Macroeconomic instability of the less developed country economy when bank credit is rationed

During the early 1980s, many less developed countries (LDCs) experienced a phenomenon which is not readily explicable using conventional macroeconomic theory: accelerating inflation coupled with output contraction. Moreover, arguments based on supply shocks do not adequately explain the performance of the LOCs over this period. In explaining the apparent anomaly of accelerating inflation coupled with output contraction, the model developed here assigns an important role to the availability of bank credit. ; In many LDCs, the government fixes interest rates on bank deposits and loans. If rates on loanable funds are set below market clearing levels, this leads to credit rationing. Generally, firms must pay wages to workers in advance of the receipts from sales. Bank credit is needed to finance the hiring of labor when there are few alternative sources of finance. Loan availability can thus have a crucial impact on the supply of output. The credit constraint is exacerbated when the government's fiscal deficit instigates inflationary pressure. In response, households reduce deposit holdings leading to a contraction in loan availability and recession. ; Initially, the fiscal deficit and the money supply are assumed to be exogenously determined. Later, the analysis examines a feedback effect of inflation leading to increases in the fiscal deficit and further inflationary pressure. As inflation accelerates, individuals try to shift out of money balances and into inflation hedges contracting the real money supply, real loan availability, and output. Thus the model suggests an explanation for the vicious circle of accelerating inflation and declining output which is observed in many LDCs.