MACRO POLICIES IN DEVELOPING COUNTRIES Chapter 34 MACRO POLICIES IN DEVELOPING COUNTRIES

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.

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.

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

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.

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

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.

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.

Fiscal Structure of Developing 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.

Financial Institutions of Developing 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.

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.

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.

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.

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.

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

Review Question 34-1 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 34-2 What are seven problems of developing economies? Lack of investment, political instability, corruption, inappropriate institutions, inappropriate education, overpopulation, and disease and bad health.