THE RELEVANCE OF CONVENTIONAL MACROECONOMIC MODELS TO LDC

ECONOMIES

Introduction

The economies of less developed countries have unique characteristics that require different
models to analyze macroeconomic phenomena. This chapter discusses important
macroeconomic characteristics shared among developing nations that do not usually figure
prominently in mainstream industrial country macroeconomic models and explores how
standard macroeconomic policy prescriptions result in different and sometimes perverse results
when applied to developing economies using the standard ISLM framework.

 The relevance of standard macroeconomic analysis to developing nations has been subject
to debate, with two main schools of thought.

I. The Monetarist or the Orthodox view: The Monetarist or orthodox view holds that
mainstream macroeconomic orthodoxy is directly applicable to both long and short run
macroeconomic issues in developing countries, with long-run growth promoted by giving
full scope to market mechanisms and short-run issues addressed through tight fiscal policy,
devaluation, and raising interest rates.

II. Structuralist : The Structuralist view, including the Early Structuralist view, argues that due
to lower income elasticity of demand for raw materials, primary exporting countries in
developing countries would face deteriorating terms of trade and production specialization
along classical comparative advantage lines should be avoided.

 Instead, policy interventions, including protecting domestic industries, trade barriers, and
foreign exchange controls, should promote industrialization with special advantages for the
industrial sector such as cheap inputs, credit, and labor.

 The recent Structuralist view : identifies several hypotheses that challenge the wisdom and
efficacy of orthodox short-run macroeconomic policy prescriptions.

 This view attributes an accommodative rather than a causal role to money growth in
inflation and emphasizes the importance of the structure of the financial system, imported

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 intermediate and capital goods, and direct complementarity between public and private
investment.

Basic Macroeconomic features of LDCs

The macroeconomic features that differentiate developing countries from industrial ones cover
a wide range, including openness to trade, exogenous terms of trade, capital importation,
exchange rate management, and domestic financial markets.

 Developing countries tend to be more open to trade than industrial countries but have little
control over the prices of the goods they export and import.

 Exchange rate management is one of the most important policy areas for developing
countries, with officially determined rates predominating.

 Financial markets in developing nations are dominated by commercial banks and have long
been characterized by financial repression, with inappropriate reforms often resulting in
financial crashes.

 Developing countries tend to exhibit higher fiscal deficits, substantially higher rates of
inflation, and higher average growth rates than industrial countries. However, high inflation
has been a symptom of policy instability and uncertainty, which has frequently been
associated with policy uncertainty. As a result of many of the phenomena described
previously, the macroeconomic environment in developing countries is often much more
volatile than in industrial countries.

4. Basic LDC Macroeconomic Models

Aggregate supply: the aggregate supply function of any economy depends importantly on both
products and labour market structure, production relationships, and entrepreneurial behaviour.

 The Aggregate Supply of LDCs is generally characterized as being relatively inelastic compared to
that of developed countries. This means that LDCs are often unable to respond quickly (in short run)
to changes in demand, and as such, their production levels and prices may not adjust as easily.

 The prevalence of oligopoly in product markets and imperfect labor markets results in a fixed
money wage rate and labor surplus.

 LDCs heavily rely on imported raw materials and intermediate inputs, and production depends on
the availability of foreign exchange.

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 Entrepreneurial behavior in LDCs involves variable-cost-markup pricing and borrowing from the
curb market to finance variable costs, affecting factor prices for profit maximization or markup
calculations.

 The standard LDC aggregate supply curve is relatively flat in (Y, P) space, due to nominal wage
rigidity, accompanied by an excess supply of labour; and idle capacity suggest that there are not
significantly diminishing returns to labour in the relevant range of production.

 As a result, an increase in the price level induces an increase in both employment and output, and
the increase is likely to be quite large due to the flat marginal product of labour curve.

 as the level of output approaches maximum potential output and the assumption that the money
wage is fixed in the short run becomes less tenable, the aggregate supply curve becomes steeper.

 Variables that affect the cost of production, such as the wage rate, the domestic-currency price of
foreign currency, and the cost of borrowing, shift the aggregate supply curve up and to the left in (Y,
P) space.

In sum, the standard LDC aggregate supply curve is written as:

s s
y =y ( p, i w,e)
+ −− −

 The differences between the standard LDC and MDC aggregate supply curves are that the LDC curve
is flatter and more frequently found to have unemployed labour and an underutilized capital stock,
while the MDC is usually close to full employment with less nominal wage rigidity. Changes in the
exchange rate also shift the aggregate supply curve as the domestic price of imported inputs and
raw materials are affected.

Aggregate Demands
 The analysis of aggregate demand in LDCs involves examining the equilibrium in the markets for the
flow of current output and for the stock of money.

 The equilibria involve three dependent variables - domestic output (Y), the price level of that output
(P), and an interest rate (i) - among various exogenous and policy variables, functions, and
parameters.

a. Money market equilibrium and financial markets

 The difference in the macroeconomic analysis of advanced and less developed economies is due to
the underdevelopment and compartmentalization of the financial mechanism in LDCs, which is
perpetuated by government policy in many cases.

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 Financial repression, which involves holding down nominal interest rates and inducing non-price
rationing in the allocation of credit, has allocative inefficiencies and implications for macroeconomic
modeling and policy.

 The LM curve has the usual upward slope in (Y, i) space and is likely steeper due to the lower ratio
of money to GNP in LDCs, which means that interest elasticity of demand for money is low.

 The LM curve is affected by changes in P, q, e, w, J, or B. The LM curve is shifted upward and to the
left by an increase in P, q, e, or w, and downward and to the right by an increase in J or B.

b. Goods Market equilibrium

 Equilibrium in the LDC market for domestic production occurs when the flow of domestic output
equals the demand for it.

 The total demand for domestic output consists of household consumption, business investment,
government spending, and net exports.

 Differences in LDCs include the consumption function depending on the functional distribution of
income and the higher marginal propensity to consume out of wage income.

 investment financing primarily through direct lending from the government and retained earnings
of business firms.

 government spending composed largely of wage payments and public sector investment.

Net exports: Most LDCs are small relative to the rest of the world, and face exogenously determined
world prices. Thus, domestic prices of tradables depend on world prices subsidies and tariffs, and the
exchange rate.

 The price elasticity of export supply is likely to be small in the short run due to capacity constraints
and delays in increasing exports.

 Imports and domestically produced goods are poor substitutes, and remaining imports consist
largely of noncompetitive intermediate inputs.

 The government generates significant revenue from ad valorem taxes on imports, and the trade
sector is large.

The real value of net exports is in domestic currency (NX) is expressed as:

e
NX= [(1−t x ) X (e (1−t x )/ p ]
p where X is the value of exports, valued in foreign currency.

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The LDC IS curve to be derived from the above stylized facts has the usual downward slope in (Y, i)
space. With the stylized facts discussed above, it is likely to be quite steep; the low short-run interest
elasticity of investment demand and the high income elasticity of import demand both act to increase
the slope. There are, however, two forces acting in the reverse direction, to reduce the IS-curve slope:

1. the large overall marginal propensity to consume attributed to low income countries;
and

2. the possibly high income elasticity of investment demand suggested by some

empirical studies

 Policy variables affecting the IS curve include tax rates, government employment, government
investment, and the exchange rate.

 Changes in tax rates and government expenditures have the same qualitative impact as in a
standard macro model, while devaluation of the real exchange rate (e/P) has a negative impact on
investment and shifts the IS curve to the left, known as contractionary devaluation.

In a general context, without taxes and given constant world prices, the balance of trade valued in
domestic currency will worsen with devaluation (for a given level of income) if:

B
+ X η xs + M ε mD <0
e

 Changes in the real wage rate (w/P) have an ambivalent impact on the IS curve, but the down-and-
to-the-left effects of real wage cuts are expected to dominate. The impact of changes in the price
level on the IS curve is ambiguous but likely small.

Aggregate Demand Function

 The LM and IS curves in LDCs can be used to create an aggregate demand curve that relates price,
output, and various exogenous and policy variables.

y D= y D ( p , q , i B , N G , I G ,t y , t x , t m , e , w , ΣJ , ΣB )
− − − + + − − − − ? + +

 This aggregate demand curve is downward sloped in (Y, P) space, but likely to be steeper than the
standard MDC aggregate demand curve due to a high marginal propensity to import and a low
interest rate elasticity of investment demand.

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 The signs of the partial derivatives of the aggregate demand curve equation differ from the
standard MDC aggregate demand function, including the opposite sign for e due to devaluation
increasing the demand for money and the indeterminate sign for the nominal wage rate.

COMPARATIVE STATIC ANALYSIS

The comparative static analysis focuses on the impact of various policies on the economy of LDCs. The
analysis considers four exogenous variables - monetary policy(q), fiscal policy(IG), exchange-rate
policy(e), and incomes policy(w). The impact of these policies on the aggregate supply and demand
curves is examined, as well as the continuing effects through changes in the government deficit(J) and
balance-of-payments surplus(B).

 the aggregate supply and aggregate demand curves of the standard LDC model are:

s s
y =y ( p, i w,e)
+ −− −

y D= y D ( p , q , I G , e , w , ΣJ , ΣB )
− − + − ? + +

 we can write an equation for the curb market interest rate as a function of the price level and
exogenous variables:

i=i( p , q , I G , e , w , ΣJ , ΣB )
+ + + ? + − −

by substituting the interest rate function above into the aggregate supply function of equation
developed earlier:

y s= y s (i( p , q , I G , e , w , ΣJ , ΣB ), p , e , w ))
+ + + ? + − − + − −

 The slope of the aggregate supply curve in the above equation in (Y, P) space is steeper than the
aggregate supply curve of equation we developed from the very beginning of this section where i is
held fixed.

 A decrease in the monetary base shifts both the aggregate demand and supply curves to the left,
the net impact being primarily a decrease in output.

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a. Monetary contraction : An increase in the reserve requirement ratio (q), reducing the money supply,
has a large impact on the LM curve (for a given price level) because of the low interest rate elasticity of
money demand.

 The decrease in the availability of low interest commercial bank loans also reduces retained
earnings somewhat, shifting the IS curve down.

 due to the flatness of the aggregate supply curve, any shift that does occur is relatively ineffective in
reducing the price level.

 In the LDC, this restrictive monetary policy also raises the aggregate supply curve through the
increase in the interest cost on variable inputs.

 The net impact of monetary contraction is, for the MDC that the price level falls and output declines
moderately; for the LDC, output also falls, but the price level may increase.

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  restrictive monetary policy has few appealing implications for the policy-maker in the LDC economy,
even the functional distribution of income is likely to worsen as output falls, especially if the
price level rises.
 Restrictive fiscal policy is likely to be more successful in reducing the price level without the
costs of a major recession.
 Devaluation has a direct impact of reducing the monetary base, and the net effect is
ambiguous.
 An incomes policy that lowers the nominal wage directly affects the standard LDC economy in a
number of ways, and the impact on output and the price level is ambiguous.

Conclusion
The conclusion drawn from the standard LDC macro model and comparative static analysis is that
traditional stabilization policies have different and generally less desirable effects in LDCs than in
advanced country models. Restrictive policies are likely to fuel inflationary tendencies and worsen
income distribution. Additionally, attacking balance-of-payment crises is difficult and all macro policies
have effects on the government budget and balance of payments, limiting policy-makers' ability to alter
economic conditions in the long run. These difficulties indicate why policy-makers are hesitant to
undertake short-run stabilization policies in LDCs, as there are major conflicts between short-run crisis
cures and long-run growth and equity objectives. Therefore, the high price of stability indicates why
many LDCs have been reluctant to buy much of it.