**Policy, Research, and External Affairs**

# **Country Operations**

# WPS 767

This papera product of the Country Opcrations Division, Eastern Africa Department, Africa Regional Office - is part of a larger PRE effort, led by the Macroeconomic Adjustment and Growtlh Division, Country Economics Department, to develop a macroeconomic projection model that will improve and extend the Bank's RMSM model. Copies are available free from the World Bank, 1818 H Street NW, Washingtor DC 20433. Please contact Margaret Lynch, room 110-271, extension 34046 (10(4 pages, including figures and tables).

Bruce anl Ndii develop a macroeconomic model for Kenya that projects detailed national, fiscal, monetary, and private sector accounts, and the balance of payments. With no changes in its logical structure, the model also calculates the magnitude of policy adjustments that would eliminate external and internal imbalances.

Their approach emphasizes transparcticy and user-friendliness, which they achieve in two ways. First, historical data - the basis for projections - are entered in worksheets that are similar (in format, coverage, and units of account) to standard tables produced by the data generating agencies. Second, key behavioral assumptions and targets are entered in a clearly designated worksheet. This worksheet contains details such as commodity price projections and the LIBOR rate that would nornally be provided by the Bank's International Trade Division. This worksheet also accommodates coefficients for the import and export price and income elasticities by major commodity groups; the interest and income elasticities of private investment; and the impact of inflation, income growth, and changes in interest rates on the demand for currency, demand deposits, and time deposits. The targets include domestic inflation and sectoral growth rates.

Initially, they use the f'ramework to project detailed national and sectoral accounts, including the financeable fiscal deficit. But they arc especially interested in the external financing gap and the residual public sector borrowing requirement (PSBR) that emerge in these base projections. For ease of exposition, these gaps are assumed to be independent.

Next, Bruce and Ndii illustrate the model's usefulness in calculating the policy adjustments - exchange rate, interest rate, and monetization - that would eliminate intemal and extemal macroeconomic imbalances. The policy adjustments are applied independently and jointly. Predictably, the exchange rate depreciates to eliminate the external financing gap. Similarly, the real domestic loan interest rate rises, crowds out private investment, and releases financing for the residual PSBR. The model also calculates the level to which domestic inflation would have to rise to finance the residual PSBR throughi an inflation tax.

When activated jointly with exchange rate depreciation, a smaller increase in the interest rate eliminates the residual PSBR. This is because the exchange rate adjustment improves the net foreign assets position and increases the scope for creating domestic credit. Understandably, therefore, the increase in interest rate is even smaller whCIl action in the exchange rate is combined with partial monetization of the fiscal deficit.

As an important by-product. these simulations also illustrate the impact of exchange rate and interest rate adjustments on the fiscal deficit.

Subsequent versions of the model will endogeniize growth andi extend coverage to the consolidated public sector.

The PRE Working Paper Serics disseminates **thc** findings of work under way in the Bank's l'olicy, Research, and Extemal AffairsCornplcx. An objectiveofthcseries is to get these finidingsout quickly. even if presentations are less than fully polished The findings, interpretations, and conclusions in these papers do not necessarily represent offic ial Bank policy.

ProdUced hy the PRE Dissemination Center