ECONOMIC RESEARCH CENTERDISCUSSION PAPER

No.171

Evaluation of Macroeconomic Policy in LaosbyPhouphet Kyophilavong

March 2009

ECONOMIC RESEARCH CENTERGRADUATE SCHOOL OF ECONOMICSNAGOYA UNIVERSITY

Evaluation of Macroeconomic Policy in Laos
Phouphet KYOPHILAVONG*

Abstract
Macroeconomic stability is one of the most important factors in maintaining higheconomic growth, especially in a transitional economy likes Laos. The Government of
Laos (GoL) seems to prioritize growth over macroeconomic stability in order to escapefrom Least Developed Country (LDC) status by 2020. However, there are very few
studies on this issue in Laos in terms of quantitative analysis. Therefore, the main
objective of this study is to evaluate the impact of macroeconomic policy, especially
growth and stability policies on the economy. A simple macroeconomic model wasdeveloped for this simulation, whose results show that stability policy has a more positive
impact on the economy than growth policy. Therefore, in order to maintain high growth,
it is important for the GoL to implement stability policy by controlling prices through atight money supply and a stable exchange rate.
Keywords: macroeconomic policy, macroeconomic model, GDP and Price.
JEL Classification: E17; E52; C01

1. 0 Introduction
The development goal of Lao People’s Democratic Republic (Laos) is to liberate thecountry from the group of Least Developed Countries (LDCs) by the year 20201. To
achieve this national goal, the National Economic Development Plan (NEDP) and the
National Poverty Eradication Programme (NPEP) were implemented. The main NEDP
target is to maintain high economic growth with macroeconomic stability (GoL, 2006).
*

Visiting researcher at Economic Research Center, Graduate School of Economics, Nagoya University,
and Associate Professor at the Faculty of Economics and Business Management, National University of
Laos. Phouphet20007@hotmail.com
1
According to UNDP(2007/2008), in terms of human development index, Laos was ranked as 130th outof 177 countries. GDP per capita was US$580 in 2007 (WB, 2008). 34 percent of population live below thepoverty line (NSC, 2003)

1

Since introducing the New Economic Mechanism (NEM) in 1986, Laos has maintained
high growth. The average growth during 1990-1995 was about 6 %, and the average
inflation rate in the same period was about 15 % (table 1). However, during the Asian
Financial Crisis (AFC) in 1997-1998, Laos was facing high depreciation of its currency(kip) and hyperinflation: the kip had depreciated about 70 % against the U.S. dollar andinflation had reached 150 % in 1999. In addition, agricultural production and Foreign
Direct Investment (FDI) also decreased during that period2. It was not only the AFC
which caused economic instability in Laos, but also poor macroeconomic management(Okonjo-Iweala et al, 1999). Therefore, it is vital for the GoL to improve its
macroeconomic management abilities in order to maintain growth with macroeconomic
stability.

However, there are some arguments over whether the GoL should prioritize growth or
macroeconomic stability3. If the GoL gives priority to macroeconomic stability, atightening monetary policy and an appreciated exchange rate policy are indispensable. On
the other hand, if the GoL gives priority to economic growth, loosening the money supply
and a depreciated exchange rate policy are vital. However, due to the lack of quantitative
studies on this issue4, it is still not clear whether the GoL should prioritize growth or
macroeconomic stability, and what would be a sound macroeconomic policy for Laos.
Therefore, the main objective of this paper is to use a simple macroeconomic model toevaluate the impact of growth and stability policies and to identify a macroeconomic
policy for the Lao economy.

2. 0 Economic Reforms
2. 1 Economic Reforms and Development Goals
2

However, the Lao economy have recovered from AFC since 2002; the average GDP growth during 20002006 was 6.5 %, the inflation rate was less than one digit and the exchange rate was stable (table 1). Moredetailed discussion of the impact of AFC on Lao economy see Keomixay et al (1999).
3
According to Esterly (1993) and Bleaney (1996), macroeconomic stability is good for growth. IMF (2006)
and WB (2007) also point out that macroeconomic stability is one of the most important priorities for Laos.
4
For macroeconomic management and impact of macroeconomic policies see Kyophilavong (2003) andKyophilavong and Toyoda (2004; 2008), Toyoda and Kyophilavong (2005; 2007).

2

After the 1975 communist revolution, Laos set up a centrally-planned economy underwhich domestic prices, foreign trade and trade among provinces were strictly controlled
by the State (Bourdet, 1995 and Ljunggren, 1993). Since 1986, Laos has implemented
various reforms under NEM, which include the following vital components: (γ) the
promotion of private production through improved incentives, (δ) the upgrading ofinstitutional infrastructure to improve market economy operation, (ε) the strengtheningof Lao competitive advantages through trade liberalization and future specialization, and(ζ) the establishment of price stability through macroeconomic policy measures(Bourdet, 1995; Ljunggren, 1993).

The national development vision for the year 2020 is to have graduated from LDC statusthrough sustainable development that balances social and environmental concerns (GOL,
2006). In order to achieve these national development goals, the GoL has set up the
National Economic Development Plan (NEDP) and the National Poverty Eradication
Programme (NPEP). The main targets of the 6th NEDP (2006-2010) are to maintain GDP
growth (real) at about 7 to 8%; keep the inflation rate at less than 10 %; stabilize theexchange rate; ensure that budget deficit is 6 %of GDP; ensure the trade deficit is 6 % of
GDP; and reduce poverty to 20- 25 % (GOL, 2006).

2.2 Financial Reforms
Prior to 1988, the State Bank conducted both central and commercial banking activities.
The State Bank’s principal operations were to accept deposits from State Owned
Enterprises and provided credit to them under the central government’s economic plan; toact as the government’s treasury; and to manage the supply of currency (Kyophilavong,2007).

During this period, the principal aim of monetary policy was to help fulfill the development
plan. The monetary policy framework was operated through direct monetary instruments5;5

Such as credit ceilings, interest rate control throughout 1979-85, and directed credit.

3the mono-banking sector was influenced by the fiscal needs of the Government.6(Kyophilavong, 2007).

In 1988, the Government began major reforms aimed at transforming the financial system
in line with the objectives of the NEM. With a view to making the banking sector moremarket oriented and improving the mobilization and allocation of resources, the State Bank
was reorganized into a two-tier system, with central banking separated from commercial
banking. The proper central banking activities of the State Bank were formally separated
with the enactment of the Central Bank Law in 1990, which established the Bank of Lao
PDR (BOL) as a central bank, and assigned it primary responsibility for exercising control
over monetary and financial developments by developing indirect instruments7. Under the
two-tier banking system, commercial banks have played their roles by providing banking
services such as mobilizing deposits and allocating credit. However the Lao banking sector
is also relatively small when compared to the size of the Lao economy. The ratio of total
assets of the banking system to GDP is about 25.8%; the ratio of deposit to GDP was 19%;
and the ratio of bank loans to GDP was 8.8% in 2006 (Kyophilavong, 2007).

2.3 Fiscal Reform
During the pre-reform period, the Lao economy was divided between a large state sector,
including public enterprises at the central and provincial levels, and a non-state sector,
including cooperatives and private farms and enterprises (Bourdet, 1994). The Laobudget structure looked like those of other socialist countries in which the public sector
played an important role in terms of both the revenue and the expenditure sides. Duringthat period, Laos experienced large budget deficits which were financed by externalsources, mainly from socialist countries in the form of commodity assistance, projectloans and grants.
6

Many of these loans were non-performing or past due. Technical review of commercial bank portfolios
undertaken with Asian Development Bank (ADB) support in 1992 found that on average of 47 percent of
total loans were past due and an additional 34 percent were non-performing (ADB, 1992).
7
BOL introduced reserve requirement rates in October 1990; opened a formal credit window (1992-1994);
commenced to regularly auction treasury bills in March 1994 and discount window for T-bills in May 1994;
removed all interest rate ceilings in 1991; and eliminated rate guidelines on deposit and lending rates in
1992-93, (Otani and Pham, 1996)

4

Fiscal reforms have been one of the components of NEM since 1986. These fiscal
reforms have addressed the revenues and expenditure sides of the budget and consist of
three main components. The first and most important component was the reform of thetax system. The second was the establishment of an allocation and a total level of public
expenditure. The third was a reform of the institutional framework and an upgrading ofadministrative capacity and procedures to facilitate the implementation of the revised
budget policy (Bourdet, 1994). These reforms are mainly supported by internationalorganizations such as the World Bank (WB), International Monetary Fund (IMF), andAsian Development Banks (ADB); these organizations continue to support fiscal reforms
in order to resolve lingering issues.

3.0 Policy Framework
3.1 Monetary policy framework
Under the two-tier system, BOL has fully implemented monetary policy. At the
beginning of the banking sector evolution, it was still unclear whether a monetary policy
framework operated. Monetary instruments had been applied through the mixture of
direct and indirect tools without clear monetary channels and objectives (Kyophilavong,2007).

BOL had relied on direct instruments, including interest rate control (both on lending anddeposit rates) during the 1990s and a credit ceiling (as % of total loans outstanding) tolimit and target credit expansion from1995 to 1996. However, indirect instrument such as
reserve requirements8 and market operations9 were introduced in 1999. Subsequently,
BOL adopted a monetary policy framework as an IMF-supported program (2001-2005).
According to this monetary policy framework, price stability is an ultimate goal of the
BOL’s policy implementation, which also supports economic growth in order to reducepoverty. This policy involves implementation of monetary and exchange rate policies
8
According to Dalaloy (2006), before 1995, the reserve requirement ratio did not separate between kip andforeign currency; it was 5% in 1985, 10% in 1994 and 12% in 1995. The reserve requirement ratio for kip
and foreign currency has been introduced since 2000; it was 6% (kip), and 12% (foreign currency) in 2000;
8% (kip) and 15% (foreign currency) in 2002; and 5% (kip) and 10% (foreign currency) in 2006.
9
The instrument of open market operation included BOL bill and Treasury bill.

5within the confines of a framework that establishes floors for international reserves andceilings for net domestic assets of the central bank. BOL conducts monetary policy byusing the Quantity Theory of Money theoretical framework to set the annual growth rateof the money supply as an intermediate target in line with the rate of growth and pricestability. Reserve money and interest rates are closely monitored as operational targets inorder to attain the intermediate target. A reserve requirement rate, BOL bills, treasury
bills, bank rates and refinancing facilities are main the monetary policy instruments10.

3.2 Exchange rate policy framework
Before economic reform in 1986, there existed seven different exchange rates11, ranging
from 10 to 400 Kip/US$ dollar under a fixed exchange rate regime. Lao authorities began
a dramatic reform of the exchange regime in September 1987 (Otani and Pham, 1996).
According to Prime Minister Decree No. 18/CCM dated July 1989, a managed floatingexchange regime was adopted. Under this regime, the official rate was adjusted
proportionally to be in line with the parallel market rate. For example, a benchmark was
set for BOL to maintain a spread of less than 10 percent between the official rate andmarket rate. In tandem with these policy initiatives, various reforms of the financial
sector were undertaken. The government allowed non-bank foreign exchange dealers in1990 and restrictions on deposits in foreign currency were also abolished (Otani andPham, 1996). In addition, the difference between the official rate and the market rate was
reduced to 2 percent under the enhanced IMF structural adjustment program. Under the
managed floating exchange rate regime, BOL currently determines the daily reference
rate of Kip against US$. This reference rate is calculated by a weighted average of

10

Under the BOL Law No.5, all the key monetary and exchange rate policies have to be approved by theGovernment. Applying instruments has to be approved by the Governor. The Monetary Policy Department
directly monitors and adjusts the above tools in order to achieve policy targets. The Banking Operation
Department mainly operates those tools that work together with financial institutions.

11

These included a symbolic official rate of 10 kip per U.S. dollar; a commercial rate of 95 kip per U.S.
dollar, at which most transactions by state enterprises were made; and several rates close to the thenprevailing parallel market rate of roughly 400 kip per U.S. dollar, which applied to transactions by theprefecture of Vientiane (Otani and Pham, 1996).

6

previous foreign exchange transactions of commercial banks and market rates12. Thisreference rate is modified corresponding to particular conditions (Kyophilavong, 2007).

3.3 Fiscal policy framework
The main objective of the fiscal framework, based on NEDP, is to support growth andreduce poverty (GoL, 2006). In order to achieve these aims, the GoL set an increase intotal investments; the target of total investment was set at 32 % of GDP and the ratio ofbudget deficit to GDP was set at 5.8 % (GoL, 2006). Therefore, government income
sources and effective government expenditures are keys for achieving fiscal policy
objectives, and so in early 2005, GoL adopted a comprehensive medium-term Public
Expenditure Management Strengthening Program that focuses on strengthening Public
Financial Management systems and building the capacity of the Ministry of Finance andProvincial Finance Department. These programs have been supported by internationalorganizations.

4.0

Macroeconomic Condition and Issues

Since the NEM was introduced in 1986 until the AFC occurred in 1997, Laos had beenachieving high rates of economic growth with low inflation. The average economic
growth rate was about 6.5 % during 2000-2006 and the inflation rate has been maintainedat one digit since 2005; it was about 4.5 % in 2007 (table 1). Since 2005, the exchange
rate has appreciated; it was 9,670 kip per US$ in 2007 compared to 10,655 kip per
US$ in 2005. Laos has an agriculture-based economy; in a total GDP of 2.8 US$ billion,
agriculture accounted for 44% of GDP, industry for 30% and services for 26% in 2005
(WB, 2008). However, since 2003, the industry sector has grown more than 10%, which
has caused the agriculture share of GDP to decline.

12

Like monetary policy, the key exchange rate policies have to be approved by the Government. The
Monetary Policy Department also responds directly to adjusting the reference exchange rate daily. The
Banking Operation Department calculates the BOL exchange rate and uses it as a reference for foreignexchange in the interbank market amongst financial institutions.

7

Even though Laos has been maintaining high economic growth with low inflation and astable exchange rate, there are still serious macroeconomic issues to overcome. Firstly,
Laos is basically facing chronic twin deficits in both government spending andinternational trade deficit.

The budget deficit to GDP was 2.5% in 2007 (fiscal year),compared to 4.4% in 2005 (fiscal year) (WB, 2008). Current account balance deficit to
GDP was 17.8% in 2005 compared to 17.4% in 200713 (IMF, 2008). These deficits aremainly financed by Official Development Assistant (ODA), FDI, and remittances. In
particular, the fiscal issue is very serious in Laos. If the budget deficit continues toexpand, it will cause an accelerating inflation rate and devaluation of the kip, and could
lead to economic instability like the period during the AFC (Okonjo-Iweala et al, 1999).
Secondly, there is a huge gap between savings and investment. The saving rate is low in
Laos for two main reasons: low incomes—GDP per capita was about US$580 in 2007—
and the underdevelopment of financial sectors. The banking sectors are occupied by state
commercial banks, which lack the ability to perform the full banking functions14. Thirdly,
Laos is also facing a high burden of external debt, which had accounted to more than
60 % of GDP in 2007.

Laos is currently dependent on foreign savings to cover budget deficits. If Laos becomes
too dependent upon foreign finance, especially to meet its debt obligations, it could cause
a foreign debt crisis15. Therefore, it is important to consider macroeconomic issues first
before building a macroeconomic model to identify the impact of macroeconomic policy.

5.0 Issues of Macroeconomic Management
5.1 Monetary policy
Nevertheless, the implementation of monetary policy still has a number of shortcomings.
The four main reasons for the constraints on monetary policy in Laos are as follows.

13

However, the trade deficit has narrowed since 2003 due to increased exports of gold and copper coupledwith the high price of minerals.
14
More details of financial issues in Laos are discussed in Kyophilavong (2008).
15
More detailed discussion of the roles of government in transition, global intregration and economic
development in Laos see Hara (2002).

8

Firstly, the Lao economy is a partially dollarized economy16. Therefore, the monetary
authorities can not conduct their policy effectively (BOL et. al, 2002). Secondly, thelengthy and opaque decision-making process makes implementing monetary policy
inefficient. According to BOL law, all key monetary policies and action plans have to beapproved by the government (BOL et. al, 2002), which is time consuming17. Thirdly, theundeveloped financial situation limits the effectiveness of implementing monetary
policies. BOL has very limited monetary policy instruments with which to conduct aneffective monetary policy. The bond market is still at an early stage of development; itsvolume is too small to operate an open market operation effectively. Lastly, BOL lacks
business expansion funds and general reserve accounts to compensate for the losses from
implementing monetary policy (BOL et. al, 2002).

5.2 Exchange rate policy
Under the managed floating exchange rate policy, the exchange rate has shown
significant stability; it was fluctuating around 10,000 kip per U.S. dollar during 20052006 and moving in line with market rate no more than 0.5 percent. However, theexchange rate mechanism has some limitations. The range of the exchange rate set forcommercial banks is too small18, limiting flexibility in the foreign exchange market andleading to a dis-incentive to develop inter-bank market. This also creates an informal
market for speculation (Kyophilavong, 2007). To stabilize the value of the Kip, BOLintervened in the foreign exchange market in order to adjust the exchange rate by sellingand buying foreign currency. However, foreign reserves were quite small during the AFC,so the intervention was not effective. In addition, as with monetary policy, the longprocess of decision-making is an important constraint in implementing exchange rate
policy. However, recently the foreign reserves are increasing and the decision-making
process has improved.

5.3 Fiscal policy
16

In 2005, more than 60 percent of bank deposits are in foreign currencies. For more detail discussions ofdollarization in Laos see Menon (2006), and Furukawa (2002).
17
However, the decision making progress has been improving since the AFC.
18
More study is need on the effect of the range of reference rate on foreign exchange markets in Laos.

9Fiscal policy plays an important role in achieving the national goal of maintaining highgrowth and reducing poverty. While the GoL is continuing to reform the fiscal system,some issues need to be considered. Firstly, there is lack of qualified staff and modern
office equipment for monitoring and checking traders (Lathouly, 2000). Secondly, GoL
will implement of a Value Added Tax (VAT) which is currently planned for 2009; thiswill require close coordination between the Tax, Customs and Treasury Departments(WB, 2008). Thirdly, GoL is financing budget deficits by foreign sources such as external
debt and grants; it is important to consider domestic finance by improving the quality andquantity of treasury bills. In addition, the high burden of external debt might cause a debt
crisis and macroeconomic instability.

6.0 Building a Macroeconomic Model of Laos
6.1 Literature reviews
At this time, due to lack of interest and data limitations, there are only a few studies onmacroeconomic models for the Lao economy. Kyophilavong (2003) developed a pioneer
macroeconomic model, called LAOMACROMODEL-1, which consists of 32 equations(17 definitions). This model took into consideration demand and supply sides, anddivided trade between Thailand and other trading partners. The main purpose of building
this model was to analyze the impact of macroeconomic policies, the accession of
ASEAN Free Trade Area (AFTA), and FDI. Because this was an early model, someissues needed to be addressed and updated in LAOMACROMODEL-1; therefore
Kyophilavong and Toyoda (2004) modified and developed LAOMACROMODEL-2.
This model consists of 11 behavior equations, 12 definitions and 3 statistic equations, andwas built to analyze the impact of macroeconomic policies and the ODA on the Lao
economy. This paper uses LAOMACROMODEL-2 as the basis for evaluating themacroeconomic management of Laos.

However, this model is different from Kyophilavong and Toyoda (2004) and Toyoda andKyophilavong (2005) in several respects. Firstly, there are some adjustments in generalprice function. As inflation is strongly linked with the exchange rate in Laos, the10exchange rate19 (kip/US$) has been added to the general price function as a proxy ofimport price. Secondly, this paper focuses on the impact of mixed-policy, which
combines monetary policy, exchange rate policy and fiscal policy together.
6.2 Characteristics of the model
The key distinguishing features of the model are as follows. Firstly, time series data andthe market economy mechanism are the two most important hypotheses being used tobuild this model. Laos continues to reform its market economy, so even though theeconomic structure is different from the economic structure of capitalist countries20, it isassumed that the Lao economy has basically the same structure as capitalist countries.
Secondly, the current Lao economy is facing supply-side issues, and the Lao economy
has faced demand-side issues such as high inflation and the devaluation of kip in the past.
Therefore, a Lao model must focus on both demand- and supply-side issues. In thismodel, the ratio of supply-side GDP and demand-side GDP are used to determine generalprice function. In addition, the demand and supply are also adjusted accordingly bygeneral price mechanism. Thirdly, Laos is an agricultural country, with about half of
GDP from the agriculture sector21. From this viewpoint, the author has divided the
supply-side into agricultural GDP and non-agricultural GDP in order to analyze
agricultural structure change.

I used the Two Stage Ordinary Least Square (2 SLS) method to estimate behavior
equations and the Newton method to solve the model equations. The data used in thismodel is mostly based on information from IMF, WB and ADB22. The model flowchart23
is shown in Figure 1. Before running the simulation, I evaluated the model by conducting
19

The exchange rate is an endogenous variable which is linked to general price in the previous model.
The intervention of government in financial sectors is strong, and state-owned commercial banks have ahigh share in terms of assets, deposits and loans.
21
The share of agriculture to GDP has declined since 2002 due to the implementation and export of mining
and hydropower sectors. See more details of the impact of these resource sectors on the Lao economy in
Kyophilavong and Toyoda (2008).
22
The main reason for using data from international agencies in model building is that there are someinconsistencies of GoL’s data. In addition, the availability of GoL’s data is low. For details of the main
variables see table 2. Due to the limited availability of data to build the model, I have made modifications
and adjustments to the data set by using various assumptions and estimation methods. See more details in
Kyophilavong and Toyoda (2005).
23
More detail of equations and estimation result of behavior equation is shown in appendix 1 and 2.
20

11

final test24. The final test result shows that the percentage of Root Mean Squared Percent
Error (RMSPE) in important variables such as GDP and prices were low, which confirmsthat this model can be used for simulation and forecasting.

7.0 Evaluation of macroeconomic management
7.1 Simulation Design
As mentioned in previous sections, there are various challenges to conducting
macroeconomic policy effectively in Laos25. However, I assume that these impacts are
small. Here, growth-priority policy refers to GDP growth. There are two instruments ofgrowth-priority policy: expanding the money supply to increase domestic investment anddepreciating the exchange rate to increase exports. On the other hand, stability-priority
policy refers to price stability. The two instruments of stability-priority policy include
tightening the money supply and stabilizing the exchange rate.

In order to identify the impact of these policies on Lao economy, I combine three policies:
monetary policy, exchange rate policy and fiscal policy (table 4). I make assumptions
about the three policies as follows. Fiscal policy refers to a decrease or increase of 100
billion kip of government investment. Monetary policy refers to a decrease or increase of
100 billion kip in the money supply. Exchange rate policy refers to a decrease or increaseof 5 percent of exchange rate (Kip/US$). Based on the combination of the three policies,
I generated eight simulation scenarios in table 5.

Within the eight simulation scenarios, scenario five refers to growth-priority policy. This
policy includes an expansion of the money supply and a depreciation of the exchange rate;
expansion of government investment is also included in this policy. On the other hand,
scenario seven refers to stability-priority policy. This policy includes decreasing themoney supply and appreciating the exchange rate; again, the expansion of government

24

See the results in table 3.
There are mainly three issues for limiting macroeconomic policy as discussed in previous section. Firstly,
Laos has high degree of dollarization. Secondly, monetary authority lacks effective indirect monetary
policy instruments. Thirdly, there an is informal exchange rate market which shows the limitation of
conducting exchange rate policy effectively.

25

12

investment is also included. It is important to note that the two policies are different onlyin changing the money supply and exchange rate perspectives.

I chose the period from 1993 to 1996 as shock periods for two reasons. Firstly,
macroeconomic variables during this period were quite stable compared to other periods.
Secondly, I want to avoid the influence of the AFC The effect of simulation scenarios26on
the Lao economy refers to changing endogenous macroeconomic variables such as realGDP, prices, private consumption, exports, imports etc which are calculated fromdifference between shock simulation (C) and base case simulation (B).

7.2 Simulation results
The impacts of each simulation scenario are shown in table 6. Out of the eight policy
scenarios, scenario seven exerts the highest impact on increased GDP, indicating that the
government should prioritize stability27. The average increase in GDP is 7.1 %. In thefirst simulation period, GDP increases by 6.8 %; it increases by 7.3 % in the second
period and 7.3 % in the third period. At the same time, the average increase in price is
1.8 %. There is a 5.4 % increase of general price in the first period and 1.5 % in thesecond one, but a 1.6 % decrease in the third period. The declining money supply and theappreciation of the exchange rate lead28 to declining prices. Then, declining prices
increase real macroeconomic variables which increase the demand side of GDP. In
addition, the increase in government investment has two effects on GDP. Firstly, it
increases demand-side GDP through increasing domestic investment. Secondly, it
increases supply-side GDP though increasing capital stock.

26

Effect= (C-B)*100/C. C refers to value of shock simulation shock. B refers to value of base casesimulation.
27
There, it is very important to note that we omit constraints of expansion of fiscal policy in this model.
We assume that sources for financing fiscal deficit are from external sources such as ODA and debt.
However, the two variables are exogenous variables in this model.
28
The appreciation of the exchange rate also has a negative impact on growth though declining exports.
See a more detailed discussion of the impact of exchange rates on the Lao economy in Kyophilavong andToyoda (2008).

13

On the other hand, scenario five, which refers to growth priority policy, has a negative
impact on real GDP. GDP declines by an average of 7.7 %. In the first simulation period,
GDP decreases by 7.6 %; it decreases by 7.9 % in second period and 7.7 % in third
period. At the same time, the average price increase is 0.6 %. In the first period of
simulation, price declines by 5.1 %, in second periods there is no change, and in third
period it increases by 3.4 %. According to the simulation results, a growth-priority policy
surprisingly results in the most negative impact on the Lao economy. Conversely, astability-priority policy yields results that have the highest positive impact on growth.

8. 0 Conclusions
The two main objectives of this paper are to evaluate the impact of growth and stability
priority policies and to identify the most effective macroeconomic policy for Laos using amacroeconomic model simulation.

From the simulation results, we conclude that growth-priority policy that expands themoney supply and depreciates the exchange rate does not bring high growth as expected.
Instead, it actually has a negative impact on growth. On the other hand, stability-priority
policy that decreases the money supply and appreciates the exchange rate has a positive
impact on growth. It is clear that stability-priority policy is better than growth- priority
policy. Therefore, in order to maintain high growth with price stability, the GoL should
focus on stability-priority policy that prudently controls the money supply and stabilizes
the exchange rate, and increase government investment29.

It is important to note that this model, unlike macroeconomic models in the developed
countries, has some unique characteristics that highlight features of the Lao economy.
However, the model is limited by data constraints and because it is an early-stage model.
Firstly, this model neglects the influence of polarization. Secondly, some important29

Here, it is important to note that expansion of fiscal policy might accelerate inflation and cause
macroeconomic instability. Empirical studies show that fiscal deficit is highly correlated with inflation,
especially in developing countries. For detailed discussion of issues of fiscal deficit see Edwards andTabellini (1991), Ashra et al (2004) and Woodford (2001).

14

macroeconomic variables such as external debt and ODA were neglected. Thirdly,
monetary sectors did not include more detail in this model30.

ACKNOWLEDGEMENTS
I would like express my sincere appreciation to Prof. Nozaki Kenji, Economic ResearchCenter, Graduate School of Economics, Nagoya University for inviting me as visiting
researcher and providing valuable comments. I would like to thank Mr. Nakamura
Takeho for his kindness. I would like also to thank Prof. Toyoda Toshihisa, Prof.
Okumura Ryuhei, and Prof. Hirakawa Hitoshi for providing me with valuable comments.
I would like to thank Ms. MINEGISHI Nanae, Ms. SAKAI Ayako, Ms. ITAKURA
Ayano and Mr. OGAWA Keiko, administrative staff at Economic Policy ResearchCenter, for their kindly support. Finally I would like to thank researcher Dr. Kawai Shin,for his kind support.

30

As mentioned in the previous sector, Lao financial system is underdeveloped, so it is difficult to include
detailed financial variables in the model. However, it is a challenge for future study.

15

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Kyophilavong, P. & Toyoda,T. (2008). “Impacts of foreign capital inflows on the Lao
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18

Table 1. Main macroeconomic variables for the Lao economy
Macroeconomic indicators
Population (million. person)*
Population growth (%)

2001-2006 1996-2000 1990-1995
5.46
4.86
4.40
2.12
2.06
2.52

GDP (current million US$) **GDP growth ( %)GDP per capita (constant 2000 US$) **GDP per capita growth (%)

2,416
6.53
379
4.04

1,618
6.18
307
3.68

1,276
6.46
248
3.80

Reserve Money (M2) (million US$)*
Money supply (M2) (%)*
In flation -CPI (%)

450,981
21.14
9.73

270,728
65.99
57.00

148,280
30.92
15.27

Trade Deficit (million. US$)***
Trade Deficit /GDP (%)-219.91-9.24-263.21-16.06-174.92-13.14

220

127

48

External debt (million US$) *External debt /GDP (%)

2,640
115

2,410
152

1,965
161

Buget Deficit (including grants)(million US$)
Buget Deficit /GDP (%)
Buget Deficit (exclude grants)(million US$)
Buget Deficit /GDP (%)

-104
-4.42
-149
-6.29

-58
-3.60
-121
-7.58

-100
-7.61
-145
-11.21

Foreign reserve (million. US$)***

Exchange Rate (kip/US$) Official Rate***
10,163
4,094
727
Sources:* Asian Development Bank (ADB), Key Indicators for Asia and the Pacific 2008 www.adb.org/statistics** World Bank,World Development Indicators CD-ROM (2005) and*** International Monetary Fund, International Financial Statistics CD-ROM August 200819

Table 2. Data sources of main variables
variables

Code

Unit

en/ex

Would Development Indicators CD-ROM 2007

SourceGovernment consumption(real)CG

Bill.Kip

Endogenous

Private consumption(real)CP

Bill.Kip

Endogenous

Would Development Indicators CD-ROM 2007

Export (real)EX

Bill.Kip

Endogenous

International Financial Statistics CD-ROM 2007

Import (real)IM

Bill.Kip

Endogenous

International Financial Statistics CD-ROM 2007

General PricePL

1995=100

Endogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Non-tax revenue(real)

NOTAX

Bill.Kip

Exogenous

Bank of The Lao PDR, Annual Report, Various Issues

Exchange rate (Kip/Dollar)

RATEU

Kip/Dollar

Exogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Government revenue(real)

REV

Bill.Kip

Endogenous

Bank of The Lao PDR, Annual Report, Various Issues

Lending rate(nominal)

RISI

Percent

Exogenous

Bank of The Lao PDR, Annual Report, Various Issues

Direct tax(real)

DTAX

Bill.Kip

Endogenous

IMF Staff Country Report Various Issues

Indirect tax(real)

ITAX

Bill.Kip

Endogenous

IMF Staff Country Report Various Issues

Foreign direct investment(real)

FDI

Bill.Kip

Exogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Gross domestic productGDP

Bill.Kip

Endogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Potential non-agriculture GDP(reaGDPNS

Bill.Kip

Endogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Potential agriculture GDP(real)

GDPAS

Bill.Kip

Endogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Government investment(real)

IG

Bill.Kip

Exogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Import priceIP

1995=100

Exogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Agriculture population

LA1000 persons Exogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Non-agriculture population

LN

1000 persons Endogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Money supply(nominal)

MONP

Bill.Kip

Exogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Total population

NP

1000 persons Endogenous

Key Indicators Of Developing Asian And Pacific Countries 2007

Agriculture area

HPA

1000 Hector Exogenous

National Statictic Center

Capital stock(real)

K

Bill.Kip

Endogenous

Calculation

Domestic investment(real)DI

Bill.Kip

Exogenous

National Statictic Center

Source: the author

Table 3. Results of the final test(%)
Variables

RMSPE

CP
18.04
DI
25.00
EX
12.75
GDP
17.72
I
30.56
IM
20.18
K
5.66
LN
4.68
NP
0.80
PL
9.59
TAX
11.70
WAGE
15.89
Source: authors estimation from model.
Note: RMSPE: Root-Mean-Squared Percent Error

20

Table 4: Assumptions for simulation
PolicyAssumptions

IGP

Fiscal policy

Government investment+/- 100 bil.kip

MONEP

Monetary policy

Money supply+/- 100 bil.kip

RATEU

Exchange rate policy

Exchange rate (Kip/US)+/- 5%

Source: the author.

Table 5: Policy simulation scenarios
Scenarios
Scenario1 IGP(+)
MONEP(+)
RATEU(+)
Scenario2 IGP(+)
MONEP(+)
RATEU(-)
Scenario3 IGP(-)
MONEP(-)
RATEU(-)
Scenario4 IGP(-)
MONEP(-)
RATEU(+)
Scenario5 IGP(-)
MONEP(+)
RATEU(+)
Scenario6 IGP(-)
MONEP(+)
RATEU(-)
Scenario7 IGP(+)
MONEP(-)
RATEU(-)
Scenario8 IGP(+)
MONEP(-)
RATEU(+)
Souce: the author

Policies
1. Increased government investment by 100 billion kip
2. Increased money supply by 100 billion kip
3. Exchange rate (Kip/US) appreciation by 5%
1. Increased government investment by 100 billion kip
2. Increased money supply by 100 billion kip
3. Exchange rate (Kip/US) depreciation by 5%
1. Decreased government investment by 100 billion kip
2. Decreased money supply by 100 billion kip
3. Exchange rate (Kip/US) depreciation by 5%
1. Decreased government investment by 100 billion kip
2. Decreased money supply by 100 billion kip
3. Exchange rate (Kip/US) appreciation by 5%
1. Decreased government investment by 100 billion kip
2. Increased money supply by 100 billion kip
3. Exchange rate (Kip/US) depreciation by 5%
1. Decreased government investment by 100 billion kip
2. Increased money supply by 100 billion kip
3. Exchange rate (Kip/US) depreciation by 5%
1. Increased government investment by 100 billion kip
2. Decreased money supply by 100 billion kip
3. Exchange rate (Kip/US) appreciation by 5%
1. Increased government investment by 100 billion kip
2. Decreased money supply by 100 billion kip
3. Exchange rate (Kip/US) appreciation by 5%

21

Table 6. Simulation results
Scenarios Variables
Scenario1 GDP

Year 1

Year 2

Year 3(%)
Average

0.50

0.45

0.34

0.43

31.60

25.61

18.14

25.12

0.87

0.96

0.97

0.93

28.64

22.47

15.09

22.07

-0.59

-0.77

-0.75

-0.70

-32.32-25.27-17.11-24.90

-1.10

-1.38

-1.44

-1.31

-30.28-22.96-14.69-22.64

-7.63

-7.86

-7.71

-7.73

-5.08

-0.02

3.39

-0.57

-7.26

-7.40

-7.16

-7.28

-8.11

-3.22

0.32

-3.67

6.78

7.28

7.35

7.14

5.39

1.54

-1.57

1.79

Scenario8 GDP

6.32

6.67

6.61

6.53

PL
Source: the author

7.67

4.01

0.94

4.20

PL
Scenario2 GDP
PL
Scenario3 GDP
PL
Scenario4 GDP
PL
Scenario5 GDP
PL
Scenario6 GDP
PL
Scenario7 GDP
PL

22

Figure 1. Model Flowchart

Agriculture
Population

World
demandAgriculture
Area

Lending Rate

ExportImportDomestic Investment

FDI

Agriculture
Potential
GDP

DemandGDP
PrivateConsumption

Non-Agriculture
General Price
Non-Agriculture
Population
Capital Stock

Government
Consumption

Government
Investment

Import Price
Government Revenue
Money Supply
Tax Revenue

Total
Population

Exogenous

Wage

Endogenous

Exchange Rate

Non Tax Revenue

Source: the author

23

Appendix 1: Behavior equations and identity
In this model, there are behavior equations, identities and statistic equations31 as follows:
Gross domestic product (GDP)GDP = CP + I + G + EX – IM

(1)

CP = Private investment

EX = Export

I = Total investment

IM = Import

G = Government expenditure
Nominal GDP (GDPP)
GDPP= GDP*PL/100
GDP= Gross domestic product(2)
PL = General prices

Gross national product (GNP)
GNP = GDP + IFA
GDP= Gross domestic product(3)
IFA = Net income from abroad

National income32 (NI)NI = GDP – ITAX
GDP= Gross domestic product(4)
NI

ITAX = Indirect tax

Potential production function33 (GDPS)
GDPS = GDPAS + GDPNS(5)GDPAS = Potential agriculture production
GDPNS = Potential non-agriculture production
Potential agriculture production34 (GDPAS)
31

It is important to note that most of variables is real value except price, agriculture area, interest rate andexchange rate.
32
There are no time series depreciation data for Laos. To make it simpler, the author assumed no
depreciation. Therefore, real net national income is equal to real gross national product (GNP).
33
The author assumed that potential production (GDPS) has the estimated value of real GDP, which isdetermined by capital stock lag one year and labor. In developing countries, it is common to divide
potential production function into agricultural and non-agricultural sectors. In Laos, the agricultural sector
is an important one. Therefore, the author divided potential production function into agricultural and nonagricultural sectors.

24

Ln(GDPAS/LA) = f ( (+)Ln(HPA/LA) )LA= Agricultural labor(6)

HPA= Agricultural area

Potential non-agriculture production35 (GDPNS)
Ln(GDPNS/LN) = f ( (+) Ln ( Kn(-1) / LN ) )LN(7)= Non-agriculture population

Kn(-1) = Non-agriculture capital stock lag one year

Demand pressure definition (DS)DS= (GDP/GDPS)*100
GDPS= Potential GDP(8)
GDP = Gross domestic productPrivate consumption function36 (CP)CP = f ( (+) NI , (+) CP(-1))(9)

CPI (-1) = Private consumption lag one year
NI

= National income

Domestic investment function (DI)DI= f ( (+) (GDP – GDP(-1)) , (-) K(-1), (+) RISI )GDP= Gross domestic product
K(-1) = Capital stock lag one year

(10)

GDP(-1)= Gross domestic product lag one year
RISI = Nominal lending rate

Total investment (I)I = DI + FDI + IG
DI= Domestic investment(11)
FDI= Foreign direct investment

IG= Government investment
34

GDPAS is determined from agricultural area (HPA) and agricultural population (LA). GDPAS isassumed as the homogeneous Cobb-Douglas production function.
35
In addition, GDPNS is determined from non-agricultural capital stock lag one year K(-1) and nonagriculture population (LN). GDPNS is also assumed as the homogeneous Cobb-Douglas production
function.
36
To make is simple, the author followed Keyne’s theory in which consumption is determined only byincome. In general, private consumption is determined by personal disposable income. But income tax is asmall percentage of tax revenue. Therefore, the author assumed that only real national income isdetermined by real private consumption.

25

Capital stock (K)K= K(-1) + I(12)

K = Total capital stockK(-1) = Total capital stock lag one year

I = Total investment
Wage function37 (WAGE)
WAGE= f ( (+) GDP , (+)PL ,(+) WAGE(-1) )GDP = Gross domestic product

PL = General prices(13)

WAGE(-1)= Wage lag one yea

Direct tax function (DTAX)
DTAX= f ( (+) NI , (+) DTAX(-1) )NI= National income(14)

DTAX(-1) = Direct tax lag one year

DTAX = Direct tax

Indirect tax function (ITAX)
ITAX= f ( (+)NI , (+) ITAX(-1) )
NI

(15)

= National income

ITAX(-1) = Indirect tax lag one year

Total tax function (TAX)TAX= ITAX +

DTAX

(16)

DTAX= Direct tax
ITAX = Indirect tax

37

In general, wage can be explained by the unemployment rate and general price. Due to an incomplete

labor market in Laos, the author assumed that unemployment does not strongly affect wage. In addition,
there are no time series wage data in Laos. Therefore, the author assumed that real wage is determined fromreal GDP, general price, and lag one year of itself.

26

Government expenditure (G)G = IG+ CG(17)

CG= Government consumption
IG= Government investment
Total government revenue (REV)REV= TAX+ NOTAX(18)

TAX = Tax revenue
NOTAX= Non-tax revenue
Government consumption function (CG)
CG= f ( (+) REV
REV,(+) CG(-1) )(19)= Government revenue

CG(-1)= Government consumption lag one year

Export function (EX)EX= f

( (+) TV,(+) RATEU )(20)

TV= GDP of Thailand and Vietnam
RATEU= Nominal exchange rate (Kip/US$)
Import function (IM)
IM= f ( (+)GDP , (+) RATEU)(21)

GDP= Gross domestic product
RATEU= Nominal exchange rate (Kip/ US$)

Agricultural population (LA)LA = NP

-

LN

(22)

NP= Total population
LN= Non-agriculture population

Non-agriculture population function (LN)27

LN= f ( (+) WAGE , (+) LN(-1) )(23)

WAGE= Wage
LN(-1)= Non-agriculture population lag one year
General prices function38 (PL)PL= f ( (+) DS , (+) MONP/GDP , (+) RATEU )DS= Demand pressure

MONP=Money supply

GDP= Gross domestic product

RATEU= Exchange rate (kip/ US$)

38

(25)

High inflation is not a serious problem in developed countries as it is in developing countries. Because in

Laos the monetary sector is incomplete, the circle of wage and price cycle cannot explain inflation.
Drawing on previous studies of macroeconomic models in developing countries, the author used thequantity theory of money to explain inflation.

28

Appendix 2: Estimated equations
Behavior equation
1.

Private Consumption Function

CP = -217.67 + 0.46*NI + 0.67*CP(-1)(-2.62) (2.46)
R-SQ = 0.91
2.

(3.45)

F = 40.98

Domestic Investment Function

DI = 323.29 + 0.59*(GDP -GDP(-1)) -0.04*K(-1) – 1.01*RISI(2.84)(2.84)

R-SQ = 0.88(-3.96)(-0.20)F = 25.51

3. Wage Function
WAGE = 130.02 +0.81*GDP + 0.05*PL – 0.02WAGE(-1) + 43.14*DD1(5.77)(12.63)R-SQ = 0.99

(2.85)(-0.29)(5.63)

F = 1637.45

4. Direct Tax Function
DTAX = -33.71 + 0.05*NI – 0.12*DTAX(-1) + 5.95*DD1(-2.12)(2.75)

R-SQ = 0.85(-0.37)(1.39)

F = 22.41

5. Indirect Tax Function
ITAX = -76.57 + 0.10*NI + 0.49*ITAX(-1) – 56.53*DD1(-3.5)(6.63)

R-SQ = 0.84

(3.19)(-5.98)F = 48.52

6. Government Consumption Function
CG =16.13 + 0.16*REV + 0.72*CG(-1) - 32.02*DD1(0.72)(1.68)

R-SQ = 0.75

(4.84)(-0.55)F = 12.51

7. Export Function
EX = -230.59 + 2.43*TV + 0.03*RATEU + 90.85*DD1(-1.40)(2.49)

R-SQ = 0.73

(3.93)(2.15)

F = 10.43

8. Import Function
IM = -586.12 + 0.77*GDP – 0.02*RATEU(-5.69)R-SQ = 0.93

(9.26)(-2.12)

F = 72.23

9. Non-agriculture Population
LN = 10.62 + 0.02*WAGE + 1.02*LN(-1)(1.56)(0.37)(16.34)29

R-SQ = 0.91

F = 40.98

10. General Price Function
PL = -17.84 + 0.12*GDP/GDPS + 324.56*MONP/GDP + 0.04*RATEU(-0.38)R-SQ=0.98(0.70)(10.68)(6.00)

F=196.28


Statistic Equation
11. Potential Agriculture Production Function
Ln(GDPAS/LA)=-0.44+0.13*Ln(HPA/LA)-0.07*DDI
12. Potential Non-agriculture Production Function
Ln(GDPNS/LN)=-0.62+0.71*Ln(k(-1)/Ln)-0.005*DDI

30