Workshop On Macroeconomic Aspects: Macroeconomics of A Developing Economy

REFORM Project, USAID/India
Workshop on Macroeconomic
Aspects
Macroeconomics of a Developing
Economy
Khwaja M. Sultan
1
Macroeconomic Problems in
.
Developing Countries
• General poverty ~ low per capita income – India classified
as a low income country – per capita income ~$530 in 2003
one of the poorest countries
• Occupational pattern ~ primary producers – agriculture the
main occupation – in India 61% of the population – in US,
UK, Japan it is less than 5%
• Dualistic economy ~ Existence of paradoxes – especially
pronounced in India - maldistribution of assets - inequalities
• Heavy population pressures – imbalance between
population, resources and capital
• Low level of urbanization
2
Macroeconomic Problems in
.
• Low level of capital formation – poor infrastructure –
e.g., per capita electricity consumption low
US 13,000 kWH
Japan 8,200 kWH
China 1,100 kWH
India 561 kWH
• Low rate of economic growth
• Low level of technology
• Poor quality of human capital
• Low ranking in Human Development Indicator – India
ranked 127th
• High level of indebtedness 3
Vicious Circle of Poverty
.
Low Productivity
Capital Deficiency Low Income
Low Investment Low Saving
Low Demand
4
Dualistic Models for Developing
.
Countries
• Social dualism – questionable ???
• the clash of imported social system with
indigenous social system
• limited needs; satisfied people - lack of initiative ?
• backward sloping supply curve ??
• Technological dualism
• use of different production functions in the
industrial sector and the traditional farming sector
• the technological dualism leads to surplus labour,
and disguised unemployment arising from 5
misallocation of resources
Dualistic Models for Developing
.
Countries
• Financial dualism –
• existence of different rates of interest between the
organized and the informal money markets
• rate of interest in the informal sector much higher
• lack of guarantees, collaterals, credit history
• low penetration of banking in rural areas – in
India only 40% of households have access to credit
• substantial amount of savings is hoarded in gold
and jewellery
6
Relevance of Keynesian Theory
.
to Developing Countries
Keynes Theory :
•Total income is a function of total employment.
•Employment depends on effective demand.
•Variation in employment and income depends on
investment
•A rise in the propensity to consume can raise employment
•Rise in investment leads to increase in income, and out of
increase in income, there is more demand for goods which
leads to further increase in income and employment
• As a result, a given rise in investment causes a multiplier
effect
•Fiscal and monetary measures to increase effective demand
7
Keynesian Assumptions and
.
Keynes Theory not applicable to developing countries, but
only to advanced capitalist economies.
Keynesian assumptions:
1. Unemployment caused by deficiency in effective demand
2. Cyclic unemployment during depression – this can be
removed by increasing the level of effective demand
3. Short run analysis
4. An elastic horizontal supply curve
5. Excess supply of labour
6. Underutilized capital co-exists with underutilized labour
8
.
Keynes Theory not applicable to developing countries, but
only to advanced capitalist economies.
1. The supply is relatively inelastic due to structral
rigidities, market imperfections, and bottlenecks; the
supply curve, even in the short run is not horizontal but
vertical
2. In developing countries there is no cyclic unemployment
but disguised unemployment
3. Unemployment is caused not by lack of effective demand
but by lack of complementary resources
4. In developing countries, relationships between income,
consumption and saving do not hold. In poor countries
the marginal propensity to consume is high while the 9
propensity to save is low

.
According to Keynes, when marginal propensity to consume
is high, consumer demand, output and employment
increase faster than income
In a developing country, it is not possible to increase
production of goods due to scarcity of capital and
infrastructure, and the small size of the market.
As a result, fiscal and monetary measures aimed at
increasing effective demand will increase prices instead
of employment
Deficit financing to increase investment leads to inflationary
pressures
The rate of interest in developing countries is not influenced
by the demand and supply of money but by institutional 10
factors
The Solution to Keynes in
.
Deficit financing for structural changes will not be
inflationary because it will impart elasticity to the
aggregate supply curve
This means providing a supply-side response, rather than a
demand-side response–
1. Investment in infrastructure to facilitate private
investments
2. Investment in social capital
3. Investment in institutional building – contract
enforcement, law and order, transparency, political
stability
4. Creating an enabling environment by reducing
unnecessary regulations and controls 11
Macroeconomic Dimensions of
.
Fiscal Policy
Fiscal policy plays an important role in developing countries
for economic development
• The problem of capital formation in developing countries
•Marginal propensity to save is a crucial determinant of
growth
• Taxation as a means to increase savings
•Taxation as a means to increase investment
• Fiscal policy for building social infrastructure – health,
education, empowerment of weaker sections
•Fiscal policy to correct market imperfections
• Fiscal policy to increase opportunities for employment
•Fiscal policy to counter inflation
12
Macroeconomic Dimensions of
.
Fiscal Policy
Deficit financing is always expansionary but can also be
inflationary.
The existence of market imperfections and low elasticity of
supply tends to raise prices
Deficit financing becomes inflationary only when it crosses
the safe limit.
What is this safe limit?
•Deficit financing is non-inflationary if he increase in
money supply matches the rate of growth of the economy
•To the extent that the non-monetized sector is monetized
13
Evaluation of IMF Macromodels
in Developing Countries
•Improving growth outcomes
•Sustaining growth is essential for poverty reduction
•Studying sources of and obstacles to growth
•How macroeconomic policies affect growth
•Assessing the macroeconomic consequences of aid

•Foreign aid inflows affect the macroeconomic scenario
in developing countries in many ways
•Countries with sound poverty reduction strategies
benefit
•Countries with poor utilization become indebted without
improving their standards
14
Evaluation of IMF Macromodels
in Developing Countries
•Addressing vulnerability and exogenous shocks
•Exposure to exchange rate fluctuations
•Dutch disease problem
•Assessing debt sustainability
•Assessing private capital formation
15

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REFORM Project, USAID/India

Capital Deficiency Low Income

Low Investment Low Saving

propensity to save is low

•Assessing the macroeconomic consequences of aid

•Assessing debt sustainability

•Assessing private capital formation

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