1. 1 Chapter 2 Aggregate Accounts, Production, and Market Structure © Pierre-Richard Agénor and Peter J. Montiel

2. 2 l A General Accounting Framework. l Production Structure in an Open Economy. l The Structure of Labor Markets. l Informal Financial Markets.

3. A General Accounting Framework

4. 4 l The Nonfinancial Private Sector. l The Public Sector. è The Nonfinancial Banking Sector. è The Central Bank. è The Consolidated Public Sector. l The Commercial Banking System. l Aggregate Relationships.

5. 5 The Nonfinancial Private Sector l This sector holds both financial and real assets. Financial assets: l currency issued by the central bank CU, l deposits issued by the commercial banks D p, l net foreign assets EF p (E is exchange rate and F p is the foreign-currency value of these assets), l loans extended by households in informal markets, L h. Liabilities: l credit from banks, L p, l loans received through informal markets.

6. 6 Real assets: l Inflation hedges with price p H and quantity H. l Nonfinancial private sector's marketable net worth:  p = CU + D p +EF p +p H H - L p. (1) l L h does not affect net worth, because these loans are transacted entirely within the nonfinancial private sector. l Change in  p consists of the purchase of financial assets (S p ) plus capital gains:  p = S p +EF p +p H H. where S p = CU + D p +EF p - L p.... (3) (4)....

7. 7 l S p is the difference between disposable income and expenditure on consumption and investment: S p = Y + i d D p + i*EF p - i c L p -  p - C p - I p, (5) Y: factor income, i d D p + i*EF p - i c L p : net interest income (income from deposits and foreign assets minus interest payments on bank credit),  p : net taxes, C p : private consumption, I p : private investment.

8. 8 The Public Sector l Nonfinancial public sector is a substantial net financial debtor. l Its debt is owed to è central bank (L bg ); è commercial banks (L cg ); è foreigners (-EF g ). l Nonfinancial public sector's net worth:  g = EF g - L bg - L cg. The Nonfinancial Public Sector (6)

9. 9 l The change in  g is negative of new borrowing by the nonfinancial public sector plus capital gains on net foreign assets:  g = S g + EF g. where S g = EF g - L bg - L cg. l Total new borrowing must be equal to the overall fiscal deficit: -S g = C g + I g + i b L bg + i c L cg -i*EF g -  p -  g,  g : transfers from central bank to nonfinancial public sector; i b : interest rate paid on loans received from central bank......

10. 10 l Central bank's balance sheet:  b = ER* + (L bg +L bc ) - M, R* : net foreign assets of the central bank, L bc : credit from the central bank to commercial banks, M: high-powered money. l M is the sum of currency held by the nonfinancial private sector and reserves of the commercial banking system held in the vaults of the central bank, RR: M = CU + RR. The Central Bank (11)

11. 11 l The change in  b :  b = S b + ER*. where S b = ER* + (L bg +L bc ) - M. l S b is “quasi-fiscal” surplus: difference between the central bank’s earnings and its expenditures. l Earnings: è interest earnings on net foreign exchange reserves, è credit to commercial banks, è net credit to the nonfinancial public sector. l Expenditures: transfers to the government,  g....... (15)

12. 12 l So S b : S b = i* ER* + i b (L bg +L bc ) -  g. l (15) can be rewritten as: M = L bg + ER* - S b + L bc. l Sources base money growth: è central bank financing of the nonfinancial public sector, è balance-of-payments surpluses, è quasi-fiscal deficits, è credit extended by the central bank to the private banking system.....

13. 13 l It consists of the nonfinancial public sector and the central bank. l Financial net worth of consolidated public sector:  ps =  g +  b = E(F g +R*) + (L bc -L cg ) - M. l It changes:  ps = S ps + E (F g +R*), where S ps = S g + S b = E(F g +R*) + (L bc -L cg ) - M. The Consolidated Public Sector.......

14. 14 l Overall financial surplus of the consolidated public sector: S ps = S g + S b = (  p -C g -I g ) + i b L bc + i*E(F g +R*) - i c L cg. l Primary surplus: non-interest portion of the overall public sector surplus. l Operational surplus: primary surplus plus real interest payments.

15. 15 The Commercial Banking System l Commercial banks' financial net worth is the difference between bank assets and liabilities:  c = L p + L cg + RR - D p - L bc. l Changes:  c = S c = L p + L cg + RR - D p - L bc where S c = i c (L p +L cg ) - i d D p - i b L bc.......

16. 16 Aggregate Relationships l Aggregate net worth is net international indebtedness plus stock of inflation hedges:  =  p +  ps +  c = E(F p +F g +R*) + p H H = EF + p H H. l Change:  = S p + S ps + S c + EF + p H H = S + EF + p H H where S = EF. _ _ __......

17. 17 l National financial saving represents the net accumulation of claims on the rest of the world. l Alternative expression of S: S = Y + i* EF - (C p +C g ) - (I p +I g ). l Gross national product: GNP = Y + i*EF. l Domestic absorption: DA = (C p +C g ) + (I p +I g ). l Negative national financial saving is referred as foreign saving (current account deficit).

18. 18 l National income accounting identity: GNP = C p + I g + G + CA where CA = S and G = C g + I g. l Flow-of-funds version of (32): CA = S T - (I p +I g ) where S T = GNP - C p - C g. l This equation links total saving (S T -CA) to total investment (I p +I g ). (32)

19. 19 l Balance-of-payments identity expressed in domestic- currency terms: ER = (GNP-C p -I p -G) - E(F p +F g ). l Left-hand side: reserve accumulation by the central bank (the overall balance of payments). l First term on the right-hand side: current account. l Second term: capital account....

20. Production Structure in an Open Economy

21. 21 l The Mundell-Fleming Model. l The “Dependent Economy” Model. l A Model with Three Goods.

22. 22 The Mundell-Fleming Model Assumptions: l Economy specializes in the production of a single good. l It is an imperfect substitute for the single good produced by the rest of the world. l Law of one price holds for each individual good. l So the domestic-currency price of the foreign good is equal to the foreign-currency price (P*) multiplied by the domestic-currency price of the foreign currency, E. l Foreign-currency price of the domestically produced good is its domestic-currency price, P, divided by the domestic-currency price of the foreign currency.

23. 23 l Domestic residents demand both the domestic and foreign goods, as do foreign residents. l Foreign good is the home economy's importable good, and the domestic good is its exportable good. l Relative price of the foreign good in terms of the domestic good is referred to as the domestic economy's terms of trade. l Key property of the model: domestic economy's terms of trade are endogenous. l Reason: home country is small in the market for its importable good but large in the market for its exportable good. l Result: changes in domestic demand for the exportable good will affect its relative price or level of production.

24. 24 l Focus on the production side of the economy (goods and labor markets). l Consider the case of fixed exchange rates. l Equilibrium condition of the market for domestic goods: y = a + b(z, a), y : output of the domestic good, a: level of domestic absorption, b: trade balance. (36)

25. 25 l Because domestic and foreign goods are imperfect substitutes, trade balance is b = b(z,a), -1< b a < 0, z = EP*/P : terms of trade. l Production function ( diminishing returns to labor): y = y(n), y’ > 0, y’’< 0 n: employment. +- (35)

26. 26 l Labor demand: y’(n) = z   n d = n d (z  ) z  : real wage in terms of exportables. l Labor market equilibrium: n d (z  ) = n, n : exogenous supply of labor. l Rewrite equilibrium under classical condition: y(n) = a + b(z,a). l This determines z implicitly as a function of a. dz/da = -(1+b a ) / b z < 0. - - -

27. 27 l Reason for negative sign: increase in domestic absorption increases the domestic price level, so terms of trade improve. l In Keynesian mode, labor market-clearing condition does not hold: y[n d (z  )] = a + b(z,a), dz/da = (1+b a ) / (  y’n d ’-b z ) < 0. l Change in domestic absorption has a smaller effect on the terms of trade in the Keynesian case. l Reason: change in z is more effective in eliminating excess demand in the market for domestic goods. (41)

28. 28 Figure 2.1: l Simultaneous determination of internal and external balance. Classical mode: l CC: set of combinations of z and a compatible with equilibrium in the market for home goods that prevails when the model operates in classical mode. l Slope of CC: dependence of the terms of trade on domestic spending. l BB: set of combinations of z and a compatible with a given trade balance outcome (b 0 ).

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30. 30 l Its slope is positive (-b a /b z ). l Points above BB : improvement in the trade balance relative to b 0. l Points below: deterioration relative to b 0. l (36) implies that the economy must always lie along CC. l Given a level of absorption a 0, CC determines the value of z required to clear the market for domestic goods (z 0 ). l Trade balance at point B is b 0. l In the classical case, B represents a point of internal, but not external, balance. l Simultaneous achievement of external and internal balance, at point E, requires a reduction in a from a 0 to a. ~

31. 31 Keynesian mode: l Commodity-market equilibrium schedule is derived from (41). l Its position depends on the initial value of the real wage measured in terms of importables, . l Change in  causes the commodity-market equilibrium locus to shift vertically. l Downward shift for an increase in  and upward for a reduction. l KK: Keynesian commodity-market equilibrium locus that passes through the initial point B. l Since z is more responsive to a in the classical than in the Keynesian mode, KK is flatter than CC.

32. 32 l In the Keynesian case internal balance may not hold at B since labor market equilibrium condition may not hold. l Increasing absorption to a 1 would move the economy to F, achieving internal balance. l But this implies further departure from external balance. l External balance could be restored at point A, but this would move the economy away from internal balance. l Simultaneous adjustment of a and  is required in Keynesian case. l Achieved by an adjustment in nominal exchange rate. l Reduction of a from a 0 to a, and nominal exchange-rate depreciation are sufficient to shift KK to K’K’. l This would simultaneously achieve external and internal equilibrium at point E. ~

33. 33 The “Dependent Economy” Model l Endogeneity of the terms of trade in the Mundell- Fleming model is inconsistent for developing countries. l Dependent economy model by Swan (1960) and Salter (1959). l Two domestic production sectors, one producing traded and the other nontraded goods. l Traded goods sector consists of both importables and exportables. l Since terms of trade are exogenous and constant, exportables and importables can be treated as a single Hicksian composite good.

34. 34 l What matters for macroeconomic equilibrium is the total value of domestic production and consumption of traded goods. l Domestic residents spend on both traded and nontraded goods. l Real exchange rate is price of traded goods in terms of nontraded goods: z = P T / P N, P T : domestic-currency price of traded goods, P N : price of nontraded goods. l Linearly homogeneous sectoral production function in capital and labor in each sector. l In the short run capital stock is fixed.

35. 35 l Labor is homogeneous and intersectorally mobile. l In the short run, supply of output depends on employment: y h = y(n h ), y’ h > 0, y’’ h < 0, h = N, T, y T and y N : value of domestic production of traded and nontraded goods, n T and n N : employment in each of the two sectors. l Demand for labor from each sector is inversely related to that sector's product wage: n T = n T (  ), n N = n N (z  ), n T ’, n N ’ < 0,  = w/P T : real wage in terms of traded goods. dddd d d (43) (42)

36. 36 l Substituting (43) in (42) yields the sectoral supply functions: y T = y T (  ), y N = y N (z  ), y T ’, y N ’ < 0.  = w/P T : real wage in terms of traded goods. l Domestic demand for traded and nontraded goods depends on the relative prices of the two goods (real exchange rate), and on a given by a = a T + z -1 a N. l Thus a T = a T (z, a), 0 <  a T /  a < 1, a N = a N (z, a), 0 < (  a N /  a) = (1-  a T /  a) < 1. s s s ss s + - ++

37. 37 l Trade balance b: value of domestic excess supply of traded goods: b = y T (  ) - a T (z, a). l Equilibrium in the nontraded goods market: y N (z  ) = a N (z, a). l Labor market-clearing condition: n T (z  ) + n N (z  ) = n. l Equilibrium values of  and z are simultaneously clear the labor and nontraded goods markets. s s - dd (50) (49) (48)

38. 38 Figure 2.2: l LL: set of combinations of  and z that satisfy (50). l NN satisfies (49). l Slope of LL = - (n N ` + n T `) / n N ` < -1. l Slope of NN = -y N ` n N ` / (y N ` n N ` -  a N /  z) > -1. l CD has a slope of -1. l Right (left) of LL: real wage is too high (low), and excess supply (demand) prevails in the labor market. l Below (above) NN: real exchange rate is excessively appreciated (depreciated), and excess supply (demand) prevails in the market for nontraded goods. l Equilibrium combination of z and  is given by (z,  ), where LL and NN intersect (point E). ddd d d ss ~~

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40. 40 l Effects of an increase in a: NN shifts down to N’N’. l Reason: equilibrium in this market requires a more appreciated real exchange rate when aggregate spending is higher. l New equilibrium is B: appreciated real exchange rate and an increase in the real wage. l Since B lies below CD, the proportional reduction in z exceeds the proportional increase in . l So product wage in the nontraded goods sector falls, thus, labor is released from the traded goods sector and absorbed by the nontraded goods sector.

41. 41 l For this reason, and because the appreciation of the real exchange rate shifts demand towards the traded good, the trade balance deteriorates. l Determination of internal and external balance. l Solve (50) for  in terms of z. l Slope of this relationship is LL in Figure 2.2. l Substituting this into (48) and (49). l This determines the trade surplus and the nontraded goods market equilibrium as functions of z and a. Keynesian form: l It takes  to be exogenous. l Figure 2.2: if the initial value of  is  2, the market for nontraded goods will clear at point A.

42. 42 l There is an excess supply in the labor market, because point A is to the right of LL. l Increase in a: new equilibrium point is F. l This reduces the excess supply in the labor market since the nontraded goods sector would expand by absorbing unemployed workers. l Analysis of internal and external balance: since nominal devaluation would alter , Keynesian version of both (49) and (50) shift in z-a space.

43. 43 A Model with Three Goods l Dependent economy model includes exogenous terms of trade, but not capture variability in the terms of trade as a source of macroeconomic shocks. l Allowing changes in the terms of trade requires three- good model. l It disaggregates traded goods sector into exportables (X) and importables sectors (I). l Assumption: exportable good is not consumed at home. l Production takes place in three sectors with sectoral production functions y h = y h (n h ), y h ’ > 0, y h ’’ < 0, h = X, I, N. (51)

44. 44 l Labor demand: n X = n X (  -1 ), n I = n I (  ), n N = n N (z  )  : terms of trade, given by P X /P I ; z = P I /P N : real exchange rate measured in terms of importables;  : real wage in terms of importables; P X, P I, and P N : domestic-currency prices. l P X and P I are given by the law of one price, so that P X = EP X * and P I = EP I *. l P N is determined domestically. (52) d dd dd d

45. 45 l Changes in the terms of trade have è sectoral resource reallocation effects on supply side, è demand-side effects because terms of trade changes affect a country's real income. l To incorporate these effects, assume a is measured in terms of importables: a = a( , g). l Equilibrium in the market for nontraded goods y N (z  ) = a N (z, a), 0 <  a N /  a < 1. (53) (54) ++ ++

46. 46 l Trade surplus is given by the domestic excess supply of traded goods: b =  y X (  -1 ) + y I (  ) - a I (z,a). l Full employment condition: n X (  -1 ) + n I (  ) + n N (z  ) = n. Effects of terms-of-trade changes on z and . Classical mode: l Figure 2.3: NN and LL depict (54) and (56), and determines the equilibrium at point E. l Assume terms of trade deteriorates by a reduction in P X. l  and absorption fall. (56) _ dd d (55)

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48. 48 l NN shifts to N’N’ since real exchange rate must depreciate to maintain equilibrium in nontraded goods market. l Product wage rises in the exportables sector. l To maintain full employment, excess labor must be absorbed by the nontraded goods sector. l This can happen only if z falls, so LL shifts down. l New equilibrium E with a depreciated real exchange rate and reduced real wage.

49. 49 Keynesian mode: l Since  cannot change, new equilibrium is at point B, rather than E ’. l Unemployed labor since point B lies to the right of L’L’. l Real exchange rate depreciation is less than that in the classical case. l Maintaining full employment requires nominal devaluation (reduce real wage from  to  ’). l New equilibrium point is E ’. l Application of the model to the “Dutch disease”: macroeconomic implications of the existence of a booming sector. l “Boom” is represented by an increase in P X.

50. 50 l In this case, z falls, and  rises. l Result: contraction of output in the importables sector. l In developing countries, “Dutch disease” has been aggravated by expansionary macroeconomic policy responses to favorable terms-of-trade shocks. l In this case, it is difficult to reverse when the shocks are transitory.

51. Structure of Labor Markets

52. 52 l Functioning of Labor Markets. l Output and Unemployment. l Indexation and Wage Rigidity. l Labor Market Segmentation.

53. 53 Functioning of Labor Markets l Key differences in labor markets in developing nations and those in industrial countries: è importance of agricultural sector, è importance of self-employment, è irregular work activities. l So standard labor market concepts used in the industrial world do not necessarily have the same meaning in developing countries. Three sectors of labor market in developing countries: l Rural sector: large share of self-employed persons and unpaid family workers.

54. 54 l Informal urban sector: self-employed individuals or small, privately owned enterprises producing mainly services and other nontradables. In this sector: è Activities rely on the provision of labor services by owners and their families, but occasionally on paid labor without any contract. è Job insecurity is pervasive, wages are highly flexible, and workers get very few benefits from their employers. è Legal minimum wage laws do not apply, and labor unions play a very limited role. l Formal urban sector: medium and large enterprises that hire workers on the basis of formal contracts. In this sector:

55. 55 è Workers and employers are subject to labor market regulations. è Employers must provide benefits to their workers. è Labor unions play an important role in the determination of wages, and legal minimum wage laws exist. l Functioning of rural and urban labor markets differs (Rosenzweig, 1988): è Heterogeneity and diversity of production in urban areas requires a wider variety of competence and skills among workers. è Seasonal and climatic effects on production in urban areas are less pronounced. è Urban production activities are more concentrated geographically.

56. 56 l Due to informal sectors, proportion of wage earners in total employment is lower than in the industrial world. l Wage employment accounts for 10% of total employment in some sub-Saharan African countries, but 80% in some Latin American countries. l Share of informal sector employment in total urban employment is sizable in many developing countries and may vary between 30 and 60%.

57. 57 Output and Unemployment Problems: l Available data on employment and unemployment in developing countries are not very reliable. l Published measures of unemployment are based on unemployed workers looking for jobs in the formal sector. l Underemployment is more pervasive than open unemployment. Figure 2.4: l Behavior of output and unemployment rate. l Economic slowdown of the early 1980s translated into increases in the rate of unemployment.

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63. 63 l Relationship between output growth and unemployment rate is weak and varies over time. l This absence of a stable “Okun's law” may be the result of spillover effects across different segments of the labor market.

64. 64 Indexation and Wage Rigidity l In high-inflation countries in particular, wage indexation is an essential feature of the labor market. l Indexation allows for adjustment of wages for productivity changes and past inflation. l Procedures differ among countries and over time in three main respects: è interval between wage adjustments, è degree of indexation to inflation, è nature of adjustments for productivity changes. l Manner in which indexation operates is important for the transmission of policy shocks to output, inflation, and unemployment.

65. 65 l Indexation helps to insulate output and employment from monetary (demand) shocks, but not from real (supply) shocks. l High degree of wage indexing at the sectoral level may distort policy-induced price signals and hamper the reallocation of resources. l Indexed contracts are viewed as the root cause of the stickiness of inflationary expectations and inflation persistence in many Latin American countries. l Despite wage indexation, real wages in many countries seem to be more flexible (Horton et al., 1994). l Figure 2.5: some degree of real wage flexibility in Chile. l So persistence of unemployment cannot be attributed to excessive real wage rigidity.

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67. 67 l It may result from è aggregate demand effects associated with declining real wages, è output market imperfections. First type of effect: l Emphasized by new structuralists economists and is known as the Keynes-Kalecki effect (Taylor, 1991). l Assumption: propensity to save is lower for wage earners than for profit recipients. l If a fall in real wages is accompanied by a fall in the share of wages in national income, aggregate demand will also fall. l Unemployment may therefore persist.

68. 68 Second type of effect: l Result of imperfect competition in product markets, even if labor markets are competitive and real wages flexible (Layard et al., 1991). l Nominal wage rigidity is a pervasive feature of the labor market in many developing countries. l Reasons for nominal wage inertia: è lagged indexation, è staggered and overlapping wage contracts, è slow adjustment in inflationary expectations, è existence of multiperiod labor contracts.

69. 69 Labor Market Segmentation l Reasons for labor market dualism in developing countries: è sector of employment or the production structure, è geographic location of activities, è legal nature of activities (formal and informal), è composition of the labor force (skilled and unskilled workers). l Frequent implication of dualism is labor market segmentation. l This is a situation where observationally identical workers receive different wages depending on their sector of employment.

70. 70 Reasons: l Restrictions on occupational mobility between sectors. This prevents workers in the “low-wage” segment from having full access to a job in the “high-wage'' segment. l Existence of sectoral wage rigidities. This leads to demand-constrained employment. Migration model of Harris and Todaro (1970): l Model of labor market segmentation. l Objective: explain the persistence of rural-to-urban migration, despite widespread urban unemployment in developing countries. l Equality of expected wages is the basic equilibrium condition across the different segments of the labor market.

71. 71 l Rural workers, in deciding to migrate, compare the current wage in agriculture w A to the expected urban wage w U. l w U : multiply the prevailing wage w U (fixed) by the urban employment ratio (probability of being hired). l In equilibrium: a a w A = w U = w U nUnU n U + L U a (57) n U : urban employment; L U : absolute number of workers unemployed in urban areas.

72. 72 l One set of extensions of the Harris-Todaro model: efficiency wage theories. l Real wage cuts lower productivity because they è reduce incentives to provide effort, è raise incentives to shirk, è increase the quit rate, è reduce loyalty to the firm. l Each firm will set its wage so as to minimize labor costs per efficiency unit, rather than labor costs per worker. l Efficiency wage: wage that minimizes labor costs per efficiency unit. l When each firm offers its efficiency wage, aggregate demand for labor falls short of labor supply, so that involuntary unemployment emerges.

73. 73 l Efficiency wage theories are useful for explaining why modern-sector firms pay more than the market-clearing wage in models with segmented labor markets. l They predict the existence of noncompetitive wage differentials even in the absence of unions. Importance of market segmentation and the degree of wage flexibility to understand the effects of macroeconomic shocks on unemployment. l Consider a small open economy producing traded and nontraded goods using only labor. l Figure 2.6: determination of wages and employment under four different assumptions regarding labor market adjustment. l Horizontal axis: total labor available to the economy, O T O N.

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76. 76 l Vertical axis: wage rate in the economy, which is either uniform across sectors or sector specific. l L T (L N ) : demand for labor in the traded (nontraded) goods sector. Panel 1: l Assumption: wages are perfectly flexible and labor perfectly mobile across sectors. l Initial equilibrium: point E. Wage rate is equal to w*. l Labor employed in the traded goods sector is O T L T *, and labor used in the production of nontraded goods is L T *O N. l In panels 2, 3, and 4 the wage rate in the traded goods sector is fixed at w T whereas wages in the nontraded goods sector remain flexible. dd c

77. 77 Panel 2: l Perfect labor mobility and wage flexibility in the nontraded goods sector, prevents the emergence of unemployment. l Initial equilibrium at point A in the traded goods sector employment level of O T L T. l And at point E N in the nontraded goods with wages equal to w N and employment to L T O N. Panel 3: l Labor is completely immobile. l Labor in the traded goods sector: O T L T. l Labor in the nontraded goods sector: L T O N. l Unemployment will typically emerge in traded goods sector. c c

78. 78 Panel 4: l Equilibrium obtains when the wage rate in the nontraded goods sector is equal to the expected wage in the traded goods sector. l QQ: hyperbola along which this equality holds (Harris- Todaro curve). l Intersection of the L N curve with QQ determines wage rate and the employment level in the nontraded goods sector. l Intersection of the L T curve with the horizontal line drawn at w T determines employment in the traded goods sector. l Initial equilibrium is characterized by sectoral unemployment (L T L N ). c d d c

79. 79 l If demand for labor in the traded goods sector falls, as a result of a macroeconomic shock, è L T shifts to left; è demand curve for labor in the nontraded goods sector is unchanged. l If wages are perfectly flexible and labor perfectly mobile across sectors, adjustment of the labor market leads to è fall in the overall wage rate in the economy; è reallocation of labor across sectors; è new equilibrium (E’ in panel 1) with full employment. When there is sector-specific wage rigidity: l If labor is perfectly mobile, the demand shock leads to è reallocation of the labor force; è fall in wages in the nontraded goods sector (panel 2). d

80. 80 l If workers cannot move across sectors, the reduction in demand leads to è increase in unemployment in the traded goods sector; è no effect on wages and employment in the nontraded goods sector (panel 3). l With a labor allocation mechanism of the Harris-Todaro type, the demand shock è reduces employment in the traded goods sector; è has ambiguous effect on unemployment rate. d

81. 81 Reason: l QQ curve shifts to the left following the shift in L T since the fall in employment reduces è likelihood of being hired; è expected wage in the traded goods sector. l More workers seek employment in the nontraded goods sector, bidding wages down. l In equilibrium unemployment may increase in the traded goods sector. d

82. 82 Agénor and Aizenman (1999): l Interactions between the formal and informal urban labor markets may be characterized by substitutability in the short run. l In periods of weak output growth, workers è laid off in the formal sector; è seek employment in the informal sector where wages and labor productivity tend to be lower. l If skilled workers' reservation wage is not higher than unskilled workers’ wage in the informal sector, è fluctuations in aggregate demand will translate into changes in average productivity; è not a rise in open unemployment.

83. Informal Financial Markets

84. 84 l Informal Loan Markets. l Parallel Markets for Foreign Exchange.

85. 85 Informal Loan Markets l Transactions can be classified into four categories: è regular money lending by individuals or institutions; è occasional lending by individuals, firms, and institutions with a surplus of funds; è tied credit; 4 lending by those whose main activity lies in markets other than the credit market; 4 but who tie credit to transactions in markets where their primary activities lie; l Group finance aimed at generating loanable funds for individual credit needs.

86. 86 l Informal credit markets are an important feature of developing-country financial markets. l Montiel et al. (1993): share of informal credit in total credit varies from about one-third to three quarters. l Interest rates in informal credit markets are substantially higher than those in official markets. l Figure 2.7: some evidence for Korea. l Interest rates in informal credit market may è represent opportunity cost of holding money; è so respond to 4 domestic money market conditions and/or; 4 arbitrage opportunities between domestic lending and foreign lending.

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88. 88 l Distinction between è "autonomous" informal sector (relating to indigenous activities), è "reactive“ informal sector (activities that emerge as a response to regulations, credit constraints, or other deficiencies of the formal sector). l Second component is more directly affected by credit policy and the level of financial repression.

89. 89 Parallel Markets for Foreign Exchange l Parallel currency markets have emerged due to foreign trade restrictions and capital controls. Under foreign trade restrictions: l Imposition of tariffs and quotas creats excess demand for goods at illegal, pretax prices. l Illegal trade creates a demand for illegal currency. l This leads to creation and establishment of a parallel currency market if the central bank is unable to meet all demand for foreign exchange.

90. 90 Under capital controls: l Parallel market becomes a major element in financing capital flight and portfolio transactions. l Foreign currency is a hedge against adverse political change and inflation tax. l Other factors to explain the development of a parallel currency market, private transfers in the context of è overvalued exchange rate; è illegal activities. l Size of illegal, parallel currency markets depends on è range of transactions subject to exchange controls; è degree to which restrictions are enforced by the authorities.

91. 91 l When there are large and chronic balance-of-payments deficits, è central bank rations foreign exchange allocated to private sector; è so parallel currency markets provides foreign exchange rate with more depreciated rate. l Figure 2.8: evolution of the parallel market premium. l Premium reflects asset-price characteristics of parallel exchange rate. l When there is uncertainty over macroeconomic policies, parallel market rates react rapidly to expected changes in future economic circumstances.

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95. 95 l Illegal supply of foreign currency from five sources: è under-invoicing of exports, è smuggling of exports, è over-invoicing of imports, è foreign tourists, and è diversion of remittances through nonofficial channels. l Under-invoicing of exports is the major sources of supply. l When there is a tax on exports, under-invoicing allows the exporter to avoid the tax and sell the illegally acquired foreign exchange at premium. l Higher the parallel market premium is, the higher will be the propensity to under-invoice exports.

96. 96 l Demand for foreign currency in the parallel market results from four main components: è imports (legal and illegal), è residents traveling abroad, è portfolio diversification, è purposes of capital flight. Macroeconomic implications of parallel currency market: l It entails costs for the government: è cost of enforcement in attempting to counteract parallel market activities and to prosecute and punish offenders; è loss of tariff revenue and revenue from income taxes and domestic indirect taxes;

97. 97 è reduced flow of foreign exchange to the central bank; è suboptimal allocation of scarce resources. l Parallel market in foreign exchange weakens effectiveness of central bank’s capital controls. è It leads to an increase in the degree of substitution between domestic and foreign currencies. è This results in a loss of seigniorage for the government. l Parallel exchange rates may have a large impact on domestic prices. è If domestic prices of tradables are based on the marginal cost of parallel market rate, aggregate price will reflect the behavior of this exchange rate.

98. 98 è Figure 2.9: countries with the highest degree of parallel exchange variability also tend to exhibit a greater degree of price variability. l Because there are two prices for foreign exchange, exports whose proceeds are repatriated at the official exchange rate are taxed relative to other exports. l Parallel market for foreign exchange plays an important role in the transmission mechanism of short-term macroeconomic policies.

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