In a recent paper Khan and Montiel used elements of both the Polak monetary approach to the balance of payments and the World Bank's two-gap approach to economic growth to analyse concurrently growth and adjustment in LDCs. They do not use their `merged model', however, to investigate the effects of a negative external shock. Nor do they study explicitly the adjustment policies appropriate to such a shock. In addition, Khan and Montiel make major simplifications compared with conventional macro-models, particularly on the supply side.
In Discussion Paper No. 406, Research Fellow David Vines explores the robustness of results when these simplifications are removed by presenting a more general model, which nests those of Polak and of Khan and Montiel within a very conventional mainstream macro-model. In Vines's model, the demand for money is interest-elastic and an investment function is explicitly introduced, and the supply side is respecified to relax the assumption that prices are perfectly flexible and to let real exchange rate depreciation reduce aggregate supply.
Vines shows that these generalizations significantly affect the results. A fall in foreign demand for exports stimulates output in the Khan and Montiel model, whereas in the generalized model it will be contractionary in a familiar Keynesian manner. A programme of adjustment to such a shock designed on the basis of the Khan and Montiel model, or on the Polak model, may not produce `adjustment with growth'. Although the external account need not remain in deficit (it may over-adjust), output falls, prices increase, and capacity output may fall. The classic complaints about IMF adjustment programmes are that they cause exactly the kinds of outcome just described, and the `adjustment with growth' literature has, in fact, been developed in order to propose policies that would not do so.
Vines's analysis suggests that neither the Polak model nor the Khan and Montiel model adequately incorporates the recent literature on `adjustment with growth'. His results indicate that the design of growth-oriented adjustment programmes may require the consideration of supply-side features that are not included in the Khan and Montiel model. Also, the achievement of adjustment with growth may require a wider range of policy measures than those considered by Khan and Montiel. Specifically, a fiscal contraction may be needed to enable a growth-sustaining increase in capacity to be achieved.

Growth Oriented Adjustment Programs: A Reconsideration
David Vines

Discussion Paper No. 406, March 1990 (IM)