The macroeconomics of the public sector deficit : the case of Colombia

Policy, Research, and External Affairs WORKING PAPERS Macroeconomic Adjustment and Growth Country Economics Department The World Bank March 1991 WPS 626 The Macroeconomics of the Public Sector Deficit The Case of Colombia William Easterly There is a close relationsF ip between the means of financing the fiscal deficit and macroeconomic outcomes in Colombia. A debt-financed deficit increase of about I percent ofGDP translates into a real interest rate increase of 3 to 5 percent; a money- financed deficit increase of about I percent translates into 15 percentage points more inflation. lhc olnhcy. Rcsarch, and l xtemal Affairs (omplcx distributes PRI' Working Papers tdissectoate tche findings of work in progress and in encouirage thc c%.h4ngc if ideas among liank staff and all others imcrested in devclopment issues 'Ihese papers carrn he nanics of the atthors. rTclci onvl thetI sicas. and should he used and cited accordingly 'I'hc findings. intcrpretauons, and conchlsions; are the at'hors' own -I Itcs shIiuld n,t hc atinhuted i., the World lianik, its loard of Directors, its inanaganient, or any of its icirber couuiitr,cs.  Policy, Research, and External Affairs Macroeconomic Adjustment and Growth WPS 626 This paper -a product of the Macroeconomic Adjustment and Growth Division, Country Economnics Department-is partof PRE researcl project, The Macrocconomics of the Public Sector Delicit (Rl' 675- 31). Copies are available free from the World Bank, 1818 H Street NW, Waslhingtoni DC 20433. Please contact Raquel Luz, room Ni 1-057, extension 39059 (97 pages). Colombia is justly celebrated in Latin America and fundamental policy changes, especially the for its prudent macroeconomic management, the latter. To restore long-tenn growth, some fiscal cornerstone of which is careful management of reform will be needed to reverse some measure fiscal deficits. implemented between 1985 and 1989. From the 1960s through the early 1970s, Easterly finds a close relationship between Colombia's macroeconomic policy was mostly the means of financing the fiscal deficit and conservative - supportive of an export-oriented macroeconomic outcomes in Colombia. Using a development strategy associated with high simulation model, he traces how money-financed growth of both GDP and trade. Authorities were and domestic debt-financed fiscal deficits partially successful at steril; n'g a surge in translate into inflation and the real interest rate. coffee export revenues in the second half of the 1970s. In the early 1980s, the end of the coffee Roughly speaking, a debt-financed deficit boom coincided with a large increase in public increase of about 1 percent of GDP translates investment - especially in energy - which led into a real interest rate increase of 3 to 5 percent; to an incipient balance of payments and debt a money-financed deficit increase ol about I crisis. This crisis was largely avoided through a percent translates into 15 percentage points more strong, continuing adjustment effort that began inflation. in 1985. Easterly finds that many changes in the real Episodes of loose fiscal policy in Colombia exchange rate between 1975 and 1987 are have been minor compared with other Latin attributable to fiscal policy. He shows how American countries. The crisis of the early external debt financing and domestic debt 1980s was cut short by a sharp fiscal adjustment. financing have relatively different effects on the This adjustment was a combination of good luck real exchange rate and the real interest rate. Thc PRE Working Paper Series disseminates thc findings of work under way in the Bank's lPolicy, Rcsearch, and Extcrnal AffairsCoinplcx. An objcctive of thchsriesis togctthese findings outquickly, cven if prcsentations arc less than fully polished. The findings, interpretations, and conclusions in thiese papers do not necessarily rcprcsent official Bank policy. Produce(d by thc P'RE Diserninationi Center  TABLE OF CONTENTS I. Introduction 1 II. Historical Background 1 1. Macroeconomic management 2 2. Public sector accounts, 1975-87 14 3. The adjustment program of 1985-89 19 4. Decomposition of the coffee balance in Colombia 26 III. Fiscal Deficits, Real Interest Rates and Inflation 39 1. Basic Framework 39 2. Econometrically-estimated behavioral equations 41 3. Simulation results 56 IV. The Real Exchange Rate and the Fiscal Deficit 64 1. Determination of the real exchange rate 64 2. Determination of the resource balance 74 3. Joint simulation of the real exchange rate and resource balance 80 4. Conclusion 83 V. Simulations of the Fiscal Deficit, Real Exchange Rate, and Real Interest Rate 84 VI. Conclusion 94 References 96 This paper is part of World Bank Research Project 675-31, 'The Macroeconomics of the Public Sector Deficit'. I am grateful to Luis Jorge Garay for advice and assistance in the construction of a historical time se;ies on the public sector in Colombia, to Paolo Leme, Carmen Reinhart, and Luis Valdivieso for useful discussions, and to Piyabha Kongsamut and Maria Cristina AlV,ro for research assistance. I am also grateful to participants in the World Bank Workshop on Macroeconomics of the Public Sector Deficit and to the discussant. John Cuddington, as well as to Bela Balassa, for comments.  I. INTRODUCTION This paper analyzes the macroeconomic effects of public sector deficits in Cole -ia, using the methodology set out in the research proposal.' The first section will review the historical evolution of fiscal policy in Colombia, with an emphasis on the adjustment program of 1985-89. Since the fiscal deficit is particularly sensitive to developments in the coffee sector, a section looks at how much of the public coffee balance is explained by exogenous shocks. The next section examines how fisca' deficits affect the inflation rate and the real interest rate, using an econometrically-estimated model of the money and credit markets. The following section discusses the relationship between the fiscal deficit and the real exchange rate, using a reduced form model of traded and nontraded goods. The concluding section puts together the models of the preceding sections to look at the simultaneous determination of the real exchange rate and the real interest rate in response to fiscal policy changes. II. HISTORICAL BACKGROUND Colombia is justly celebrated in Latin America for its prudent macroeconomic management, of which careful management of fiscal deficits is the cornerstone. Even the occasional departures from conservative macroeconomic policy seem tame by Latin American standards. We will review the broad outlines of macroeconomic policy in this section. In the following section, we will look in more detail into the adjustment that has taken place since 1985. 'Easterly, W., K. Schmidt-Hebbel, and C. Rodriguez, The Hacroeconomics of Public Sector Deficits', March 1989.  2 1. Macroeconomic Management. 1960-89 A very brief synopsis of Colombian macroeconomic policy will help to introduce t.