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Macro Policies in

Developing Countries

Chapter 16

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Laugher Curve
Did you hear about the economist who
dove into his pool and broke his neck?
He forgot to seasonally adjust his pool.

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Developing Countries in
■ Of the over 6 billion people in the world, 75
percent live in developing countries.
■ Per capita income in developing countries
is around $500 per year.
■ Per capita income in the U.S. is about

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Don’t Judge Society by Its
Income Alone
■ Economically poor societies often have
cultures that provide individuals with a
deep sense of fulfillment and satisfaction.
■ You just can’t judge an economy, you must
judge the entire culture.

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Some Comparative Statistics on
Rich and Poor Nations
■ When comparing living standards among
countries, economists use purchasing
power parity to adjust for the differences in
exchange rates.

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Some Comparative Statistics on
Rich and Poor Nations
■ Purchasing power parity – a method of
comparing income by looking at the
domestic purchasing power of money in
different countries.

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Growth versus Development
■ Development refers to an increase in
productive capacity and output brought
about by a change in a country’s
underlying institutions.
■ Growth refers to an increase in output
brought about by an increase in inputs.

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Growth versus Development
■ Growth occurs because of an increase in
inputs, given a production function.
■ Development occurs through a change in
the production function.

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Growth versus Development
■ Institutions in developed economies may
also change, for example, when the
economy is restructured.
■ Restructuring – changing the underlying
economic institutions.

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Growth versus Development
■ Compared to Western developed
economies, developing economies have:
● Different institutional structures.
● A different weighting of goals.

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Differing Goals
■ The normative goals of developing and
developed countries differ because their
wealth differs.
● Developing countries face true economic
needs like adequate food, clothing, and
● The needs of developed countries are
considered by most people to be less pressing.

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Differing Institutions
■ Because the problems they face are
different, economies at different stages of
development have different institutional

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Political Differences and
■ Institutional checks and balances on
government leaders often do not exist in
many developing countries.

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The Dual Economy
■ A developing country’s economy is
generally characterized as a dual
■ Dual economy – the existence of two
sectors: a traditional sector and an
internationally oriented modern market

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Dual Economy
■ The traditional sector does business in
local currency and produces in traditional
■ The internationally oriented sector is often
indistinguishable from a Western

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Fiscal Structure of Developing
and Transitional Economies
■ Developing countries often don’t have the
institutional structures to collect taxes.
■ May governmental expenditures are
mandated by political considerations.

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Fiscal Structure of Developing
and Transitional Economies
■ A developing country may experience a
regime change.
● Regime change – a change in the entire
atmosphere within which the government and
the economy interrelate.
● Policy change – a change in one aspect of
government's actions, such as monetary or
fiscal policy.

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Financial Institutions of
Developing and Transitional
■ The financial institutions in developing
countries are often quite different from
those in developed countries.
■ The reason arises from the dual nature of
developing countries’ economies.

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Financial Institutions of
Developing and Transitional
■ Before one can understand its economy
and talk meaningfully about policy it is
important to specific knowledge of a
country’s institutions.

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Monetary Policy in Developing
■ The primary goal of a central bank in a
developing country is different than the
primary goal in developed countries.

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Central Banks Are Less
■ Central banks in developing countries are
generally less independent than ones in
developed countries.

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Central Banks Are Less
■ The central bank in a developing country
usually must print money to buy bonds
when its government runs a deficit.
■ They recognize that printing too much
money causes inflation, but are often
compelled to by political considerations.

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Central Banks Are Less
■ Inflation works as a tax on holders of cash
and obligations specified in nominal terms.

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Central Banks Are Less
■ Central banks in developing countries are
faced with the choice of inflation or the
unpleasant alternatives of not funding the
government deficit.

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Central Banks Are Less
■ The central bankers know that inflation is
only a temporary solution.
■ That doesn’t stop them from using it.

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Focus on the International
Sector and the Exchange Rate
■ Almost no developing country has fully
convertible currencies.

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Various Types of
■ Full convertibility – individuals may
change their currency into any currency
they want for whatever legal purpose they

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Various Types of
■ Convertibility on the current account –
a system that allows people to exchange
currencies freely to buy goods and
services, but not to buy assets in other

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Various Types of
■ Limited capital account convertibility –
a system that allows full current account
convertibility and partial capital account

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Various Types of
■ Because almost no developing country has
full convertibility, the international part of
the dual economy is dollarized.
■ Dollarized – contracts are framed in, and
accounting is handled in, dollars, not in
the home country’s currency.

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Various Types of
■ Nonconvertibility does not halt international
■ It merely makes international trade more

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Various Types of
■ Exchange rate policy is an important
central bank function when the developing
country has partially convertible exchange
■ Exchange rate policy – buying and
selling foreign currencies in order to
stabilize the exchange rate.

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Conditionality and Balance of
Payments Constraints
■ Developing countries often rely on advice
from the International Monetary Fund
● The IMF has experienced economists.
● The IMF is a major source of temporary loans
to stabilize their currencies.

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Conditionality and Balance of
Payments Constraints
■ The basis for most IMF loans is
■ Conditionality – the making of loans that
are subject to specific conditions.

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Conditionality and Balance of
Payments Constraints
■ A partially flexible exchange rate presents
the country with the balance of payments
■ Balance of payments constraint –
limitations on expansionary domestic
macroeconomic policy due to shortage of
international reserves.

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Need for Creativity
■ Macro policy in developing countries is
dominated by domestic political concerns
and international constraints.
■ The development of new institutions can
have enormous effects.

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Obstacles to Economic
■ Seven problems face developing
● Politicalinstability.
● Corruption.
● Lack of appropriate institutions.
● Lack of investment.
● Inappropriate education.
● Overpopulation.
● Health and disease.

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Political Instability
■ A successful development strategy
requires the existence of a stable
■ Lack of stability is often exacerbated by
social and cultural differences among
groups within a county.

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Influence of Political
Instability on Development
■ Political instability closes off external and
internal sources of financial investment.
■ Foreign companies and members of the
wealthy elite in developing countries are
reluctant to invest when there is a high
risks of loss.

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Political Instability and
Unequal Distribution of
■ The economic prospects for many people
in developing countries are so bleak that
they are willing to support or join a guerrilla

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Political Instability and
Unequal Distribution of
■ Monetary policy affects the trade balance
in three ways.
● Through income.
● Through price levels.
● Through exchange rates.

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■ Developing countries often lack well-
developed institutional setting and a public
morality that condemns corruption.
■ As a result, bribery, graft, and corruption
are ways of life in most developing

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Lack of Appropriate
■ Markets do not just exist – they are
■ Their existence is meshed with the cultural
and social fabric of society.

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Lack of Investment
■ Economic growth requires savings that are
channeled into investment.
■ The saving could be brought in from
outside the country or generated internally.

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Investment Funded by
Domestic Saving
■ With very low per capita incomes, poor
people in developing countries don’t have
the wherewithal to save.
■ Few members of the middle class in those
countries trust putting savings in local

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Investment Funded from
■ External savings take the form of foreign
aid or foreign investment.

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Foreign Aid
■ Foreign aid – funds that developed
countries lend or give to developing
■ Total foreign aid from all countries comes
to about $11 per person in developing

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Foreign Investment
■ Foreign businesses have a greater
incentive to invest in a country if that
country has:
●A motivated, cheap workforce.
● A stable government supportive of business.
● Sufficient infrastructure investment.

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Foreign Investment
■ Infrastructure investment – investment in
the underlying structure of the economy.
■ In the poorest countries, this infrastructure
doesn’t exist.

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Competition for Investment
Among Developing Countries
■ Developing countries often compete
against each other to get a business to
locate a facility there.
■ This competition often leads to the benefits
being passed on to Western consumers.

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Focal Points and Takeoff
■ Developing countries that have been
successful in attracting investment often
get further investment.
■ Economic takeoff – a stage when the
development process becomes self-

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Inappropriate Education
■ The right education is a necessary
component of any successful development
■ The wrong education is an enormous

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Inappropriate Education
■ When education doesn’t match the needs
of society, the credentials become more
important than what is learned.
■ Credentialism – the degrees, or
credentials, become more important than
the knowledge learned.

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Inappropriate Education
■ Many good students from developing
country who study abroad often don’t
return to the developing country.
■ Brain drain – the outflow of the best and
brightest students from developing
countries to developed countries.

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■ A country can increase its per capita
income by:
● Decreasing the number of people in the
country (without decreasing the country’s
total income).
● Increasing total income (without decreasing
the population).

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■ Most Western economies have avoided
the Malthusian fate because output has
grown faster than population.
■ Thomas Malthus predicted that population
would outrun the means of subsistence.

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■ Many developing countries have not
avoided the Malthusian fate.
■ Population growth has exceeded
productivity growth, leading to per capita
output growth small or negative.

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■ Population grows for a number of reasons:
● Infant mortality rates and death rates fall as
public health measures are improved.
● As peoples incomes grow, they can afford
more children.
● In rural areas, children are useful in working
the fields.

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■ Some developing nations have tried
various ways to limit population growth –
from advertising campaigns to forced
■ Even successful population control
programs have there problems.

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Health and Disease
■ A country must have a reasonably healthy
population before it can hope to develop.
■ Some diseases make it difficult to work
and take care of children.
■ Because of financial and infrastructure
reasons, it is often difficult to get the
necessary drugs to developing countries.

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Mission Impossible
■ Economic development is a complicated
■ It is entwined with cultural and social
■ The appropriate answer depends on the

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Macro Policies in
Developing Countries

End of Chapter 16

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