barbados 1.14 0.85 0.95

Fiji 0.64 0.44 0.59

Jamaica 0.76 0.50 0.91

Malta 0.97 1.02 0.32

Mauritius 0.81 0.79 0.37

Singapore 1.58 1.38 0.82

Summary of Findings• Prudent fiscal policy seems to be

prerequisite for achieving economic resilience and stable growth

• Low and stable inflation can be achieved with either a fixed or a managed floating exchange rate

• External debt and current account positions become less of a concern if domestic macroeconomic policies are appropriate

Concluding Remarks• Economic resilience is an important and useful

concept for small states• Macroeconomic stability is critical to economic

resilience• Good fiscal, monetary and exchange rate policies

can foster macroeconomic stability and “nurture” economic resilience

• Financial policies are also important for resilience; strong financial institution and access to global capitals

• Despite the challenges small states face, it is in their best interest to adopt best-practice macroeconomic policies

Closing Remark - Role of IMF

• Given the challenges small states face, the IMF (and other international organizations) should provide technical assistance to them to put in policies that will increase resilience

• They should also consider providing access to precautionary lines of credit so that these states can borrow when they are affected by an adverse economic shock