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.