RDP 9507: Macroeconomic Policies and Growth 1. Introduction

‘Is there some action a government of Australia could take that would lead the Australian economy to grow like Korea's or Taiwan's? If so, what, exactly? If not, what is it about the ‘nature of Australia’ that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else’ (With apologies to Lucas (1988)).

Conferences on macroeconomics and macroeconomic developments usually conclude with a paper on the implications for macro-policies. However, for a conference on growth, this poses a bit of a dilemma. On the one hand, according to the natural-rate hypothesis which is accepted by many analysts, macroeconomic policies are neutral with respect to long-run real output and employment. Moreover, in the neoclassical theory of growth, technological progress falls like manna from heaven and the level of investment – the only variable susceptible to policy changes – affects the steady-state level of output, but not its rate of change. Endogenous growth theory recognises that technological change can be endogenous and that changes in the stock of capital – human as well as non-human – may generate positive externalities and are not necessarily subject to diminishing returns. However, most policy implications are microeconomic in nature and the theory does not assign any specific role to macroeconomic policies.

On the other hand, when looking at the growth performance of different countries over various periods and the policies they pursued, it is difficult to believe that macro-policies did not play a role. The impressive economic achievements of most industrial countries during the 1950–73 period owed much to reconstruction and technological catch-ups, but these catch-ups did not take place automatically. They were facilitated by policies promoting economic integration and investment in human and non-human capital. Growth was also helped by low inflation, the absence of fiscal imbalances and stable factor-income shares. While macro-policies aimed at full employment may well have had a positive effect, they may also have sowed the seeds for the slowdown during the 1970s and 1980s. The astonishing growth performance of the four NIEs (the four Asian ‘tigers’) and later the South-East Asian economies also seems to be associated with policies favouring low inflation and sound fiscal policies. At the same time, the ‘lost decade’ of the 1980s in Latin America and depressing developments in most of Africa can be traced, not only to political instability, but also to inward-looking policies that stimulated domestic demand growth while paying little attention to the costs in terms of inflation and external imbalances.

If we accept the view that actual developments should receive a larger weight than pure theory, one important question remains: how should ‘macroeconomic policies’ be defined and measured and through which channels do ‘good’ or ‘bad’ policies affect growth? In this paper, we associate macroeconomic policies with monetary, fiscal and exchange rate policies as reflected in, or measured by, the rate of inflation, the budget balance, the real rate of interest, the real exchange rate and the current account of the balance of payments. This is not a very precise definition and it has the added problem that these measures of macroeconomic policies are to some extent endogenous to actual economic developments. As regards transmission channels, we are persuaded by Fischer's (1993) hypothesis that policies which lead to high inflation or large internal or external imbalances generate uncertainty which adversely affects growth. We also discuss additional channels which may exist if potential output depends on past developments in actual output because of path dependence.

The rest of the paper is divided into four sections. Section 2 provides a broad review of macroeconomic developments in the post-war period in an attempt to detect some preliminary evidence of the role of policies. Section 3 looks at the policy related variables in the generally-accepted theories of growth and the empirical evidence from cross-country regressions, reviewing major results as well as problems of measurement and interpretation. Section 4 deals with the relationship between inflation and growth while Section 5 summarises and derives tentative policy implications.