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Development Macroeconomics
By Pierre-Richard Agénor, Peter J. Montiel PRINCETON UNIVERSITY PRESS
Copyright © 2015 Princeton University Press
All rights reserved.
ISBN: 978-0-691-16539-4
CHAPTER 1
Economic Structure and Aggregate Accounts
This chapter describes the structural features that, in our view, distinguish most developing countries from the textbook industrial-country model, and provides an overview of some general analytical features of developing-country macroeconomic models. It takes a model-based perspective, focusing on the general structure of macroeconomic models for developing countries, including the accounting framework, the level of commodity disaggregation, and the particular role of labor markets. Chapter 2 will focus on specific components of macroeconomic models, examining evidence on the properties of private behavioral functions in developing nations.
This chapter is divided into four sections. Section 1.1 identifies the distinctive aspects of development macroeconomics. It also documents a range of regularities in macroeconomic fluctuations for developing countries. Section 1.2 sets out a general accounting framework consisting essentially of budget constraints for each type of agent typically appearing in a developing-country macroeconomic model, and defines several concepts that will prove useful later on. In Section 1.3, we consider how economic structure can be imposed on these accounting relationships by reviewing three alternative approaches to commodity disaggregation in an open economy: the Mundell-Fleming model, the "dependent economy" model, and a three-good structure distinguishing exportables, importables, and nontraded goods. Almost all macroeconomic models for developing countries rely on some variant of one of these approaches. Each of these three production structures is analyzed in both classical and Keynesian modes.
Section 1.4 looks at the labor market, a market that plays a central analytical role in all macroeconomic models, and the functioning of which is widely accepted to depend on country-specific institutional factors, both in the industrial- and developing-country contexts. As emphasized in Section 1.3, labor markets play a key role in determining the properties of an economy's short-run aggregate supply function. Accordingly, in Section 1.4 we examine the structural features of labor markets in developing nations. We focus on the short-run implications of these features, emphasizing the role of wage rigidity and the nature of labor market segmentation.
1 Economic Structure and Macroeconomics
The structural characteristics that differentiate a "representative" developing economy from the textbook industrial-country model cover a wide spectrum, spanning most of the standard components of a macroeconomic model. Many of these features are not shared by all developing countries, and some may be found among industrial countries as well. Nevertheless, we will provide evidence in this section that the features described below—all of which can be readily recognized as affecting macroeconomic behavior—systematically differentiate developing countries as a group from the standard textbook representation of an industrial-country economy. They include the nature of openness to trade with the rest of the world in both commodities and assets, the nature of financial markets, the characteristics of fiscal institutions and the government budget, the properties of the economy's supply function, the degree of income inequality, the stability of policy regimes, and the degree of macroeconomic volatility.
1.1 * Openness to Trade in Goods and Assets
1. Developing economies, like small industrial countries, tend to be much more open to trade in goods and services than are the major industrial countries.
A standard measure of openness is the trade share, that is, the sum of the shares of exports and imports in GDP. By this measure, developing nations tend to be substantially more open than the major industrial countries. Openness to this extent, of course, limits at the outset the applicability of the closed-economy textbook industrial-country model to the developing-country context. Very few developing nations can even approximately be described as closed economies by this measure.
2. Developing countries typically have little control over the prices of the goods they export and import—that is, they typically face exogenous terms of trade.
This characteristic tends to distinguish developing countries even from small industrial countries. The exogeneity of the terms of trade for developing economies is suggested both by their small share in the world economy and by the composition of their exports.
Very few developing countries account for a significant portion of the world market even for the commodities in which their exports are heavily specialized. Moreover, various studies confirm that, with limited exceptions for particular goods, these countries continue to have limited individual influence over the prices at which they buy and sell. Exogenous terms of trade call into question the usefulness, for the analysis of many macroeconomic policy issues in developing nations, of the open-economy model that continues to be widely used in the industrial-country context, the Mundell-Fleming model. This model assumes endogenous terms-of-trade determination, with the domestic economy completely specialized in the production of a good over which it exerts significant market power. Instead, the production structure most suitable for the analysis of developing-country macroeconomic phenomena is likely to be the Salter-Swan "dependent economy" model or (given that terms-of-trade changes tend to be very important for such countries) a three-good model consisting of exportables, importables, and nontraded goods. Such a production structure permits a distinction to be drawn between the exogenous terms of trade and an endogenous real exchange rate, which is the central intratemporal macroeconomic relative price in these economies.
The importance for many developing nations of primary-commodity exports with exogenously determined prices accounts for an important source of macroeconomic instability in these countries. Prices of primary commodities tend to fluctuate quite sharply. Consequently, developing countries have faced highly unstable terms of trade at various times over the past two decades, with large asymmetric effects; for instance, in a study of the behavior of the real prices of thirty-six world commodities over the period 1957–1999, Cashin et al. (2002) found that price slumps typically last a lot longer than price booms. Episodes of drastic changes in the terms of trade for these countries have often been dominated by changes in oil prices, but at times nonfuel commodities also undergo sharp fluctuations in price. Coupled with the relatively large share of exports and imports in domestic economic activity, such fluctuations in export prices represent substantial exogenous changes in national income from one year to the next, and constitute an important source of macroeconomic volatility for such countries.
3. The extent of external trade in assets has tended to be more limited in developing than in industrial countries, though this situation has recently begun to change in dramatic fashion for an important group of developing economies.
Perfect capital mobility is often used as the standard textbook assumption for industrial countries. In developing countries, capital controls have long been the rule, and although their effectiveness is questioned, the degree of capital mobility that characterizes economies that do not retain such restrictions remains far less than is assumed in textbook industrial-country models. Thus, unlike standard macroeconomic modeling for industrial countries, in the developing-country case the assumption of perfect capital mobility is generally inappropriate. Evidence on this issue is discussed in Chapter 13 and used in Chapters 6 and 10 to formulate appropriate models of the monetary transmission process and for the analysis of stabilization policies in developing countries.
4. Greater integration with international financial markets exposes many middle-income countries to abrupt reversals in capital flows, which exacerbate macroeconomic volatility.
For many developing countries, a large stock of gross external debt presents important macroeconomic challenges. Among highly indebted low-income countries, the problem emerged essentially because of borrowing by the government. The existence of such debt therefore has important implications for the level and composition of public expenditure. But among countries that have recently become integrated with international capital markets, external debt has tended to be incurred by the private sector. In this context, the policy challenges involve coping with potential macroeconomic overheating associated with a sudden inflow of capital, as well as with vulnerability to macroeconomic volatility induced by abrupt reversals in capital flows. As suggested by Caballero (2000), possible factors behind the high degree of volatility experienced by many middle-income developing countries are greater, but still weak, links with international financial markets (which limit the ability to borrow and lend to smooth shocks) and insufficiently developed domestic financial systems (which limit the speed of resource reallocation following an adverse shock and may magnify contractions in output).
1.2 * Exchange-Rate Management
5. In contrast to the major industrial countries, the vast majority of developing countries have neither adopted fully flexible exchange rates nor joined monetary unions.
Industrial countries are typically modeled either as operating flexible exchange rates or as members of a currency union, whereas in developing countries, officially determined rates, adjusted by a variety of alternative rules (loosely referred to as "managed" rates) predominate. A brief description of the nature of exchange-rate regimes in individual developing countries is presented in Chapter 8. Exchange-rate regimes in developing countries have evolved toward greater flexibility since the collapse of the Bretton Woods system in 1973. However, in practice this has meant either more frequent adjustments of an officially determined parity or the adoption of market-determined exchange rates with extensive official intervention. The prevalence of intermediate exchange-rate regimes implies that issues relating to the macroeconomic consequences of pegging, of altering the peg (typically in the form of a devaluation), and of rules for moving the peg are of particular importance in developing countries. These issues are discussed in Chapters 8 and 9.
1.3 * Domestic Financial Markets
6. Financial systems in many developing nations have been the subject of extensive deregulation in recent years. However, they continue to be dominated by banks. They also remain fragile and often exacerbate macroeconomic and financial volatility.
Although several developing countries have recently developed very large equity markets, such markets (as well as secondary markets for securities) continue to be small or nonexistent in many of them. Financial markets in the vast majority of developing economies continue to be dominated by a single type of institution—the commercial bank. Thus, the menu of assets available to private savers is limited. Moreover, even where equity markets have developed, they tend to be dominated by a few closely held firms and exhibit very low turnover ratios.
The commercial banking sector in developing countries has traditionally been heavily regulated: it has often been subjected to high reserve and liquidity ratios as well as legal ceilings on interest rates together with sectoral credit allocation quotas. Over the last two decades, however, many countries have taken steps to deregulate their financial markets, resulting in enhanced competition, greater access to foreign banks, and improved efficiency. Rather than being legally imposed, as before, credit rationing in the developing world tends now to be endogenously generated by information asymmetries, as is commonly taken to be the case in industrial countries.
Nevertheless, the financial system remains, in many countries, underdeveloped. In spite of the more limited range of financial assets available to savers in developing nations, monetization ratios (as measured by the ratio of a monetary aggregate to nominal GDP) are generally lower for such countries than for industrial countries. In large part because of the nature of the financial system, but also because of some of the other features mentioned previously, the specification of standard textbook macroeconomic behavioral relationships (decision rules) may need to be modified in the developing-country context. In particular, it becomes necessary to incorporate the implications of credit rationing in private decision rules when such rationing is present. This affects, for instance, private consumption, investment, and asset demand functions. The incorporation of these phenomena has been treated in different ways—by including, for instance, quantity constraints in consumption and investment equations. These issues are taken up in Chapter 2.
Another issue relates to the fact that the institutional prerequisites for successful liberalization—in the form of appropriate regulatory and supervisory mechanisms—have frequently not been in place, resulting in enhanced macroeconomic instability and severe crises involving interactions between the balance of payments and the financial system. As discussed in Chapters 14 and 15, the weakness of the institutional framework in many developing countries has made both the frequency and depth of such crises much more extensive in such countries than in industrial countries.
1.4 * The Government Budget
7. The composition of the government budget differs markedly between industrial and developing countries.
In many developing nations, the state plays a pervasive role in the economy. This role is exercised through the activities of not just the nonfinancial public sector (consisting of the central government, local governments, specialized agencies, and nonfinancial public enterprises), but also of financial institutions owned by the government. Regarding the nonfinancial public sector itself, the government tends to play a more active role in production than is the case in most industrial nations, and the performance of public-sector enterprises is often central in determining the fiscal stance.
Unfortunately, systematic data on the size and performance of the consolidated nonfinancial public sector are not available for a large number of developing countries. Published information tends to refer to the finances of the central government only. Even so, existing studies suggest that the central government absorbs a smaller fraction of output in developing than in industrial countries, and that the composition of spending differs between the two groups of countries. Developing nations devote a substantially larger fraction of expenditures to general public services, defense, education, and other economic services (reflecting the role of government in production) than do industrial nations, whereas the latter spend somewhat more on health and substantially more on social security.
As for revenue, the main source of central government revenue is taxation, but the share of nontax revenue in total revenue tends to be much higher in developing than in industrial countries. The collection of tax revenue in developing countries is often hindered by limited administrative capacity and political constraints (Bird and Zolt, 2005). One consequence of this is that direct taxation plays a much more limited role in developing than in industrial nations; as noted by Bird and Zolt (2005), the tax structure in most developing countries is dominated by taxes on consumption, whereas in industrial countries, income taxes account for the largest share and taxes on foreign trade are negligible. Of direct taxes, the share of tax revenue raised from individual incomes (which often amount to withholding taxes on labor income in the formal sector) tends to be much larger than that from corporations in the developing world, whereas the reverse is true in the industrial world. In part, this is the result of high collection costs on capital income. Trade taxes consist primarily of import rather than export duties in developing countries and are used more extensively in the poorest countries.
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Excerpted from Development Macroeconomics by Pierre-Richard Agénor, Peter J. Montiel. Copyright © 2015 Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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