Macroeconomic Topics in Development & Transition EC938

1. Macroeconomic Topics in Development & TransitionEC938 Sharun W. Mukand

2. Development Policy and Macroeconomics • Economic Growth • Globalization, Trade and Inequality • Political and Economic Crises: Currency Crises • Governance and Institutions • Political Economy of Policymaking • Foreign Aid, Corruption • Miscellaneous Topics

3. Background: Some stylized facts about developing countries (macroeconomy) • Economic Growth….Theory + evidence -- proximate versus ultimate causes -- growth and policymaking.

4. Some stylized facts (Macro)…. • 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. • Emphasis on politics, reputation, credibility, inequality, exchange rate management, crises….

5. Stylized facts (contd…) 1. 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.

8. 2. 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.

10. 3. 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 in some countries.

11. 4. 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.

12. Domestic Financial Markets 5. 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. • Equity markets tend to be dominated by a few firms and exhibit very low turnover.

13. Macroeconomic Volatility 6. 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.

14. Politics Matters! • Policymaking in developing/transition countries is vulnerable to political factors to a far greater extent than in developed countries.

16. 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. Why?

17. Economic Growth: the Questions • Why are some countries rich and others poor? • What accounts for differences in income levels and growth rates across countries? • What is the role of political factors in accounting for differences in growth and income across countries? • What is the role of policy interventions and governance in generating economic growth and decreasing poverty?

19. Economic Growth • Present a policy-oriented overview of the theory and empirical evidence of economic growth • Trace linkages between economic growth and its main determinants: (i) proximate: saving, investment, and economic efficiency • (ii) ultimate(?): Institutions, culture, geography….

20. Growing apart Country B: 2% a year • Investment • Efficiency • Institutions • Policy Threefold difference after 60 years GNP per capita Country A: 0.4% a year 60 0 Years

21. China vs. Europe: • 1:1 in 1400 • 1:20 in 1989

22. Economic growth: The short run vs. the long run Economic growth in the long run Potential output Actual output Upswing National economic output Business cycles in the short run Downswing Time

23. Botswanaand Nigeria: GNP per capita 1962-2001 Current US$, Atlas method

24. Spain and Argentina: GNP per capita 1962-2001 Current US$, Atlas method

25. Thailand and Burma….

26. TECHNICAL PRELIMINARIES (1) 1. The rate of change of a variable, say Y, with respect to time (t), is: 2. The (continuous) rate of growth of Y is: 3. From elementary calculus we know that: NB Here “log” means the natural log, the log to the base e (= 2.7182818….). 26

27. Technical preliminaries (3) Notation The “dot” notation: So a growth rate is: The “hat” notation: 27

28. Technical preliminaries (4) Growth rates of products Eg if then Growth rates of divisions Eg if 28

29. Solow model: overarching assumptions 1. One good (“corn”) 2. Constant returns to scale 3. Perfect competition in input and factor markets 4. Population growth is exogenous The capital stock decays at a constant rate Output requires only labour and capital 29

30. Solow model: simplifying assumptions 7. Production function is Cobb-Douglas 8. Households save a constant fraction of their income 9. Households work a constant fraction of their time 30

31. The Solow model: production Production function: NB: Units for Y, K, and L are flows, ie quantities per period 31

32. The Solow model: returns to inputs (Monopoly) profits are: where are the real input prices: eg pK = PK/P Note that the price of capital is the rental price, not the asset price. Firms are assumed to maximise profits. 32

33. The Solow model: returns to inputs (2) Profit maximisation implies that real input prices are equated to marginal products: 33

34. Implications 1. Input payments exhaust output (there is nothing left over): The marginal product of capital (labour) declines as capital (labour) input is increased, holding constant the other input 3. Input shares are constant: 34

35. Solow model: evolution of capital The capital stock grows through investment (I) but also declines due to physical decay at the constant rate d: 35

36. Solow model: household behaviour (1) Households save a constant fraction of their income. To save is to invest, so: Alternatively, because of the national income identity they consume a constant fraction of their income: 36

37. Solow model: household behaviour (2) Population grows at a constant, exogenous rate and households devote a constant fraction of their time to work: whence 37

38. Solow model: equations 38

39. The set-up: summary For the basic Solow model, we have the following parameters: αand d relate to technology, while s and n relate to household behaviour. There are also two initial conditions: 39

40. Solving the model (1) Substituting from equations (1) and (2) into (3) and dividing through by K: 40

41. Solving the model (2) Now put all variables into per head terms: Also, 41

42. Solving the model (3) The capital accumulation equation is: and in per head terms (substitute in k*/k = K*/K – n)) this becomes: 42

43. For future reference We wrote the production function as: And we can re-write it in per head terms as: 43

44. The production function, y 0 k 44

45. Solving the model (4) Back to the capital accumulation equation that we just derived: The right hand side contains two terms. Let’s graph these as functions of k. 45

46. The basic Solow model 0 k* k 46

47. Conclusions of the basic Solow model The only possible equilibrium is one where output per head and capital per head (y and k) are constant. This equilibrium is stable --- if output and capital per head are initially above (below) the equilibrium levels, then they will fall (rise) till they are at the these equilibrium levels. The long run (equilibrium) growth rate is zero. 47

48. Typical paths for k (and y) log k log k* time 48

49. An important relationship 49

50. Equilibrium levels 50