TABLE OF CONTENTS:

Preface to the Second Edition xvii
Introduction and Overview 3

Chapter 1: Overview of the Book 4 2 Some Methodological Issues 10
1 Scope of Development Macroeconomics 13
1 Monetarism, Structuralism, and Developing Nations 15
2 Economic Structure and Macroeconomics 18
2.1 Openness to Trade in Commodities and Assets 19
2.2 Exchange Rate Management 25
2.3 Domestic Financial Markets 26
2.4 The Government Budget 28
2.5 Aggregate Supply and the Labor Market 32
2.6 Stability of Policy Regimes 36
2.7 Macroeconomic Volatility 37
3 Some Special Topics 38

PART I: MACROECONOMIC RELATIONSHIPS AND MARKET STRUCTURE 43
Chapter 2: Aggregate Accounts, Production, and Market Structure 45
1 A General Accounting Framework 46
1.1 The Nonfinancial Private Sector 46
1.2 The Public Sector 48
1.2.1 The Nonfinancial Public Sector 48
1.2.2 The Central Bank 48
1.2.3 The Consolidated Public Sector 49
1.3 The Commercial Banking System 50
1.4 Aggregate Relationships 51
2 Production Structure in an Open Economy 52
2.1 The Mundell-Fleming Model 52
2.2 The "Dependent Economy" Model 56
2.3 A Model with Three Goods 60

Chapter 3: The Structure of Labor Markets 63
3.1 Functioning of Labor Markets 64
3.2 Output and Unemployment 65
3.3 Indexation and Wage Rigidity 66
3.4 Labor Market Segmentation 71

Chapter 4: Informal Financial Markets 76
4.1 Informal Loan Markets 76
4.2 Parallel Markets for Foreign Exchange 78
3 Behavioral Functions 86
1 Consumption and Saving 86
1.1 Consumption Smoothing 90
1.2 Length of Planning Horizon and Liquidity Constraints 92
1.3 Effects of Interest Rate Changes on Savings 93
1.4 Public and Private Consumption 95
2 Private Investment 95
2.1 Specification Issues 96
2.2 Determinants of Private Investment: The Evidence 99
3 The Demand for Money 102
3.1 Conventional Money Demand Models 103
3.2 Currency Substitution and the Demand for Money 105
3.2.1 Domestic- and Foreign-Currency Deposits 106
3.2.2 Currency Substitution: The Evidence 109
4 Aggregate Supply Functions 111
4.1 Cross-Regime Tests 113
4.2 Within-Regime Tests 114
4.3 An Assessment of the Evidence 117
Appendix: Uncertainty, Irreversibility, and Investment: A Simple Example 120

PART II: SHORT-RUN MACROECONOMIC POLICIES 123
Chapter 4: Sources of Macroeconomic Fluctuations 125
1 The Data 126
2 Detrending Techniques 128
2.1 The Hodrick-Prescott Filter 129
2.2 The Band-Pass Filter 130
2.3 The Nonparametric Method 130
3 Assessing Macroeconomic Fluctuations 131
4 Summary of the Findings 133
Chapter 5: Fiscal Deficits, Public Solvency, and the Macroeconomy 136
1 The Government Budget Constraint 137
1.1 The Consolidated Budget Constraint 137
1.2 The Measurement of Fiscal Deficits 141
1.3 Seigniorage and Inflationary Finance 143
1.3.1 The Optimal Inflation Tax 146
1.3.2 Collection Lags and the Olivera-Tanzi Effect 148
1.3.3 Collection Costs and Tax System Efficiency 153
2 Policy Consistency and the Solvency Constraint 154
2.1 The Intertemporal Solvency Constraint 155
2.2 Financing Constraints and Policy Consistency 158
3 Macroeconomic Effects of Fiscal Deficits 159
3.1 Ricardian Equivalence 160
3.2 Deficits, Inflation, and the "Tight Money" Paradox 161
3.2.1 The Analytical Framework 165
3.2.2 Constant Primary Deficit 167
3.2.3 Constant Conventional Deficit 169
3.3 Deficits, Real Interest Rates, and Crowding Out 173
3.3.1 Expectations, Deficits, and Real Interest Rates 174
3.3.2 Deficits, Investment, and Crowding Out 181
3.4 Deficits, the Current Account, and the Real Exchange Rate 182
Appendix: Fiscal Effects of Privatization 186

Chapter 6: Financial Markets, Capital Mobility, and Monetary Policy 189
1 Financial Repression: Macroeconomic Effects 190
2 Financial Repression, the Inflation Tax, and Capital Controls 192
2.1 Financial Repression and Inflationary Finance 192
2.2 A General Public-Finance Approach 196
3 Capital Mobility: Empirical Evidence 198
3.1 The Magnitude of Gross Flows 199
3.2 Tests of Interest Parity Conditions 200
3.3 Tests of Monetary Autonomy 204
3.4 Saving-Investment Correlations 205
3.5 Summary 206
4 Models of Informal Credit and Foreign Exchange Markets 207
4.1 Models of Informal Credit Markets 207
4.1.1 Stagflationary Effects of Monetary Policy 207
4.1.2 Interest Rate Policy and Output 208
4.2 Models of Informal Currency Markets 214
4.2.1 Illegal Trade and Parallel Markets 214
4.2.2 Portfolio and Currency Substitution Models 217
5 Monetary Policy with Informal Financial Markets 221
5.1 The Analytical Framework 222
5.2 Changes in Monetary Policy Instruments 226
5.2.1 Credit Expansion 227
5.2.2 Changes in the Administered Interest Rate 228
5.2.3 Change in the Required Reserve Ratio 229
5.2.4 Intervention in the Parallel Foreign Exchange Market 229
6 A Simulation Model with Informal Financial Markets 230
6.1 Structure of the Model 230
6.1.1 Aggregate Supply 231
6.1.2 Aggregate Demand and Disposable Income 233
6.1.3 Asset Accumulation and Financial Wealth 234
6.1.4 The Current Account and the Balance of Payments 235
6.1.5 The Banking System 236
6.1.6 Fiscal Deficits and Domestic Credit 237
6.1.7 Calibration of the Model 238
6.2 Effects of Stabilization Policies 238
6.2.1 Government Spending on Home Goods 239
6.2.2 Central Bank Credit to Commercial Banks 240
6.2.3 Increase in Lending Rates 241
6.2.4 Devaluation of the Official Exchange Rate 242

Chapter 7: Exchange-Rate Regimes: Evidence and Credibility Aspects 246
1 Evidence on Exchange-Rate Regimes 246
2 Credibility and Exchange-Rate Management 251
2.1 Time Inconsistency and Exchange-Rate Policy 253
2.2 Credibility of a Fixed Exchange Rate 258
2.3 Reputation, Signaling, and Exchange-Rate Commitment 259
2.4 Credibility Effects of Monetary Unions 262
3 Exchange Rate Bands 266
3.1 Rationale for Exchange Rate Bands 266
3.2 Bands and Monetary Policy Credibility 268
3.3 Experience with Exchange Rate Bands 269
3.3.1 Central Parity 270
3.3.2 Band Width 276
3.3.3 Intramarginal Intervention 278
3.4 Lessons from Experience 278
Appendix: Krugman's Target Zone Model 282

Chapter 8: Exchange-Rate Management: Contractionary Devaluation and Real-Exchange-Rate Rules 286
1 Contractionary Devaluation 287
1.1 Effects on Aggregate Demand 287
1.1.1 Consumption 288
1.1.2 Investment 298
1.1.3 Nominal Interest Rates 301
1.2 Effects on Aggregate Supply 304
1.2.1 Effects on the Nominal Wage 305
1.2.2 Imported Inputs 308
1.2.3 Effects Through Costs of Working Capital 310
1.3 Empirical Evidence 312
1.3.1 Before-After Approach 312
1.3.2 Control Group Approach 313
1.3.3 Econometric Models 315
1.3.4 Macro-Simulation Studies 317
2 Real-Exchange-Rate Targeting 320
2.1 The Analytical Framework 321
2.2 Targeting the Real Exchange Rate 323
2.3 Effects of Macroeconomic Shocks 325
9 Stabilization and the Labor Market 329
1 The Model 330
1.1 The Formal Economy 332
1.2 The Informal Sector 334
1.3 Consumption and Wealth 335
1.4 Market for Informal Sector Goods 336
1.5 The Informal Labor Market 336
1.6 Government 337
2 Dynamic Structure 337
3 The Steady State 339
4 Government Spending Cut 342

PART III: STABILIZATION: THEORY, EVIDENCE, AND EMPIRICAL MODELS 347
Chapter 10: An Overview of Stabilization Programs 349
1 Populism 351
1.1 Chile under Allende (1970-1973) 352
1.2 Peru under Garc?´a (1986-1990) 354
2 Orthodox Money-Based Stabilization 355
2.1 Chile (September 1973) 356
2.2 Bolivia (August 29, 1985) 358
3 Exchange-Rate-Based (Southern Cone) Stabilization Programs 361
3.1 Chile (February 1978) 362
3.2 Uruguay (October 1978) 364
3.3 Argentina (December 1978) 366
4 Heterodox Programs 368
4.1 Argentina (June 14, 1985) 369
4.2 Israel (July 1, 1985) 373
4.3 Brazil (February 28, 1986) 379
4.4 Mexico (December 1987) 382
5 Argentina's Convertibility Plan (1991-1997) 385
6 Brazil's Real Plan (1994-1997) 390
7 Lessons of Stabilization 395

Chapter 11: Inflation and Short-Run Dynamics 397
1 Models of the Inflationary Process 397
1.1 Inflation, Money, and Fiscal Deficits 398
1.1.1 Adaptive Expectations 400
1.1.2 Perfect Foresight 402
1.2 Food Supply, Distribution, and the Wage-Price Cycle 405
1.3 A Structuralist-Monetarist Model 411
2 Dynamics of Monetary and Exchange-Rate Rules 414
2.1 A One-Good Framework 414
2.1.1 Households 415
2.1.2 Government and the Central Bank 418
2.1.3 Money Market Equilibrium 419
2.1.4 Dynamic Form 419
2.1.5 Devaluation Rule 421
2.1.6 Credit Growth Rule 425
2.1.7 Dynamics with Alternative Fiscal Policy Rules 427
2.2 A Three-Good Model with Flexible Prices 428
2.2.1 Households 429
2.2.2 Output and the Labor Market 431
2.2.3 Central Bank and the Government 432
2.2.4 Market-Clearing Conditions 432
2.2.5 Dynamic Form 432
2.2.6 Policy Shocks 436
2.3 Extensions 442
2.3.1 Imported Intermediate Inputs 442
2.3.2 Sticky Prices 443
Appendix: The Three-Good Model 447

Chapter 12: Analytical Issues in Disinflation Programs 450
1 Topics in Exchange-Rate-Based Programs 450
1.1 The Boom-Recession Cycle 453
1.1.1 Expectations, Real Interest Rates, and Output 453
1.1.2 The "Temporariness" Hypothesis 457
1.1.3 An Assessment 466
1.2 The Behavior of Real Interest Rates 473
1.2.1 Credibility, Nominal Anchors, and Interest Rates 474
1.2.2 Expectations, Fiscal Adjustment, and Interest Rates 475
1.3 Disinflation and Real Wages 477
2 The Role of Credibility in Disinflation Programs 487
2.1 Sources of Credibility Problems 488
2.1.1 Internal Inconsistency 488
2.1.2 Time Inconsistency 489
2.1.3 Asymmetric Information 491
2.1.4 Policy Uncertainty and Stochastic Shocks 491
2.1.5 Political Uncertainty 492
2.2 Enhancing the Credibility of Disinflation Programs 493
2.2.1 Signaling and Sustainability 494
2.2.2 Price Controls 496
2.2.3 Central Bank Independence 503
2.2.4 External Enforcement and Foreign Assistance 505
2.2.5 Sequencing and Political Support 507
2.3 Policy Lessons 509
3 Disinflation and Nominal Anchors 512
Appendix: Output Effects of Price Controls 517

Chapter 13: Empirical Models of Stabilization 521
1 Bank-Fund Models 523
1.1 The IMF Financial Programming Model 523
1.2 The World Bank RMSM Model 525
1.3 A Simple Bank-Fund Model 527
2 Three-Gap Models 527
3 Macroeconometric Models 531
3.1 Structure of Production 532
3.2 Aggregate Supply 533
3.3 Aggregate Demand 535
4 Computable General Equilibrium Models 537
Appendix: The Khan-Knight Monetary Disequilibrium Model 541

PART IV: EXTERNAL DEBT, CAPITAL FLOWS, AND CURRENCY CRISES 545
Chapter 14: The Debt Crisis of the 1980s 547
1 Origins of the Debt Crisis 548
1.1 Public Sector Solvency 550
1.2 Application to the Debt Crisis 551
2 Policy Response and Macroeconomic Implications 556
3 Resolution of the Crisis: The Brady Plan 558
3.1 Outline of the Plan 558
3.2 Macroeconomic Effects: Conceptual Issues 559
3.3 An Overview of Some Early Brady Plan Deals 567
Appendix: Incentive Effects of a Debt Overhang 572
15 Capital Inflows: Macroeconomic Effects and Policy Responses 575
1 Capital Inflows in the Early 1990s 576
1.1 The Domestic and External Context 576
1.2 Characteristics of the New Inflows 577
1.2.1 Magnitude 577
1.2.2 Timing 579
1.2.3 Regional and Country Destination 579
1.2.4 Asset Composition 580
1.2.5 Sectoral Destination 582
2 Factors Driving Capital Inflows 582
2.1 "Pull" Factors, "Push" Factors, and Changes in Financial Integration 582
2.1.1 "Pull" Factors 584
2.2.2 "Push" Factors 585
2.1.3 Financial Integration 585
2.2 The Empirical Evidence 586
2.3 An Assessment 591
3 Policy Responses: Issues and Evidence 591
3.1 Policy Options 591
3.1.1 Restrictions on Gross Inflows 593
3.1.2 Encouragement of Gross Outflows 594
3.1.3 Trade Liberalization 595
3.1.4 Exchange-Rate Flexibility 596
3.1.5 Sterilization 597
3.1.6 Policies to Influence the Money Multiplier 598
3.1.7 Fiscal Contraction 599
4 Variations in Policy Responses 599
4.1 Measures to Impede Gross Inflows 600
4.2 Encouragement for Gross Outflows 601
4.3 Measures to Reduce Reserve Accumulation 602
4.3.1 Commercial Policy 602
4.3.2 Exchange-Rate Policy 602
4.4 Measures to Restrict Base Money Growth 603
4.5 Reduction in the Money Multiplier 604
4.6 Restrictive Fiscal Policy 604
5 Macroeconomic Outcomes 605
6 Policy Lessons 607
Appendix: Reduction in the World Risk-Free Interest Rate in the Three-Good Model 612

Chapter 16: Speculative Attacks and Exchange-Rate Crises 616
1 The Conventional Approach 617
1.1 The Basic Model 617
1.2 Extensions to the Basic Framework 623
1.2.1 Sterilization 623
1.2.2 Alternative Post-Collapse Regimes 624
1.2.3 Real Effects of an Anticipated Collapse 626
1.2.4 Borrowing, Controls, and the Postponement of a Crisis 628
2 Optimizing Policymakers and Self-Fulfilling Crises 631
2.1 The Output-Inflation Tradeoff 632
2.2 Public Debt and Self-Fulfilling Crises 635
2.3 Credibility, Reputation, and Currency Crises 637
3 A "Cross-Generation" Framework 641
4 Evidence on Exchange-Rate Crises 641
4.1 The 1980s 642
4.2 The 1994 Crisis of the Mexican Peso 644
4.2.1 Background: Structural Reform and the Solidarity Pact 644
4.2.2 Policy Responses to Capital Inflows, 1989-1993 646
4.2.3 The Balance-of-Payments Crisis 648
4.3 Thailand's Currency Crisis 654
4.3.1 Background 654
4.3.2 Triggering Events 656
4.3.3 Emergence and Management of the Crisis 658

PART V: GROWTH, STRUCTURAL REFORMS, AND POLITICAL ECONOMY 667
Chapter 17: Macroeconomic Policies and Long-Term Growth 669
1 The Neoclassical Growth Model 671
2 Externalities and Increasing Returns 678
3 Human Capital, Knowledge, and Growth 680
3.1 The Production of Human Capital 680
3.2 The Production of Knowledge 681
4 Effects on Financial Intermediation 687
4.1 Effects on the Saving Rate 688
4.2 Effects on the Allocation of Capital 689
4.3 The "Conduit" Effect, Financial Repression, and Growth 690
4.4 Financial Development and Growth: Empirical Evidence 691
5 Inflation Stabilization and Growth 692
6 Government Size and Growth 697
7 Commercial Openness and Growth 698
8 Exchange-Rate Unification and Growth 701

Chapter 18: Trade, Financial, and Exchange Market Reforms 705
1 Trade Reforms: Some Recent Evidence 706
2 Trade Liberalization, Wage Rigidity, and Employment 709
2.1 The Analytical Framework 710
2.1.1 Fixed Nominal Wages 712
2.1.2 Flexible Wages 713
3 Monetary and Financial Liberalization 714
3.1 Monetary Reform 715
3.2 Financial Liberalization 719
4 Unification of Foreign Exchange Markets 721
4.1 Short-Run Dynamics of Unification 722
4.1.1 The Pre-Reform Dual Rate Regime 722
4.1.2 The Post-Reform Flexible Rate Regime 724
4.1.3 Dynamics in Anticipation of Reform 726
4.2 Longer-Run Effects of Unification 730
4.3 Evidence on Unification Attempts 732

Chapter 19: The Political Economy of Stabilization and Adjustment 737
1 Politics, Economic Policy, and Adjustment 738
1.1 The Political Economy of Structural Adjustment 738
1.2 Political Instability, Inflation, and Budget Deficits 740
2 Political Stabilization Cycles 741
2.1 Opportunistic Models 742
2.1.1 Elections, Inflation, and Unemployment 742
2.1.2 Elections and Devaluation Cycles 745
2.2 Models With Informational Asymmetries 750
3 Elections-Induced Economic Cycles: The Evidence 752
3.1 Informal Evidence 752
3.2 Econometric Evidence 754
3.2.1 General Cycles and Government Expenditure 755
3.2.2 Determinants of Domestic Credit to the Government 757
3.2.3 Elections and the Composition of Public Expenditure 758

Chapter 20: Sequencing and Speed of Reforms 761
1 Sequencing of Reforms 761
1.1 Macroeconomic Stabilization, Financial Reform, and the Opening of the Capital Account 762
1.2 Capital and Current Account Liberalization 764
1.3 Macroeconomic Stabilization and Trade Reform 767
2 Uncertainty and Gradualism 770
3 Adjustment Costs, Credibility, and the Speed of Reform 774

Epilogue 777
References 781
Index of Names 827
Index of Subjects 835