Macroeconomics for small and developing countries

1. Macroeconomics for small and developing countries René A. Hernández DDPE/ECLAC July 2007

2. Introduction • Figure 1.1 : 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. • Standard analytical tools of modern macroeconomics are relevant to developing countries. • But different models are needed to analyze. • Purposes to which the models have been applied also distinguish macroeconomics in developing countries.

4. Introduction • Monetarism, Structuralism, Neostructuralism and Developing Nations. • Economic Structure and Macroeconomics. • Some Special Topics.

5. Monetarism, Structuralism, Neostructuralism and Developing Nations

6. The debate • Debate on relevance of industrial-country macroeconomic analysis to developing nations. • “Monetarist” or “orthodox” versus “structuralist”.

7. Orthodox view • Long-run growth in developing countries is hampered by dirigiste policies that distort the allocation of resources. • Prescription: giving full scope to market mechanisms via free trade and noninterventionist domestic policies. • In the short run, high inflation and balance-of-payments deficits reflect excessive money growth fueled by large fiscal deficits. • Cure: tight fiscal policy and “getting prices right”, by devaluing and raising domestic interest rates. • Policies based on the orthodox view have been promoted by international financial institutions.

8. Early Structuralist School • Primary-exporting countries would face deteriorating terms of trade relative to the manufactured goods-exporting industrial-nation. • Reason: Lower income elasticities of demand for raw materials than for industrial goods. • Policy intervention was required to change the structure of production in the periphery. • Industrialization should be promoted by protecting “infant industry” against competition through: • use of trade barriers and foreign exchange controls; • providing special advantages to the industrial sector. • This “import substitution” strategy was adopted in the immediate postwar period.

9. “New structuralist” view (NSV) • Turned their attention to short-run macroeconomic stabilization. • The analytical framework is influenced by the keynesian and postkeynesian schools and focuses on the design and implementation of strategies and economic policies. • Best-known proponent: Lance Taylor. • Taylor (1990) identifies “new structuralist” view. • many agents possess significant market power; • macroeconomic causality in developing countries tends to run from “injections” to “leakages”; • money is often endogenous; • structure of the financial system can affect macroeconomic outcomes; • imported intermediate and capital goods, complementarity between public and private investment are empirically important.

10. “New structuralist” view • New structuralists question orthodox short-run prescriptions. • Source of inflation: • slow relative productivity growth in agriculture; • administered prices in industry, together with wage indexation. • Monetary policy is passive in the face of these inflationary forces. • Combining devaluation with tight fiscal and monetary policies will result in stagflation in the short run. • Reason: Roles of working capital and imported inputs, and substitution possibilities are more limited than assumed.

11. “New structuralist” view • Alternative new structuralist policy prescription: • greater element of gradualism; • direct intervention; • emphasis on the medium-term resolution of structural problems. • Macroeconomic reality in the developing world combines features of both. • ECLAC’s “productive transformation and equity” is an expression of the NSV

12. Economic Structure and Macroeconomics

13. Openness to Trade in Commodities and Assets. • Exchange Rate Management. • Domestic Financial Markets. • The Government Budget. • Aggregate Supply and the Labor Market. • Stability of Policy Regimes. • Macroeconomic Volatility.

14. Openness to Trade in Commodities and Assets

15. 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. • Openness limits at the applicability of the closed-economy textbook industrial-country model to the developing-country context.

17. 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.

18. Very few developing countries account for a significant portion of the world market. • Only sixteen developing countries account for as much as 10% of the world market. • These countries have little individual influence over the prices at which they buy and sell (Goldstein, 1986). • Exogenous terms of trade questions the usefulness of the open-economy model for developing nations. • Suitable models are • Salter-Swan “dependent economy” model or • three-good model consisting of exportables, importables, and nontraded goods.

19. Such production structure permits a distinction between the exogenous terms of trade and an endogenous real exchange rate. • Importance of primary-commodity exports with exogenously determined prices: important source of macroeconomic instability. • Figure 1.3: prices of primary commodities tend to fluctuate sharply. • Top panel of Figure 1.4: several episodes of drastic changes in the terms of trade for developing countries. • Episodes are dominated by changes in oil prices. • Bottom panel in Figure 1.4: nonfuel commodities have undergone sharp fluctuations in price during the 1970s and 1980s.

25. 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.

26. Developing countries are capital importers, and the servicing of external debt is a central policy issue • Figure 1.5: set of external-debt indicators. • Debt crisis problem emerged because the domestic sector that held the external assets was not the same as the sector that holds the external liabilities. • In countries that have recently become integrated with international capital markets, external debt has tended to be incurred by the private sector. • Policy challenges involve coping with • potential macroeconomic overheating associated with the sudden arrival of large inflows, • vulnerability to macroeconomic volatility induced by sudden capital flow reversals.

28. Exchange Rate Management

29. 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.

30. Prevalence of official parities implies that issues relating to the macroeconomic consequences of • pegging, • altering the peg (devaluation), • rules for moving the peg are important in developing countries.

31. Domestic Financial Markets

32. 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. • So assets available to private savers are limited. • Equity markets tend to be dominated by a few firms and exhibit very low turnover ratios.

33. The commercial banking sector has been heavily regulated and subjected to • high reserve and liquidity ratios; • legal ceilings on interest rates; • sectoral credit allocation quotas. • Thus credit rationing is legally imposed. • Policies toward the financial sector is known as “financial repression.” • Restrictions cause the size of the commercial banking system to be curtailed. • Figure 1.6: monetization ratios (banking sector liabilities over GDP) are lower in developing countries.

36. Informal financial sector has often arisen. • Thus, instruments of monetary policy and monetary transmission mechanism tend to be different. • Thus, modification of standard textbook macroeconomic behavioral relationships may be needed. • Incorporate the implications of credit and foreign exchange rationing in private decision rules by including • quantity constraints in consumption and investment equations • employing prices in informal credit and foreign exchange markets. • Weakness of the institutional framework in developing countries has made both the frequency and depth of such financial crises much more extensive.

37. The Government Budget

38. The composition of the government budget differs between industrial and developing countries • In developing nations, the pervasive role of the state in the economy is exercised through the activities of • nonfinancial public sector and • financial institutions owned by the government. • Government tends to play an active role in production. • Performance of public-sector enterprises is central in determining the fiscal stance. Figure 1.7: • Central government absorbs a smaller fraction of output in developing countries.

41. Composition of spending differs. • Developing nations spend more on general public services, defense, education, and other economic services. • Industrial nations spend more on health and social security. Figure 1.8: • Main source of central government revenue is taxation. • Share of nontax revenue in total revenue is higher in developing countries. • Reason: Limited administrative capacity and political constraints hinder collection of tax in developing countries.

44. Direct taxes, taxes on domestic goods and services, and taxes on foreign trade have equal shares of total tax revenue in developing countries. • Industrial countries: income taxes have the largest share. • Reliance on seigniorage, and therefore to higher levels of inflation in developing countries due to • lack of tax collection, • limited issuance of domestic debt. Figure 1.9: • Industrial countries: seigniorage revenue is less than 0.8% of GDP. • Developing countries: more than 1% of GDP. • Macroeconomic implications of budget institutions:

46. Macroeconomic implications of budget institutions: • nature of the constitutional rules used to impose constraints on the size of the fiscal deficit; • procedural rules that guide the elaboration of the budget by the executive branch, its approval by the legislative branch, and its execution; • type of rules that may enhance the transparency of the budgetary process.

47. Aggregate Supply and the Labor Market

48. Due to large direct role of the state in production, size and efficiency of the public capital stock figures prominently in the aggregate production • Figure 1.10: importance of the public sector in capital accumulation. • Glen and Sumlinski (1998): public sector accounted for 39% of total investment over 1980-1989 and 36% over 1990-1996. • In recent years, several developing countries have undertaken massive privatizations of nonfinancial public enterprises.

50. Imported intermediate goods play an important role in the aggregate production function • Mirakhor and Montiel (1987): Such goods account for half of all developing-country imports. • Figure 1.11: In some countries the share of energy and non-energy intermediate imports can even exceed 70%. Results: • Difference between the value of domestic production and domestic value added is larger. • Exchange rate has an important influence on the position of the economy's short-run supply curve. • Availability of foreign exchange may have a direct effect on the position of the short-run supply curve.