Monetary and Fiscal Policy in LDCs: Limitations and Constraints

By Khalil, Samina | Economic Review, November 1993 | Go to article overview

Monetary and Fiscal Policy in LDCs: Limitations and Constraints


Khalil, Samina, Economic Review


The LDCs (Less Developed Countries) encounter greater Limitations than Developed countries in using monetary and fiscal policies to achieve macroeconomic goals. The banking system, often limited in its ability to regulate the money supply to influence output and prices in developed countries, is even more ineffective in LDCs. Usually the money market in developing countries is externally dependent, poorly organized, fragmented and cartelized. The following are the major limitations of Monetary Policy in LDCs including Pakistan:-

1. Many of the major Commercial Banks in LDCs are branches of large private banks in developed countries, such as Chase Manhattan or Barclay's Bank. Their orientation is external. They are concerned with profits in dollars, pound sterling, or other convertible currency, not rupees, pesos and other currencies that cannot be exchanged on the world market.

2. Many LDCs are so dependent on international transactions that they must limit the banking system's local expansion of the money supply to some multiple of foreign currency held by the central bank. Thus the government can not always control the money supply because of the variability of foreign exchange assets.

3. The LDC central banks do not have much influence on the amount of bank deposits. They generally make few loans to commercial banks. Furthermore since securities markets are usually not well developed in LDCs, the central bank usually buys and sells few bonds on the open market.

4. Commercial banks generally restrict their loans to large and medium enterprises in modern manufacturing, mining, power, construction, transport and plantation agriculture. Small traders, artisans, and farmers obtain most of their funds from close relatives or borrow at exorbitant interest rates from local money lenders and landlords. Thus LDC banking system have less influence than developed countries on the interest rate, level of investment and aggregate output.

5. Demand deposits (checking accounts) as a percentage of the total money supply are generally lower in LDCs than developed countries. In United States, they make up three fourths of the total money supply, but in most developing countries, the figure is less than half. Generally commercial banks in LDCs control a smaller share of the money supply than in developed countries.

6. The links between interest rate, investment and output assumed in developed countries are questionable in LDCs. Investment is not very sensitive to the interest rate charged by commercial banks, partly because a lot of money is lent by money lenders, landlords, relatives and others outside the banks. Furthermore because of supply limitations, increases in investment demand may result in inflation rather than expanded real output. The LDCs often face these limitations at far less than full employment because of poor management, monopolistic restraints, bureaucratic delay, and the lack of essential inputs (resulting from licensing restrictions on foreign exchange or domestic materials).

Tax Ratios and GNP Per Capita:-

As the monetary policy in LDCs suffers some constraints, the fiscal policy-taxation and government spending - has certain issues to be examined to make it another effective tool for controlling income, employment and prices. Changes in tax revenues as an economy develops, factors to be considered in formulating tax policy, political obstacles to tax collections, and patterns of government spending in developed countries and less developed countries are vital fiscal policy issues.

The concept of systematic state intervention to stimulate economic development has been a major part of the ideology of many developing countries. Yet perhaps surprisingly, taxes as a percentage of GNP in less developed countries are generally less than in developed countries. If social security contributions are included, the differences in tax ratios widen. Among the LDCs, the tax revenue as a percentage of GNP is 12.

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Monetary and Fiscal Policy in LDCs: Limitations and Constraints
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