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Some economic concepts and policy issues in developing countries: What perspectives should be borne in mind by decision makers in developing countries when they are faced with economic problems?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1975
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U Tun Wai

How do the economics of developing countries compare with those of developed countries? The answer depends largely on the definition of economics.

If economics is the study of economies, then each country’s economic problem is unique and no generalization can be made. But if one defines economics as a field of study which attempts to derive universal principles regarding the allocation of scarce resources toward competing ends, then one would have to conclude that these principles of economics are applicable universally. Nevertheless, one could still discuss the relevance of a given set of principles to a particular situation.

The confrontation of a given theory with economic reality helps to determine its relevance. It also enables economists to improve a theory and make it more applicable to developing countries. From this point of view, there is scope for discussing economic concepts and issues which may be different from those in developed countries. Two further points will help to clarify the relationship between concepts and policy issues and between theories and economic realities.

The first point concerns the relevance of macroeconomic models for developing countries. Most macroeconomic models, built with developed countries in mind, are designed to approximate reality. Therefore, there is bound to be a gap (G) between the model (M) and reality (R). The relevance of the model becomes greater when G approaches zero or when the difference is one of degree and not of kind. The gap will be large if the assumptions of the model are not realistic. Since economic reality is different for developing and developed countries, one should not be surprised if the gap between the model and reality is greater for developing countries than for developed countries. Even for developed countries, when policy issues are under consideration one needs complicated models. R.G.D. Allen in the preface to his book, Macro-Economic Theory: A Mathematical Treatment (1968), states: “The models considered here, despite their formidable appearance at times, are many stages removed from policy applications. They attempt to explain how things work in precise terms. But just because of their precision, they are not easily used in any consideration of how the working of the economic system should be viewed in practice, when the strategic variables change from one situation to another. Moreover, in order to obtain precision, the models are drastically simplified to keep down the number of variables and parameters.”

The second point may be made through an analogy with medicine. Even though human beings have the same anatomy and physiology, tropical medicine is studied as a separate field of specialization. For similar reasons, development economics is studied separately in many universities throughout the world.

Thus one would expect to find economic problems in developing countries very different from those in developed countries. This analogy also helps to explain why certain parameters and the strength of some variables may be different in the two types of countries.

The techniques of economic analysis that are universally useful include ceteris paribus (other things being equal), marginal analysis, and trade-offs. Ceteris paribus enables the economist to break up a complicated problem into its components and into manageable units. Marginal analysis helps to show the policymaker the additional effort needed to solve an economic problem. Trade-offs between conflicting objectives and between alternative policy instruments highlight the nature of economics. Bearing these points in mind, we examine below some of the important economic concepts and issues facing policymakers in developing countries, without relating them to specific theories or to particular economic situations. There are other important problems which are not dealt with in this article, for example, the need to develop domestic financial markets and bring about social and other institutional changes to obtain a high rate of economic growth.

CONCEPTS AND ISSUES AT THE NATIONAL LEVEL

Per capita income

The one measure used widely by economists and policymakers to indicate material progress is per capita income (national income divided by total population). When this measure is deflated by prices to give real per capita income over time in a given country, one cannot quarrel with this indicator. But when it is used to make international comparisons, there are many pitfalls because the exchange rate does not measure the purchasing power of currencies for goods and services that are not internationally traded. Then, again, consumption patterns and needs between countries may be so different for climatic, social, and institutional reasons that per capita income may be a poor measure of economic welfare—not to mention the social costs of pollution, overcrowding of cities, and other factors which are not taken into account in computing national income.

Despite these shortcomings in evaluating material progress, policymakers in developing countries place great weight on development plans to increase total output and to reduce the so-called gap between standards of living in developing and developed countries. The first objective is desirable if it is regarded only as a first approximation of what a country really wants and if other equally desirable social objectives, such as more equal distribution of income, are not disregarded. The second objective is desirable, politically speaking, but it will be very difficult to reduce the gap since the standards of living in developed countries are rising rapidly.

Unemployment

Two views can be taken of the unemployment problem in developing countries. One is to regard the problem in the same way as in developed countries—that is, to be very concerned with it either in the form of open unemployment or of disguised unemployment. Consequently, considerable impetus must be given in development plans to increasing employment. The other view would be to point to the evils of unemployment but to put less pressure on the government to solve this problem on the grounds that the family is still an economic unit in developing countries and provides private social security. Both views are valid—the former for urban areas and the latter for rural areas; the relevance of the two views depends in part on whether the country is generally overpopulated (as, for example, India and Bangladesh) or on whether it is not overpopulated (as many African and Southeast Asian countries).

The availability of unemployed labor is both a challenge and a possibility for more rapid growth in developing countries, says W. Arthur Lewis (“Economic Development with Unlimited Supplies of Labour,” The Manchester School, May 1954). However, Ragnar Nurkse (Problems of Capital Formation in Underdeveloped Countries and Patterns of Trade and Development, 1967) believes that there are a number of problems to be overcome before excess workers in rural areas can be put to work on new investment projects in urban areas, including the cost of transporting food from farms to projects and the need to give tools to workers on these new investment projects. In short, any sizable reduction in unemployment depends on additional free resources to finance investment for infrastructure and to train unemployed workers.

Besides the question of supply of labor, there is the problem of factor proportions in developing countries, which has an important bearing on the choice of projects and the relative use of labor and capital. Since developing countries have to import capital equipment it may be desirable to choose more labor intensive projects to save foreign exchange and give employment to nationals. Furthermore, since these innovations are based on relative prices of labor and capital in developed countries, the latest machinery is not necessarily the best choice for developing countries. Hence, there should be more research and development expenditures for capital saving innovations specially suited to their něeds. If the innovations can be both capital and labor saving, as for example improved higher yielding seeds suited to the local climate, then the needs of developing countries would be well served.

“there should be more research and development expenditures for capital saving innovations”

Sometimes the unemployment problem in developing countries is said to originate from structural factors which are nonexistent in developed countries. A number of explanations have been given for the existence of structural unemployment in developing countries, many of which are related to structural disequilibrium at the factor (input) level. For example, market imperfections, technological restraints, and overpopulation have been stressed by R. S. Eckaus, (“The Factor Proportions Problem in Underdeveloped Areas,” in American Economic Review, September 1955). The policy implications of this analysis for developing countries is that one needs to improve the institutional framework and adapt existing technology to developing countries.

Nonmonetized sector

A nonmonetized sector exists in developing countries because a certain part of output produced by the villagers is purely for home consumption. It can also exist when goods are bartered rather than bought with money. The size of the non-monetized sector is believed to be important in a large number of developing countries, even though it has never been measured accurately. Such a sector also exists in developed countries—for example, when wives provide services in the home without direct monetary gain—but it is generally believed to be less important than in developing countries.

Should the authorities take this sector into account in planning? Should they take steps to monetize the sector gradually or merely ignore it? Most economists would say that it cannot be ignored and that if developing countries are to grow rapidly one must integrate such a sector into the rest of the economy, not only to motivate villagers to produce more and be more responsive to the objectives of the plan but also to enable the government to tax more heavily. Further, growth can be more rapid if there is specialization and division of labor. What better way is there to do this than to make the villager more specialized, selling his product to the market and buying practically all his needs from the market?

If the objective is growth per se and not stability of income, this view is valid. The production of goods for home consumption provides the villager with his own built-in stabilizer except when there are widespread droughts or floods. Therefore, perhaps, what is needed is not to reduce the size of the nonmonetized sector absolutely, but only relatively, by increasing the monetized sector. This can be done only if the villager will either work longer hours or use more capital to produce goods for the market without diminishing production for home consumption.

CONCEPTS AND ISSUES AT THE INTERNATIONAL LEVEL

Terms of trade

In the international field, terms of trade is perhaps the most widely used concept by policymakers, partly because it is relatively easy to understand and partly because it is convenient to explain difficulties in a country’s balance of payments. The technicalities of terms of trade are the same for both developed and developing countries. But owing to the greater sensitivity of prices of raw materials over the business cycle of developed countries, the greater dependence on fewer export commodities by developing countries, and the importance of international trade to growth, this subject has been associated more with the problems of developing countries than those of developed countries.

By the terms of trade is meant the ratio of export prices to import prices over time with a fixed base year. Terms of trade are said to improve when export prices rise more rapidly (or fall less rapidly) than import prices or when export prices rise while import prices fall. When this occurs a country is able to obtain a larger volume of imports for a given quantum of exports. There is a deterioration in the terms of trade when the reverse happens.

There are a number of technical questions before terms of trade can be used as a basis for policymaking. First, the terms of trade should be measured in foreign currency prices; they can also be measured in local currency prices provided the conversion factors are the same for both exports and imports. Complications arise when there is a marked shift over a period in the commodity mix of exports and imports. Then there is the question of the choice of the base year. If the chosen year is one when export prices are relatively high, then the terms of trade will appear to be unfavorable in the subsequent period. If export prices are low in the base year, then the terms of trade will appear unrealistically favorable. While policymakers may have special reasons for choosing one year over another, one could partly avoid the base year problem by fitting trend lines to export prices and import prices and then compare the two trends. Even here, there is the question of what overall period one should consider. How far back should one go to make such a comparison?

“cartels for other commodities are not likely to have the same success as OPEC because there are close substitutes for other raw materials”

The policy objective of not wishing to allow a country’s terms of trade to deteriorate is commendable but the means to achieve this objective are neither simple nor clear cut. Judging from innumerable speeches at international conferences, policymakers in developing countries rely a great deal on urging their more developed trading parties to maintain the demand for raw material exports from their countries, while taking appropriate steps to prevent the prices of industrial products from rising. Such exhortations have some propaganda value but have not prevented terms of trade from fluctuating or deteriorating according to changes in market conditions.

More recently, the oil producing countries have succeeded in improving their terms of trade through restricting output and raising the export price of oil. Their success has resulted partly from the solidarity shown by the OPEC (Organization of Petroleum Exporting Countries) countries and partly by the inelastic demand for oil, at least in the short run. While other developing countries would like to take similar measures to improve their terms of trade, cartels for other commodities are not likely to have the same success as OPEC because there are close substitutes for other raw materials.

International inflation

In the 1950s and early 1960s it used to be thought that mainly developing countries suffered from chronic inflation. During the past ten years, inflation has become a world-wide phenomenon, and there are many developed countries, such as Italy, Japan, the United Kingdom, and the United States, where the inflation level is now measured in double digits (that is, above 9 per cent a year), and exceeds that of many developing countries. This phenomenon is all the more remarkable when we consider that most industrial countries experienced a long period of about two decades of relative price stability and growth. The recent period of inflation is different from some of the earlier ones because price increases are accompanied by declining output and rising unemployment, and hence the term “stagflation.”

While it is not our main concern to analyze the causes of this change in the world situation, all periods of inflations have excess demand situations with some cost-push elements; some of the basic reasons might be

  • a slowing down of the rate of technical advance in industrial countries which formerly helped to raise labor productivity to match the demand for higher money wages,

  • pre-empting by governments in developed countries of bigger shares of the gross national product for government consumption and national defense, financed to a large extent by central bank credit,

  • the rapid expansion of output in industrial countries leading to a world-wide boom in prices of primary products which, in turn, through the foreign trade multiplier, increased imports of industrial products by the developing countries,

  • the breakdown of the built-in safeguards among industrial countries; in the past there was considerable slack in the capacity to produce output in other countries whenever one country was in a boom period. (In other words, the timing of business cycles was not coincidental in the early postwar period, but in the last decade business cycles have become more synchronized.),

  • the breakdown of the Bretton Woods system and the temporary abandonment of the fixed exchange rate system.

The interrelationships between inflation and exchange flexibility were discussed by H. Johannes Witteveen, the Managing Director of the Fund, in the March issue of Finance and Development. Although dealing mainly with developed countries, his views are also relevant to some developing countries.

A major policy issue before planners in developing countries is how to take policy measures to reduce the impact of world-wide inflation, or alternatively how to learn to live with a changed world situation. First, before a developing country can take offsetting measures, it should ensure that domestic pressures are not adding to domestic or world-wide inflation. Otherwise it will be pointless to take measures to fight international inflation while letting domestic inflation go unchecked. Second, it must have the financial strength to resist the effect of world-wide inflation which many developing countries do not possess. The ability to counteract imported inflation is lower in developing countries than in industrial countries.

In brief, the policymaker has to decide how to insulate the domestic economy from the effects of inflation abroad. If the prices of exports rise at least as fast as import prices and foreign exchange reserves are adequate or rising, then an appreciation of the exchange rate would tend to keep domestic prices in local currency unchanged. Since all export prices and all import prices do not move in step, some adjustment problems may have to be faced, such as a slowing down of the growth rate (especially if prices of imported capital goods rise faster than imported consumer goods), or a loss of foreign exchange reserves, or a combination of both.

It is not possible for any economy to insulate itself completely. Therefore, domestic incomes policy, especially the determination of wage rates in different sectors, that is, export versus home market, changing the relative size of government and private sector, and the relative shares of fixed income versus business profits, and so on, will have to be reviewed and adapted.

Floating exchange rates

The Bretton Woods system of fixed exchange rates based on an international dollar-gold exchange standard received a considerable setback in August 1971 when the United States suspended the convertibility of the dollar into gold, and the de jure or de facto floating of more and more key currencies since that date. Therefore, in recent years most developing countries have had to make a choice from among complete floating, pegging, or maintaining the value of their currencies in relation to one key currency while allowing the value in relation to other key currencies to vary. This has been in marked contrast to the situation under the Bretton Woods system when a developing country could be assured that linking the value of its currency to one key currency automatically maintained its relation with respect to other key currencies as well.

For some countries in the French franc area (mainly in Africa) and the dollar currency area mainly in Latin America), the choice has been made with little hesitation because of important trading and financial relations with the dominant key currency country. But even for them, there have been adjustment problems not only for some transactions in the balance of payments, such as travel and minor exports, but also for long range policies aimed at diversifying international trade. For other developing countries in Africa (for example, the Malagasy Republic, Nigeria, and Zambia) and in Asia (for example, Sri Lanka and India) which had become integrated with many currency areas and where trade and financial relationships were not dominated by any one country, neither the choice nor the adjustment problems have been easy. In the three East African countries of Kenya, Tanzania, and Uganda, which belong to a common customs area and share certain intergovernmental services, such as transport, the choice has been further complicated by differences of opinion as to what key currency their currencies should be pegged to.

It is for these reasons that in the recent discussions on international monetary reform, the developing countries generally have been very strongly in favor of restoring the par value system as it operated before August 1971. In the envisaged new system the exchange rate mechanism will remain based on stable but adjustable values, but there is provision for countries to adopt floating rates in particular situations, subject to Fund authorization, surveillance, and review. (“Outline of Reform, June 14, 1974” in International Monetary Reform Documents of the Committee of Twenty). Meanwhile, the Executive Board of the Fund on June 13, 1974 adopted a decision on guidelines for countries with floating exchange rates. The Fund Executive Board decision is too recent to fully assess how it will operate. The important economic policy question, however, is what key currency a developing country should be linked to. This in part depends on whether the key currency itself is floating or fixed in relation to other key currencies.

This policy question can be decided in part by comparing the net benefits to be gained from linking to alternative key currencies. Although noneconomic considerations will play a role, the following economic considerations should be taken into account: the prospects of the provision of a stable and expanding market for the exports of the developing country by the key currency country; the prospects of foreign capital, both private and official, flowing in to finance temporary balance of payments deficits and to provide additional resources for financing economic development; the relative financial strength of the key currency in relation to other currencies, especially whether it is more inflation-prone than that of other industrial countries. This point is particularly important in view of the present phenomenon of world-wide inflation, and the efforts of most developing countries to resist the importation of inflation.

One could add to the list of considerations by including the amount of debt owed to the various key currency countries, the stock of foreign investments in the developing countries, and so on. But all these points can be included in the category of relative financial strength of the developing country and the key currency country. It is natural for a country to wish its currency to be linked to the strongest currency, but if its currency is likely to lag greatly behind, then the developing country will suffer from an overvalued currency. On the other hand, if its currency is linked to too weak a key currency, then it is apt to find that its foreign assets in terms of other key currencies will rapidly diminish in value. Therefore, a policymaker can choose a key currency only slightly stronger, relatively speaking, in the balance of payments field. It may also be possible to link with a very strong key currency but not follow suit, either in whole or in part, whenever the key currency is revalued. Similarly, a country could link with a less strong key currency and not follow suit, either in whole or in part, whenever the key currency is devalued. But these alternative approaches will not, of course, provide the advantage of at least a bilateral “par value-fixed exchange rate system” in a floating world.

Specialization needed

The developing countries’ preoccupation with growth, as well as the structural differences between them and the developed countries, will justify specialization in techniques of economic analysis. This can be achieved by exercising care in applying the basic principles of economics and models to developing countries, because, in a one-world economy, the interests of developing countries may not always coincide with the interests of developed countries, at least in the short run.

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