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Title: Chapter%20Twenty-One


1
Chapter Twenty-One
  • Macroeconomics of Development and Transition

2
Chapter Twenty-One Outline
  1. Introduction
  2. Development and the Macroeconomy
  3. Transition and the Macroeconomy

3
Introduction
  • Two groups of economies that exhibit distinctive
    macroeconomic characteristics, encountering
    special macroeconomic situations as a result are
  • developing economies
  • countries in transition from central planning

4
Introduction
  • Two reasons for interest from developed
    countries
  • Many important trade and financial linkages exist
    between these groups and the industrialized
    countries and
  • Emergence of 15 new economies from ex-Soviet
    Union they need to establish sustainable and
    credible economic institutions.

5
Development and the Macroeconomy
  • Developing countries pre-reform macroeconomic
    characteristics
  • Pervasive government involvement in the economy,
    with widespread government ownership of
    infrastructure, industry, and land.
  • Poorly developed financial institutions.
  • Government finance through money creation rather
    than taxes or domestic borrowing.
  • Fixed exchange rates, accompanied by capital
    controls or direct government control of FX
    transactions
  • Extensive foreign borrowing to cover
    current-account deficits.

6
Development and the Macroeconomy
  • Government ownership and control
  • Creates a variety of micro- and macroeconomic
    problems
  • Low productivity, technological backwardness, and
    ignorance of customer preferences in state-owned
    enterprises.
  • Policy decisions hinge on political
    considerations.
  • These countries withdraw from international trade
    in an attempt to protect domestic industries.

7
Development and the Macroeconomy
  • Poorly-developed financial markets and
    institutions
  • Difficult to borrow by selling long-term bonds.
  • Due to poor policy records, bad reputations, and
    lack of credibility.
  • Widespread government ownership of industry
    precludes a stock market as a major means of
    raising private funds to finance investment.

8
Development and the Macroeconomy
  • Money-financed fiscal expenditures
  • They typically printed more money due to poor tax
    collection and inability to borrow from domestic
    population.
  • Produces inflation and inflation tax.

9
Development and the Macroeconomy
  • Government control over foreign exchange
  • These governments often used capital and foreign
    exchange controls as the means to keep domestic
    funds in the domestic economy rather than
    allowing them to escape as capital flight.
  • These means render the domestic currency
    non-convertible.

10
Development and the Macroeconomy
  • External debt
  • Reached crisis proportions in the 1980s.
  • Many governments forgot or ignored a basic rule
    for borrowing external funds use the money to
    finance projects productive enough to bring
    economic return sufficient to repay the loan.
    Most projects failed for several reasons
  • Projects chosen on political basis.
  • Funds supported grossly inefficient state-owned
    firms, military buildup, or unproductive
    prestige projects like national airlines or
    huge steel mills.
  • Economic conditions changed between the time the
    projects started and the time repayment came due.
  • Export revenues fell when primary-product prices
    plunged.

11
Development and the Macroeconomy
  • Reform
  • Almost every developing country, following
    decades of dismal economic performance, reformed
    their economies.
  • Stabilization reforms refer to policy changes
    that aim to achieve macroeconomic stability.
  • Basic elements cutting excessive government
    spending and reducing excessive money growth.
  • Structural reform or structural adjustment
    refers to changes in the basic structure of the
    economy.
  • Reducing extent of government involvement in
    economy and increasing the role for markets.

12
Development and the Macroeconomy
  • Reform (cont.)
  • Panel (a) represents the typical macroeconomic
    situation in developing countries prior to
    reform.
  • Overly expansionary inefficiencies hold the LRAS
    to the left of its potential position.
  • This combination produces low levels of real
    output and rising prices.
  • Reform shifts the situation to one depicted in
    panel (b).
  • Macroeconomic stabilization stops the continual
    rightward shift of AD, and structural reform
    allows LRAS to move to right.
  • This new policy produces higher rates of real
    output and steady prices.

13
Figure 21.1 Macroeconomic Stabilization,
Structural Reform, Aggregate Demand/Supply
Price
Price
LRAS
LRAS
0
1
Level
Level
P
3
P
2
AD
3
P
1
AD
A
2
P
P
0
0
AD
1
AD
AD
0
0
0
Q
Real
Q
Real
0
1
Output
Output
(a) Pre-reform
(b) Post-reform
14
Development and the Macroeconomy
  • Privatization and deregulation
  • Reduce role of government many state-owned
    enterprises have now been privatized, or sold to
    private investors.
  • Privatization can be a slow and difficult
    process.
  • Asset valuations are a problem with new owners.
  • Efficiency improves after sale, but many
    employees are usually laid off could create
    social unrest.
  • Foreign purchase of assets can generate domestic
    resentment.

15
Development and the Macroeconomy
  • Financial integration with world capital markets
    allows a more efficient capital-allocation
    process.
  • Government did it before.
  • Encourages domestic saving and creates domestic
    sources of funds for financing projects.
  • Fiscal consolidation and tax reform.
  • To reduce inflation, government expenditures that
    continue post-reform must be financed more
    through taxes and government borrowing, and less
    through money creation.

16
Development and the Macroeconomy
  • Currency convertibility
  • A country cannot enjoy the full gains from trade
    unless its currency is convertible.
  • Currency convertibility implies that the exchange
    rate, if fixed, cannot be set too far from
    equilibrium in the FX market.
  • Convertibility means that international traders
    and investors can demand that the central bank
    buy and sell FX at the pegged rate in amounts
    sufficient to cover the desired international
    trade and finance activities.

17
Development and the Macroeconomy
  • Currency convertibility (cont.)
  • Better to operate under a flexible regime.
  • Developing countries often hesitate to do this
    for two reasons
  • Transactions in domestic currency might be so
    thin that the FX markets would not be
    competitive.
  • These countries like the price discipline
    inherent in a fixed system.
  • Economies of many of these countries are built
    around a few primary products under a fixed
    system, a recession can severely reduce demand.

18
Development and the Macroeconomy
  • Investment finance and debt.
  • The debt crisis of the 1980s reminded debtors and
    creditors alike of the fundamental rules for
    sound debt management
  • To avoid insolvency, an investment project must
    produce a rate of return sufficient to cover loan
    payments
  • To avoid illiquidity crises, loan maturity and
    project maturity must match so that returns from
    the project come in time to make loan payments
    and
  • Uncertainty regarding future economic events
    constrains the prudent amount of debt
    accumulation any country can undertake.

19
Development and the Macroeconomy
  • Lingering risks.
  • Some of the current concerns about developing
    countries macroeconomies differ between two
    groups of economies
  • Those that cling to pre-reform characteristics
    and policy choices and remain relatively isolated
    from the world economy and
  • Those that are emerging or reforming and
    integrating themselves into the world economy.

20
Five Principle Pre-Reform Macroeconomic
Characteristics for Centrally-Planned Economies
  • 1. Extensive government ownership of productive
    assets government control over all important
    aspects of economic activity, prices, and
    international trade and government resource and
    capital allocation according to a centralized
    economic plan.
  • Until mid-1980s, 95 of Soviet Union was under
    state control.
  • All firms faced a soft budget constraint no
    threat of bankruptcy more loans and credit
    always provided.

21
Five Principle Pre-Reform Macroeconomic
Characteristics for Centrally-Planned Economies
  • 2. Overly industrialized economic structure, with
    underdeveloped financial and services sector.
  • Preferred very large scale state-owned
    enterprises that held monopoly positions.
  • Little or no incentive to produce high-quality
    goods or to adopt new technologies.

22
Five Principle Pre-Reform Macroeconomic
Characteristics for Centrally-Planned Economies
  • 3. Government-set prices and capital-allocation
    procedures that encourage capital-goods
    production and discourage consumer-goods
    production, resulting in chronic shortages.
  • Workers often hoarded their cash wages (no goods
    to buy).
  • These hoarded funds, called monetary overhang,
    gave the government a further incentive to levy
    an inflation tax that eroded the funds potential
    purchasing power.

23
Five Principle Pre-Reform Macroeconomic
Characteristics for Centrally-Planned Economies
  • 4. Extensive money finance of government
    expenditure, especially subsidies to large
    state-owned enterprises.
  • Tax systems were poorly developed.
  • Government found it difficult to borrow from
    world markets, so they printed more money.

24
Five Principle Pre-Reform Macroeconomic
Characteristics for Centrally-Planned Economies
  • 5. Capital and exchange controls to maintain
    highly artificial fixed exchange rates.
  • Non-convertibility imposed bilateralism on trade
    each pair of countries imported and exported
    about equal values of goods from one another, a
    pattern that eliminated many opportunities for
    mutually beneficial trade.

25
Transition and the Macroeconomy
  • Reform
  • So many are needed political, legal, economic,
    and social.
  • Debate over the timing of the reforms
  • Big-bang approach attempt dramatic and immediate
    reforms on all margins simultaneously (Poland).
  • Gradualism approach reform more slowly and take
    the different elements of reform one-by-one
    (China).

26
Transition and the Macroeconomy
  • Privatization represent the central task of
    structural reform.
  • Cumulative progress in privatization (Fig. 21.2
    in the text)
  • The scale of the Progress Index progresses from 1
    (very little private ownership for large-scale
    firms or little progress for small-scale firms)
    to 4 (more than 50 of state-owned enterprise
    and farm assets in private ownership for
    large-scale firms and standards and performance
    typical of advanced industrial economies for
    small-scale firms).

27
Figure 21.2 Transitional Economies Progress
in Privatization, 2001
Country
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
Small-scale privatization
Large-scale privatization
4
Progress index
1
2
3
28
Figure 21.2 Transitional Economies Progress in
Privatization, 2001
Country
Latvia
Small-scale privatization
Lithuania
Moldova
Poland
Large-scale privatization
Romania
Russian Federation
Slovak Republic
Slovenia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
1
2
3
4
Progress Index
29
Transition and the Macroeconomy
  • Governance and restructuring
  • Central planning produces an economy in which
    supplies of and demands for various goods and
    resources do not match results in
  • Over-industrialization
  • Queues for consumer goods
  • Existence of large monetary overhangs
  • Sectoral restructuring occurs when
    market-determined prices begin to allocate
    resources so that the economy produces those
    goods that consumers and firms want.

30
Transition and the Macroeconomy
  • Governance and restructuring (cont.)
  • Figure 21.3 reports the transitional economies
    progress in governance and restructuring.
  • Scale of Progress Index ranges from 1 (soft
    budget constraints, few other reforms to promote
    corporate governance) to 4 (standards and
    performance typical of advanced industrial
    economies).

31
Figure 21.3 Transitional Economies Progress
in Governance and Restructuring, 2001
Country
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
1
2
3
4
Progress Index
32
Figure 21.3 Transitional Economies Progress
in Governance and Restructuring, 2001
Country
Latvia
Lithuania
Moldova
Poland
Romania
Russian Federation
Slovak Republic
Slovenia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
1
2
3
4
Progress Index
33
Transition and the Macroeconomy
  • Governance and restructuring (cont.)
  • Other piece of restructuring that involves
    designing policies to foster competitive markets.
  • Figure 21.4 documents this area the Progress
    Index ranges from 1 (no competition legislation
    and institutions) to 4 (standards and
    performance typical of advanced industrial
    economies unrestricted entry to most markets).

34
Figure 21.4 Transitional Economies Progress in
Competition Policy, 2001
Country
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
1
2
3
4
Progress index
35
Figure 21.4 Transitional Economies Progress in
Competition Policy, 2001
Country
Latvia
Lithuania
Moldova
Poland
Romania
Russian Federation
Slovak Republic
Slovenia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
1
2
3
4
Progress index
36
Transition and the Macroeconomy
  • Price liberalization
  • Privatization cannot occur without large doses of
    price liberalization.
  • Private investors will be hesitant to purchase
    enterprises that produce goods whose prices are
    held down by government price controls.
  • Figure 21.5 reports the price liberalization
    progress for the economies in transition.
  • Scale of Progress Index ranges from 1 (most
    prices formally controlled by government) to 4
    (standards and performance typical of advanced
    industrial economies).

37
Figure 21.5 Transitional Economies Progress
in Price Liberalization, 2001
Country
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
1
2
3
4
Progress index
38
Figure 21.5 Transitional Economies Progress
in Price Liberalization, 2001
Country
Latvia
Lithuania
Moldova
Poland
Romania
Russian Federation
Slovak Republic
Slovenia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
1
2
3
4
Progress index
39
Transition and the Macroeconomy
  • Fiscal consolidation
  • Extensive control of the economy translates into
    extensive government expenditures.
  • Must reduce government expenditures.
  • Must shift from money finance of expenditures to
    taxes and government borrowing.
  • Whole process of fiscal consolidation involves
    not only changes in policy makers day-to-day
    behavior, but changes in fundamental structure of
    policy making institutions.
  • Figure 21.6 illustrates 2000 government budget
    balances as a percent of GDP.

40
Figure 21.6 Government Balances in the
Transitional Economies, 2000 ( of GDP)
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
-8
-6
-4
-2
-10
0
2
General government budget ( of GDP)
41
Figure 21.6(cont.) Government Balances in the
Transitional Economies, 2000 ( of GDP)
Latvia Lithuania Moldova Poland Romania Russian
Federation Slovak Republic Slovenia Tajikistan Tur
kmenistan Ukraine Uzbekistan
-8
-6
-4
-2
-10
0
2
General government budget ( of GDP)
42
Transition and the Macroeconomy
  • Financial integration
  • A system of central planning with its artificial
    prices requires isolation from world markets,
    where demand and supply determine prices.
  • Removing capital controls allows domestic
    residents to invest abroad and allows foreign
    investors to invest in the domestic economy.
  • Figure 21.7 shows that reform of banks and
    non-bank financial institutions has proceeded
    slowly.

43
Figure 21.7 Transitional Economies Progress
in Bank and Non-Bank Financial Reform, 2001
Country
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
Securities markets and non-bank financial
institutions
Banking reform and interest-rate liberalization
1
2
3
4
Progress Index
44
Figure 21.7 Transitional Economies Progress in
Bank and Non-Bank Financial Reform, 2001
Country
Latvia
Lithuania
Securities markets and non-bank financial
institutions
Moldova
Poland
Romania
Banking reform and interest-rate liberalization
Russian Federation
Slovak Republic
Slovenia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
1
2
3
4
Progress Index
45
Transition and the Macroeconomy
  • Financial integration (cont.)
  • Most transitional economies have made significant
    progress in reforming their foreign-exchange
    systems and in liberalizing international trade.
  • Figure 21.8 indicates which countries have made
    progress on this front.

46
Figure 21.8 Transitional Economies Progress
in Trade and Foreign-Exchange Reform, 2001
Country
Albania Armenia Azerbaijan Belarus Bosnia
and Herzegovina Bulgaria Croatia Czech
Republic Estonia FR Yugoslavia FYR
Macedonia Georgia Hungary Kazakhstan Kyrgyzstan
1
2
3
4
Progress index
47
Figure 21.8 (cont.) Transitional Economies
Progress in Trade and Foreign-Exchange Reform,
2001
Country
Latvia
Lithuania
Moldova
Poland
Romania
Russian Federation
Slovak Republic
Slovenia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
1
2
3
4
Progress index
48
Transition and the Macroeconomy
  • Transition prospects
  • Differ substantially depending on the degree of
    their economic problems.
  • Russia inherited a more complete set of economic
    institutions than did the other Soviet republics.
  • Generally speaking, most countries macroeconomic
    stabilization efforts have thus far been more
    sustained and successful than their structural
    reforms.
  • By 1994, early reformers had positive real GDP
    growth.
  • By 1995, small private capital flows into the
    transitional economies had begun (Czech Republic,
    Slovakia, Hungary, and Baltics).

49
Note for Case 2 Ownership Matters
  • One benefit of privatization is the revenue it
    generates for governments.
  • Figure 21.9 summarizes the revenue effect for a
    sample of transitional economies between 1990 and
    1998.
  • Privatization created a one-time inflow of funds
    to government coffers.
  • Revenues came primarily from privatization of
    infrastructure industries, as in Figure 21.10.

50
Figure 21.9 Privatization Revenues by Sector,
1990-1998
51
Figure 21.10 Privatization Revenues by Region,
1990-1998
52
Key Terms in Chapter 21
  • Stabilization reforms
  • Structural reform (structural adjustment)
  • Privatization
  • Soft budget constraint
  • Monetary overhang
  • Bilateralism
  • Big-bang approach
  • Gradualism approach
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