Economic Development and Balance of Payments: Understanding Effective Consumption Capacity, Lecture notes of Finance

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Analysing Public

Expenditure in a

Consistent

Framework

A FRAMEWORK FOR

MANAGING THE

BUDGET

ANNEX 2

August 2015

TABLE OF CONTENTS

• 1 Analysing Public Expenditure in a Consistent Framework
  • 1.1 The Context...................................................................................................................................
• 2 Balance of Payments Details of Partner Countries
• 3 External Balance Required....................................................................................................................
  • 3.1 Trade by Sector
  • 3.2 Fiscal discipline required
• 4 Aligning the Deficits: Need for a Macroeconomic Framework
  • 4.1 The Required Framework
  • 4.2 Analysing Public Expenditure with the Model
    • 4.2.1 Managing the deficits
• Table 2-1: Typical Balance of Payments Accounts for Antigua and Barbuda ($ million) LIST OF TABLES
• Table 2-2: Typical Balance of Payments Accounts for Belize ($ million)
• Table 2-3: Typical Balance of Payments Accounts for St Kitts and Nevis ($ million)
• Table 2-4: Balance of Payments Accounts for Barbados ($ million)
• Table 3-1: Trade by Sectors ($ million)
• Table 3-2: Government Budget Performance in Antigua ($ millions EC)
• Table 3-3: Government Budget Performance in Belize ( $ million B)
• Table 3-4: Government Budget Performance in St Kitts and Nevis ($ millions EC)

2 Balance of Payments Details of Partner Countries

The balance of payments data needed to do the PER are as reported in Table 1, Table 2, Table 3 and Table 4.

Table 2-1: Typical Balance of Payments Accounts for Antigua and Barbuda ($ million) 2005 2006 2007 2008 2009 2010 2011 2012 2013 Sum 2005-9 Sum 2010- 1 Export of Goods 82.74 74.03 59.35 65.46 50.74 45.72 56.15 59.04 64.20 266.86 225. 2 Imports of Goods -455.35 -559.70 -648.91 -669.89 -478.91 -453.88 -430.72 -483.55 -494.38 -2,142.87 -1,862. 3 Trade Balance =1+2 -372.62^ -485.67^ -589.56^ -604.43^ -428.17^ -408.17^ -374.57^ -424.51^ -430.18^ -1,876.01^ -1,637. 4 Services Balance 235.16 215.43 238.44 288.25 283.31 253.07 270.68 278.43 245.47 972.35 1,047. 5 Income Balance (NetIncome from Abroad) -42.04 -46.74 -52.67 -61.08 -50.82 -31.49 -39.47 -51.09 -50.13 -192.27 -172. 6 Transfers 8.00 25.22 18.24 28.75 26.65 19.48 25.67 30.35 30.45 78.11 105. 7 The Current AccountBalance (3+4+5+6) -171.49 -291.76 -385.55 -348.51 -169.02 -167.11 -117.69 -166.82 -204.40 -1,017.83 -656. 8 The Capital Account 214.33 31.57 11.11 14.81 0.46 16.57 8.47 2.47 11.85 257.47 39. 9 Net Capital Inflows 118.19 436.01 464.51 411.92 -249.95 -267.20 -161.10 -197.11 -281.37 768.75 -906. 10 Net Capital Outflows -142.72^ -149.76^ -82.03^ -80.09^ 70.72^ 129.20^ 28.29^ 53.10^ 80.46^ -303.80^ 291. 11 of which, change inreserves -7.24 -15.36 -0.83 5.83 -10.11 -19.91 -0.04 -14.40 12.45 -33.54 -21. 12 Financial Account Balance (9+10) -24.53 286.24 382.48 331.83 -179.23 -138.00 -132.81 -144.00 -200.91 464.96 -615. 13 Errors and omissions(7+8+12) 18.30^ 26.05^ 8.04^ -1.86^ -347.80^ -288.54^ -242.04^ -308.35^ -393.46^ -295.40^ -1,232.

Table 2-2: Typical Balance of Payments Accounts for Belize ($ million) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Sum 2005-9 Sum 2010- (^1) Export of Goods 650.5 854.3 851.1 960.3 766.2 956.4 1,207.1 1,243.0 1,217.0 1,177.9 4,082.4 5,801. (^2) Imports of Goods -1,112.4 -1,223.9 -1,284.0 -1,576.5 -1,240.2 -1,305.9 -1,549.1 -1,636.2 -1,751.8 -1,877.5 -6,437.0 -8,120. 3 Trade Balance=1+2 -462.0 -369.6 -432.9 -616.2 -474.0 -349.5 -342.0 -393.2 -534.8 -699.6 -2,354.7 -2,319. (^4) Services Balance 286.0 421.4 459.8 433.8 365.3 349.9 336.7 442.5 480.5 571.2 1,966.4 2,180. 5 Income Balance (Net Income from Abroad)

-228.9 -250.6 -317.9 -330.4 -181.3 -277.0 -194.4 -240.3 -236.0 -275.6 -1,309.0 -1,223. 6 Transfers 102.4 147.9 186.8 223.1 158.8 183.7 167.5 -261.0 145.9 147.9 819.0 384. 7

The Current Account Balance (3+4+5+6)

-302.5 -50.8 -104.2 -289.7 -131.2 -93.0 -32.2 -452.0 -144.3 -256.1 -878.2 -977.

8 The Capital Account 5.9 18.3 8.2 18.1 37.0 11.3 47.3 45.0 75.4 87.9 87.5 266. 9 Net CapitalInflows 368.8 181.6 232.5 438.3 224.7 87.2 100.3 223.2 222.6 295.9 1,445.9 929. 10 Net Capital Outflows -80.2 -28.9 6.7 -27.3 17.0 -32.8 62.6 88.0 -46.2 -13.2 -112.7 58. 11 of which, changein reserves 24.4 -99.6 -45.8 -115.8 -94.5 -8.6 36.2 105.6 227.7 163.5 -331.4 524. 12 Financial Account Balance (9+10) 288.7 152.7 239.1 411.0 241.8 54.4 -37.8 -135.2 -268.8 -85.2 1,333.2 987. 13

Errors and omissions (7+8+12)

-7.9 120.2 143.1 139.4 147.6 -27.3 -22.6 -542.2 -337.7 -253.4 542.5 276.

Table 2-3: Typical Balance of Payments Accounts for St Kitts and Nevis ($ million) 2005 2006 2007 2008 2009 2010 2011 2012 2013 Sum 2005-9 Sum 2010- 1 Export of Goods 63.51 58.29 57.70 68.96 37.44 57.90 67.72 62.82 58.05 285.90 188. 2 Imports of Goods -185.21 -219.57 -239.52 -285.84 -265.69 -252.68 -246.36 -227.74 -251.25 -1195.84 -726. 3 Trade Balance=1+2 -121.70 -161.29 -181.82 -216.88 -228.26 -194.77 -178.64 -164.93 -193.20 -909.94 -538. 4 Services Balance 68.23 76.31 71.35 41.00 36.89 38.85 59.49 74.85 110.12 293.77 173. 5

Income Balance (Net Income from Abroad)

-35.14 -32.34 -29.98 -32.44 -33.90 -29.18 -29.65 -23.78 -14.62 -163.80 -82. 6 Transfers 23.89^ 32.21^ 29.18^ 33.12^ 45.15^ 46.52^ 46.60^ 29.11^ 35.00^ 163.56^ 122. 7 The Current Account Balance (3+4+5+6)

-64.72 -85.11 -111.27 -175.19 -180.12 -138.58 -102.20 -84.75 -62.70 -616.40 -325. 8 The Capital Account 14.72 13.32 14.18 22.29 21.38 55.65 81.62 164.00 128.48 85.90 301. 9 Net CapitalInflows 74.90 110.26 143.68 249.59 14.46 12.70 38.92 213.56 186.20 592.90 265. 10 Net Capital Outflows -45.97 -20.66 -42.58 -63.38 -227.06 -154.88 -106.77 -103.21 -123.97 -399.65 -364. 11 of which, changein reserves 6.68 -17.15 -7.18 -14.73 22.68 33.30 40.33 -13.66 33.74 -9.70 59. 12 Financial Account Balance (9+10) 28.93 89.60 101.10 186.21 -212.60 -142.18 -67.85 110.35 62.23 193.25 -99. 13 Errors and omissions (7+8+12)

-21.06 17.82 4.01 33.32 -371.33 -225.12 -88.42 189.60 128.01 -337.25 -123.

Table 2-4: Balance of Payments Accounts for Barbados ($ million) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Sum 2005-9 Sum 2010- 1 Export of Goods 361.48 510.13 526.63 489.57 380.21 430.64 849.00 826.00 786.00 792.00 2268.01 3683. 2 Imports of Goods -1515.60 -1602.44 -1701.69 -1832.52 -1366.06 -1506.62 -1729.00 -1688.00 -1681.00 -1652.00 -8018.32 -8256. 3 Trade Balance=1+2 -1154.12^ -1092.31^ -1175.07^ -1342.96^ -985.85^ -1075.99^ -880.00^ -862.00^ -895.00^ -860.00^ -5750.31^ -4572. 4 Services Balance 797.86 911.42 1032.98 1086.46 792.77 904.45 660.00 641.00 706.00 702.00 4621.49 3613. 5

Income Balance (Net Income from Abroad)

-175.00 -256.37 -189.75 -245.96 -86.80 -113.09 -300.00 -172.00 -195.00 -197.00 -953.88 -977. 6 Transfers 65.44^ 82.85^ 56.07^ 26.80^ 18.79^ 48.25^ -39.00^ -9.00^ -13.00^ -14.00^ 249.95^ -26. 7 The Current Account Balance (3+4+5+6)

-465.82 -354.41 -275.76 -475.66 -261.10 -236.38 -559.00 -402.00 -397.00 -369.00 -1832.74 -1963. 8 The Capital Account 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0. 9 Net CapitalInflows 551.91 348.02 973.24 311.65 161.44 599.17 2346.27 599.

10 Net Capital Outflows -134.03 -145.75 -596.42 75.17 -195.13 342.59 -996.16 342.

11 of which, changein reserves -21.89 24.84 -169.72 102.65 66.53 -45.29 -264.00 -28.00 152.00 41.00 2.42 -144.

12 Financial Account Balance (9+10) 417.88 202.27 376.82 386.82 -356.57 -256.58 972.00 159.00 234.00 306.00 1350.11 941.

13 Errors and omissions (7+8+12)

-47.94 -152.14 101.06 -88.83 -617.66 -492.96 413.00 -243.00 -163.00 -63.00 -482.64 -1021.

For all partner countries, the deficit on the balance of trade is the dominant cause of the current account deficit. Another interesting pattern in the data on invisible trade for all of the countries, is that the net transfers and services balance are always in surplus while the net income balance is always negative. The available evidence suggests that the balance of trade in goods and services tends to be in deficit, and that this is compounded by deficits on the income account as net factor incomes flow abroad (from foreign investment in the economy, including loans). Further, a significant share of the demand for savings comes from excessive growth of the loans to a country’s government. This suggests that in a PER, competing savings options should be judged by whether the activity or business unit fosters capital accumulation to support growth in export-competitiveness. Activities and business units that do not foster growth of exports and export competitiveness should be the first targets of reform.

3.1 Trade by Sector

To support the level of detail in the balance of payments, the PER should document the associated import and export competitiveness of the economic sectors should also be documented and analysed in this process. The trade of the partner countries is highly specialized and this specialization is not really captured in the shares of exports and imports in GDP. A more useful approach to the PER is to monitor variations in the ratio of exports of the individual sectors to output and the ratio of imports of the sectors to apparent consumption. Apparent consumption is defined as the sum of output plus imports minus exports. Then, the analysis must define a standard of classification of industries as import-competing and export-competing. Traditionally, a benchmark of 20% is used. That is, an industry that exports more than 20% of its output is export-competing. Similarly, an industry that has a ratio of imports to apparent consumption greater than 20% is import-competing.

Table 3-1: Trade by Sectors ($ million) Exports Imports Sector 2005 2010 2014 2005 2010 2014 Food/agricultural products Raw materials Ores and other minerals Fuels Metals Total Primary Products Chemicals Semi-processed manufactures Steel Automotive products Machinery and equipment Other capital goods Textiles and clothing Other Consumer goods Total Manufactures Total Trade in Goods Services Tourism Travel Financial services Education Other services Total Services

3.2 Fiscal discipline required

Tables 6-9 report the budget aggregates for all the partner countries. All the partner countries are running budget deficits and mounting up public debt. These conditions indicate that the countries must devise suitable strategies to control all the key aggregates under government’s control: total revenue, total spending, the budget deficit (or borrowing requirements), and the consequential public debt.

Table 3-2: Government Budget Performance in Antigua ($ millions EC) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Revenue 493.7^ 602.7^ 724.7^ 736.0^ 595.9^ 639.6^ 596.3^ 646.6^ 597.8^ 664. Expenditure 563.3 684.1 749.6 766.3 781.7 676.2 714.7 671.5 700.7 718. Interest Expenditure 89.3 98.1 104.5 102.6 95.6 72.6 77.3 80.0 66.3 88. Non-Interest Expenditure 474.0^ 586.0^ 645.1^ 663.7^ 686.1^ 603.6^ 637.4^ 591.5^ 634.4^ 629. Deficit (69.6)^ (81.4)^ (25.0)^ (30.3)^ (185.9)^ (36.6)^ (118.4)^ (24.8)^ (102.8)^ (53.9)

Table 3-3: Government Budget Performance in Belize ( $ million B) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Revenue 482.3 559.9 634.6 767.7 784.0 729.0 783.0 846.2 840.3 943. Expenditure 662.7^ 640.0^ 735.3^ 771.7^ 767.6^ 768.0^ 817.1^ 889.2^ 852.1^ 999. Interest Expenditure 177.8 268.6 266.9 193.7 162.4 153.2 162.8 158.0 123.8 153. Non-Interest Expenditure 484.9^ 371.4^ 468.4^ 578.0^ 605.2^ 614.8^ 654.3^ 731.2^ 728.3^ 846. Deficit -180.4 -80.2 -100.7 -4.0 16.5 -39.0 -34.1 -43.0 -11.8 -56.

Table 3-4: Government Budget Performance in St Kitts and Nevis ($ millions EC) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Revenue 433.7 491.5 516.1 542.9 536.4 507.8 650.0 644.6 812.7 891. Expenditure 439.8 478.2 500.1 536.2 545.2 530.1 594.9 546.5 560.6 625. Interest Expenditure 95.8 109.2 115.9 128.3 123.2 131.0 125.8 116.7 81.1 77. Non-Interest Expenditure 344.0^ 369.0^ 384.2^ 407.9^ 422.1^ 399.1^ 469.2^ 429.8^ 479.5^ 547. Deficit (6.1) 13.3 16.1 6.7 (8.9) (22.3) 55.1 98.1 252.2 266.

Equation (2) is an identity. To make it behavioral, observe that the component (^) やぃ〙 ㉙】^ is the import

cover. It adjusts endogenously as a function of exports and of foreign capital inflows into the

official accounts. It can be written as some proportion of ぃぃ㉔〥 ㉙】^

. Here, ‑ can be interpreted as the

share of exports held as reserves. Also, the component (^) やぃぃ㉴㉙〦】 can be viewed as a function of ぃぃ㉔㉙〥】.

Since ぃ ぃ㉔㉙ is an exogenous factor, we can also write it as some function of the export/import ratio.

In seeking to influence ᡒ, government has no significant influence over ぃ ぃ㊙ ㉙

. It might promote

foreign exchange saving by growing the fraction of exports held as reserves. Government might

also encourage growth of (^) やぃぃ㉴〦 ㉙】 , but as a rule this generates only a moderate effect in the absence

of a strong pool of emerging non-traditional exporters. Currency depreciation always helps, but it adds a penalty in terms of a rising cost of imports. The major immediate opportunity for government to influence growth is to allow imports to grow as fast as possible, while

encouraging diversification and growth of 〥】. Thus, Z is modeled using five core independent

factors that should grow exports while growing reserves and output even faster: the amount of aggregate demand generated per dollar investment over time (ᡓぇ⡹ぉ), the capital-labour ratio (ᡣ), the ratio of the foreign rate of interest to the local rate of interest (ᡰ), and the reserves (‥). It is important to observe that most of the capital in partner countries is imported and transmit exogenous technological spillovers. All the variables are in natural logarithms and the equation in dynamic OLS form as the multiplicative form:

㊂ ㍄ (^) 䙲〒 〕䙳

ょㄘ (ᠧぇ⡹ぉ)ょㄙ^ ‵⡹ょㄡ^ (ᡰぇ⡹う)ょㄢ

Dynamic OLS makes sense since all the variables can be made stationary by simple first differencing, and so are integrated of order 1, and only 42 years of data are available.

Taking natural logs gives,

4. ᡶ〷 = ‖⡩ + ‖⡰ᡣ + ‖⡱ᡓぇ⡹ぉ + ‖⡲〴ゖ − ‖⡳‵ + ‖⡴ᡰぇ⡹う + ∑^ ぁ⡨ ‱ぁ(ᡖᡴぇ⡹ぁ) + ᡗけ

The estimated model for the case of Trinidad and Tobago is:

With an adjusted-R^2 of 0.92, the estimated equation explains about 92% of all the variation observed in the effective capacity to consume of Trinidad and Tobago.

Equation (3) can be integrated into a simple econometric specification of a macroeconomic development model that allows for long run changes in all variables in the system, including prices.

6. ᡔ = (^) ⡨ + (^) ⡩ 〸㌀㊁ 〸㌀㉹^ +^ ⡰ᡨ +^ ⡱ᡰ +^ ⡲ᡙ −^ ⡳^ −^ ⡴

぀ げ + ∑^ ‰〷(ᡖ

ぁ ⡨ ᡴぇ⡹〷) + ᡗ〩

7. ᡳ = ‐⡨ + ‐⡩ᡔ + ‐⡰ぐげ − ‐⡱ᡩ + ‐⡲ᠸ + ‐⡳ᡨ〰ぃ〶 + ∑ ぁ⡨ ′〷 (ᡖᡴぇ⡹〷) + ᡗえ
8. ᡨ〰ぃ〶 = ‑⡨ + ‑⡩ᡥ + ‑⡰ᡨ + ‑⡱ᡷ + ‑⡲– − ‑⡳† + ‑⡴ᡰ + ‑⡵ + ∑ ぁ⡨ ‑〷(ᡖᡴぇ⡹〷) + ᡗぃ
9. ᡷ = ‒⡨ + ‒⡩ᡩ + ‒⡰ᡶ + ‒⡱ᡸ + ‒⡳ᠵげ + ‒⡴ 〸㌀㊁ 〸㌀㉹^ − ‒⡴

〸㊇㊁ 〸㊇㉹^ + ‒⡵ᡨ〸^ + ‒⡶ᡙけ^ + ‒⡷ᡆ + ∑ ぁ⡨ ’〷(ᡖᡴぇ⡹〷) + ᡗげ

10. ᡸ = ‖⡩ + ‖⡰ᡣ + ‖⡱ᡓぇ⡹ぉ + ‖⡲〴ゖ − ‖⡳‵ + ‖⡩ᡰぇ⡹う + ∑^ ぁ⡨ ‱ぁ(ᡖᡴぇ⡹ぁ) + ᡗけ
11. ᡣ〹〱 = 〒 〓㉹ ㉹
12. ᠷ〱 = ᠷ〱,ぇ⡹⡩ + ᠵ〱
13. ᠷ〳 = ᠷ〳,ぇ⡹⡩ + ᠵ〳
14. ᡣげ〱 = 〒 〦㉹ ㉹
15. ᡙ = ᡙ⡨ + ᡙけ

The variables of the alternative model and their endogeneity status are as follows: ᡔ – is the natural logarithm of the debt to GDP ratio ᡷ- is the natural logarithm of per capita income or output per worker, an endogenous variable. ᡣげ〳- is the natural logarithm of the benchmark capital-output ratio of the economy, which can be treated as that of the country’s main trading partner. ᡣげ〱 – is the natural logarithm of the economy’s capital output ratio. ᡨ – is the natural logarithm of the GDP deflator, an indicator of the general level of prices ᡨ〰ぃ〶 – is the natural logarithm of the consumer price index ᡰ – is the natural logarithm of the ratio of the foreign rate of interest to the domestic rate of interest, a variable which also proxies the flow of foreign direct investment. ᡙ – is the natural logarithm of the ratio of government spending to GDP

• is the natural logarithm of the ratio of taxes to GDP. ᡥ – is the natural logarithm of the money supply ᡵ- is the natural logarithm of gross wages ᠸ is the natural logarithm of the labour force
• – is the natural logarithm of the exchange rate (the domestic price of a foreign currency, mainly the US dollar)

The equation also includes the effects of effective consumption capacity on growth. The PER Team might find it interesting to further disaggregate Equation (9) by industrial sector to allow sharper consideration of the effects of sector policy, especially on the export-competing sectors. Suitable identities would have to be added if the Team chooses to move in this direction.

Equation (10) describes the path effective consumption capacity. This capacity grows with the capital-labour ratio, aggregate demand and the level of government spending relative to available reserves, with reserves pushed to grow as fast as possible. It declines with the exchange rate and the ratio of the foreign (US) rate of interest to domestic interest rate. The dependence of reserves on exports explains why policy should promote growth of exports as the main source of import capacity. The interest rate effects exists because an increase in the foreign rate of interest relative to the local will draw foreign investment funds away from the local financial market to the foreign (US) market in search of higher yields. Finally, of considerable importance to the PER exercise, effective consumption increases with government spending in two ways. The first is through interaction with the ratio of reserves to the sum of exports and reserves. Thus, if government spending targets growth of exports as a share of the total, and therefore lowers the share of exports held as reserves, effective consumption capacity will grow. The second effect of government is generated through the capital-labour ratio. Thus, if government spending is driven by the need to support growing investment relative to labour, then effective consumption capacity will grow.

This type of model allows the PER Team to deal with a time horizon long enough such that changes in the capital stock, population, and technology are all ongoing and some or all of these factors have a significant dominating influence on the level of production as well as prices. All of these changes affect employment capacity, debt capacity and effective consumption capacity. This is the perspective that the Team must adopt when addressing the fundamental challenges of development. The model features recursion from effective consumption capacity to income and then from income to price, and therefore uses an analytical framework that is supply led, with causality running from effective consumption to income and then to price. Variations in the employment capacity and rate generated by these long run changes are more important than variations in short run effective demand, and these variations manifest themselves as variations in the amount of labour and capital when demand fluctuations are ignored.

The model also allows analysis over the medium term as conceived by an integrated expenditure framework for say the next five years. In this time horizon, the model considers the business cycles, which is to say dynamic changes induced by the interplay of demand and supply factors, including changes in wages and prices.

The parameters of each of the four behavioural equations can be estimated independently with known precision using the Stock and Watson (1993) dynamic OLS. In each equation, ∑ ぁ⡨ ‑〷(ᡖᡴぇ⡹〷) is an indication that lagged rates of change of all equation variables are used to

address endogeneity and the general requirements of cointegration, with significant ones retained in the final specification model. These allow the model to provide an indication of the persistence of the effects of government spending. The dynamic OLS method escapes the small sample and other specification challenges of the large sample methods that dominate the modern cointegration literature. During the estimation process, constraints may also have to be imposed on some of the equation parameters.

4.2 Analysing Public Expenditure with the Model

Evaluation of the past budgets requires analysis of the level and composition of the total allocations. The first issue is the consistency of the method of adjustment of the deficits, and hence the expenditures and tax revenues, with the macroeconomic framework.

4.2.1 Managing the deficits Consider a budget in deficit, so that spending is currently above revenues, as is evident in the data on the partner countries. The projected deficits will have consequences that depend on the way they are financed. In general, government will have to borrow.

1. By equation (6), if they are financed by borrowing, the public debt to GDP ratio will grow. a. If the borrowing is from foreign sources, it will increase foreign debt service payments and can lead to a foreign debt crisis if the borrowing is excessive. Foreign interest rates will be unaffected. b. If the borrowing is from domestic sources, it can lead to two initial effects. i. The domestic debt will grow and so will domestic debt service payments. ii. If the borrowing is excessively large, the domestic rate of interest will also rise. Then, by equation (6), that will further increase the gross debt to GDP ratio, usually by being forced to add debt to cover the interest due. c. However, if the domestic rate of interest rises, that will produce three additional effects. i. By equation (8), one is that the rate of inflation will increase. ii. The rate of private investment will also fall, which is a crowding-out effect. By equation (9), that would lead to a fall in per capita income, directly and through the fall in GDP per capita. iii. By equation (10), the rise in the domestic rate of interest will produce two different effects on effective consumption capacity.
2. One is to increase effective consumption capacity by lowering the ratio of foreign to local interest. This is the result of the higher local rates attracting portfolio investment inflows from abroad through the financial sector.

4. Some partner governments have the option to finance the deficit by printing money. This is possible in Barbados and Belize. The model provides guidance on the consequences of this approach. a. By equation (8), a decision to print money leads immediately to inflation if the money supply grows excessively. b. By equation (7) inflation leads to higher unemployment. c. Inflation will also hurt those who lose their jobs, those with savings, as well as the poor who tend to have incomes that are relatively fixed and little assets on which they can draw as their real balances fall. d. If high, inflation can lead to dual foreign exchange markets, as it becomes more attractive to hold foreign currency to hedge against the loss of value of the domestic currency.
5. All of the above consequences affect the pursuit of sector goals, including the social protection goals. For example, if debt service payments become excessive, government will lose the fiscal space to fund its key priorities in education, health and social protection.
6. Instead of financing large deficits, which worsens the current situation, government has the option to require budget cuts from all Ministries, aimed at avoiding the deficit as well as restoring external balance. The model also provides guidance on this choice.

a. By equation (6), the cut on government spending will tend to lower the debt to GDP ratio. b. By equation (7), a direct effect of lowering the debt to GDP ratio is to reduce the rate of unemployment. This is usually a consequence of lowering the debt service requirements and freeing budget space to support key sectors like education, health and other activities that provide stepping stones to better employability. c. Budget cuts also lead to reduced demand and output. By equation (7), an immediate effect will be to raise the unemployment rate. d. By equation (10), an immediate effect of the fall in government spending will be to lower the effective capacity to consume. By equation (9), that effect will cause a fall in per capital income. This will lead to lower taxes, unless government moves to raise the tax rate. Lower taxes will grow the deficit. e. The budget cuts will also lower effective demand and therefore lower the level of imports. This will partially and directly restore balance on the current account. i. However, by equation (2), one effect of the fall in imports will be to increase the effective consumption capacity. This is because the ratio of reserves to imports will rise along with the ratio of exports to mports, as long as the fall in imports make domestic resources more attractive to exporting firms.

ii. By equation (9), the rise in the effective capacity to consume can generate an increase in per capita income. This is generally because the increase capacity is tied to the potential to grow output by growing exports.

1. Reduced demand and unemployment makes resources available that can be used by exported.
2. However, this response depends on whether a set of potential exporters exists (or can be developed) that can use the freed-up resources to supply the foreign market. Absence of this pool of responsive firms is the main development challenge of the partner countries.
3. If a responsive set of firms exist or can be developed in a timely manner, then when seeking to reduce the budget deficits, an across-the-board cut will normally prove to be worse that a targeted cut. This is because a targeted cut can be used to redirect resources to support the export-competing sectors and firms. Their absorption of the free resources under the stimulus can lead to a growth in exports. If this happens, then by equation (10), the ratio of reserves to exports will fall, causing the domestic effective capacity to consume to grow. By equation (9), lead to growth in per capital income. Growth in per capita income increases the flow of taxes, which, by equation (6) will reduce the deficit and lower the debt to GDP ratio. This will then improve fiscal space by reducing debt service payments.

The consequences described above are intended to illustrate the intricacies involved and thus suggest why a numerical model of the macroeconomic framework is helpful to the PER exercise. It also illustrates why the model must explicitly account for the effective capacity to consume. The sector PER Team will benefit from having access to the macroeconomic model or the experts who built it, if one was used by the government to develop its policy framework and budgets. In the absence of that, it would be helpful to the government for the sector PER Team to observe the challenges of trying to evaluate the choices made when managing the deficits and recommend that an appropriate model be developed as soon as possible.