Edward F. Buffie

Public Investment, Growth, and Debt Sustainability: Putting Together the Pieces

We develop a model to study the macroeconomic effects of public investment surges in low-income countries, making explicit: (i) the investment-growth linkages; (ii) public external and domestic debt accumulation; (iii) the fiscal policy reactions necessary to ensure debt-sustainability; and (iv) the macroeconomic adjustment required to ensure internal and external balance. Well-executed high-yielding public investment programs can substantially raise output and consumption and be self-financing in the long run. However, even if the long run looks good, transition problems can be formidable when concessional financing does not cover the full cost of the investment program. Covering the resulting gap with tax increases or spending cuts requires sharp macroeconomic adjustments, crowding out private investment and consumption and delaying the growth benefits of public investment. Covering the gap with domestic borrowing market is not helpful either: higher domestic rates increase the financing challenge and private investment and consumption are still crowded out. Supplementing with external commercial borrowing, on the other hand, can smooth these difficult adjustments, reconciling the scaling up with feasibility constraints on increases in tax rates. But the strategy may be also risky. With poor execution, sluggish fiscal policy reactions, or persistent negative exogenous shocks, this strategy can easily lead to unsustainable public debt dynamics. Front-loaded investment programs and weak structural conditions (such as low returns to public capital and poor execution of investments) make the fiscal adjustment more challenging and the risks greater.

Some Misconceptions about Public Investment Efficiency and Growth

We reconsider the macroeconomic implications of public investment efficiency, defined as the ratio between the actual increment to public capital and the amount spent. We show that, in a simple and standard model, increases in public investment spending in inefficient countries do not have a lower impact on growth than in efficient countries, a result confirmed in a simple cross-country regression. This apparently counter-intuitive result, which contrasts with Pritchett (2000) and recent policy analyses, follows directly from the standard assumption that the marginal product of public capital declines with the capital/output ratio. The implication is that efficiency and scarcity of public capital are likely to be inversely related across countries. It follows that both efficiency and the rate of return need to be considered together in assessing the impact of increases in investment, and blanket recommendations against increased public investment spending in inefficient countries need to be reconsidered. Changes in efficiency, in contrast, have direct and potentially powerful impacts on growth: “investing in investing” through structural reforms that increase efficiency, for example, can have very high rates of return.

Trade liberalization, credibility and self-fulfilling failures

Abstract This paper addresses the question of whether there may be a self-fulfilling aspect to the failure of liberalization attempts when it is widely known the government will abandon the reform if the central bank suffers an unacceptably large loss in reserves. I derive the conditions for both sustained reform and a self-fulfilling failure to be equilibrium outcomes. Under certain well defined conditions, liberalization is most likely to succeed when the capital account is open.

Aid volatility, monetary policy rules and the capital account in African economies *

We examine the properties of simple quantity-based monetary policy rules of the kind widely used in low-income African economies. Using a DSGE model and focusing our attention on responses to positive aid shocks, we suggest that policy rules involving substantial reserve accumulation in the face of aid surges serve to ease macroeconomic adjustment to shocks, particularly when a portion of aid is used to support fiscal adjustment. These rules are robust to assumptions about the degree of integration of the domestic public debt market with world capital markets. Although an open capital account facilitates smoother adjustment to temporary aid surges when an aid inflow is fully spent, it exacerbates the adjustment problem when aid is accompanied by fiscal adjustment and hence reinforces the case for a managed float in such circumstances.

Tight Money, Real Interest Rates, and Inflation in Sub-Saharan Africa

The consequences of tight monetary policy are analyzed in an optimizing currency-substitution model of a small, open economy that operates under an open capital account and a flexible exchange rate. There is a reasonably good fit between the dynamics generated by the model and the stylized facts in the tight-money episodes that occurred in Kenya in 1993 and Nigeria in 1989-91. The studys results shed light on two issues: why tight money has provoked stupendous increases in inflation and the real interest rate in some episodes, and whether tight money is a foolish, unsustainable policy that always worsens the fiscal deficit and raises the inflation rate in the long run.

Public investment, private investment, and inflation

Abstract In this paper I investigate the short- and long-run effects of cutting investment in social infrastructure in a simple perfect foresight model. Even though the equilibrium capital stock falls, private investment increases in the short run provided the intertemporal elasticity of substitution is not extremely large. When the productivity of social infra-structure is comparable to or above that of private capital, inflation is likely to increase in the long run. Furthermore, inflation may be higher throughout the adjustment process if a modest degree of intertemporal substitution is possible.

Solving the Unit Root Problem in Models With an Exogenous World Market Interest Rate

The standard model of the small open economy is burdened with a unit root that greatly complicates numerical computation of the global saddle path. In this paper we solve the unit root problem by developing a set of innovative forward-shooting algorithms. Exploiting the fact that the algorithms are mechanical and model-free, we have placed canned, fully automated programs in the public domain. The programs do not require any substantive human input. The users only responsibility is to type in the equations of the model correctly.

Exchange-Rate-Based Stabilization, Durables Consumption, and the Stylized Facts

In this paper we show that a model featuring durables consumption, weak credibility, and sticky prices can explain many of the stylized facts associated with exchange-rate-based stabilization, including the quantitative variation exhibited by key macroeconomic variables. In standard models, the boom phase of ERBS is nothing more than a tepid expansion – changes in spending, real output, and the real exchange rate are unexceptional. But when durables are part of the choice set, the boom is truly a boom: following a temporary reduction in the crawl, total consumption spending rises 12-20%, the real exchange rate appreciates 40-55%, and the current account deficit swells to 5-7% of GDP. None of these results requires easy intertemporal substitution in consumption.

Public Sector Wage Cycles and the Co-movement of the Fiscal Deficit and Inflation in Less-Developed Countries

In this paper I analyze the co-variation of the fiscal deficit and inflation in a simple perfect foresight model that incorporates low- and high-wage cycles of equal depth and duration. When money and consumption are not extremely strong complements and the wage-cycle not extremely short-lived, inflation rises above its pre-stabilization level while the deficit is lower. The results thus argue that public sector wage cycles may underlie the weak empirical correlation of the deficit and inflation.

Stabilization policy and public sector prices

Abstract This paper analyzes the impact of public sector price increases combined with employment cuts in a dynamic optimizing model. If the government adopts a tough layoff policy, the real wage is highly flexible and the reforms are perceived to be permanent, there is a strong presumption that real output will be higher and inflation lower over all time horizons. Problems may arise during the adjustment process, however, when the reforms are not credible or the real wage adjusts slowly to clear the labor market.