An implication of the model is that increases in the domestic supply of credit will lead to an increase in imports and a corresponding outflow of foreign reserves restoring the overall money supply to its initial level. It is therefore clear that an increase in credit creation will result in a decline in international reserves. For a country the external performance of the economy would be dependent on the extent to which the government restrained itself to borrowing domestically .A major conclusion of the Polak model is that the control of the supply of money is the key stabilisation policy for reducing the balance of payment deficit.
Selection of the key target variables is the first step. Mainly derived from the Polak model, these include the level of international reserves, level of domestic credit and level of inflation. This is vital as aforementioned above that the balance of payment equilibrium largely depends on the control of money supply which is largely influenced by the level of domestic credit and level of foreign reserves.
Next an estimation of the level of various variables that are considered exogenous is made. In the Polak model as explained above, exports (X), net capital inflows of the nonbank sector (K) and nominal income (Y) are considered as variables that are influenced by external factors i.e. exogenous. Once such information is obtained, a desirable level of imports which should consistent with the targeted level of international reserves is determined. This is usually based on past experience and overall needs and more often than not this estimation has not been accurate, leading to the need to consider how any gaps should be filled.
Hence the fourth step of the financial programming is assessing whether a devaluation is required or not. Consideration should be made on the effect this would have on the exogenous variables earlier stated (Tarp) .Once this is done, the level of the demand of money is determined next, by setting a target price level with the assumption that the money circulates at a constant velocity. Depending on the level of the demand of money, an analysis is made as to whether there is need to adjust the interest rate to attempt to affect the demand for money and velocity.
The sixth step entails determining a permissible level of credit expansion .As earlier noted, money supply is a factor of international reserves, as set in the first step, and domestic credit. At a state of equilibrium, money supply is equal to money demand hence the level of credit extension that will maintain that level of equilibrium is what is determined as permissible. This leads to the next step where a comparison is made between the acceptable level of credit expansion and the actual level of demand for domestic credit .If the actual is noted to be higher than what is acceptable, the gap should be closed.
This can be through either taking fiscal or monetary policy steps .Such fiscal policy steps can be: increasing the level of government’s fiscal revenues or reducing the level of government expenditure. Both steps work to reduce the level of demand of domestic credit. Monetary policy steps may include the increase in the level of interest rates which lead to reduction in money demand hence restoring the equilibrium with money supply (Tarp).Once the negotiations on the policies to be adopted is done the policies are then tested against the consistency of the overall programme. An agreement is reached as to the manner in which the programme will be implemented and the performance criteria in which this will be monitored against. This is expressed through a letter of intent from the government to the IMF.
The Polak model remains pivotal in the application of conditionalities by the IMF. It forms the very basis of the most basic monitoring tool, performance criteria (PC’s).These are conditions formally specified in the country’s financing arrangement with the IMF. Such criteria may be quantitative which means that they are measurable and can be monitored .The justification of such measures is well explained by the Polak model hence providing a sound basis to IMF’s approach to stabilisation. In the Ukraine’s MEFP, quantitative criteria included a ceiling on the cash deficit of the general government, ceiling on publicly guaranteed debt among others. From the MEFP, these criteria have set timelines and set levels.
The model is also important in determining prior actions, the steps the authorities agree to take before a Board decision is made on the use on the IMF resources. The effect of such actions is examined against the Polak model to measure the impact such actions would have in the economy and ultimately in the IMF’s approach to stabilisation. Using the Ukraine MEFP, an example of prior action was that the parliament would approve legislation that introduces unlimited liability of bank owners on losses arising from loans granted directly or indirectly to the benefit of bank shareholders holding 10 percent or more of total voting shares as of end-2014.The implementation of such a policy would promote stabilisation by eventually reducing the level of domestic credit.
One of the most substantial criticisms of the IMF stabilisation approach (which is based on the Polak Model) is that the lack of growth in the member countries that enter into IMF- supported stabilisation programmes. This can be argued to be rooted in the fact that the assumptions of the financial programming model limit policy makers to policies that reduce the level of consumption and not those that lead to the increase of national income. Such policies curb demand which might lead to reduced levels of growth.
The approach has also led to excessive social costs, with some of the most diverse short-term effects of stabilisation programmes tending to affect the poorest sectors of a country’s population. In part this has been attributed to the policies constraining demand as required by the financial reprogramming approach explained above.
Another criticism is that the financial programming model takes a one-size-fits-all approach to stabilisation despite the fact that situations vary from country to country. This was noted to be apparent in developing countries whose needs and challenges are dissimilar from those of emerging market economies.