Macroeconomics DVP

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					Macroeconomics for small
and developing countries

        René A. Hernández
          DDPE/ECLAC
            July 2007



                            1
    Introduction
   Figure 1.1 : In 1997 developing countries accounted for
    32% of world output.
   132 of the 183 countries are developing countries.
   Although most of production takes place in the industrial
    countries, country-specific macroeconomic policy
    formulation is carried out in a developing-country context.
   Developing countries behave similarly to industrial
    countries, but operate in a different environment.
   Standard analytical tools of modern macroeconomics are
    relevant to developing countries.
   But different models are needed to analyze.
   Purposes to which the models have been applied also
    distinguish macroeconomics in developing countries.
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                             3
    Introduction
   Monetarism, Structuralism, Neostructuralism
    and Developing Nations.
   Economic Structure and Macroeconomics.
   Some Special Topics.




                                                  4
  Monetarism, Structuralism,
Neostructuralism and Developing
            Nations




                                  5
The debate
   Debate on relevance of industrial-country
    macroeconomic analysis to developing
    nations.
   “Monetarist” or “orthodox” versus
    “structuralist”.




                                                6
Orthodox view
   Long-run growth in developing countries is hampered by
    dirigiste policies that distort the allocation of resources.
   Prescription: giving full scope to market mechanisms via
    free trade and noninterventionist domestic policies.
   In the short run, high inflation and balance-of-payments
    deficits reflect excessive money growth fueled by large fiscal
    deficits.
   Cure: tight fiscal policy and “getting prices right”, by
    devaluing and raising domestic interest rates.
   Policies based on the orthodox view have been promoted by
    international financial institutions.

                                                                 7
    Early Structuralist School
   Primary-exporting countries would face deteriorating terms
    of trade relative to the manufactured goods-exporting
    industrial-nation.
   Reason: Lower income elasticities of demand for raw
    materials than for industrial goods.
   Policy intervention was required to change the structure of
    production in the periphery.
   Industrialization should be promoted by protecting “infant
    industry” against competition through:
      use of trade barriers and foreign exchange controls;

      providing special advantages to the industrial sector.

   This “import substitution” strategy was adopted in the
    immediate postwar period.
                                                                  8
    “New structuralist” view (NSV)
   Turned their attention to short-run macroeconomic
    stabilization.
   The analytical framework is influenced by the keynesian and
    postkeynesian schools and focuses on the design and
    implementation of strategies and economic policies.
   Best-known proponent: Lance Taylor.
   Taylor (1990) identifies “new structuralist” view.
      many agents possess significant market power;

      macroeconomic causality in developing countries tends to
       run from “injections” to “leakages”;
      money is often endogenous;

      structure of the financial system can affect macroeconomic
       outcomes;
      imported intermediate and capital goods, complementarity
       between public and private investment are empirically
       important.
                                                                    9
    “New structuralist” view
   New structuralists question orthodox short-run
    prescriptions.
   Source of inflation:
      slow relative productivity growth in agriculture;

      administered prices in industry, together with wage
        indexation.
   Monetary policy is passive in the face of these inflationary
    forces.
   Combining devaluation with tight fiscal and monetary
    policies will result in stagflation in the short run.
   Reason: Roles of working capital and imported inputs, and
    substitution possibilities are more limited than assumed.

                                                                   10
    “New structuralist” view
   Alternative new structuralist policy prescription:
      greater element of gradualism;

      direct intervention;

      emphasis on the medium-term resolution of

       structural problems.
   Macroeconomic reality in the developing world
    combines features of both.
   ECLAC’s “productive transformation and equity” is
    an expression of the NSV
                                                         11
 Economic Structure
and Macroeconomics




                      12
   Openness to Trade in Commodities and Assets.
   Exchange Rate Management.
   Domestic Financial Markets.
   The Government Budget.
   Aggregate Supply and the Labor Market.
   Stability of Policy Regimes.
   Macroeconomic Volatility.



                                                   13
 Openness to Trade in
Commodities and Assets




                         14
Developing economies tend to be more
 open to trade in goods and services
than are the major industrial countries

   Openness: trade share (sum of the shares of
    exports and imports) in GDP.
   First panel of Figure 1.2: developing nations
    tend to be more open than the major
    industrial countries.
   Mean value of the trade share is 45%,
    compared with about 25% in the G-7
    countries.
   Openness limits at the applicability of the
    closed-economy textbook industrial-country
    model to the developing-country context.
                                                15
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                                              16
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     Developing countries typically have little
     control over the prices of the goods they
                export and import
   Exogeneity of the terms of trade is suggested both
      by their small share in the world economy;

      by the composition of their exports.

   In 1990 developing nations accounted for about
    one quarter of world exports and imports.
   In 1991 over half of the exports of low- and middle-
    income countries consisted of primary
    commodities.
   Second panel of Figure 1.2: share of primary
    commodities in the exports of a selected group of
    developing countries.
   Third panel: two-thirds of the exports of the
    countries went to industrial countries.            17
   Very few developing countries account for a
    significant portion of the world market.
   Only sixteen developing countries account for as
    much as 10% of the world market.
   These countries have little individual influence over
    the prices at which they buy and sell (Goldstein,
    1986).
   Exogenous terms of trade questions the usefulness
    of the open-economy model for developing nations.
   Suitable models are
      Salter-Swan “dependent economy” model or

      three-good model consisting of exportables,
       importables, and nontraded goods.                18
   Such production structure permits a distinction between
    the exogenous terms of trade and an endogenous real
    exchange rate.
   Importance of primary-commodity exports with
    exogenously determined prices: important source of
    macroeconomic instability.
   Figure 1.3: prices of primary commodities tend to
    fluctuate sharply.
   Top panel of Figure 1.4: several episodes of drastic
    changes in the terms of trade for developing countries.
   Episodes are dominated by changes in oil prices.
   Bottom panel in Figure 1.4: nonfuel commodities have
    undergone sharp fluctuations in price during the 1970s
    and 1980s.
                                                          19
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                           23
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                     24
 Extent of external trade in assets has been
more limited in developing countries, though
this situation has recently begun to change

   Developing countries have undergone an
    increase in their degree of integration
    with the world capital market.
   Integration occurred in the context of
    immature domestic financial systems,
    limited policy flexibility, and fragile
    credibility.
   This situation has caused to the capital
    inflow problem.
                                           25
     Developing countries are capital importers,
       and the servicing of external debt is a
                central policy issue
   Figure 1.5: set of external-debt indicators.
   Debt crisis problem emerged because the domestic sector
    that held the external assets was not the same as the sector
    that holds the external liabilities.
   In countries that have recently become integrated with
    international capital markets, external debt has tended to be
    incurred by the private sector.
   Policy challenges involve coping with
      potential macroeconomic overheating associated with the
        sudden arrival of large inflows,
      vulnerability to macroeconomic volatility induced by
        sudden capital flow reversals.



                                                                26
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S Wk
o on
u ra
 r
 c lB
 ed.
  :                                                                                                                         27
Exchange Rate Management




                       28
   Majority of developing countries have
neither adopted fully flexible exchange rates
         nor joined monetary unions

   In developing countries officially determined rates
    predominate.
   Exchange regimes in developing countries have
    evolved toward greater flexibility since the
    collapse of the Bretton Woods system in 1973.
   This has meant that more frequent adjustments
    of an officially determined parity rather than the
    adoption of market-determined exchange rates.


                                                     29
   Prevalence of official parities implies that issues
    relating to the macroeconomic consequences of
      pegging,

      altering the peg (devaluation),

      rules for moving the peg

    are important in developing countries.




                                                          30
Domestic Financial Markets




                             31
Financial markets in developing nations have
   been characterized by the prevalence of
  rudimentary financial institutions and by
            “financial repression
   Only some of the developing countries have
    developed large equity markets.
   Financial markets are dominated by commercial
    banks.
   So assets available to private savers are limited.
   Equity markets tend to be dominated by a few
    firms and exhibit very low turnover ratios.



                                                     32
   The commercial banking sector has been heavily regulated
    and subjected to
      high reserve and liquidity ratios;

      legal ceilings on interest rates;

      sectoral credit allocation quotas.

   Thus credit rationing is legally imposed.
   Policies toward the financial sector is known as “financial
    repression.”
   Restrictions cause the size of the commercial banking
    system to be curtailed.
   Figure 1.6: monetization ratios (banking sector liabilities
    over GDP) are lower in developing countries.
                                                                  33
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                          34
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 I ot
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                       35
   Informal financial sector has often arisen.
   Thus, instruments of monetary policy and monetary transmission
    mechanism tend to be different.
   Thus, modification of standard textbook macroeconomic behavioral
    relationships may be needed.
   Incorporate the implications of credit and foreign exchange
    rationing in private decision rules by including
      quantity constraints in consumption and investment equations

      employing prices in informal credit and foreign exchange

        markets.
   Weakness of the institutional framework in developing countries
    has made both the frequency and depth of such financial crises
    much more extensive.
                                                                  36
The Government Budget




                        37
The composition of the government budget
 differs between industrial and developing
                 countries

  In developing nations, the pervasive role of the state in the
   economy is exercised through the activities of
     nonfinancial public sector and

     financial institutions owned by the government.

 Government tends to play an active role in production.

 Performance of public-sector enterprises is central in

   determining the fiscal stance.
Figure 1.7:
 Central government absorbs a smaller fraction of output in

   developing countries.


                                                              38
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                      39
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                          40
  Composition of spending differs.
     Developing nations spend more on general public

      services, defense, education, and other economic
      services.
     Industrial nations spend more on health and social

      security.
Figure 1.8:
 Main source of central government revenue is taxation.

 Share of nontax revenue in total revenue is higher in

   developing countries.
 Reason: Limited administrative capacity and political

   constraints hinder collection of tax in developing countries.
                                                                   41
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                     42
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                         43
  Direct taxes, taxes on domestic goods and services, and
   taxes on foreign trade have equal shares of total tax revenue
   in developing countries.
 Industrial countries: income taxes have the largest share.

 Reliance on seigniorage, and therefore to higher levels of

   inflation in developing countries due to
     lack of tax collection,

     limited issuance of domestic debt.

Figure 1.9:
 Industrial countries: seigniorage revenue is less than 0.8% of

   GDP.
 Developing countries: more than 1% of GDP.

 Macroeconomic implications of budget institutions:           44
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                                                     45
   Macroeconomic implications of budget institutions:
     nature of the constitutional rules used to impose

      constraints on the size of the fiscal deficit;
     procedural rules that guide the elaboration of the

      budget by the executive branch, its approval by
      the legislative branch, and its execution;
     type of rules that may enhance the transparency

      of the budgetary process.



                                                       46
 Aggregate Supply
and the Labor Market




                       47
   Due to large direct role of the state in
production, size and efficiency of the public
  capital stock figures prominently in the
            aggregate production

   Figure 1.10: importance of the public sector in
    capital accumulation.
   Glen and Sumlinski (1998): public sector
    accounted for 39% of total investment over
    1980-1989 and 36% over 1990-1996.
   In recent years, several developing countries
    have undertaken massive privatizations of
    nonfinancial public enterprises.


                                                      48
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                        95
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                                                                                              49
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  i
  a p
N,i a.
      Imported intermediate goods play an
    important role in the aggregate production
                      function

 Mirakhor and Montiel (1987): Such goods account for
  half of all developing-country imports.
 Figure 1.11: In some countries the share of energy and

  non-energy intermediate imports can even exceed
  70%.
Results:
 Difference between the value of domestic production

  and domestic value added is larger.
 Exchange rate has an important influence on the

  position of the economy's short-run supply curve.
 Availability of foreign exchange may have a direct effect
                                                          50
  on the position of the short-run supply curve.
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              56
        Short-run supply functions may be
     significantly affected by working-capital
                  considerations
 Costs of working capital tend to give interest rates and
credit availability an important short-run supply-side role
 But empirical importance of this is mixed.

 If relevant, contractionary monetary policy may have

short-run stagflationary consequences.
Informal sector plays an important role in the
determination of wages and employment
 Informal urban sector accounts up to 60% of economic

activity and total employment in developing countries.
 Result: segmentation of the urban labor market.



                                                              57
Stability of Policy Regimes




                              58
 Developing countries exhibit
    higher fiscal deficits,

    higher rates of inflation,

    higher average growth rates.

During 1979-88:
 Industrial countries: real GDP growth is 2.8% per
  annum and inflation is 6.3%.
 Developing countries: real GDP growth is 4.3% per
  annum and inflation is 31.8%.
During 1989-1998:
 Industrial countries: real GDP growth is 2.2% per
  annum and inflation is 3.1%.
                                                      59
   Developing countries: real GDP growth is 5.8% per annum
    and inflation is 33.2%.
   High inflation has been a symptom of policy instability and
    has been associated with policy uncertainty.
   Policy uncertainty is important in:
      triggering currency substitution;

      capital flight;

      exchange-rate crises;

      collapse of private investment.

   Uncertainty in policy environment must be included in
      developing-country macroeconomic models,

      design of macroeconomic reform programs.
                                                                  60
Macroeconomic Volatility




                           61
Macroeconomic environment in developing
     countries is much more volatile

 Roots of macroeconomic instability are both
  external and internal:
    Volatility in the terms of trade and international
     financial conditions.
    Inflexibility of domestic macroeconomic
     instruments and political instability.
Figure 1.12:
 Latin America case.

 All components of the governments budget is
  less stable.

                                                     62
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                                    63
   Instability causes
      relative prices such as the terms of trade and real

       exchange rate;
      unstable growth rates of real GDP and private

       consumption.
   Gavin and Perotti (1997): volatility in some Latin American
    countries have been compounded by a procyclical fiscal
    policy response:
      increase in government expenditure and fiscal deficits

       during periods of expansion;
      fall during recessions.

   Overall, boom and bust phenomena tend to be much more
    common and more costly in developing countries.               64
Some Special Topics




                      65
    Exchange-Rate Management
   Long-standing issues:
      desirability of alternative exchange-rate regimes;

      “new structuralist” critique of the role of the

       exchange rate in orthodox stabilization.
   Recent issues:
      macroeconomic consequences of alternative

       nominal exchange-rate rules;
      role of the exchange rate as a nominal anchor in

       an open economy.


                                                            66
    Stabilization of High Inflation
   Alternative approaches to price-level stabilization
    ranging
      from “orthodox” money-based programs relying

       on tight fiscal and monetary policies and
       exchange-rate policy,
      to “heterodox” programs based on tight

       aggregate demand policies, an exchange-rate
       freeze, and wage and price controls.
   The evaluation of this experience and its lessons
    for future stabilization efforts have been important.
                                                            67
    Managing Capital Flows
   Since the early 1990s many Asian and Latin
    American countries have faced a surge in capital
    inflows.
   The causes of such inflows, their welfare
    implications, and appropriate policy responses
    have been the subject of much recent attention.




                                                       68
Currency Crises
   In recent years research have focused on
      roles of self-fulfilling expectations and

       policymakers' preferences,
      links between banking and currency crises

       and predictive content of various economic
       indicators.




                                                    69
    Trade and Financial Reform
   Reforms are designed to
      enhance role of financial intermediaries in

       channeling domestic saving
      give the real economy a more outward

       orientation.
   But these reforms have been controversial.
   Their relationship with macroeconomic stabilization
    has been a focus of attention.


                                                      70
Political Aspects of the
Macroeconomy
   Political factors are important to understand
    many macroeconomic phenomena, such as
      inflation inertia,

      setting of policy instruments,

      sustainability of reform programs.




                                                    71
    The Functioning of Labor
    Markets
   Important issues:
      incidence of labor market segmentation,

      role of government regulations,

      low degree of labor mobility across sectors in

       the short run.




                                                        72

				
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