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 Perspective
Of the over 6 billion people in the world, 75 percent live in developing countries. s Per capita income in developing countries is around $500 per year. s Per capita income in the U.S. is about $36,000.
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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. s 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
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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
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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. s Growth refers to an increase in output brought about by an increase in inputs.
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Growth versus Development
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Growth occurs because of an increase in inputs, given a production function. s Development occurs through a change in the production function.

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

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Growth versus Development
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Compared to Western developed economies, developing economies have:
q Different

institutional structures. q A different weighting of goals.

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Differing Goals
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The normative goals of developing and developed countries differ because their wealth differs.
q Developing

countries face true economic needs like adequate food, clothing, and shelter. q The needs of developed countries are considered by most people to be less pressing.
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Differing Institutions
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Because the problems they face are different, economies at different stages of development have different institutional needs.

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Political Differences and Laissez-Faire
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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 economy. s Dual economy – the existence of two sectors: a traditional sector and an internationally oriented modern market sector.
s
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Dual Economy
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The traditional sector does business in local currency and produces in traditional ways. s The internationally oriented sector is often indistinguishable from a Western economy.

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Fiscal Structure of Developing and Transitional Economies
Developing countries often don’t have the institutional structures to collect taxes. s May governmental expenditures are mandated by political considerations.
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Fiscal Structure of Developing and Transitional Economies
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A developing country may experience a regime change.
change – a change in the entire atmosphere within which the government and the economy interrelate. q Policy change – a change in one aspect of government's actions, such as monetary or fiscal policy.
q Regime

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

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Financial Institutions of Developing and Transitional Economies
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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 Countries
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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 Independent
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Central banks in developing countries are generally less independent than ones in developed countries.

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Central Banks Are Less Independent
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The central bank in a developing country usually must print money to buy bonds when its government runs a deficit. s 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 Independent
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Inflation works as a tax on holders of cash and obligations specified in nominal terms.

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

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

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

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Various Types of Convertibility
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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 countries.

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

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Various Types of Convertibility
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Because almost no developing country has full convertibility, the international part of the dual economy is dollarized. s 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 Convertibility
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Nonconvertibility does not halt international trade. s It merely makes international trade more difficult.

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Various Types of Convertibility
Exchange rate policy is an important central bank function when the developing country has partially convertible exchange rates. s 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
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Developing countries often rely on advice from the International Monetary Fund (IMF).
q The

IMF has experienced economists. q The IMF is a major source of temporary loans to stabilize their currencies.

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

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Conditionality and Balance of Payments Constraints
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A partially flexible exchange rate presents the country with the balance of payments constraint. s 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. s The development of new institutions can have enormous effects.
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Obstacles to Economic Development
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Seven problems face developing countries:
q Political

instability. q Corruption. q Lack of appropriate institutions. q Lack of investment. q Inappropriate education. q Overpopulation. q Health and disease.
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Political Instability
A successful development strategy requires the existence of a stable government. s 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. s Foreign companies and members of the wealthy elite in developing countries are reluctant to invest when there is a high risks of loss.
s

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

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Political Instability and Unequal Distribution of Income
s
q Through

Monetary policy affects the trade balance in three ways.
income. q Through price levels. q Through exchange rates.

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Corruption
Developing countries often lack welldeveloped institutional setting and a public morality that condemns corruption. s As a result, bribery, graft, and corruption are ways of life in most developing countries.
s

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

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

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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. s Few members of the middle class in those countries trust putting savings in local banks.
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Investment Funded from Abroad
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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 countries. s Total foreign aid from all countries comes to about $11 per person in developing countries.
s

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Foreign Investment
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Foreign businesses have a greater incentive to invest in a country if that country has:
qA

motivated, cheap workforce. q A stable government supportive of business. q Sufficient infrastructure investment.

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

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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. s 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. s Economic takeoff – a stage when the development process becomes selfsustaining.
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Inappropriate Education
The right education is a necessary component of any successful development strategy. s The wrong education is an enormous burden.
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Inappropriate Education
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When education doesn’t match the needs of society, the credentials become more important than what is learned. s 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. s Brain drain – the outflow of the best and brightest students from developing countries to developed countries.
s

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Overpopulation
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A country can increase its per capita income by:
q Decreasing

the number of people in the country (without decreasing the country’s total income). q Increasing total income (without decreasing the population).

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

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

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Overpopulation
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Population grows for a number of reasons:
q Infant

mortality rates and death rates fall as public health measures are improved. q As peoples incomes grow, they can afford more children. q In rural areas, children are useful in working the fields.

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Overpopulation
Some developing nations have tried various ways to limit population growth – from advertising campaigns to forced sterilization. s 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. s Some diseases make it difficult to work and take care of children. s 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 problem. s It is entwined with cultural and social issues. s The appropriate answer depends on the country.
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Macro Policies in Developing Countries
End of Chapter 16

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