Fiscal adjustment and the real exchange rate: the case of Bangladesh

Kazi M. Matin

No 850, Policy Research Working Paper Series from The World Bank

Abstract: The author examines the effect of fiscal adjustment on the real exchange rate. The argument is made that the direction and extent of that effect depends on the way fiscal adjustment is carried out. If a fiscal deficit is reduced mainly by reducing total government spending, the effect on the real exchange rate depends on whether the adjustment is achieved through proportionate cuts in both capital and current spending or through disproportionately greater cuts in capital spending. A disproportionately high cut in capital spending affects the composition of government spending between tradables and nontradables. Econometric estimates of the model for Bangladesh show that the propensity to spend on nontradables is greater for government spending than for private, and greater for the government's current spending than for its capital spending. The author emphasizes two important implications of fiscal adjustment for developing countries like Bangladesh : a) when fiscal adjustment involves unsustainably heavy cuts in capital spending, appreciation of the real exchange rate misaligns that rate, causing misallocation of resources and b) when disproportionate cuts in capital spending occur at the same time as trade liberalization, appreciation of the real exchange rate undermines the effectiveness of trade.

Keywords: National Governance; Economic Theory&Research; Macroeconomic Management; Environmental Economics&Policies; Economic Stabilization (search for similar items in EconPapers)
Date: 1992-02-29
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