AM05 MMT16

Chapter 16 of MMT Textbook about Open Economies -- basic facts about balance of payments, sovereign currencies, and monetary crises

Questions:ANSWERS GIVEN ARE CUT AND PASTE -- questions asked will be minor variations, so UNDERSTANDING will be required to ANSWER THEM

Read Akmal Hussain's article on After the IMF Program and then read Zaman on Rupee Over-Valuation.

1. Akmal Hussain says that devaluation will not lead to increased export earnings because Marshall-Lerner condition does not hold. EXPLAIN his argument.

Ans. The aim of an IMF programme is to reduce the balance of trade by devaluing the exchange rate. Akmal hussain argued that devaluation policies are counterproductive, because Marshall–Lerner Conditions for successful devaluation are not met in Pakistan: the volume of imports and exports is inelastic with respect to dollar price reduction. So even if the dollar prices of exports fall and rupee prices of imports rise following devaluation, foreign exchange earnings would tend to fall, rather than rise. Second, whatever little increase in export orders occurs due to devaluation, orders cannot be supplied because lack of underutilized productive capacity in the manufacture of exportable goods. In Pakistan, almost 50 percent of the textile industry is paralyzed due to acute cash flow problems. Most of the industrial units are operating at full capacity, and would need to expand capacity in order to increase supply. At the same time due to devaluation, the cost of production of domestic manufactures has increased, thereby pushing up prices. Devaluation has also increased the prices of fuel and fertilizers that have turned on the four main switches to inflation in Pakistan: electricity, gas, petrol/diesel and food prices.

2. Explain why, according to the Zaman argument, this is a short run argument, and different considerations govern long run consequences of devaluation -- Under what conditions (as per article) would we expect to see long run increase in export earning following devaluation.

Ans. The argument that additional demand will be created by lower prices for Pakistani goods, cannot be supplied because our export industries are working at full capacity and will not be able to expand production to meet the additional demand. But this is true in the short run – we may not see an immediate response in terms of increased exports. In the long run, export oriented industries could come into existence to satisfy additional global demand created by cheaper PKR. However, it is costly and risky to setup industries because large investments in production capacity requires confidence that the government will maintain its exchange rate policies. The domestic economy will never learn to produce if it is cheaper to import goods at prices subsidized by government borrowing. The long run health and prosperity of the economy requires either fair or under-valuation exchange rate. Cut and Paste suggest LACK OF UNDERSTANDING -- You must UNDERSTAND, DIGEST, and RE-Express Argument in YOUR OWN WORDS.

3. Explain why, with over-valuation, expansionary monetary policy and job guarantee program would lead to problems with Balance of Payments, but NOT with under-valuation.

Ans. Expansionary monetary policy and job guarantee program would create excess demand for local goods and demand for imports. With an overvalued rupee, we subsidize all imports and can’t afford to increase local demand, since that drains our foreign reserves. However, an undervalued rupee acts as a tax on imports which creates foreign reserves for the State Bank

4. Explain how the Job Guarantee Program requires that we give jobs in the right sectors so as to avoid inflation. IN which sectors should jobs be provided? How can we estimate where to create jobs? See Employment for All in Dawn

Ans. By pumping billions into the economy and providing millions of jobs to all who wish to work, a huge amount of additional demand for goods and services will be created by this additional money being paid to the formerly unemployed. Careful sectoral planning is needed to ensure a match between additional demands generated and the additional production that will be created. However, even if we fail in matching supply to demand, excess demand which leads to inflation To avoid inflation, we need to ensure that employment is provided in that sector or to produce that goods for which we anticipate excess demand will be generated, forexample if we forecast additional demand for a million tones of food, we must employ the laborers to produce the additional million of food. . Using household income and expenditure surveys which shows consumption patterns of the poor so we get estimates of the nature of the additional demand generated and allocate labors in that sector where demand is generated .