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The IMF Monetary Model
A Hardy Perennial
JACQUES J. POLAK
The IMF monetary model has been adapted to changing circumstances since its
inception over 40 years ago. The model's chief architect examines why it still remains
ROM THE DAY in 1947 when the International
Monetary Fund opened its doors for business and member countries came to it seeking credit
to help them meet deficits in their balances of payments, the IMF had to have an
understanding of the causes of such deficits and, both qualitatively and quantitatively,
of the policy measures necessary to overcome them. Only then could it come to a judgment
on whether a country's policies would be sufficient to restore balance and, if they were
not, to insist on a strengthened policy package as a condition for IMF credit.
The model that the IMF introduced in the 1950s to meet this need is still very much
alive today. IMF Stand-By Arrangements and other financial support continue to be designed
around monetary targets serving as "performance criteria" for the release of
successive amounts of financial assistance or as "benchmarks" that play a major
role in the reviews of such arrangements.
The case for a simple model
One key characteristic of the model is its simplicity. There were two good reasons for
this. First, at the analytical level, simplicity was inevitable in view of the paucity of
basic economic data such as national income in the early postwar years for many of the
Fund's member countries, the total absence of econometric models to describe their
economies, and indeed, the probability that this situation would not be remedied for
decades ahead. Hence the choice of a model that needed as inputs only two sets of
statistics that were generally available--banking data and trade data. Second, and even
more important, simplicity kept the model focused on the key variable that governments
could control--domestic credit creation--that was seen as crucial to the correction of the
balance of payments problems for which IMF assistance had been invoked.
The limitations on statistical data have to a considerable extent subsided, but there
are still many IMF customers, both in the developing world and among the transition
economies, for which constructing an empirical model suitable for inferences about policy
choices and outcomes would be a questionable undertaking. For program design as well as
control, the IMF has continued to need a simple model, with a very limited number of
standard variables, subject to elaboration on an ad hoc basis.
The model was designed to study the effects on both income formation and the balance of
payments of the two most important exogenous variables (variables determined outside the
model) operating on the economies of the great majority of countries in the early postwar
period: autonomous changes in exports and the creation of domestic bank credit; or, in
monetary terms, foreign and domestic autonomous additions to a country's money supply. To
handle the effects of these two variables required a model that explicitly recognized a
demand-for-money function. The evidence from many countries suggested that the simplest
form of such a function--namely, assuming that the demand for money is proportional to
income--would be a reasonable approximation. As a second behavioral equation, the model
contained a function for the demand for imports. The full model appears, in its simplest
form, in the box.
The dynamic character of this model derives from the fact that it contains both income
and the change in income. Solving the model gives us values for the variables that are
determined by the model, such as income and the change in foreign reserves, as weighted
averages of the values for the current and past years of exports, capital inflows of the
nonbank sector, and the change in the domestic credit of the banking system.
We made a large effort to test the validity of this proposition. For those interested
in the never-ending debate between Keynesians and monetarists, it may come as a surprise
that the simple assumptions of the model make it both Keynesian (a multiplier model with a
marginal propensity to spend of 1) and monetary (based on a constant velocity of
circulation). The dynamic nature of the IMF model, in contrast to most of the academic
monetary models of the balance of payments, yields not only the final equilibrium value of
the endogenous variables but also the time path toward these values. It was essential to
be able to derive these short-term effects if the model was to be used in analyzing
current policy problems and finding their solutions.
The set of four equations in the model constitutes the logical core of the IMF's
programming exercise, which is known as "financial programming." Since the early
1950s, it has been the centerpiece of the analysis leading to IMF conditionality--the
policy actions that a borrowing country must take to have access to IMF credit.
|The IMF monetary model
|MO = kY
|The change in a country's money supply (MO) is proportional to the change
in its income (Y) by a factor k, which is the inverse of the velocity of
circulation of money (Y/MO); thus, k = MO/Y.
|M = mY
|The demand for imports (M) is a function of a country's income (Y),
where m is the country's marginal propensity to import.
|MO = R + D
|The change in the money supply (MO) is by definition equal to the change in
a country's foreign reserves (R) plus the change in the domestic credit of the banking
|R = X - M + K
|The change in foreign reserves (R) is by definition equal to exports (X)
minus imports, plus net capital inflows of the nonbank sector (K).
The model over time
Although the IMF has continued to use essentially the same model as the foundation of
its credit arrangements, these arrangements themselves have continued to broaden and
deepen over the years. Thus, the analytically neutral variable "credit creation"
was split into credit to the private sector (usually to be encouraged) and credit to the
government sector (usually to be discouraged). In a further specification, the IMF moved
toward advice on specific types of taxes (with some taxes judged more acceptable than
others) and on various types of expenditure, endorsing social safety nets and education
(especially primary, but not necessarily tertiary, education) and frowning on military and
other nonproductive expenditures.
Beyond filling in with ever-increasing precision the credit creation component of its
conditionality, it also added further specifics of a nonmonetary character, relying on a
wide spectrum of policy instruments, many of them in fields where the World Bank was also
Many IMF-supported programs in recent years have contained major policy understandings
on structural adjustment, price and trade liberalization, deregulation of the labor
market, privatization, and many other policies. But, since none of these could
conveniently be captured in econometric equations, no attempt was made to build them into
the model. Thus, while financial programming and the simple model underlying it continued
to provide the packaging for the IMF's lending arrangements, the contents of the packages
became increasingly complex over the years. Over time, a number of changes to the model
have been considered, in particular with respect to the exchange rate, medium-term growth,
and control over inflation.
The exchange rate. The design of the model in the early postwar years
reflected two characteristics of the world economy at that time: the par value regime of
fixed exchange rates and a dominant upward trend in world demand. Balance of payments
problems that brought countries to seek the assistance of the IMF were typically due to
bursts of excessive domestic expansion and could usually be cured by the introduction of
financial restraint. If the expansion had festered long enough to raise the domestic price
level above that of the rest of the world, there would be a need for a compensating change
in the par value. And, in the limited number of countries subject to chronic inflation, it
might even be necessary to include a regular dose of compensating depreciation in
IMF-supported programs. In an age when the world was broadly on a full-employment path,
there was, unlike the situation in the 1930s, little incentive for countries to resort to
currency depreciation to raise their real incomes, quite apart from the fact that the
IMF's founding charter, its Articles of Agreement, banned competitive depreciation.
As the par value system unraveled, provisions about the exchange rate became a frequent
component of IMF Stand-By Arrangements. But this did not require a radical change in the
model. Exports already entered the model as an exogenous variable, and forecasting them,
with or without the exchange rate as one of the determining variables, was in any event
performed outside the model. To the import equation (determined within the model) an
exchange rate term could readily be added. Effects on prices, output, government finance,
and (if they could be ascertained) on capital movements, had, of course, also to be taken
into account. Since, as noted, it is in any event not feasible to design a complete set of
structural equations for most of the economies with which the IMF works, the addition of
the exchange rate as a variable merely had the effect of making the process of iteration
more laborious rather than changing it in a fundamental way. It also made it possible to
address explicitly two policy objectives: maintaining a healthy balance of payments and
the pursuit of full use of the country's productive capacity.
To ensure that a country's exchange rate would remain sufficiently competitive during
the period of a Stand-By Arrangement, the IMF normally includes in such an arrangement a
provision that a country must hold a minimum level of net international assets to be able
to draw successive installments of its stand-by credit, the idea being that the instrument
by which countries would ensure the observation of this limit would be the exchange rate.
The standard IMF conditionality thus evolved toward the inclusion of a double monetary
prescription: setting a ceiling on the expansion of the domestic assets of the central
bank to achieve an acceptable balance of payments result (a flow concept) and a floor
under the central bank's holdings of net foreign assets (a stock concept) to bring about a
satisfactory level of foreign reserves, and to ensure that the central bank would not use
excessive intervention to counter market pressures for a more depreciated exchange rate.
Medium-term growth. As the strongly expansionary trends that had
characterized the world economy in the third quarter of the twentieth century came to an
end, the IMF and its members became increasingly concerned about the impact of IMF
programs on the growth prospects of the countries that needed to borrow under them.
Growth, in this context, meant two different things, which were not always sufficiently
distinguished in the policy discussions, namely: (i) the increase in real GDP--especially
after a country had experienced a negative shock--that could be achieved with the
country's existing productive capacity; and (ii) the increase in output over the
medium or long term that could be achieved through the growth of productive
I mentioned earlier the potential impact of a change in the real exchange rate on
capacity utilization. With respect to the second dimension, it is curious that for their
medium-term macroeconomic projections both the IMF and the World Bank continue to rely on
highly mechanical growth models of the Harrod-Domar family, first developed in the late
1940s. In these models there is no place for what the two institutions themselves consider
the most important factors determining the growth of developing countries, such as outward
orientation, realistic prices, privatization, reform of the financial sector, and, in
general, government attitudes toward the economy.
Rather than expanding its model, the IMF has pursued the double objective of
stabilization with growth by appraising the different items entering its existing model on
the basis of their potential contributions to growth. The first step in this direction,
the introduction of a sub-ceiling on credit to the government, served the purpose of
ensuring an adequate supply of credit to the private sector. The further refinement of the
entries on both the taxation and the expenditure sides of "net credit to the
government," referred to earlier, reflected an increasing desire on the part of the
IMF that the understandings reached with member countries on short-term stabilization
would, at the same time, contribute to medium-term growth.
Inflation concerns. Limits on credit creation can ensure a minimum
balance of payments outturn, but they do not provide protection against deviations from
the program in the opposite direction. Exceeding the foreign reserve target is often
followed by a larger increase in the money supply than had been assumed in the program. It
is probably fair to say that up to the 1970s, this possible outcome did not cause much
concern; it might rather be seen as a welcome development that might lead to early
repayment of IMF credit. But developments in the 1980s, and even more strikingly in the
1990s, have shown how such overperformance might also lead to shockingly high inflation,
both in countries that had been afflicted by the 1980s debt crisis and in many of the
IMF's new members in Eastern Europe, the Baltics, and the Commonwealth of Independent
States (CIS). In all these countries, controlling inflation became the first order of
business, often ahead of dealing with potential balance of payments problems. The IMF thus
had to face the question of how this objective was to be integrated into its model.
Changes in three directions seemed to be necessary:
The flexibility of international capital movements makes the treatment of that variable
as exogenous no longer tenable; their dependence, at least in part, on both the domestic
interest rate and exchange rate expectations would need to be allowed for. Bearing in mind
that an important component of international capital flows nowadays may be the outflow or
the return flow of domestic flight capital, this change in the model alone would present a
Allowance would have to be made for the fact that the domestic interest rate, which
does not even appear in the simple model, may be strongly affected by the size of the
government deficit, whether that deficit is financed from the banking system or in a
nascent domestic capital market.
The exchange rate would need to find a place in the model, not only in terms of its
effect on trade flows but also with respect to inflation expectations, since governments
have to face the choice between two possible exchange rate policies: a floating rate to
block the inflationary impact of an oversupply of "money of foreign origin"; or
a fixed (or crawling) exchange rate to provide a psychological anchor to the price level,
even though that might cause a competitive disadvantage if there remained some inertial
inflation in the economy.
In a formal sense, it would not be particularly difficult to introduce these three
extensions into the model. But that would be essentially useless unless it were also
possible to obtain some order of magnitude of the coefficients for the variables in the
newly introduced equations. And that, unfortunately, is not possible. In this setting, the
IMF has had to forgo the comfort of its old model and base its conditionality on a set of
ad hoc instruments that seemed plausible in the circumstances.
With respect to government finance, the IMF has found it necessary in recent years to
go behind ceilings on bank credit to the government and introduce direct restrictions on
government deficits. Even if financed in a noninflationary way in the domestic capital
market, such deficits crowd out investment by the private sector. Indeed, in the IMF's
relations with many countries (Argentina, Pakistan, and Russia, to name a few), agreed
limits on the budget deficit as a percent of GDP have become the most prominent feature of
To stave off imported inflation caused by an expansion in the money supply owing to
higher foreign inflows, the IMF has favored a free (upward) float in many of the CIS
countries, taking comfort from the fact that the currencies of many of these countries
were so deeply undervalued that a measure of appreciation would not undermine their
competitiveness, in particular since they were also experiencing a rapid increase in labor
While the prevention of excessive domestic credit creation and the targeting of a
desired increase in foreign reserves are relatively straightforward, the avoidance of an
excessive increase in the money supply raises more questions. In the first place, the
normal effect of a successful stabilization after a period of high inflation is an
increase in the demand for money. An inflow of money from abroad to meet this demand--and
the corresponding overshooting of the foreign reserve target--are entirely desirable, and
to frustrate this demand by either floating the exchange rate or (with a fixed exchange
rate) putting a ceiling on the money supply would needlessly depress the economy, as
Brazil found out in 1994. Putting a ceiling on base money (currency held outside banks
plus banks' claims on the central bank) would imply that the central bank would have to
engage in open-market sales of government paper at high domestic interest rates, which
could be extremely costly. In addition, the resulting rise in domestic interest rates
could attract more money from abroad, thus setting up a vicious circle.
Finding itself without much of a model to go by, the IMF has in recent years tended to
adopt an "all risk" policy, furnishing its arrangements with CIS countries and
with the Baltic states with a triple set of keys: a ceiling on domestic credit, a floor
under net international assets, and an indicative target for base money, in addition to
using the occasions of periodic Executive Board reviews under Stand-By Arrangements to
judge the need for additional action.
The exceptional situation in these countries may be expected to subside as and when
inflation comes down and the exchange rate stabilizes at something closer to an
equilibrium level. In that new situation, the concerns about inflation may to some extent
have abated, but concerns about the payments position can no longer be safely disregarded.
Increasingly, then, the CIS countries will find themselves in the position where the
prescription offered by the simple version of the monetary model suffices: a ceiling on
net domestic credit to protect the balance of payments, plus a floor under foreign
reserves to ensure that governments do not overreach themselves in defending the value of
their currencies. At some stage, confidence in the currency and the banks, which is still
painfully low in these countries, will rise and the resulting increase in the demand for
money will pull in foreign reserves. When that occurs, it will be possible to rejoice over
the increase in reserves without feeling qualms about the rise in the money supply.
For an entirely different group of countries, however, namely those that are part of a
monetary union, the model would seem definitely to have lost most, if not all, of its
applicability. In such countries there is no meaningful concept of a national money
supply, and government finance, in particular the government's domestic borrowing
requirement, becomes the only way to influence the level of demand. The IMF has had to
figure this out in its dealings with the African countries of the CFA franc area. Perhaps
it will some day get an opportunity to apply this knowledge in Europe if a member of the
future European Economic and Monetary Union finds it necessary to avail itself of the
IMF's balance of payments support.
This article draws on the author's paper, The IMF Monetary Model
at Forty, IMF Working Paper No. 97/49 (Washington, April 1997).
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