The fiscal policy options available to developing countries attempting to implement simultaneously programmes of stabilization and of structural adjustment are severely restricted by the often extreme initial conditions of macroeconomic and structural disequilibrium that they face. These problems warrant a fresh restatement and adaptation of conventional macroeconomic analysis addressed specifically to these countries' problems.
In Discussion Paper No. 260, Research Fellow Willem Buiter analyses the role of fiscal policy in stabilization and structural adjustment, starting from a `financial balances' identity for the economy as a whole. An inspection of this identity reveals that an increase in the current account surplus requires an increase in the combined private and public sector financial surpluses or, equivalently, an increase in national income relative to domestic absorption. This underlines the likelihood of a fiscal dimension to a current account improvement.
Policies to influence the current account are also concerned with the nation's intertemporal allocation of resources. Intertemporal relative prices (such as the real interest rate, rates of return on other assets, and the cost and availability of credit under widespread credit rationing) will play a central role in the effects of fiscal policy actions on the current account. Fiscal tightening today implies fiscal relaxation (relative to what would otherwise have occurred) in future.
Buiter uses the `forward-looking' accounting framework involved in solvency assessments to evaluate the internal consistency of the entire range of a government's fiscal, financial and monetary policies. Solvency in this sense requires that (as proportions of GDP) the present discounted value of future trade surpluses plus net inflows of aid and remittances are just equal to current net external debt. The sum of the trade surplus and net current transfers can be defined as the nation's primary surplus.
Buiter explores various applications of this solvency approach to the problems faced by developing and newly industrializing countries. In one approach, monetary financing is treated as the residual. To implement this, projections are provided for the operational deficit. Calculations of the solvency identity will determine the value of the real resources that the government will have to appropriate through seigniorage, and thus the inflation rate implied by the fiscal-financial programme. The converse approach is to start with a target path for inflation and then to derive the path it implies for the operational deficit, given the amounts that can be borrowed at home and abroad and the target change in international reserves. Any inconsistencies will have to be reconciled by a combination of revised inflation projections, cuts in the primary deficit or the interest burden, increased borrowing, or lower foreign exchange reserves.
Buiter argues that this approach is potentially useful because it imposes the discipline of looking at the totality of public sector outlays, receipts and financing. He warns, however, that this exercise requires projections for the key endogenous variables in the identity, e.g. domestic real interest rate, real exchange rate, and the growth rate and level of real economic activity, whose determination requires the kind of gen eral equilibrium macroeconometric modelling that the consistency check appears to short-cut

Some Thoughts on the Role of Fiscal Policy in Stabilization and Structural Adjustment in Developing Countries
Willem H Buiter

Discussion Paper No. 260, August 1988 (IM)