MACRO POLICIES IN DEVELOPING COUNTRIES

1. MACRO POLICIES IN DEVELOPING COUNTRIES Chapter 19

2. Today’s lecture will: • Examine some comparative statistics on rich and poor countries. • Differentiate the normative goals of developing and developed countries. • Discuss why economies at different stages in development have different institutional needs. • Explain what is meant by the term dual economy.

3. Today’s lecture will: • Distinguish between a regime change and a policy change. • Explain why the central bank issuing too much money is not a sufficient explanation of inflation for developing countries. • Distinguish various types of convertibility. • Identify seven obstacles facing developing countries.

4. Statistics on Selected Developing, Middle-Income, and Developed Countries, 2006 Daily Infant Calorie Life Mortality GDP per Country Supply Expectancy (per 1000) Capita ($) Developing Ethiopia 1857 42 110 $ 160 Haiti 2086 52 74 450 Middle-Income Brazil 3050 71 32 3,460 Iran 3085 71 32 2,770 Developed Japan 2761 82 3 38,980 U.S. 3774 77 7 43,740

5. Growth versus Development • Development refers to an increase in productive capacity and output brought about by a change in a country’s underlying institutions. • Development occurs through a change in the production function. • Growth refers to an increase in output brought about by an increase in inputs, given a production function.

6. Differences Between Developed and Developing Economies • Different weighting of goals due to differences in wealth • Developing countries face urgent needs, such as food, shelter, and clothing. • Differences in institutions • Political differences and laissez-faire • Dual economy • Fiscal systems • Financial institutions

7. Political Differences and Laissez-Faire • Institutional checks and balances to prevent government leaders using government for their benefit often do not exist in developing countries. • In these circumstances, economists who would favor an activist macroeconomic policy in a developed country might favor laissez-faire policies in developing countries.

8. The Dual Economy • A developing country’s economy is usually a dual economy. • Dual economy – the existence of two sectors: • A traditional sector which does business in local currency and produces in traditional ways. • An internationally oriented modern market sector which is often indistinguishable from a Western economy.

9. Fiscal Structure ofDeveloping Economies • Discretionary fiscal policy is almost impossible for developing economies. • They don’t have the institutional structure necessary to levy and collect taxes. • Many government expenditures are mandated by political considerations. • Developing countries may experience a regime change, which is a change in the entire atmosphere within which the government and the economy interrelate. • A policy change is a change in one aspect of government’s actions, such as monetary or fiscal policy.

10. Financial Institutions ofDeveloping Economies • Financial institutions in developing countries are different from those in developed countries because of the dual economy in developing countries. • In the traditional economy the financial sector is unsophisticated, with some trades made by barter. • In the international economy, the financial sector may be very advanced. • Some of the limitations of the traditional economy are overcome with micro credit programs on the Internet.

11. Monetary Policy in Developing Countries • The primary goal of central banks in developing countries is to keep the economy running. • Central banks in developing countries are generally less independent than ones in developed countries. • Buying and selling foreign currencies in order to stabilize the exchange rate is an important function.

12. Various Types of Convertibility • Full convertibility – individuals may change their currency into any currency they want for whatever legal purpose they want. • Convertibility on the current account – a system that allows people to exchange currencies freely to buy goods and services, but not assets in other countries. • Limited capital account convertibility – a system that allows full current account convertibility and partial capital account convertibility.

13. Various Types of Convertibility • 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. • Nonconvertibility makes international trade more difficult.

14. Various Types of Convertibility • Exchange rate policy is an important central bank function when the developing country has partially convertible exchange rates because trade in the currency is thin – there are not many buyers and sellers. • Exchange rate policy – buying and selling foreign currencies in order to stabilize the exchange rate.

15. Conditionality and Balance of Payments Constraints • Developing countries often rely on advice from the International Monetary Fund (IMF). • The IMF is a major source of temporary loans to stabilize their currencies. • The basis for most IMF loans is conditionality – the making of loans that are subject to specific conditions, usually that deficits be lowered and money supply growth be limited.

16. Conditionality and Balance of Payments Constraints • A partially flexible exchange rate presents the country with the balance of payments constraint. • Balance of payments constraint – limitations on expansionary domestic macroeconomic policy due to a shortage of international reserves. • Many developing countries borrow from the IMF to meet both its domestic goals and its balance of payments constraint.

17. Obstacles to Economic Development • Political instability • Corruption • Lack of appropriate institutions • Lack of investment • Inappropriate education • Overpopulation • Health and disease

18. Political Instability • Political instability closes off external and internal sources of financial investment. • Foreign companies and wealthy citizens are reluctant to invest when the government is unstable creating a high risk of loss. • An unequal distribution of income contributes to the instability because economic prospects are so bleak that many people are willing to support or join a guerilla insurgency.

19. Corruption • Developing countries often lack a well-developed institutional setting and public morality that condemns corruption. • As a result, bribery, graft, and corruption are ways of life in most developing countries. • Knowing that bribes must be paid prevents many people from doing things that would lead to growth.

20. Lack of Appropriate Institutions • Markets require the establishment of property rights, which is a difficult political process. • The existence of markets is meshed with the cultural and social fabric of society. • Some of the cultural and social institutions in developing countries may not be conducive to growth.

21. Lack of Investment • Savings for investment can be generated internally or brought in from outside the country. • With very low per capita income, people in developing countries aren’t able to save. • Savings from abroad is in the form of private investment or aid from foreign governments. • Foreign aid amounts to about $14 per person in developing countries.

22. 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. • Raw materials that can be developed. • Developing countries that have been successful in attracting investment often get further investment. • Economic takeoff – a stage when the development process becomes self-sustaining.

23. Inappropriate Education • The right education is a necessary component for growth. • Often educational systems in developing countries resemble Western educational systems and may be irrelevant to growth. • Basic skills – reading, writing, and arithmetic- are likely to be more conducive to economic growth in developing countries. • Developing countries often experience a brain drain – the outflow of the best and brightest students from developing countries to developed countries.

24. Overpopulation • Thomas Malthus predicted that population would outrun the means of subsistence. • Malthus’ prediction has been avoided in developed countries. • In many developing countries, however, population growth has exceeded productivity growth, leading to small or negative per capita output growth. • Some developing nations have tried to limit population growth by various means – from advertising campaigns to forced sterilization.

25. Health and Disease • A country must have a reasonably healthy population in order to develop economically. • Some diseases, such as AIDS and tuberculosis, make it difficult to work and take care of children. • Drug companies have very little incentive to work on developing low-cost medicines to treat diseases in developing countries because the people are poor and can’t pay for the drugs.

26. Summary • While policies in developed countries focus on stability, developing countries struggle to provide basic needs. • Development is an increase in productive capacity and output brought about by a change in underlying institutions. • Growth is an increase in output brought about by an increase in inputs. • Many developing countries have dual economies – one a traditional, nonmarket economy, and the other an internationalized market economy.

27. Summary • Rather than policy changes, most developing countries need regime changes – changes in the entire atmosphere within which the government and the economy relate. • Central banks in most developing countries lack independence and print too much money, which causes inflation, but keeps the government running. • Most developing countries have some type of limited convertibility to limit the outflow of saving.

28. Summary • Seven obstacles to economic development are: • Political instability • Corruption • Lack of appropriate institutions • Lack of investment • Inappropriate education • Overpopulation • Poor health and disease

29. Review Question 19-1 What is the dual economy in developing countries? A developing country has two sectors; a traditional economy that uses the local currency and involves most of the population and an internationally oriented modern market sector that resembles Western economies. The international sector may use a foreign currency and contracts governed by international law. Review Question 19-2 What are seven problems of developing economies? Lack of investment, political instability, corruption, inappropriate institutions, inappropriate education, overpopulation, and disease and bad health.