The document discusses the International Monetary Fund's (IMF) approach to economic stabilization, highlighting its reliance on theoretical frameworks developed by economists such as Polak, Mundell, and Fleming. It critiques the validity of these models in addressing the unique economic realities of developing countries and suggests that the IMF's policies may inadvertently create 'blind spots' that overlook alternative causes of macroeconomic imbalances. Additionally, it proposes structuralism as an alternative perspective that considers the holistic nature of economies and warns against the blind application of orthodox economic policies.

1. UNIVERSITY OF LONDON
The International
Monetary Fund’s Approach
to Stabilization
Carlos Eduardo Guice, Sr.

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Table of Contents
1. Introduction
2. Theoretical Framework
3. The IMF Approach to Stabilization
4. Structuralism – An Alternative Theory of Stabilization Policy
5. Conclusion

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Introduction
For over six decades, the International Monetary Fund (“IMF” or “Fund”) has performed
various functions for its members with respect to exchange-rate, economic, monetary, fiscal, and
financial issues. In accordance with its Articles of Agreement, the Fund makes its general resources
available to member countries that experience severe, macroeconomic shocks to their economies
that threaten the country’s financial stability and external viability. These shocked economies have
to be stabilized and the Fund assists member countries in doing so by designing stabilization
programs, and providing policy advice, technical assistance, and emergency funding.
Over the years, various criticisms have been advanced, questioning the Fund’s motives and
effectiveness, challenging the validity of important points of economic theory and practical
application1. A key criticism remains consistent throughout the ongoing debate concerning the
Fund’s role in the changing global economy. It questions the validity and universality of the
economic theory which provides the rationale for the Fund’s policy instruments and program
implementation: Does its economic orthodoxy create policy ‘blind-spots’ that can render its policy
instruments irrelevant, and at times detrimental, to clients countries facing severe macroeconomic
imbalances?
This paper will focus on this question, exploring the theoretical framework, stabilization policy, and
alternative approaches to stabilization.
Theoretical Framework
Much of the theoretical core of the Fund’s approach to economic stabilization developed in
the works of three IMF economists: Jean Jacques Polak, Robert Mundell, and J. Marcus Fleming.
These economist created analytical models that explored the casual interplay and behavioral
relationships among the macro-economic aggregates and they formed certain hypothesizes that
form the theoretical framework of the IMF’s stabilization policies.
The Polak Model
J. J. Polak was the first of the three to explore these behavioral relationships. Polak2
published his influential paper with the following purpose:
“to bring monetary events, monetary data, and monetary problems within the framework of
income analysis, and thereby to bridge the gap between (1) the views widely held on the
1
Avramovic, Dragoslav, “Conditionality: Facts, Theory and Policy”. (Finland: World Institute for Development
Economics Research United Nations University, 1989),5.
2 Polak, J.J. “Monetary Analysis of Income Formation and Payments Problems”. Staff Papers – International
Monetary Fund 6, no. 1 (Nov., 1957): 1-50.

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relation between financial policies and payments questions and (2) the analytical tools used
to explain payments developments”.3
His paper was said to be the first to transform into an analytical model an “empty
framework” of economy-wide, sector-based, macroeconomic identities.4 Polak’s model can be
placed within a “large class of theoretical models…consistent with the absorption approach”5, that
provides the basis for the “macroeconomic policies normally recommended by the IMF”.6
Polak studied the two exogenous variables - domestic bank credit creation and autonomous
changes in exports - and their effect on nominal income and the balance of payments. He
investigated monetary variables most likely to be influenced by policy instruments designed to
address balance of payment disequilibria.7His model incorporated two key behavioral assumptions:
a stable demand for money; and a change in the import variable is positively induced by an increase
in nominal income. By assuming (1) a proportional positive link between income and money
supply, (2) imports are a positive function of income, (3) an increase in imports causes a reduction
in foreign reserves, (4) an increase in exports and net capital inflows increases foreign reserves,
Polak’s model defined the change in the money supply as the sum of a change in the foreign
reserves, and a change in domestic bank credit. Therefore, the money supply increases as the result
of an increase in domestic bank credit or an increase in foreign reserves. Conversely, the money
supply decreases as the result of a decrease in domestic bank credit, or a decrease in foreign
reserves. Assuming a fixed money supply or a money growth rate target, this relationship can be
expresses as follows:
1. ∆𝑀𝑠 = ∆𝑅 + ∆𝐷𝐶 (1.1)
Thus Polak’s hypothesis: There is a dynamic relationship between changes in the domestic
money supply and changes in the external account. He concluded that the only permanent effect of
an increase in domestic credit expansion is an identical decrease in international reserves (due to
increased imports), and that a credit contraction brings about an improvement in the balance of
payment. If credit expansion is reflected in the excessive fiscal deficits of most developing
economies, then Polak lays the foundation for two IMF policy instruments: credit constraint and
fiscal discipline.
The Mundell-Fleming Model
The pioneering works of Robert Mundell8 and J. Marcus Fleming9 continued to develop
behavioral assumptions to include open market economics. Their papers addressed the short-run
3 Ibid. 1.
4 Tarp, Finn. “Stabilization and Structural Adjustment: Macroeconomic Frameworks for Analyzing the Crisis in
Sub-Saharan Africa”. (London: Routledge, 1993), 60.
5 Mussa, Michael and Savastano, “The IMF Approach to Economic Stabilization”. NBER Macroeconomics
Annual 14 (1999): 101
6 Ibid.
7 Polak, 9-10
8 Mundell R.A., “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian
Economics Association, 29, no.4 (Nov. 1963) 475-485

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effects of monetary and fiscal policy in a small open economy; however, they expanded their
analysis to include both a fixed and flexible exchange rate regime. This analytical framework
became known as the Mundell-Fleming model (M-F model).
The M-F model integrates the foreign sector the closed economy IS-LM model10 to capture
the response of capital movements to interest rates and the effect of the exchange rate on net
exports. The M-F model (IS-LM-BP) became a tool for policy analysis in a world trending towards
financial integration. The M-F model’s enduring influence on IMF policy is a testament to its ability
to bring into focus monetary and fiscal policy and the appropriate instruments to correct
disequilibria in the “balance of payments without resorting to measures destructive in national or
international prosperity11.” The M-F model suggests that fiscal policy (the national budget) and
monetary policy (the interest rate) should be targeted to achieve either of two objectives, internal
or external balance. The M-F model leads to some very specific policy recommendations assuming
perfect capital mobility12:
1. Under flexible exchange rates, monetary policy’s strong effect on the level of income and
employment is due, not to effects of interest rate movement, but it induces a capital
outflow, depreciates the exchange rate; and stimulates an export surplus. Moreover,
central bank operations in the foreign exchange market can be considered an alternate
form of monetary policy. Conversely, fiscal policy has no effect on employment or
income but has the impact of altering the balance of trade13
.
2. Under a fixed exchange rate regime, it is fiscal policy has the strongest effect on income
and employment while monetary policy has no sustainable effect on the level of income.
An increase in government expenditure instantaneously places upward pressure on the
domestic interest rate, which results in an appreciation of the currency to cancel the
fiscal expansion. Under the fixed exchange rate regime, monetary policy can only alter
the level of foreign exchange reserves.
The IMF Approach to Stabilization Policy
Receiving financial support from the IMF for balance of payments difficulties is predicated
upon an arrangement that governs the recipient country’s choice of economic policy (known as IMF
conditionality). The Fund’s approach to developing reform policy is based on an accounting,
9 Fleming, J. Marcus, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,” Staff
Papers, International Monetary Fund, 9 (Nov. 1962), 367-79
10 The IS-LM model is a diagram that details the simultaneous determination of equilibrium values of the
interest rate and the level of national income for a closed economy as a result of conditions in the real and
monetary sectors of the economy. The IS-LM model was developed by economist John Hicks.
11
Mussa and Savastano, 82
12 Mundell R.A., 1963
13 Mundell, R.A., 478
John Floyd, “Government expenditure policies in a small open economy,” Canadian Journal of Economics, Aug.
1979 refutes this theorem on the grounds that Mundell overlooks the influence of government on the
production and supply of goods and the fiscal policy effects that arise as a result.

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framework known as ‘financial programming’.14 It is a method of establishing short to medium term
quantitative performance targets for key macro-economic aggregates using a flow-of-funds
framework that emphasizes monetary, balance of payments, and fiscal identities in its program
design.
The behavioral relationships behind financial programming are derivatives of the Polak and
the M-F models which established links between the money supply and the external accounts,
making domestic credit expansion, international reserves, and inflation policy targets. Financial
programming assigns importance to two core policy instruments: domestic credit and the nominal
exchange rate. This is based on the following conclusions:
> Domestic credit expansion reduces international reserves (Polak model).
> Under flexible exchange rates, monetary policy induces capital outflow, depreciates the
exchange rate; and stimulates an export surplus while fiscal policy is ineffective (M-F
model).
which supports the IMF thesis that a balance of payment deterioration is principally caused by
excessive monetary expansion, through domestic credit growth triggered by fiscal deficits.
Financial programming incorporates other behavioral relationships which are applied to the
economy-wide, sector-based, macroeconomic identities, such as:
 Monetary expansion is the primary cause of imbalances.
 Monetary expansion is the product of changes in domestic credit and foreign reserves;
 A constant velocity of money;
 Real output is exogenously determined;
 Perfectly flexible prices;
 Markets clear instantly;
 The price mechanism allocates resources;
 A constant import elasticity;
 The perfect competition exists.
Does the theoretical framework cause ‘blind-spots’ that can render its policy instruments
irrelevant, and at times detrimental, to clients countries facing severe macroeconomic imbalances?
Macroeconomic imbalances can have many causes and therefore are likely to require different
policy solutions. The IMF has been accused of taking a narrow approach to assessing imbalances
and prescribing corrective measures. It takes the view that a monetary expansion, caused by a fiscal
deficit, creates a deficit in the external accounts.
The literature is replete with claims that the conditionality imposed by the IMF is often
inappropriate to client country’s circumstances. The IMF emphasizes internal adjustment via
monetary contraction by significantly reducing the government’s budget deficit. The expenditure
cut requires a reduction in the wage bill, price subsidies, social programs such as healthcare and
education. Wage repression and fiscal restriction are wrong-headed policies in the context of a
global recession, and can be recessionary in the advent of external shocks.
14 Polak, 1952

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Monetary contraction and a decrease in government demand could produce unemployment.
Relaxing the assumption of flexible prices, a real wage increase makes it unfeasible to sustain the
workforce at the pre-stabilization level. Subsidy cuts can reduce real income by a sudden increase
in basic goods such as food, heating oil, health care, or transportation.
Liberalization and reform of the exchange rate will not always conform to the behavioral
assumptions employed in financial programming. Currency devaluation may not bring about
economic expansion. In fact, it could lead to a contraction due to transferring real purchasing
power to a sector with a higher marginal saving propensity, leading to a reduction in real output
and imports. Moreover, devaluation could further deteriorate the external account if assumptions
about import elasticities are incorrect.
Structuralism – An Alternative Theory of Stabilization Policy
The other causes of macro-aggregate imbalance such as low import demand elasticity,
inflexible prices, market fragmentation, supply bottlenecks, and fiscal deficits caused by external
shocks, are not considered in the IMF neo-classical, free-market framework. An alternative theory
is required to factor them into policy design.
Structuralism provides this alternative; it views the economy as a system that must be
studied holistically understanding the reciprocal relationships among parts of the whole15. This is
in stark contrast to the neo-classical, free-market orthodoxy. In fact, this theory posits that the
structural and institutional difference between developed and less-developed economies was so
significant that aspects of orthodox economic theory are inapplicable. From a structuralist
perspective, blindly applying economic policy rooted in orthodox theory could cause significant
harm to the less-developed nations.16 According to Stiglitz, “even if Smith’s invisible hand theory
were relevant for advanced industrialized countries, the required conditions are not satisfied in
developing countries.”17
How do the two approaches compare say, for example, in their approach to inflation? How
do they approach the phenomenon; what policy do they choose? Inflation is an increase in the
average price level; it represents a decrease in the purchasing power of the domestic currency.
Both camps would agree that inflation is an indicator of disequilibria in the economy; they may not
agree on its origin or an approach to manage it.
A structuralist begins with assumption that nominal prices are downwardly rigid. Thus, a
change in relative price causes a onetime price increase. This translates into inflation through a
propagation mechanism reflected in labors attempts to maintain real wages and producers to retain
profit margins. Structuralist theory suggests that inflation arises due to supply-side shocks,
production bottlenecks, or institutional rigidities caused by incomplete or missing markets. Policy
15 James M. Cypher and James L. Dietz (1997) The Process of Economic Development, Chapter 6, Pages 170-
171: London, Routledge
16 ibid
17 Stiglitz, Joseph E, (2003) Globalization and its Discontents, Chapter 3, Page 74: New York, W. W. Norton

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choice for managing inflation could include land reform, non-traditional export expansion, and
monetary or fiscal reform.
In contrast, the IMF views inflation as the result of an excessive monetary expansion caused
by fiscal deficits financed by the central bank. Government spending reductions and increased tax
collections are standard conditions imposed by the IMF. The reduction in spending takes the form
of worker lay-offs in the public sector, wage freezes, eliminating subsidies for food products,
utilities, petroleum, the privatization of national enterprises, and establishing target growth rates
for the money supply.
Conclusion
The IMF has based much of it policies on a theoretical framework developed by Polak,
Mundell, and Fleming over fifty years ago. Their models were based on a set of assumptions that a
do not reflect the economic realities in the developing countries. The IMF’s insistence on demand
management policies created policy “blind spots” that prevented it’s acknowledgment of causes of
macroeconomic imbalances other than government fiscal mismanagement. There has been some
movement toward reform by the Fund and better alignment with its sister organization, the World
Bank. Just as the East Asian crisis momentum for change, recent events seem to have created a
significant shift in the thinking of the Fund’s staff and policy analyst. The recent global crisis has
caused the Fund to acknowledge the limits of monetary policy and bring fiscal policy “center
stage”18 as an important countercyclical tool. In short, the crisis has “exposed flaws in the pre-crisis
policy framework”19 .
18
Blanchard, Oliver, Dell’Ariccia, Giovanni, Mauro, Paolo Rethinking Macroeconomic Policy, International
Monetary Fund, Staff Position Note, (2010), page 9
19 Ibid.

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References
Avramovic, Dragoslav, “Conditionality: Facts, Theory and Policy”. (Finland: World Institute for
Development
Cypher, James M, Dietz, James L. (1997), “The Process of Economic Development”, London, Routledge
Fleming, J. Marcus, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,”
Staff Papers, International Monetary Fund, 9 (Nov. 1962), 367-79
Floyd, John, “Government expenditure policies in a small open economy,” Canadian Journal of
Economics, Aug. 1979
Mundell R.A., “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,”
Canadian Economics Association, 29, no.4 (Nov. 1963) 475-485
Mussa, Michael and Savastano, “The IMF Approach to Economic Stabilization”. NBER
Macroeconomics Annual 14 (1999)
Pilbeam, Keith, (2006) “International Finance”, New York, Palgrave Macmillan
Polak, J.J. “Monetary Analysis of Income Formation and Payments Problems”. Staff Papers –
International Monetary Fund 6, no. 1 (Nov., 1957): 1-50.
Stiglitz, Joseph E, (2003) Globalization and its Discontents, New York, W. W. Norton
Tarp, Finn. “Stabilization and Structural Adjustment: Macroeconomic Frameworks for Analyzing the
Crisis in Sub-Saharan Africa”. (London: Routledge, 1993)
Weiss, J (1988) Industry in Developing Countries: Theory, Policy, Evidence, London, Routledge