Access to technology and other issues

1. The industrial development of developing countries is hampered by their lack of technologies. Give two major reasons with brief explanations as to why the developing countries lack access to appropriate technology.

New technologies tend to naturally diffuse throughout the areas where they are most useful. Depending on their level of development, different countries may obtain access to new technologies at different times. The first consideration is usually a cost-benefit analysis. For instance: usually, technologies seek to replace labour-intensive activities with a more capital-intensive approach, e.g. replacing oxen with tractors. However, a cost-benefit analysis carried out in a developing country where oxen are relatively plentiful and cheap, and where tractors are expensive to import and maintain, will conclude that it is still more cost-effective to use oxen over tractors. Supposing the cost-benefit hurdle is cleared, new problems will arise. Since new technology must almost always be imported, and since there is usually a learning curve in the operation of the new technologies, the technical assistance and knowhow to maintain and repair the technologies must also be imported, which dampens their effectiveness and stunts the growth of the domestic labour market. Moreover, the rapid obsolescence of new technologies perpetuates the game of catch-up, which further enhances the labour market deficiencies in domestic economies.

2. Briefly explain why capital formation is considered to be an essential ingredient of economic expansion and diversification.

The formation of new physical and human capital lies at the crux of economic growth, because growth depends on the discovery and utilisation of new efficiencies and markets. The formation of new human capital drives innovation and entrepreneurship, which are essential for a vibrant business environment and elimination of inefficiency and waste. Increased human capital brings about the formation of new physical capital--new goods--or creates more efficient methods of production via greater competition. At the same time, increased efficiency enhances competition and creates new markets in a feedback loop. Successful models of entrepreneurship and innovation encourage further investment, and this promotes economic growth.

3. Suppose you are given a set of differential rates of inflation for a group of market-type economies. What effects might such differences have on exchange rates in the short and long run under flexible and fixed exchange rate systems?

Flexible exchange-rate systems, such as a float or a managed float, will allow money to flow to the most profitable currencies. Assuming macroeconomic policies and interest rate regimes are all identical in the given economies, monies will flow into the economies least affected by inflation, where the funds' value will depreciate the least. The influx of investment into the lower-inflation economies will cause upward pressure in prices and wages, which will increase inflation. At the same time, the outflow of funds from high-inflation economies will exert downward pressure on prices and wages and will prompt banks to raise interest rates in order to attract savings, all of which will lower inflation. The long-term result, barring any external shocks, will be an equalisation of inflation rates among the given economies.

Under a fixed exchange-rate regime, the situation will differ slightly depending on each country's monetary policy. Assuming all the economies have identical fixed exchange-rate regimes, the short-term result of an endogenous rise in inflation in one country will be pressure on the peg and, if the pressure is not relieved via open market operations (OMOs), the formation of a black market in forex. This is where monetary policy will come into play: central banks cannot control black markets, but they may dampen their usefulness with good management of the money supply and interest rates. In an inflationary environment under a fixed exchange rate, a central bank may raise interest rates (and occasionally reserve requirements) to discourage investment flight. The central bank may also carry out OMOs in the form of issuing debt in order to take excess money out of the financial system, thereby creating incentives to save.

4. Specify under which conditions a country can show a current account surplus at the same time as a trade balance deficit. Specify also the conditions under which the current and trade accounts are in deficit while the overall balance of payments is in surplus. Briefly discuss.

Disclaimer: I had to cheat for this one. Wikipedia ftw.
A country's current account is defined as its trade balance plus net factor income and net unilateral transfers from abroad. Therefore, a country may show a trade balance deficit--i.e. it has imported more than it has exported--but still possess a current account surplus if the net factor income and net unilateral transfers from abroad exceed the trade balance deficit.

The balance of payments is composed of the sum of the current account, the capital account, and the financial account. Therefore, if both the current and trade accounts are in deficit, a country may still show an overall balance-of-payments surplus if the sum of the capital account and the financial account exceed the current account deficit.

5. If the income elasticity of imports in a developing country is 1.75 and GNP is growing at 7 percent per annum, at what rate would you expect real imports to grow on average? Give two reasons why the growth of imports tends to out-strip the growth of GNP and exports in developing countries. Discuss three possible policies designed to curb the rate of growth of imports.

The growth of imports tends to outstrip the growth of GNP and exports in developing countries due to the increased reliance on debt as a source of domestic funds. The growth rate of imports can be curbed via import tariffs and quotas.

6. Discuss the economic rationale and the goodness of statistical fit of the statistically estimated relationship set out below. Would the estimated relationship suggest policy recommendations?

C(t) = 100.27 + 0.73 Y(t) - 1.25 r(t-1)
(1.06) (4.17) (-0.35)

R-sq = 0.922
DW = 1.73
n = 37

C(t): private consumption in real terms;
Y(t): personal disposable income deflated by the consumer price index;
r(t): Nominal interest rate minus the rate of increase in consumer prices.

The equation above would seem to indicate a statistically significant correlation between private consumption in real terms (C(t)) and personal disposable income deflated by the consumer price index, and no significant correlation between C(t) and the nominal interest rate minus the rate of increase in consumer prices. However, there are serious problems with this regression. The sample population is extremely small at 37 observations, which is barely enough for a statistical regression under the central limit theorem. The value of R squared is huge for a statistical relationship, suggesting there exist significant autocorrelation and endogeneity problems in this regression.

7. An investment project is expected to yield, in constant dollars, returns of $100, $100 and $1,100 at the end of 1, 2 and 3 years respectively and nothing thereafter. If the investment costs $1,000 now, would it be profitable at an expected real interest rate of 8 percent per annum? 12 percent?

Using the compound interest formula E = Ae^rt, saving $1000 would yield $1271.25 after three years at 8% interest and $1433.33 at 12% interest. Therefore, the investment is profitable under the 8% interest rate regime but not under the 12% interest rate regime.

8. Given a fiscal deficit, describe two ways in which such a deficit could be financed and explain whether each way would have different impacts on the economy.

There are only two ways to finance any deficit: spend less or issue more debt. Spending less will ease the deficit but will be painful financially and politically, while issuing more debt will deepen it but delay the pain. To spend less government services and consumption must be cut or scaled back, and maturing debt must be repaid. This may be contractionary in the short term, depending on the health of the private economy and its size relative to the public economy, but it is likely to provide for a healthier economy in the long run given that a reduction in debt will likely be passed on to the citizenry in the form of a lowered tax burden.

The issuance of more debt to finance a fiscal deficit is liable to have a short-term stimulating effect on the whole economy. However, depending on what the source of the additional debt is, what the terms of repayment are, and how that additional debt is managed, the long-term result is likely to be counterproductive, as the debt will eventually be passed on to the people in the form of new or higher taxes. Furthermore, mismanaged debt usually results in macroeconomic instability in the form of inflation and misdirected appropriations.

9. It is said that, under fixed exchange rates, countries lose control over monetary policy, while under flexible exchange rates they have full control over this policy instrument. Explain briefly your agreement or disagreement with this statement.

Economic theory holds that countries must make trade-offs regarding the following: (1) Free capital movements, (2) a fixed exchange rate, and (3) the ability to effectively use monetary policy. This is called the "Impossible Trinity", because it is not possible to have all three at once; countries must choose which two they prefer and renounce the third. Under fixed exchange rates, countries may still control monetary policy if they restrict free capital flows. Currently, China is the preferred example of this: the yuan renminbi is pegged to the dollar, and Chinese authorities can still use monetary policy to regulate the economy as capital flows are strictly regulated. In Western countries where capital movement has been liberalised, however, countries must choose between monetary policy or a fixed exchange rate. Britain, for example, has opted to retain use of monetary policy and allowing the pound to float; while most of continental Europe has renounced independent monetary policy in order to peg their currencies to the Euro.

Therefore, the statement above is correct only if we assume that capital flows are unregulated.

10. Many countries in the world are seeking to privatise their public sector enterprises. What difficulties do you see for a developing country in such privatisation?

Public sector enterprises (PSEs) often are inefficient because they do not adequately respond to market incentives. However, this is not just a curse; in many cases, it is also a blessing, because often public projects have goals that markets have continually failed to reach, and as such are probably unprofitable and unattractive to private enterprises. Examples include building of roads to remote populations, expanding electricity and potable water supply to these areas, and building appropriate education and health infrastructure there. Once these are set up, governments have an incentive to keep costs for these services low, while market-based solutions often will not. Therefore, the overarching difficulty privatised PSEs face is maintaining a minimum level of service and expanding service to hard-to-reach/unprofitable populations even while maintaining overall profitability.

Another set of difficulties developing countries will face in privatisation of PSEs is the proper and orderly transfer of the PSE from government to private control. There are many ways for the process to fail. If the wrong auction model is chosen, PSEs may end up being sold at far below their market value. If collusion between potential buyers is not spotted and action is not taken, the same could happen. If there is corruption at the government level, the PSE may be underpriced or sold to a favoured bidder rather than the highest bidder, thus robbing the state of a vast amount of funds. There are many other ways the transfer process can go awry.

Finally, another difficulty privatised PSEs may face is proper management under private ownership. It is not uncommon for a privatised PSE to function for a few years, find it cannot maintain profitability, and neglect infrastructure for years before something vital fails and the state is forced to re-enter the picture, re-nationalise the project, and take on the financial burden of years of neglect. The state has an obligation, even under the privatised model, to carefully audit and supervise the maintenance of the infrastructure. Though it is privatised, the state must still function to protect the interests of the citizenry.

The international division of labour

What are the main determinants of the international division of labour? In which types of economic activity has this division of labour progressed the most and what are its global advantages? Give examples based on the experiences of one or more countries.

The international division of labour is, for the most part, predicated on the benefits of economic specialisation. National economies most fully integrated into the global economy have experienced a shift towards the most efficient use of its resources, be they human resources, national capital, or geography. Economic activities that are easily transferrable between persons and require minimal capital investment are the likeliest to thrive in a globalised environment, as business will naturally flow to the most cost-effective solution. This partly explains the rise of manufacturing in Asia, the rise of financial services in the developed world, and the rise of information technology services in India, among other trends.

Economic specialisation pertains to any kind of economic activity performed by human agents where voluntary exchange of goods or services takes place. Any mutually beneficial exchange that has a locational advantage will be more successful--i.e. derive more profits--in that location. So, for instance, one may suppose there are two factories operating with identical constraints and producing identical products. However, if one factory is closer to the town marketplace, it will derive an economic advantage from lower transportation costs to the market and will be able to undercut its opponent. This is the essence of economic specialisation. However, specialisation includes not just factors of distance, but also human and physical capital. If workers are more skilled in one area of production in a particular country, they are likelier to derive greater benefit from focusing on production in this particular area of expertise. They needn't have an absolute advantage over other countries in production of this product, as long as they have a comparative one.

Thus has the international division of labour seen manufacturing jobs flow to countries where unskilled manual labour is cheaper--the developing world; and where domestic regulations favour direct business investment--East Asia. Cheap labour, combined with a stable macroeconomy and thus a favourable business climate, have been largely responsible for the rise of manufacturing in China in the past two decades. In contrast, areas such as Latin America, while possessing a surplus of cheap unskilled labour, fared comparatively less well in attracting manufacturers due to their comparatively higher wages for unskilled labour and their often unstable macroeconomies.

The comparative specialisation of financial services in the developed world stems again from the labour force. The developed world possesses a firm advantage in skilled labour, and given that financial services are highly flexible enterprises due to the international nature of financial capital, financial firms are likeliest to headquarter in highly active urban centers with the most advantageous proportion of skilled labour. Thus New York, London, Tokyo, and so forth are well-positioned to take advantage of this trend.

Information technology services are perhaps the most easily diffused and least cost-intensive of the new economy. A country such as India has many natural advantages in providing this service, e.g. a large population versed in English and a depressed wage level for unskilled labour. This has resulted in extraordinary savings for information technology firms (and thus consumers of such technology) as they are able to service many more customers via India than would otherwise be possible. At the same time, it has awarded India a comparative advantage in the area of information technology services via network effects.

Availability of certain forms of physical capital can also be a crucial comparative advantage in certain industries. Depending on their geography, countries may possess farming, ranching, mining, and other advantages over others. Countries near the equator will be better at producing bananas, and countries with mediterranean-like weather conditions will produce better wine. Geography can also be crucial in specialising labour towards trade services. Places like Singapore, Hong Kong, Panama, and Sinai possess natural geographical advantages that encourage growth and investment in trade and all aspects of services associated with trade.

Economic specialisation, whether it be absolute or comparative, is largely responsible for the current international division of labour. Countries, just like individuals, will specialise in whatever discipline or area best suits them based on their endowments and levels of investment in education and physical capital. The most cost-effective solution will tend towards the most profits and the most success, both domestically and internationally.

Debt servicing in the developing world

The debt servicing problem of developing countries has been a matter of continuing concern since the early 1980s. What are the factors that contributed to this problem? What were the domestic effects of rising external debts? What measures have been undertaken to alleviate this problem? What kinds of policies would you recommend for alleviating the balance of payments difficulties of affected countries?

The developing world was caught up in a global paradigm shift in the late 70s and early 80s when the price of oil spiked due to collusion among OPEC members and international banks were flooded with oil proceeds (the so-called petrodollars) from oil-producing nations. Banks lent the excess petrodollars to developing countries based on over-optimistic expectations of future growth, a sustained high price for oil, and ability and willingness of the recipient nations to pay back. Once the domestic governments realised that their expectations were unlikely to materialise, it was too late in some cases, and balance-of-payments crises ensued, along with high inflation and eventual default on loans. In most cases, these government's myopic profligacy and out-of-control spending was to blame for much of the suffering that followed the end of the petro-fuelled boom. Fiscal restraint, along with sound macroeconomic policies of a countercyclical nature, remain the best preventive against future crises such as this.

The formation and eventual supremacy of OPEC in the world oil markets was largely the beginning of the future balance-of-payments crises of the 1980s. Flooded with foreign currency, host countries deposited their extra proceeds in large multinational banks, who in turn lent several times the amount to developing nations at high interest rates. The governments of developing countries, perpetually strapped for investment, were eager to receive these investments, which were often backed by the international community. Putting aside the issue of corruption or misuse of these now public funds, many times the investments were improperly accounted for in governmental budgets. This was especially true in oil-producing developing nations that were also receiving loans, because budgets were constructed with the expectation of a high oil price built into the equation. Finally, not all governments spent the loan funds efficiently: many were run in a populist fashion that precluded long-term planning and emphasized short-term gain for government agents in office. This continued to be a problem when the crisis unfolded and countries were unable to easily repay: populist governments were likelier to default on loans rather than risk losing political support from their political base, which were often composed of the same people that had benefited from the boom.

As rising external debts mounted during the 1980s, a twofold process took place. Firstly, the global economy slumped and import proceeds fell, constraining the inflow of tax funds. This was combined with a reduction in foreign direct investment and in loans from banks, and it sharply constricted domestic government's purses. Secondly, as national debt matured and was paid with further debt issuance, while at the same time income fell, sovereign debt-income ratios became less and less attractive, to the point where the banks and investors most strapped for cash began refusing new debt issuance and demanded repayment. These two effects combined led to balance-of-payments crises in several countries, e.g. Mexico and Brazil. Deep recessions followed when governments, in an effort to stymie a recession, began to repay debt by simply printing more money without having sufficient foreign reserves to back up the new issues. This worsened the situation further by causing massive inflation as both foreign and domestic consumers lost confidence in these particular currencies. Eventually, the situation became unsustainable and the affected countries suffered deep recessions as debt and imports income dried up, while debt payments due ballooned.

In the years since, contingency plans to prevent similar future crises have been created, and a set of fiscal and monetary guidelines, known as the Washington Consensus, has been promoted among liberal governments to minimize the danger of a repeat. Fiscal restraint and planning is the most obvious of the bunch. To achieve this, the independence of the central bank is encouraged as not just a way to ensure that monetary policy is not politically motivated, but also to project an image of fiscal responsibility to outside investors. Also encouraged is the creation of a countercyclical policy, such as Chile's copper fund. Such policies are tasked with achieving budgetary balance during recessionary periods and with saving and safe investing in boom periods. Finally, to promote openness and transparency, governments are encouraged to disclose the necessary financial and accounting information to international bodies and potential investors.

What if a balance-of-payments crisis is already underway, despite all these safeguards? Assuming an outside "rescue package", such as what Mexico received during the Tequilazo of 1998, is out of the question, there are a few steps domestic governments can take to minimise the pain. One of the first priorities of the government is to ensure the outflow of money is stopped and reversed. The Central Bank will play a crucial role in raising interest rates and properly managing the amount of domestic currency issued to minimize inflation and attract savings. Debt relief or renegotiation with creditors is another top priority in times of balance-of-payments crises. Economies inevitably contract during these crises; therefore, governments have the important job of offering the right stimuli to domestic and foreign businesses not only by maintaining sound macroeconomic policies but also by creating business incentives in the form of lowered or cancelled tariffs, preferred tax regimes, and streamlined legal processes for registering and maintaining businesses.

Time: 1hr 6min

Industrialization and redistribution

There have been serious disagreements in the literature on economic development as to the strategies that developing countries should follow to foster the development process. Two unsettled issues refer to: (1) the advantages of stressing agriculture or of fostering industrialization; (2) policies that take as given the current income distribution and depend on a trickle-down of the fruits of economic growth to the poorer segments of the population, as against a a strategy heavily oriented towards meeting basic needs. Discuss in detail these two controversies and how the current world economic situation affects them.

Democratic governments in developing nations have their preferences for economic development paths set in often contradictory or contrarian ways, for while it is possible to pursue many development policies at once, ideology--which is an important factor in politics in most democratic governments--may get in the way of practicality. So it is with agricultural versus industrial development and with trickle-down economics versus redistributive economics. The debate of agriculturalists versus industrialists may vary according to domestic contexts, but usually agriculturalist arguments assume a degree of autarkic control over the domestic food supply is a necessary good, and attach great importance to the sustainability of farmer livelihoods. Industrialists, on the other hand, stress the need for technological innovation and greater connection to the mercantile world in order to achieve prosperity, and may argue that control over the domestic food supply is good, but not necessary. Similarly, the clash over proper usage of redistributive policies may differ by region. Those embracing redistributive arguments tend to express alarm at widening income gaps and stress the need for properly funded social services such as schools, hospitals, and police departments. Meanwhile, the trickle-down camp will argue that redistribution hampers entrepreneurship and innovation, causes domestic talent to flee to societies where they will be better able to prosper, and discourages domestic and foreign investment. Naturally, all arguments are affected by current events and the relevant economic situations of the time.

Agricultural development policies have varied proponents, but most put forth a certain set of similar arguments: food security, the preservation of farmer societies, and the concomitant stability that this implies. Arguments for food security stem from varied concerns about the wisdom of the importation of food. Proponents of food security mostly tend to fear that a loss of control over the nation's food supply may endanger national survival if the producer nation refuses to sell, or is unable to sell food to the consumer nation. These fears are not unfounded, as the recent spike in food prices around the world had many poorer countries scrambling to outbid each other for supplies. In times such as these, food security arguments become much more convincing. However, some nations that import all or most of their food, such as Singapore or Malta, having no choice but to import, outgrew these arguments early on.

The preservation of farmer's livelihoods is another relevant topic for agriculturalist arguments. Apart from the cultural and anthropological gains that preservation implies, there is the politically sensitive issue of the preservation of stability, which is what governments are usually most concerned with. Typically developing nations will have large farmer constituencies, which though disenfranchised to some degree, are able to wield enormous amounts of political influence if and when they feel the government has betrayed them or somehow sold them short. The emphasis on preserving farmer societies stems from the need of governments to maintain a status quo where this potentially explosive constituency will stay in check. There have been instances of governments being toppled when they have failed to satisfy or have neglected this constituency, e.g. Ecuador in the late 90s and early 2000s.

The industrialist camp often attacks agriculturalists with efficiency arguments and points to the most successful development stories, like Korea and Taiwan, for support of industrial policies. The benefits of specialisation are touted as answers to poverty and underdevelopment. Technological innovation and globalisation are seen as the way towards greater economic prosperity, while the need for food security is downplayed. Indeed, the most successful stories in economic development show that industrialisation can peacefully and stably deliver prosperity and mitigate poverty on a national level. To achieve such prosperity, however, there are many governance and macroeconomic prerequisites domestic governments must fulfil before embarking on successful industrialisation campaigns: government must be transparent, open, and democratic; it must successfully prosecute corruption and reward efficiency; and it must promote investment and stability. Monetary and fiscal policy must move in lockstep to fight inflation and minimise waste.

In this time of globalisation and global recession, both arguments can profit from the situation. Agriculturalists may point to the unfolding fiscal crises in the least liquid countries and argue that a crisis of food security could be averted if production was local rather than imported. Industrialists may argue that attaining specialisation in the right products lends any country a competitive edge that will fend off recession and keep imports flowing.

The arguments over the proper use of redistribution have a long history and have fierce ideological and philosophical backings; however, the basic tenets of the more liberal and more conservative approaches may be briefly analysed. While liberal redistributionists argue of the necessity of providing governmental social services, conservatives argue higher taxation discourage entrepreneurship and thus hamper economic innovation and prosperity; the liberal perspective emphasizes social equality while the conservative stresses efficiency.

The conservative approach bases itself on the economic assumption of self-interest and the incentives that align to foster entrepreneurship and innovation. Entrepreneurs are individuals that invent new concepts or products that they disseminate or sell at a profit, or that seek opportunities to exploit new markets via price arbitrage. The economic argument against greater redistribution is based on opposition to the higher taxes that redistribution presupposes. Higher taxation deprives those who do not derive their sustenance from the government--a category that includes entrepreneurs--from a greater part of the fruits of their labour. Once a certain critical point is passed, entrepreneurs have no self-interested incentive left to pursue their ideas or exploit their knowledge of arbitrage opportunities. The society as a whole loses out on the efficiencies that would have otherwise been created.

The liberal approach, on the other hand, argues that society as a whole benefits most from a healthy, educated, lawful populace, and that a sustainable economic model must take into account the well-being of all citizens over the self-interest of its wealthiest, as only then will maximum efficiency--labour and otherwise--be achieved.

The current economic crisis has seen divergent arguments for both of these viewpoints. Liberals may argue that government spending on services and human resources are the best way to emerge successfully from recession, citing both humanitarian and countercyclical Keynesian arguments. At the same time, the conservative model sees increased spending as wasteful for two reasons: firstly, most government spending in times of recession is politically geared towards short-term consumption rather than long-term investment; and secondly, because most of this spending is financed with issuance of debt, which must be eventually repaid and is therefore merely pushing the pain of the current recession into the future, when taxes will inevitably be raised to pay both principal and interest.

Although invariably governments around the world must respond to the current economic crisis, it will be of much interest down the road to study and comprehend the reasons behind the failure or success of particular cases.

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