Modelling the Open Economy, Devaluation, and the Exchange Rate in Developing Countries

The chapter first examines the limitations of conventional open-economy macro models, such as the Mundell–Fleming model, when they are applied to developing countries. It discusses the Swan–Salter model and the three-sector dependent-economy model that better capture the reality of the external sector in poor countries. It then discusses the impact of devaluation under conditions of closed and open capital accounts and shows the limitation of a devaluation unaccompanied by structural measures in little diversified poor economies and in economies with large dollar liabilities. In this regard, it examines the results of the empirical literature on the contractionary or expansionary effect of devaluation in developing countries. Finally, it reviews the pros and cons of alternative exchange rate regimes, the impossible trinity theorem, and measures to control exchange rate volatility through capital controls.

Short-term Behavioural Equations for Developing Countries

This chapter discusses the structural difference in family size, structure, location, and preferences, as well as the features of the formal and informal financial markets that determine the access to credit of various types of firms. It also reviews the role of the exchange rate, interest, rate and inflation in determining money demand. It then discusses behavioural equations for aggregate consumption, investment, and money demand that fit the reality of developing countries, and compares them with those discussed in Chapter 3 for the advanced economies. It shows that their inclusion in the IS-LM and AS-AD models often modifies the impact of policy changes and endogenous shocks in relation to those obtained in the advanced economies.

Institutions, Investment, and Growth in Developing Countries

Many analyses of long-term development neglect the importance of formal and informal political and economic institutions in developing countries. This chapter discusses the nature of such institutions, their endogeneity and persistence over time as well as their impact on growth, inequality, and political stability. The chapter places particular attention on the institutions that build the market and facilitate economic exchange, and on the public organizations mandated with their enforcement. It then discusses their impact on growth and macroeconomic stability as well as the role played by informal institutions in developing countries where formal institutions are often perceived as a costly obstacle to economic development.

Rapid Population Growth and Long-term Development

This chapter reviews population trends over the last two hundred years and population projections to the end of this century. In 2100 the world population will have stabilized but its geographical distribution will have substantially changed compared to 2015. The chapter then discusses the five stages of the demographic transition, and different neo-Malthusian and non-Malthusian theories of the relation between population growth and economic development. It emphasizes in particular the effects of rapid population growth on land and resource availability, human capital formation, population quality, the accumulation of physical capital, employment, wages, and income inequality. The effects of rapid population growth rate over a given period were found to change in line with the population size and density at the beginning of the period considered.

Macroeconomic Stabilization in Developing Countries

In developing countries, the issue of macroeconomic stabilization has generated a considerable theoretical and political controversy. The chapter presents the theory behind the standard monetary models of stabilization in a closed and open economy that inspires adjustment programmes supported by the IMF, the concrete measures adopted as part of this stabilization approach, and their pitfalls. Mention is also made of the criticism attracted by the approach. The final section analyses the relation between orthodox stabilization and poverty incidence and the trade-off between rapid, front-loaded stabilization, and poverty incidence, as well as a series of measures to reduce the impact of orthodox stabilization on the poor.

External Financing, Gap Models of Growth, and the Macroeconomics of Relying on Foreign Resources

Chapter 10 reviews the factors responsible for the strong dependence of developing countries on foreign capital and foreign aid, as well as the cyclical capital inflows and long-term development problems entailed by such a situation. It then discusses a family of models, some of which were developed after the debt crisis and recession of the 1980s and 1990s. These models aim to determine the amount of foreign loans and grants required to reach a preset rate of growth of GDP. It finally assesses the macroeconomic and growth impact of high dependence on foreign finance and foreign aid.

Balance of Payments-constrained Growth

This chapter illustrates the features of the external sector of commodities-exporting and investments-importing developing countries. It discusses in particular the value of the price and income elasticities of commodity exports and compares them with those of capital goods and intermediate inputs imported from the industrialized countries. It then illustrates the Thirlwall model that shows that unfavourable values of such import and export elasticities may reduce the rate of growth of GDP compatible with balance of payments equilibrium. Such a conclusion tends to suggest a need for a structural diversification of the economy of developing countries out of the resource sector.

Genesis of Development Macroeconomics and National Accounts in Developing Countries

The chapter discusses the reasons whycKeynesian policies and development macroeconomics in low-income countries received any attention relatively late, as well as the factors that led to a gradual acceptance of demand-side measures. It also discusses the data, conceptual, and accounting problems encountered when measuring economic performance in low-income countries, including the importance of self-consumption, barter, unilateral transactions, and unrecorded monetary transactions in the informal economy. All this reduces the impact of monetary and fiscal policies and underline the importance of structural policies. The chapter also discusses the accounting conventions and practices used to overcome such problems, and the impact all this has on the estimates of the main macroeconomic aggregates and the evaluation of the impact of public policies.

Macroeconomic Policies for Growth and Poverty Reduction

This chapter reviews alternative sets of macroeconomic policies to support the achievement of the Sustainable Development Goals (SDGs) 1 and 10 to the year 2030. The first goal of this strategy is the complete eradication of poverty by 2030, following its successful halving between 2000 and 2015. While poverty can also be reduced by means of social policies, the accent of this chapter is on a macroeconomic policy consistent with the SDG goals. An appropriate policy approach includes preventative macroeconomic measures to be introduced before crises break out, and policy approaches to be adopted once unavoidable shocks hit a country. Indeed, fiscal, monetary, exchange rate, capital account, and debt management policies are shown to have an important impact on poverty eradication and income inequality.

Internal and External Liberalization, Inequality, Growth, and Poverty

This chapter presents a general framework to analyse the impact on inequality, growth, and poverty of the internal and external structural adjustment reforms introduced in a large number of the developing, transitional, and developed countries over the last three decades. It then discusses the main theories of the relation between inequality and growth and shows that the achievement of given poverty targets is influenced favourably by a decline of income inequality. This debate has acquired considerable relevance with the adoption in 2015 by the United Nations General Assembly of the Sustainable Development Goals strategy that focuses—inter alia—on eradicating poverty by 2030 and reducing income inequality to tolerable levels.