WOLAI

TASODOUNI
VERSI
TY
COLLEGEOFBUSI
NESSANDECONOMI
CS
DEPARTMENTOFECONOMI
CS

MODULENAME
BASI
CMACROECONOMI
CS
(
MACROECONOMI
CS&DEVELOPMENTECONOMI
CS)

Compi
ledBy
:
Af
eworkBerhanu(
AssistantProfessor)
Bi
rhanuHankamo(AssistantPr
of essor
)

Wol
ait
aSodo,Et
hiopi
a
March,
27/2023

1
Tabl
eofCont
ent
s
Chapt
erOne 5
I
ntr
oduct
iont
oMacr
oeconomi
cs 5
1.
2TheSt
ateofMacr
oeconomi
cs:Ev
olut
ionandRecentDev
elopment
s 5
Chapt
er-Two 8
Nat
ional
IncomeAccount
ing 8
Real
GDPv
ersusNomi
nal
GDP 9
GDPDef
lat
or 9
Ot
herMeasur
esofI
ncome 10
TheConsumerPr
iceI
ndex(
CPI
) 11
Measur
ingJobl
essness:
TheUnempl
oymentRat
e 12
TheBusi
nessCy
cleandt
heOut
putGap 13
CHAPTERTHREE 15
AGGREGATEDEMANDI
NTHECLOSEDECONOMY 15
3.
1Foundat
ionsoft
heTheor
yofAggr
egat
eDemand 15
TheMoneyMar
ketandt
heLM Cur
ve 20
TheTheor
yofLi
qui
dit
yPr
efer
ence 21
I
ncome,
MoneyDemand,
andt
heLM Cur
ve 22
CHAPTER-FOUR 24
AGGREGATEDEMANDI
NTHEOPENECONOMY 24
ExchangeRat
es 29
Exchanger
ateDet
ermi
nat
ion/
Fixedv
ersusFl
exi
bleExchanger
ateRegi
mes/ 30
TheMundel
l
-Fl
emi
ngModel 31
Smal
lOpenEconomywi
thPer
fectCapi
tal
Mobi
l
ity 32
CHAPTERFI
VE:
AGGREGATESUPPLY 37
TheLongRun:
theVer
ti
cal
Aggr
egat
eSuppl
yCur
ve 38
Cour
seTi
tl
e:Macr
oeconomi
csI
I 41
Chapt
erOne 41
Behav
iour
alFoundat
ions:
Theor
iesofConsumpt
ion 41
JohnMay
nar
dKey
nesandt
heConsumpt
ionFunct
ion 41
Secul
arSt
agnat
ion,
SimonKuznet
s,andt
heConsumpt
ionPuzz
le 43
I
rvi
ngFi
sherandI
nter
tempor
alChoi
ce 44
Fr
ancoModi
gli
ani
andt
hel
i
fe-
cycl
eHy
pot
hesi
s 47
Mi
l
tonFr
iedmanandt
hePer
manent
-I
ncomeHy
pot
hesi
s 48
Rober
tHal
landt
heRandom-
Wal
kHy
pot
hesi
s 49

2
CHAPTERTWO 49
I
NVESTMENTTHEORY 49
Thr
eet
ypesofI
nvest
mentSpendi
ng 49
Resi
dent
ial
Inv
est
ment 54
Chapt
er3:
MoneyDemandandMoneySuppl
y 56
Chapt
er4:
TheLabourMar
ket 61
Neocl
assi
cal
Micr
oeconomi
csModel
OfTheLabourMar
ket 61
TheNeocl
assi
cal
Theor
yofLaborSuppl
y 61
TheNeocl
assi
cal
LaborMar
ket 64
Unempl
oymenti
ntheNeocl
assi
cal
Model 64
Keynesi
anvi
ewsoft
heLaborMar
ket 65
CHAPTERFI
VE 68
Macr
oeconomi
cPol
i
cyDebat
es:
Stabi
l
izat
ionPol
i
cy 68
Chapt
erSi
x 71
Model
sofMacr
oeconomi
cGr
owt
h 71
TheHar
rod-DomarGr
owt
hModel 71
TheSol
owNeocl
assi
cal
Growt
hModel 73
Gr
owt
hint
heCapi
tal
Stockandt
heSt
eadySt
ate 74
EndogenousGr
owt
hTheor
y 78
Chapt
er7:Macr
oeconomi
cTheor
iesandAf
ri
canEconomi
es 80
Macr
oeconomi
cTheor
iesandAf
ri
canEconomi
es:
Anov
erv
iew 80
DEVELOPMENTECONOMI
CSMODULE 82
DEVELOPMENTECONOMI
CSI 82
CHAPTERONE 82
Economi
csofdev
elopment
:concept
sandappr
oaches 82
Chapt
ert
wo 86
St
ruct
ural
feat
uresandcommonchar
act
eri
sti
csofdev
elopi
ngcount
ri
es 86
Thesi
zeoft
hecount
ry(
geogr
aphi
car
ea,
sizeofpopul
ati
on,
andi
ncomel
evel
s) 86
I
tshi
stor
ical
andeconomi
cal
backgr
ound 87
I
tendowment
sofphy
sical
andunmanr
esour
ces 87
I
tset
hni
candr
eli
giouscomposi
ti
on 88
Ther
elat
ivei
mpor
tanceofi
tspubl
i
candpr
ivat
esect
or 88
Thenat
ureofi
tsi
ndust
ri
alst
ruct
ure 89
I
tsdegr
eeofdependenceonex
ter
nal
economi
candpol
i
tical
for
ces 89
Thedi
str
ibut
ionofpowerandt
hei
nst
it
uti
onal
andpol
i
tical
str
uct
urewi
thi
nthenat
ion.

3
 90
CommonChar
act
eri
sti
csofDev
elopi
ngCount
ri
es 90
Lowlevel
sofl
i
ving,
char
act
eri
zedbyl
owi
ncome,
inequal
i
ty,
poorheal
th,
andi
nadequat
e
educat
ion 91
CHAPTERTHREE 94
Gr
owt
hModel
sandTheor
iesofDev
elopment 94
Gr
owt
hModel
s 95
TheHar
rod-
DomarGr
owt
hModel 95
TheSol
owModel 97
Theor
iesofDev
elopment 98
Rost
ow’
sSt
ageofEconomi
cgr
owt
h 98
CHAPTERFOUR 100
Hi
stor
icGr
owt
handCont
empor
aryDev
elopment
:Lessonandcont
rov
ersi
es 100
CHAPTERFI
VE 105
I
NEQUALI
TY,
POVERTYANDDEVELOPMENT 105
I
nequal
i
tyandAbsol
utPov
ert
y 108
DEVELOPMENTECONOMI
CS-
II 110
CHAPTERONE 110
Popul
ati
onGr
owt
handt
heQual
i
tyofLi
fe 110
Wor
ldPopul
ati
onGr
owt
hthr
oughHi
stor
y 111
TheHi
ddenMoment
um ofPopul
ati
onGr
owt
h 112
Thecausef
orhi
ghf
ert
il
it
yinLDCs 112
Mal
thusi
anPopul
ati
onTr
ap 112
TheMi
croeconomi
cHousehol
dTheor
yofFer
ti
li
ty 112
UNI
T TWO 114
HumanCapi
tal
:Educat
ionandHeal
thi
nEconomi
cDev
elopment 114
Chapt
ert
hree 117
Rur
al-
urbani
nter
sect
ion,
migr
ati
on,
andunempl
oyment 117
TheUr
banI
nfor
mal
Sect
or 118
Ur
banUnempl
oyment 119
Mi
grat
ionandDev
elopment 120
Towar
danEconomi
cTheor
yofRur
al-
UrbanMi
grat
ion 120
UNI
TFOUR 122
AGRI
CULTUREANDECONOMI
CDEVELOPMENT 122
TheSt
ruct
ureofAgr
ari
anSy
stemsi
ntheDev
elopi
ngWor
ld 123

4
 TheEconomi
csofAgr
icul
tur
alDev
elopment 125
TheTr
ansi
ti
ont
oMi
xedandDi
ver
sif
iedFar
ming 125
Fr
om Di
ver
gencet
oSpeci
ali
zat
ion:
Moder
nCommer
cial
Far
ming 126
Towar
daSt
rat
egyofAgr
icul
tur
alandRur
alDev
elopment
:SomeMai
nRequi
rement
s 127
CHAPTERFI
VE 128
I
nter
national
tradeandeconomi
cdev
elopment
:thet
radepol
i
cydebat
eand
i
ndustr
iali
zat
ion 128
Tr
adeTheor
yandDev
elopmentExper
ience 128
I
mpor
tanceofExpor
tst
oDi
ff
erentDev
elopi
ngNat
ions 129

5
 Chapt
erOne

Macr
oeconomi
csI&I
I

I
ntr
oduct
iont
oMacr
oeconomi
cs

1.
1WhatMacr
oeconomi
csi
sabout
?
Economi
csi
sthest
udyoft
heeconomyandt
hebehav
iorofpeopl
eint
he
economy
.
Tr
adi
ti
onal
l
y,economi
csi
sdi
vi
dedi
ntomi
croeconomi
cs&macr
oeconomi
cs.
Mi
croeconomi
cs,whi
chst
udi
est
hebehav
iorofi
ndi
vi
dual
sandor
gani
zat
ions
(
consumer
s,f
ir
msandt
hel
i
ke)atadi
saggr
egat
edl
evel
,and
Macr
oeconomi
cs,whi
ch st
udi
es t
he ov
eral
loraggr
egat
e behav
ioroft
he
economy
.

Macr
oeconomi
csi
sconcer
nedwi
tht
hebehav
ioroft
heeconomyasawhol
e-
wi
thboomsandr
ecessi
ons,t
otalout
putofgoodsandser
vices,t
hegr
owt
hof
out
put
,ther
ateofi
nfl
ati
on,unempl
oyment
,thebal
anceofpay
ment
s,exchange
r
ates…
Macr
oeconomi
csf
ocusesont
heeconomi
cbehav
iorandpol
ici
est
hataf
fect
:
consumpt
ionandi
nvest
ment
,tr
adebal
ance,
pri
ces,
monet
aryandf
iscal
pol
i
cies,
t
hemoneyst
ock,
gov
ernmentbudget
int
erestr
ate,
andnat
ional
debt

1.
2TheStateofMacr
oeconomi
cs:Evol
uti
onandRecent
Devel
opments
(
School
soft
hought
sinMacr
oeconomi
cs)

Cl
assi
cal
(1776–1870) 1970s–pr
esent (
the new
Neo-
classi
cal
(1870–1936) cl
assi
cal
,
new Keynesi
ans,
Key
nesi
an(
1936–1970s) Monet
ari
sm)
Cl
assi
cal
(1776–1870)
I
nthi
sper
iodt
hedi
sti
nct
ionbet
weenmi
croandmacr
owasnotcl
ear
.The
cl
assi
cal
shav
emadeanampl
econt
ri
but
iont
othedev
elopmentofeconomi
c
sci
ence.Wi
thr
egar
dtot
hel
abormar
ket
,theycont
endt
hatl
abordemandand
l
aborsuppl
yar
ebr
oughti
ntoequi
l
ibr
i her
um byt ealwage.Asar
esul
tther
eis

6
noi
nvol
unt
aryunempl
oyment
.
Wi
thr
egar
dtot
hef
inanci
almar
ket
,forcl
assi
cal
ssav
ingandi
nvest
mentar
e
br
oughti
ntoequi
l
ibr
i hei
um byt nter
estr
ateandi
nvest
mentr
espondt
othe
i
nter
estr
ate.
I
nthemoneymar
ket
,moneydemandi
ssi
mpl
yat
ransact
iondemandand
moneyhasnoanyef
fectont
her
ealeconomyandhencer
aisi
ngt
hemoney
suppl
ysi
mpl
ypushes up pr
ices (
i.
e.i
nfl
ati
onar
y).The i
mpl
i
cat
ion i
sthat
,
gov
ernmenthasnoanyr
olei
ntheeconomyt
hroughi
tsmonet
arypol
i
cy.
Tot
his
end,t
hecl
assi
calar
ethepr
oponent
sofl
aissez-
fai
re(
nogov
ernmentr
ole)
.In
gener
al,f
ort
hisschoolmar
ket
s(bei
t,commodi
ty,f
act
or,andmoney
)wor
ks
besti
flef
ttot
hemsel
ves.
Neo-
classi
cal(
1870–1936)
Basi
cal
l
ytheneocl
assi
calschooli
snotdi
ff
erentf
rom t
hecl
assi
calschool
.The
mai
ndi
sti
nct
ioni
sthet
ool
ofanal
ysi
s,suchast
hemar
ginal
anal
ysi
s.
Key
nesi
an(
1936–1970s)
Themai
nthesi
soft
heKey
nesi
anst
ream i
sthatt
heeconomyi
ssubj
ect
edt
o
f
ail
ureso t
hati
tmaynotachi
evef
ullempl
oymentl
ev .Thus,gov
el ernment
i
nter
vent
ioni
sinevi
tabl
e.Thi
sschoolv
iewst
hel
abormar
keti
nthatwor
ker
sand
f
ir
msbar
gai
nforamoney(
nomi
nal
)wage,notf
orr
ealwage.Moneywages
adj
ustsl
owl
yand wor
ker
sresi
stanydr
op i
nthe moneywage.Unl
i
ke t
he
cl
assi
cal
s,f
orKey
nesi
anssav
ingandi
nvest
mentar
ebr
oughti
ntoequi
l
ibr
ium by
changesi
nincome.I
nvest
menti
snoti
nfl
uencedbyamer
echangei
nint
erest
r
ate;
rat
heri
tisaf
fect
edbyexpect
ati
onsoft
hef
utur
e,whi
chi
suncer
tai
n.
Moneydemandi
saf
fect
edbyt
ransact
ions,butal
sobyot
hert
hings,i
npar
ti
cul
ar
f
ear
,whi
chmayl
eadt
oa“
specul
ati
vedemand”f
orhi
ghmoneybal
ances.
1970s–Pr
esent
.Ther
eisnodomi
nantschooloft
houghtofmacr
oeconomi
cs.
Ther ebeent
ehav womai
nint
ell
ect
ualt
radi
ti
onsi
nmacr
oeconomi
cs.
Oneschooloft
houghtbel
i
evest
hatgov
ernmenti
nter
vent
ioncansi
gni
fi
cant
ly
i
mpr
ovet
heoper
ati
onoft
heeconomy
.Theot
herbel
i
evest
hatmar
ket
swor
kbest
i
flef
ttot
hemsel
ves.
Int
he 1960s,t
he debat
e on t
hese quest
ions i
nvol
ved
Keynesi
ans,i
ncl
udi
ngFr
ancoModi
gli
aniandJamesTobi
n,ononesi
de,and
monet
ari
sts,l
edbyMi
l
tonFr
iedman,ont
heot
her
.Int
he1970s,t
hedebat
eon
mucht
hesamei
ssuesbr
oughtt
othef
oreanew gr he new cl
oup-t assi
cal

7
 macr
oeconomi
sts,whobyandl
arger
epl
acedt
hemonet
ari
stsi
nkeepi
ngupt
he
ar
gumentagai
nstusi
ngact
ivegov
ernmentpol
i
ciest
otr
ytoi
mpr
oveeconomi
c
per
for
mance.
Ont
heot
hersi
dear
ethenew Key
nesi
ans;t
heymaynotshar
emanyoft
he
det
ail
edbel
i
efofKey
nesi
anst
hreeorf
ourdecadesago,exceptt
hebel
i
eft
hat
gov
ernmentpol
i
cycanhel
ptheeconomyper
for
m bet
ter
.
Key
nesandEconomi
cPol
icy
-monet
aryexpansi
on/f
iscalexpansi
on
ForKey
nest
odoaboutr
ecessi
ons,t
hef
ir
standmostobv
ioust
hingt
odoi
sto
makei
tpossi
blef
orpeopl
etosat
isf
ythei
rdemandf
ormor
ecashwi
thoutcut
ti
ng
t
hei
rspendi
ng,pr
event
ing t
he downwar
d spi
ralofshr
inki
ng spendi
ng and
shr
inki
ng i
ncome.The wayt
o do t
hisi
s si
mpl
eto pr
intmor
e money
,and
somehow geti
tint
oci
rcul
ati
on.Sot
heusualandbasi
cKey
nesi
ananswert
o
r
ecessi samonet
onsi aryexpansi
on.
ButKey
neswor
ri
edt
hatev
ent
hismi
ghtsomet
imesnotbeenough,
par
ti
cul
arl
yif
ar
ecessi
onhadbeenal
l ogetoutofhandandbecomeat
owedt ruedepr
essi
on.
Oncet
heeconomyi
sdeepl
ydepr
essed,househol
dsandespeci
all
yfi
rmsmaybe
unwi
l
li
ngt
oincr
easespendi
ngnomat
terhow muchcasht
heyhav
e;t
heymay
si
mpl
yaddanymonet
aryexpansi
ont
othei
rhoar
ding.Suchasi
tuat
ion,i
nwhi
ch
monet
ar cyhasbecomei
ypol
i nef
fect
ive,hascomet
obeknownasa“
li
qui
dit
y
t
rap”
.
I
nsuchacase,
thegov
ernmenthast
odowhatt
hepr
ivat
esect
orwi
l :spend.
lnot
Whenmonet
aryexpansi
oni
sinef
fect
ive,f
iscalexpansi
onmustt
akei
tspl
ace.
Suchaf
iscalexpansi
oncanbr
eakt
hev
ici
ousci
rcl
eofl
ow spendi
ngandl
ow
i
ncomes and get
ti
ng t
he economy mov
ing agai
n. Howev
er, Key
nesi
an
macr
oeconomi
cswassubj
ectt
oongoi
ngcr
it
ici
sm.
Monet
ari
sm,asadv
ocat
esoff
reemar
ket
,st
art
edchal
l
engi
ngKey
nes’
stheor
yin
t
he1970s.Mi
l
tonFr
iedman,
thef
ounderofmonet
ari
sm,
att
ackedKey
nesi
deaof
smoot
hingbusi
nesscy
cleont
hegr
oundt
hatsuchact
ivepol
i
cyi
snotonl
y
unnecessar
ybutact
ual
l
yhar
mful
,wor
seni
ngt
hev
eryeconomi
cinst
abi
l
ityt
hati
t
i
ssupposedt
ocor
rect
,andshoul
dber
epl
acedbysi e,mechani
mpl calmonet
ary
r
ules.Thi
sist
hedoct
ri
net obeknownas“
hatcamet monet
ari
sm.
”
Pol
icyRul
eunderMonet
ari
sm
I
feconomi
csl
umpsbegi
nwhenpeopl
espont
aneousl
ydeci
det
oincr
easet
hei
r

8
 moneyhol
dings,t
hent
hemonet
aryaut
hor
it
ymustmoni
tort
heeconomyand
pumpmoneyi
nwheni
tfi
ndsasl
umpi
simmi
nent
.Ifsuchsl
umpsar
eal
way
s
cr
eat
edbyaf
alli
nthequant
it
yofmoney
,thent
hemonet
aryaut
hor
it
yneednot
moni
tort
heeconomy
;itneedonl
ymakesur
ethatt
hequant
it
yofmoneydoesn’
t
sl
ump.

I
not
herwor
ds,ast
rai
ght
for
war
dr e-“
ul Keept
hemoneysuppl
yst
eady”
-isgood
enough,sot
hatt
her
eisnoneedf
ora“
discr
eti
onar
y”pol
i
cyoft
hef
orm,“
Pump
moneyi
nwheny
oureconomi
cadv
iser
sthi
nkar
ecessi
oni
simmi
nent
.”

TheNewCl
assi
calSchool

The new cl
assi
calmacr
oeconomi
cs r
emai
ned i
nfl
uent
iali
nthe 1980s.Thi
s
schoolofmacr
oeconomi
csshar
esmanypol
i
cyv
iewswi
thFr
iedman.I
tseest
he
wor
ldasonei chi
nwhi ndi
vi
dual
sactr
ati
onal
l
yint
hei
rsel
f-
int
eresti
nmar
ket
s
t
hatadj
ustr
api
dlyt
ochangi
ngcondi
ti
ons.Thegov
ernment
,iti
scl
aimed,
isl
i
kel
y
onl
ytomaket
hingswor
sebyi
nter
veni
ng.

Thecent
ralwor
kingassumpt
ionsoft
henewcl
assi
calschoolar
ethr
ee:

Economi
cagent
smaxi
mize.Househol
dsand f
ir
msmakeopt
imaldeci
sions
gi
venal
lav
ail
abl
einf
ormat
ioni
nreachi
ngdeci
sionsandt
hatt
hosedeci
sionsar
e
t
hebest
.
Expect
ati
onsar
erat
ional
,
whi
chmeanst
heyar
est
ati
sti
cal
l
ythebestpr
edi
cti
ons
oft
hef
utur
ethatcanbemadeusi
ngt
heav
ail
abl
einf
ormat
ion.
Mar
ket
scl
ear
.Ther
eisnor
easonwhyf
ir
msorwor
ker
swoul
dnotadj
ustwages
orpr
icesi
fthatwoul
dmaket
hem bet
terof
f.Accor
dingl
ypr
icesandwagesadj
ust
i
nor
dert
oequat
esuppl
yanddemand;
inot
herwor mar
ds, ketcl
ear
.
TheNewKey
nesi
ans

NewKey
nesi
aneconomi
csi
stheschooloft
houghti
nmoder
nmacr
oeconomi
cs
t
hatev
olv
edf
rom t
hei
deasofJohnMay
nar
dKey
nes.Key
neswr
oteTheGener
al
Theor
yofEmpl
oyment
,Int
erest
,andMoneyi
nthet
hir
ti
es,andhi
sinf
luence
among academi
cs and pol
i
cymaker
sincr
eased t
hrough t
he si
xti
es.
Int
he
sev
ent
ies,howev
er,newcl
assi
caleconomi
stssuchasRober
tLucas,ThomasJ.
Sar
gent
,andRober
tBar
ro cal
l
edi
ntoquest
ionmanyoft
hepr
ecept
soft
he

9
 Key
nesi
anr
evol
uti
on.Thel
abel"
new Key
nesi
an"descr
ibest
hoseeconomi
sts
who,
int
heei
ght
ies,
respondedt
othi
snewcl
assi
calcr
it
iquewi
thadj
ust
ment
sto
t
he or
igi
nalKey
nesi
an t
enet
s.The new Key
nesi
ans ar
gue t
hat mar
ket
s
somet
imesdonotcl
earev
enwheni
ndi
vi
dual
sar
elooki
ngoutf
ort
hei
rown
i
nter
est
s.

MuchnewKey
nesi
anr
esear
chat
tempt
stor
emedyt
hisomi
ssi
on:

MenuCost
sandAggr
egat
e- Coor
dinat
ionFai
l
ure
DemandExt
ernal
i
ties Ef
fi
ci
encyWages
TheSt
agger
ingofPr
ices

Chapt
er-Two

Nat
ionalI
ncomeAccount
ing
 Def
ini
ti
on:Nat
ionali
ncomeaccount
ingr
efer
stot
heaccount
ingsy
stem usedt
o
measur
eGDP andmanyr
elat
edst
ati
sti
cs.Thi
schapt
erf
ocusesont
het
hree
st
ati
sti
cst
hateconomi
stsandpol
i
cymaker
susemostof
ten.Gr
ossdomest
ic
pr
oduct
,orGDP,t
ell
sust
henat
ion’
stot
ali
ncomeandt
het
otalexpendi
tur
eon
i
tsout
putofgoodsandser
vices.Theconsumer
pri
cei
ndex,orCPI
,measur
es
t
hel
evelofpr
ices.Theunempl
oymentr
atet
ell
sust
hef
ract
ionofwor
ker
swho
ar
eunempl
oyed.
 Thesi
ngl
emosti
mpor
tantmeasur
eofov
eral
leconomi
cper
for
mancei
sGr
oss
Domest
icPr
oduct(
GDP)
.TheGDP i
sanat
temptt
osummar
izeal
leconomi
c
act
ivi
tyov
eraper
iodoft
imei
nter
msofasi
ngl
enumber
;iti
sameasur
eoft
he
economy
’st
otalout
putandoft
otali
ncome.I
not
herwor
dsGDPi
sthev
alueof
al
lfi
nalgoodsandser
vicespr
oducedi
ntheeconomyi
nagi
vent
imeper
iod
(
not
ethatGDPi
saf
lownotast
ock)
.
 Ther
ear
etwoway
stov
iew t
hisst
ati
sti
c.Onewayt
ovi
ew GDPi
sast
het
otal
i
ncomeofev
ery
onei
ntheeconomy
.Anot
herwayt
ovi
ew GDPi
sast
het
otal
expendi
tur
eont
heeconomy
’sout
putofgoodsandser
vices.

RealGDPv
ersusNomi
nalGDP
Noti
cet
hatGDPcani
ncr
easeei
therbecausepr
icesr
iseorbecausequant
it
ies
r
ise.

10
 GDP=Q*
P

Thati
s,t
hismeasur
edoesnotaccur
atel
yref
lecthow wel
ltheeconomycan
sat
isf
ythedemandsofhousehol
ds,f
ir
ms,andt
hegov
ernment
.Ifal
lpr
ices
doubl
edwi
thoutanychangei
nquant
it
ies,GDPwoul
ddoubl
e.Yeti
twoul
dbe
mi
sleadi
ngt
osayt
hatt
heeconomy
’sabi
l
ityt
osat
isf
ydemandshasdoubl
ed,
becauset
hequant
it
yofev
erygoodpr
oducedr
emai
nst
hesame.Economi
stscal
l
t
hev
alueofgoodsandser
vi edatcur
cesmeasur rentpr
icesnomi
nal
GDP.Thus,
it
i
simpor
tantt
ocor
rectf
orchangesi
npr
ices.Todot
his,
economi
stsv
aluegoods
att
hepr
icesi
nsomegi
veny
ear
.Thi
sisknownasr
ealGDP.RealGDPmeasur
es
t
heout
putpr
oducedi
nanyoneper
iodatt
hepr
icesofsomebasey
ear
.

GDPDef
lat
or
Fr
om nomi
nalGDP andr
ealGDP wecancomput
eat
hir
dst
ati
sti
c:t
heGDP
def
lat
or.TheGDP def
lat
or,al
socal
l
edt
hei
mpl
i
citpr
icedef
lat
orf
orGDP,i
s
def
inedast
her
ati
oofnomi
nal
GDPt
oreal
GDP:

NominalGDP
◦ GDPDef
lat
or=
RealGDP

TheGDPdef
lat
orr
efl
ect
swhat
’shappeni
ngt
otheov
eral
llev
elofpr
icesi
nthe
economy
.

◦ Nomi
nalGDP=Real
GDP*GDPDef
lat
or.

Nomi
nalGDP
◦ RealGDP =
GDPDefl
ator

Component
sofGDP

Thenat
ional
incomeaccount
sdi
vi
deGDPi
ntof
ourbr
oadcat
egor
iesofspendi
ng:

◦ Consumpti
on(C) ◦ Governmentpur G)
chases(
◦ Inv
estment(I) ◦ Netexport
s(NX)
Thus,
let
tngYst
i andforGDP:

Y=C+I+G+NX

Ot
herMeasur
esofI
ncome

I
tisi
mport
anttobeawar
eoft
hev
ari
ousmeasur
es,
becauseeconomi
stsandt
he
pr
essof
tenref
ertot
hem.

11
 Gr
ossnat
ional
product(
GNP)
:iti
sthev
alueoff
inal
goodsandser
vicespr
oduced
bydomest
ical
l
yownedf
act
orsofpr
oduct
ionwi
thi
nagi
venper
iod.Toobt
ain
GNP,weaddr
ecei
ptsoff
act
ori
ncome(
wages,pr
ofi
t,andr
ent
)fr
om t
her
estof
t
hewor
ldandsubt
ractpay
ment
soff
act
ori
ncomet
other
estoft
hewor
ld:
GNP=GDP+Fact
orpayment
sfr
om abr
oad-Fact
orpayment
stoabr
oad.
Wher
easGDPmeasur
est
het
otali
ncomepr
oduceddomest
ical
l
y,GNPmeasur
es
t
het
otali
ncomeear
nedbynat
ional
s(r
esi
dent
sofanat
ion)
.Netnat
ionalpr
oduct
(
NNP)
:To obt
ain netnat
ionalpr
oduct(
NNP)
,wesubt
ractt
hedepr
eci
ati
on of
capi
tal
-theamountoft
heeconomy
’sst
ockofpl
ant
s,equi
pment
,andr
esi
dent
ial
st
ruct
urest
hatwear
soutdur
ingt
hey
ear
:
NNP=GNP-Depr
eci
ati
on.

Inthenati
onali
ncomeaccount
s,depr
eci
ati
oni
scal
l
edt
heconsumpt
ionoff
ixed
capit
al.

Nat
ional
income(
NI)
:

Nat
ional
Income=NNP−I
ndi
rectBusi
nessTaxes

Nat
ional
incomemeasur
eshowmuchev
ery
onei
ntheeconomyhasear
ned.

Thenationali
ncomeaccount
sdi
videnati
onali
ncomei
ntof
ivecomponent
s,
dependi
ngonthewayt
heincomei
searned.

Per
sonalI
ncome=Nat
ional
Income

(
-Cor
por
atePr
ofi
ts-Soci
alI
nsur
anceCont
ri
but
ions-NetI
nter
est+Di
vi
dends
+Gov
ernmentTr
ansf
erst
oIndi
vi
dual
+Per
sonal
Int
erestI
ncome)

Di
sposabl
e Per
sonalI
ncome = Per
sonalI
ncome -Per
sonalTax and Nont
ax
Pay
ment
s.

Wear
eint
erest
ed i
n di
sposabl
eper
sonali
ncomebecausei
tist
heamount
househol
ds and non-
cor
por
ate busi
nesses hav
e av
ail
abl
eto spend af
ter
sat
isf
yingt
hei
rtaxobl
i
gat
ionst
othegov
ernment
.

TheConsumerPr
iceI
ndex(
CPI
)
Adol
l
art
odaydoesn’
tbuyasmuchasi
tdi
d20y
rsago.Thecostofal
most
ev
ery
thi
nghasgoneup.Thi
sincr
easei
ntheov
eral
llev
elofpr
icesi
scal
l
ed
i
nfl
ati
on.
The mostcommonl
y used measur
e oft
he l
evelofpr
ices i
sthe

12
 consumerpr
icei
ndex(
CPI
).
TheCPIt
urnst
hepr
icesofmanygoodsandser
vices
i
ntoasi
ngl
eindexmeasur
ingt
heov
eral
llev
elofpr
ices.TheCPIi
sthepr
iceof
t
hisbasketofgoodsandser
vicesr
elat
ivet
othepr
iceoft
hesamebasketi
n
somebasey
ear
.
Pr
icesofbasketofgoodsandser
vicei
ncur
rentyear
CPI=
pr
icesofthesamebasketi
nthebaseyear
Thei
ndext
ell
sushowmuchi
tcost
snowt
obuyagi
venbasketr
elat
ivet
ohow
muchi
tcostt
obuyt
hesamebasketi
nthebasey
ear
.
TheCPIandt
heGDPDef
lat
or

Ther
ear
ethr
eekeydi
ff
erencesbet
weent
het
womeasur
es.
Thef
ir
stdi
ff
erencei
s
t
hatt
heGDPdef
lat
ormeasur
est
hepr
icesofal
lgoodsandser
vicespr
oduced.
Wher
eas,t
heCPImeasur
est
hepr
icesofonl
ythegoodsandser
vicesboughtby
consumer
s.Thus,ani
ncr
easei
nthepr
iceofgoods boughtbyf
ir
msort
he
gov
ernmentwi
l
lshow upi
ntheGDP def
lat
orbutnoti
ntheCPI
.Thesecond
di
ff
erence i
sthatt
he GDP def
lat
ori udes onl
ncl ythose goods pr
oduced
domest
ical
l
y.I
mpor
tedgoodsar
enotpar
tofGDPanddonotshowupi
ntheGDP
def
lat
or.
Hence,ani
ncr
easei
nthepr
iceofaToy
otamadei
nJapanandsol
dint
his
count
ryaf
fect
stheCPI
,becauset
heToyot
aisboughtbyconsumer
s,buti
tdoes
notaf
fectt
heGDPdef
lat
or.
Thet
hir
dandmostsubt
ledi
ff
erencer
esul
tsf
rom t
hewayt
het
womeasur
es
aggr
egat
ethemanypr
icesi
ntheeconomy
.TheCPIassi
gnsf
ixedwei
ght
stot
he
pr
icesofdi
ff
erentgoods,
wher
east
heGDPdef
lat
orassi
gnschangi
ngwei
ght
s.I
n
ot
herwor
ds,t
heCPIi
scomput
edusi
ngaf
ixedbasketofgoods,wher
east
he
GDPdef
lat
oral
l
owst
hebasketofgoodst
ochangeov
ert
imeast
hecomposi
ti
on
ofGDPchanges.Economi
stscal
lapr
icei
ndexwi
thaf
ixedbasketofgoodsa
Laspeyr
esi
ndexandapr
icei
ndexwi
t ngbasketaPaaschei
hachangi ndex.

Measur
ingJobl
essness:TheUnempl
oymentRat
e
Theunempl
oymentr
atei
sthest
ati
sti
cthatmeasur
est
heper
cent
ageoft
hose
peopl
ewant
ingt
owor
kbutwhodonothav
ejobs.
Aper
soni
sempl
oyedi
fheorshespentsomeoft
hepr
evi
ousweekwor
kingata
pai
djob.

13
 Aper
soni
sunempl
oyedi
fheorshei
snotempl
oyedandhasbeenl
ooki
ngf
ora
j
obori
sont
empor
aryl
ayof
f.
Cat
egor
iesoft
hepopul
ati
on
Empl
oyed:wor
kingatapai
djob
Unempl
oyed:
notempl
oyedbutl
ooki
ngf
oraj
ob
Laborf
orce:
theamountofl
aborav
ail
abl
eforpr
oduci
nggoodsandser
vices;
all
empl
oyedpl
usunempl
oyedper
sons(
16-
65)
Noti
nthel
aborf
orce:
notempl
oyed,
notl
ooki
ngf
orwor
k(<16,
>65)
i
.Unempl
oymentr
ate:
per
cent
ageoft
hel
aborf
orcet
hati
sunempl
oyed

i
i.l
aborforcepar
ti
cipat
ionrate:
thef
ract
ionoft
headul
tpopul
ati
ont
hat
“
parti
ci
pates”i
nthelaborfor
ce

Comput
ingl
aborst
ati
sti
cs:
U.
S.adul
tpopul
ati
onbygr
oup,
May2009
Numberempl
oyed = 140.
57mi
l
li
on
Numberunempl
oyed = 14.
51mi
l
li
on
Adul
tpopul
ati
on = 235.
45mi
l
li
on
Uset
heabov
edat
atocal
cul
ate
 t
hel
aborf
orce  t
he l
aborf
orce par
ti
cipat
ion
 t
henumberofpeopl
enoti
n r
ate
t
hel
aborf
orce  t
heunempl
oymentr
ate

a:E=140.
Dat 57,U=14. 51,POP=235. 45
 laborforce
L=E+U=140. 57+14. 51=155.08
 notinlaborforce
NILF=POP –L=235. 45–155.08=80.37
 unempl oymentrate
U/ Lx100%=( 14.
51/155.08)x100%=9.4%
 laborforceparti
cipat
ionrate
L/POP x100%=( 155.08/235.
45)x100%=65.
9%

14
TheBusi
nessCy
cleandt
heOut
putGap

Thebusi
nesscy
cledescr
ibest
heupsanddownsi
nar
eal
GDPov
ert
ime.
Al
though no busi
ness cy
cles ar
eident
ical
,they al
lhav
efourdi
sti
nct

phasepeak,
cont
ract
ionorr
ecessi
on,
trough, on.
andexpansi

 Peak:
 I
sthehi
ghestl
evel
ofr
eal
GDPi
nthecy
cle
 Endofeconomi
cexpansi
onandbegi
nni
ngofr
ecessi
on
 Unempl
oymentr
atei
srel
ati
vel
ylow
 Cont
ract
ion/
recessi
on
 Out
putandempl
oymentdecl
i
ne/
fal
l
 Unempl
oymentl
evel
incr
eases
 Rat
eofchangei
snegat
ive
Tr
ough/
depr
essi
on
 Bot
tom l
evel
oft
hecy
cle
 l
owestl
evel
ofr
eal
GDPobser
vedov
ert
hecy
cle
 Excessi
veamountofunempl
oyment

15
  Expansi
on/
recov
ery
 Out
putandempl
oymentgr
ow
 Real
GDPi
ncr
eases
 Unempl
oymentl
evel
decl
i
ne
 Rat
eofchangei
sposi
ti
ve
 I
nfl
ati
on,gr
owt
h,andunempl
oymentar
erel
atedt
hr hebusi
ought nesscycl
e.
Thebusi
nesscy
clei
sthemor
eorl
essr
egul
arpat
ter
nofexpansi
on(
recov
ery
)
andcont
ract
ion(
recessi
on)i
neconomi
cact
ivi
tyar
oundt
hepat
hoft
rend
gr
owt
h.Atacy
cli
calpeak,
economi
cact
ivi
tyi
shi
ghr
elat
ivet
otr
end;andata
cy
cli
cal
trough,
thel
owpoi
nti
neconomi
cact
ivi
tyi
sreached.
 Thet
rendpat
hofGDPi
sthepat
hGDPwoul
dtakei
ffact
orsofpr
oduct
ion
ef
wer ul
lyempl
oyed.Overt
ime,
real
GDPchangesf
ort
het
wor
easons.
 Fi
rst
,mor
eresour
cesbecomeav
ail
abl
ewhi
chal
l
owst
heeconomyt
opr
oduce
mor
egoodsandser
vices,r
esul
ti
ngi
nar
isi
ngt
rendl
evelofout
put
.Second,
f
act
orsar
enotf
ull
yempl
oyedal
lthet
ime.Thus,out
putcanbei
ncr
easedby
i
ncr
easi
ngcapaci
tyut
il
izat
ion.
Dev
iat
ionsofout
putf
rom t
rendar
eref
err
edt
o
heout
ast putgap.
Theout
putgapmeasur
est
hegapbet
weenact
ualout
put
andt
heout
putt
heeconomycoul
dpr
oduceatf
ullempl
oymentgi
vent
he
exi
sti
ngr
esour
ces.Ful
lempl
oymentout
puti
sal edpot
socal
l ent
ialout
put
.
 Out
putgap=pot
ent
ial
out
put–act
ualout
put
Okun’
sLaw

Ar
elat
ionshi
pbet
weenr
ealgr
owt
handchangesi
ntheunempl
oymentr
atei
s
knownasOkun’
slaw,namedaf
teri
tsdi
scov
erer
,Ar
thurOkun.
Hisl
aw say
s
t
hatt
heunempl
oymentr
atedecl
i
neswhengr
owt
hisabov
ethet
rendr
ateof
2.
25per
cent
.Speci
fi
cal
l
y,f
orev
eryper
cent
agepoi
ntofgr
owt
hinr
ealGDP
abov
ethet
rendr
atei
ssust
ainedf
oray
ear
,theunempl
oymentr
atedecl
i
nes
byone-
hal
fper
cent
agepoi
nt.
The r
elat
ion i
s st
ated as:ΔU =-
0.5(
y-2.
25)
.Wher
e ΔU-i
s change i
n
unempl
oymentr
ate,
yisper
cent
agegr
owt
hrat
e.

I
nfl
ati
on–Unempl
oymentDy
nami
cs:ThePhi
ll
ipsCur
ve

ThePhi
l
li
pscur
vedescr
ibest
heempi
ri
calr
elat
ionshi
pbet
weeni
nfl
ati
onand

16
 unempl
oyment
:
Thehi
ghert
her
ateofunempl
oyment
,thel
owert
her
ateofi
nfl
ati
on.
Thecur
vesuggest
sthatl
essunempl
oymentcanal
way
sbeat
tai
nedby
i
ncur
ri
ng mor
einf
lat
ion and t
hatt
he i
nfl
ati
on r
ate can al
way
s be
r
educedbyi
ncur
ri
ngt
hecost
sofmor
eunempl
oyment
.
I
not
herwor
dst
hecur
vesuggest
sther
eisat
rade-
offbet
weeni
nfl
ati
onand
unempl
oyment
.

CHAPTERTHREE

AGGREGATEDEMANDI
NTHECLOSEDECONOMY
3.
1Foundat
ionsoft
heTheor
yofAggr
egat
eDemand

• Ofal
ltheeconomi
cfl
uct
uat
ionsi
nwor
ldhi
stor
y,t
heonet
hatst
andsoutas
par
ti
cul
arl
ylar
ge,pai
nful
,andi
ntel
l
ect
ual
l
ysi
gni
fi
canti
stheGr
eatDepr
essi
onof
t
he 1930s.Dur
ing t
hist
ime,t
he Uni
ted St
ates and many ot
hercount
ri
es
exper
iencedmassi
veunempl
oymentandgr
eat
lyr
educedi
ncomes.I
nthewor
st
y
ear
,1933,
one-
four
thoft
heU.
S.l
aborf
orcewasunempl
oyed,
andr
ealGDPwas
30 per
centbel
ow i
ts 1929 l
ev .Thi
el s devast
ati
ng epi
sode caused many
economi
stst
o quest
ion t
he val
idi
tyofcl
assi
caleconomi
ctheor
y.Cl
assi
cal
t
heor
yseemedi
ncapabl
eofexpl
aini
ngt
heDepr
essi
on.
• Af
tert
heonsetoft
heDepr
essi
on,
manyeconomi
stsbel
i
evedt
hat:
• A new modelwasneeded t
o expl
ain such al
arge&sudden economi
c
downt
urn&t
osuggestgover
nmentpol
i
ciest
hatmi
ghtr
educet
heeconomi
c
har
dshi
psomanypeopl
efaced.
• I
n1936t
heBr
it
isheconomi
stJohnMay
nar
dKey
nesr
evol
uti
oni
zedeconomi
cs
wi
t sbook:TheGener
hhi alTheor
yofEmpl
oyment
,Int
erest
,andMoney.
Key
nes
pr
oposed a new wayt
o anal
yze t
he economy
,whi
ch he pr
esent
ed as an

17
 al
ter
nat
ivet
ocl
assi
cal
theor
y.
• Keynespr
oposedt
hatl
owaggr
egat
edemandi
sresponsi
blef
ort
he:
• l
owi
ncomeandhi
ghunempl
oymentt
hatchar
act
eri
zeeconomi
cdownt
urns.
• Hecr
it
ici
zedcl
assi
calt
heor
yforassumi hataggr
ngt egat
esuppl
yal
one—capi
tal
,
l
abor
,andt
echnol
ogy
—det
ermi
nesnat
ionali
ncome.Economi
stst
odayr
econci
l
e
t
heset
wov
iewswi
tht ofaggr
hemodel egat
edemandandaggr
egat
esuppl
y.
• I
nthel
ongr
un,pr
icesar
efl
exi
ble,andaggr
egat
esuppl
ydet
ermi
nesi
ncome-
(
classi
calmodel
).Buti
ntheshor
trun,pr
icesar
est
icky
,sochangesi
naggr
egat
e
demandi
nfl
uencei
ncome-(
Key
nesi
anmodel
).Themodelofaggr
egat
edemand
dev
elopedi
nthi
schapt
er,cal
l heI
edt S–LM model
,thel
eadi
ngi
nter
pret
ati
onof
Key
nes’
stheor
y.Thegoaloft
hemodeli
stoshow whatdet
ermi
nesnat
ional
i
ncomef
oranygi
venpr
icel
evel
.
Ther
ear
etwoway
stov
iewt
his:
• Wecanv
i heI
ewt S–LM modelasshowi
ngwhatcausesi
ncomet
ochangei
nthe
shor
trunwhent
hepr
icel
evel
isf
ixed.Orwecanv
iewt
hemodel ngwhat
asshowi
causest
heaggr
egat
edemandcur
vet
oshi
ft
.Thet
wopar
t heI
soft S–LM model
ar heI
e-t Scur
v heLM cur
eandt ve.
• I
Sst
andsf
or“
inv
est
ment
’’
and“
sav
ing,
’
’and
heI
• t Scur
ver
epr
esent
swhat
’sgoi
ngoni
nthemar
ketf
orgoodsandser
vices.
• LMst
andsf
or“
li
qui
dit
y’’
and“
money
,’
’and
heLMcur
• t ver
epr
esent
swhati
shappeni
ngt
othesuppl
yanddemandf
or
money
.

TheGoodsMar
ketandtheISCur
ve
• TheI Scur
vepl ot
st herel
ati
onshi
pbet
weent
hei
nter
estr
ateandt
hel
evelof
i
ncome t
hatar
ises i
nthe mar
ketf
orgoods and ser
vices.To dev
elop t
his
r
elat
ionshi
p,west
artwi
thabasi
cmodelcal
l
edt
heKey
nesi
ancr
oss.Thi
smodel
i
sthesi
mpl
esti
nter
pret
ati
onofKey
nes’
stheor
yofnat
ionali
ncomeandi
sa
bui
l
dingbl
ockf
ort
hemor
ecompl
exandr
eal
i
sti
cIS–LM model
.

TheKeynesi
anCr
oss
• InhisGeneralTheor
y,Keynespr
oposedt
hataneconomy
’st
otali
ncomewas,i
n
t
heshor
trun,det
ermi
nedl
argel
ybyt
hedesi
r ospendbyhousehol
et ds,f
ir
ms,
andt
hegover
nment
.Themor
epeopl
ewantt
ospend,t
hemor
egoodsand
ser
vicesf
ir
mscansel
l
.

18
• Themor
efi
rmscansel
l
,themor
eout
putt
heywi
l
lchooset
opr
oduceandt
he
mor
ewor
ker
stheywi
l
lchooset
ohi
re.Thus,t
hepr
obl
em dur
ingr
ecessi
onsand
depr
essi
ons,accor
ding t nes,was i
o Key nadequat
e spendi
ng.
We begi
n our
der
ivat
ionoft
heKey
nesi
ancr
ossbydi
ff
erent
iat
ingbet
weenact
ualandpl
anned
expendi
tur
e.
• Act
ualexpendi
tur
eist
heamounthousehol
ds,f
ir
ms,andt
hegov
ernmentspend
ongoodsandser
vicesandi
tequal
stheeconomy
’sgr
ossdomest
icpr
oduct
(
GDP)
.
• Pl
annedexpendi
tur
eist
heamounthousehol
ds,
fir
ms,
andt
hegov
ernmentwoul
d
l
i
ket
ospendongoodsandser
vices.
• Assumi heeconomyi
ngt scl
osed,sot
hatnetexpor
tsar
ezer
o,wewr
it
e
pl
annedexpendi
tur
eADast
hesum ofconsumpt
ion(
C),i
nvest
ment(
I)and
gov
ernmentpur
chase(
G)
E=C+I+G…………………………………………(
1)
• Consumpt
ioni
saf
unct
ionofdi
sposabl
eincome(
Y-T)
C=C(
Y-T)
……………………………….
…………………(
2)
• Thi
sequat
ionst
atest
hatconsumpt
iondependsondi
sposabl
ei Y-T)
ncome( ,
whi
chi
stot
alncomeYmi
i axesT.
nust
• Tokeept
hingssi
mpl
e,f
ornow wet
akepl
annedi
nvest
mentasexogenousl
y
f
ixed:

………………………………………….
……………(
3)
• wef
urt
herassumet
hatf
iscalpol
i
cy—t
hel
evel
sofgov
ernmentpur
chasesand
t
axes—i
sfi
xed:

…………………………….
…………………………(
4)
• Combi
ningt
hesef
ourequat
ions,
weobt
ain:

• Thef
igur
eabov
egr
aphspl
annedexpendi
tur
easaf
unct
i hel
onoft evelof

19
 i
ncome.
• Thi
sli opesupwar
nesl dbecausehi
gheri
ncomel
eadst
ohi
gherconsumpt
ion
andt
hushi
gherpl
annedexpendi
tur
e.Thesl
opeoft
hisl
i st
nei hemar
ginal
pr
opensi
tyt
oconsume,t
heMPC:i
tshowshow muchpl
annedexpendi
tur
e
i
ncr
easeswheni
ncomer
isesby$1.Thi
spl
anned-
expendi
tur
efunct
ioni
sthe
f
ir
stpi
eceoft
hemodel
cal
l
edt
heKey
nesi
ancr
oss.
TheEconomyi
nEqui
li
bri
um
• Theeconomyi
ssai
dtobei
nequi
l
ibr
ium whenAct
ualexpendi
tur
eisequalt
o
pl
anned expendi
tur
e.Thi
s assumpt
ion i
s based on t
he i
dea t
hatwhen
peopl
e’
spl
anshav
ebeenr
eal
i
zed,t
heyhav
enor
easont
ochangewhatt
hey
ar
edoi
ng.Wecanwr
it
etheequi
l
ibr
ium condi
ti
onas:
Act
ual
Expendi
tur
e=Pl
annedExpendi
tur
e
Y = E

TheAdj
ust
mentt
oEqui
li
bri
um

• I
nsummar
y,t
heKey
nesi
ancr ncomeY i
ossshowshow i sdet
ermi
nedf
or
gi
venl
evel
sofpl
annedi
nv mentIandf
est i cyGandT.Wecanuset
scalpol
i his
modelt
oshowhowi
ncomechangeswhenoneoft
heseexogenousv
ari
abl
es
changes.
Fi
scalPol
icyandt
heMul
ti
pli
er:Gov
ernmentPur
chases(
Ref
ert
othegr
aph)
• Thegr
aphshowst
hat
,ani
ncr
easei
ngov
ernmentpur
chasel
eadst
oanev
en
gr
eat
eri
ncr
easei
nincome.

20
 s,ΔY>ΔG.Ther
• Thati atoΔY/
i ΔGi
scal
l hegov
edt ernmentpur
chasesmul
ti
pli
er;
i
ttel
l
sushow muchi
ncomer
isesi
nresponset
oa$1i
ncr
easei
ngov
ernment
pur
chases.
• An i
mpl
i
cat
ion oft
he Key
nesi
an cr
oss i
sthatt
he gov
ernment
-pur
chases
mul
ti
pli
eri
slar
gert
hanone.
Whydoesf
iscalpol
icyhav
eamul
ti
pli
edef
fectoni
ncome?
• Ther
easoni
sthat
,accor
dingt
otheconsumpt
ionf
unct
ionC =C(
Y-T)
,hi
gher
i
ncomecauseshi
gherconsumpt
ion.Whenani
ncr
easei
ngov
ernmentpur
chases
r
aisesi
ncome,i
tal
sor
aisesconsumpt
ion,whi
chf
urt
herr
aisesi
ncome,whi
ch
f
urt
herr
aisesconsumpt
ion,andsoon.Ther
efor
e,i
nthi
smodel
,ani
ncr
easei
n
gov
ernmentpur
chasescausesagr
eat
eri
ncr
easei
nincome.
Howbigisthemul tipl
ier ?
Thet
otaleffectoni ncomei s
• Initi
alChangei nGov ernmentPur chases=ΔG
• FirstChangei nConsumpt ion =MPC*ΔG
• SecondChangei nConsumpt ion=MPC2*ΔG
• Thi r
dChangei nConsumpt ion =MPC3*ΔG
.. ..
.. ..
• ΔY=ΔG( 1+MPC+MPC2+MPC3+... ).
• Thegov ernment -purchasesmul ti
plieris
ΔY/ΔG=1+MPC+MPC2+MPC3+...
• Thi sexpressionf orthemul ti
pli
erisanexampl eofaninfini
tegeometr
icseri
es.
2
Aresultfrom al gebraal lowsust owr it
et hemult
ipl
i
eras
ΔY/ ΔG=1/( 1-MPC) .
• Forexampl e, i
ft hemar gi nal propensi t
ytoconsumei s0.6,themult
ipl
i
eris
2 3
ΔY/ ΔG=1+0. 6+0. 6 +0. 6 +...
=1/( 1-0. 6)=2. 5.
• Int hiscase,a$1. 00i ncr easei ngov ernmentpurchasesr ai
sesequil
ibr
ium
i
ncomeby$2. 50.
Fi
scalPol i
cyandt heMul tiplier:Taxes( Refertot
hegraph)
• Justasani ncreasei ngov er
nmentpur chaseshasamul ti
pli
edef f
ecton
i
ncome, sodoesadecr easeintaxes.
• Asbef or
e, t
hei nit
ialchangei nexpenditure,nowMPC×ΔT, ismulti
pli
edby1/
1−MPC)
( .
Theov er
alleffectonincomeoft hechangeint
axesis
ΔY/ΔT=−MPC/( 1−MPC) .
• Thisexpressioni sthetaxmul t
ipl
ier,
theamounti ncomechangesi nresponse
toa$1changei ntaxes.Forexampl e,ifthemar gi
nalpr
opensi
tytoconsumei s
0.6,t
hent hetaxmul t
ipl
ieris

21
ΔY/
ΔT=−0.6/(1−0.6)=−1.5.
• I
nthisexample,a$1.00cut( decrease)i
ntaxesrai
sesequil
ibri
um incomeby
$1.
50.Themulti
pli
eri
mpl i
est hatt
axesandincomear einv
erselyrel
atedanda
uni
tdecreasei
ntaxesincreaseincomebymor ethanproport
ionatel
y.
TheI
nter
estRat
e,I
nvest
ment
,andt
heI
SCur
ve
• TheKey
nesi
ancr
ossi
sonl
yast
eppi
ngst
oneonourpat
htot
heI
S–LM model
.
• Yeti
tmakest
hesi
mpl
i
fyi
ngassumpt
iont
hatt
hel
evelofpl
annedi
nvest
mentI
i
sfi
xed.
• Her
e we setan i
mpor
tantmacr
oeconomi
crel
ati
onshi
p bet
ween pl
anned
i
nvest
mentand t
he i
nter
estr
ater
.I
fint
erestr
atei
ncr
eases,pl
anned
i
nvest
mentf
all
s,andsodoesout
put
.Thushi
gherl
evel
sofi
nter
estr
atear
e
associ
atedwi
thl
owerl
evelofout
put
.Toaddt
hisr
elat
ionshi
pbet
weent
he
i
nter
estr
ateandi
nvest
mentt
oourmodel
,wewr
it
ethel
evelofpl
anned
i
nvest
mentas,
I=I
(r
).

• I
nessence,t
heI
Scur
vecombi
nest
hei
nter
act
ionbet
weenrandIexpr
essed
byt
hei
nvest
mentf
unct
ionandt
hei
nter
act
ionbet
weenIandYdemonst
rat
ed
byt
heKey
nesi
ancr
oss.
• Becauseani
ncr
easei
nthei
nter
estr
atecausespl
annedi
nvest
mentt
ofal
l
,
whi
chi
ntur
ncausesi
ncomet
ofal
l
,theI
Scur
vesl
opesdownwar
d
HowFi
scalPol
icyShi
ft
stheI
SCur
ve
• TheI
Scur
vei
sdr
awnf
oragi
venf
iscalpol
i
cy;t
hati
s,whenweconst
ructt
he
I
Scur
ve,
wehol
dGandTf
ixed.Whenf
iscal
pol
i
cychanges,
theI
Scur
veshi
ft
s.
Fi
gur
e bel
ow uses t
he Key
nesi
an cr
oss t
o show how an i
ncr
ease i
n
gov
ernmentpur
chasesbyΔGshi
ft
stheI
Scur
ve.Thi
sfi
gur
eisdr
awnf
ora
gi
ven(
const
ant
)int
erestr
ateandt
husf
oragi
venl
evel
ofpl
annedi
nvest
ment
.

22
 TheKey
nesi
ancr
ossshowst
hatt
hischangei
nfi
scalpol
i
cyr
aisespl
anned
expendi
tur
e and t
her
eby i
ncr
eases equi
l
ibr
ium i
ncome f
rom Y1 t
o Y2.
Ther
efor
e,an i
ncr
ease i
n gov
ernment pur
chases shi
ft
sthe I
S cur
ve
out
war
d.(
Please,
ref
ert
othegr
aph)
• I
nsummar
y,t
heI
Scur
veshowst
hecombi
nat
ionsoft
hei
nter
estr
ateandt
he
l
evelofi
ncomet
hatar
econsi
stentwi
thequi
l
ibr
ium i
nthemar
ketf
orgoods
andser
vices.
• TheI
Scur
vei
sdr
awnf
oragi
venf
iscalpol
icy.
• Changesi
nfi
scalpol
i
cyt
hatr
aiset
hedemandf
orgoodsandser
vicesshi
ft
t
heI
Scur
vet
other
ight
.Changesi
nfi
scalpol
i
cyt
hatr
educet
hedemandf
or
goodsandser
vicesshi
ftt
heI
Scur
vet
othel
eft
.

TheMoneyMar
ketandt
heLM Cur
ve
• TheLM cur
vepl
otst
her
elat
ionshi
pbet
weent
hei
nter
estr
ateandt
hel
evelof
i
ncomet
hatar
isesi
nthemar
ketf
ormoneybal
ances.
• Tounder
standt
hisr
elat
ionshi
p,webegi
nbyl
ooki
ngatat
heor
yoft
hei
nter
est
r
ate,
cal
l het
edt heor
yofl
iqui
dit
ypr
efer
ence.

TheTheor
yofLi
qui
dit
yPr
efer
ence
• Thi
sisat
heor
yofi
nter
estr
atedet
ermi
nat
ioni
nshor
trun.I
tar
guest
hati
nter
est
t
are,i
ntheshor
trun,i
sdet
ermi
nedi
nthemoneymar
ket
,wher
ethedemandand
suppl
yofr
ealmoneybal
ancesi
nter
sect
.Justast
heKey
nesi
an cr
ossi
sa
bui
l
dingbl
ockf
ort
heI
Scur
ve,
thet
heor
yofl
i
qui
dit
ypr
efer
encei
sabui
l
dingbl
ock
f
ort
heLM cur
ve.
• Todev
elopt
hist
heor
y,webegi
nwi
tht
hesuppl
yofr
ealmoneybal
ances.I
fM
st
andsf
ort
hesuppl
yofmoneyandPst
andsf
ort
hepr
icel
evel
,thenM/
Pist
he
suppl
yofr
ealmoneybal
ances.Thet
heor
yofl
i
qui
dit
ypr
efer
enceassumest
her
e
i
saf
ixedsuppl
yofr
eal
moneybal
ances.

Thati
s,
• Themoneysuppl
yM i
sanexogenouspol
i
cyv
ari
abl
echosenbyacent
ralbank,
suchast
heNat
ionalBank.Thepr
icel
evelPi
sal
soanexogenousv
ari
abl
eint
his
model
(int
heshor
trunwhent
hepr
icel
evel
isf
ixed.
)
• Theseassumpt
ionsi
mpl
ythatt
hesuppl
yofr
ealmoneybal
ancesi
sfi
xedand,i
n
par
ti
cul
ar,
doesnotdependont
hei
nter
estr
ate.Thus,
whenwepl
ott
hesuppl
yof

23
 r
ealmoneybal
ancesagai
nstt
hei
nter
estr
atei
nfi
gur
ebel
ow,
weobt
ainav
ert
ical
suppl
ycur
ve.
Next
,consi
dert
hedemandf
orr
eal
moneybal
ances.
• Thet
heor
yofl
i
qui
dit
ypr
efer
enceposi
tst
hatt
hei
nter
estr
atei
sonedet
ermi
nant
ofhowmuchmoneypeopl
echooset
ohol
d.Ther
easoni
sthatt
hei
nter
estr
atei
s
t
heoppor
tuni
tycostofhol
dingmoney
:iti
swhaty
ouf
orgobyhol
dingsomeof
y
ourasset
sasmoney
.Whent
hei
nter
estr
ater
ises,peopl
ewantt
ohol
dlessof
t
hei
rweal
thi
nthef
orm ofmoney
.
We can wr
it
e t
he demand f
or r
eal money bal
ances as,

• Accor
dingt
othet
heor
yofl
i
qui
dit
ypr
efer
ence,t
hesuppl
yanddemandf
orr
eal
moneybal
ancesdet
ermi
newhati
nter
estr
atepr
evai
l
sint
heeconomy
.Thati
s,
t
hei
nter
estr
ateadj
ust
stoequi
l
ibr
atet
hemoneymar
ket
.(
pleaser
efert
othe
gr
aph)

I
ncome,
MoneyDemand,
andt
heLM Cur
ve
• Sof
arweassumedt
hatonl
yint
erestr
atedet
ermi
nest
hequant
it
yofr
ealmoney
bal
ancesdemanded.Butmor
e,r
eal
i
sti
cal
l
y,t
hel
evelofi
ncomeYal
soaf
fect
s
moneydemand.
• Wheni
ncomei
shi
gh,
expendi
tur
eishi
gh,
sopeopl
eengagei
nmor
etr
ansact
ions
t
hatr
equi
ret
heuseofmoney
.Thus,gr
eat
eri
ncomei
mpl
i
esgr
eat
ermoney
demand.Wecanexpr
esst
hesei
deasbywr
it
ingt
hemoneydemandf
unct
ionas,

• Thequant
it
yofr
ealmoneybal
ancesdemanded i
snegat
ivel
yrel
ated t
othe
i
nter
estr
ate and posi
ti
vel
yrel
ated t
oincome.
Usi
ng t
he t
heor
y ofl
i
qui
dit
y
pr
efer
encewecanseewhathappenst
othei
nter
estr
atewhent
hel
evelof
i
ncomechanges.Forexampl
e,consi
derwhathappenswheni
ncomei
ncr
eases
f
rom Y1t
oY2.

24
• TheLM cur
vepl
otst
hisr
elat
ionshi
pbet
weent
hel
evelofi
ncomeandt
hei
nter
est
r
ate.
• Thehi
ghert
hel
evelofi
ncome,t
hehi
ghert
hedemandf
orr
ealmoneybal
ances,
andt
hehi
ghert
heequi
l
ibr
ium i
nter
estr
ate.Fort
hisr
eason,t
heLM cur
vesl
opes
upwar
d,asi
npanel
(b)ofFi
gur
eabov
e.
HowMonet
aryPol
icyShi
ft
stheLM Cur
ve
• I
frealmoneybal
anceschange—f
orexampl
e,i
ftheFedal
ter
sthemoneysuppl
y-
t
heLM cur
veshi
ft
s.
• Supposet
hatt
heNat
ionalBankdecr
easest
hemoneysuppl
yfr
om M1t
oM2,
whi
chcausest
hesuppl
yofr
ealmoneybal
ancest
ofal
lfr
om M1/
PtoM2/
P.
Hence,adecr
easei
nthemoneysuppl
yshi
ft
stheLM cur
veupwar
d.(
pleaser
efer
t
othegr
aph)
• I
nsummar
y,t
heLM cur
veshowst
hecombi
nat
ionsoft
hei
nter
estr
ateandt
he
l
evelofi
ncomet
hatar
econsi
stentwi
thequi
l
ibr
ium i
nthemar
ketf
orr
ealmoney
bal
ances.TheLM cur
vei
sdr
awnf
oragi
vensuppl
yofr
ealmoneybal
ances.
• Decr
easesi
nthesuppl
yofr
ealmoneybal
ancesshi
ftt
heLM cur
veupwar
d.
• I
ncr
easesi
nthesuppl
yofr
ealmoneybal
ancesshi
ftt
heLM cur
vedownwar
d.
TheShor
t-
RunEqui
li
bri
um

• Themodelt
akesf
iscalpol
i
cy,GandT,monet
ar cyM,andt
ypol
i hepr
icel
evel
Pasexogenous.
• Gi
vent
heseexogenousv
ari
abl heI
es,t Scur
vepr
ovi
dest
hecombi
nat
ionsofr
andYt
hatsat
isf
ytheequat
ionr
epr
esent
ingt
hegoodsmar
ket
,and

25
 • TheLM cur
vepr
ovi
dest
hecombi
nat
ionsofrandYt
hatsat
isf
ytheequat
ion
r
epr
esent
ingt
hemoneymar
ket
.

Fr
om t
heI
S-LM t
oAggr
egatedemandCur
ve
• Wehav ebeenusingtheIS–LM modelt
oexpl
ainnat
ionali
ncomei
ntheshor
t
r
unwhent
hepr
icel
eveli
sfi heI
xed.Toseehow t S–LM modelf
it
sint
othe
modelofaggr
egat
esuppl
yandaggr
egat
edemand,wenow exami
newhat
happensi
ntheI
S–LM modeli
fthepr
icel
eveli
sal
l
owedt
ochange.Forany
gi
v yM,ahi
enmoneysuppl gherpr
icel
evelPr
educest
hesuppl
yofr
ealmoney
ancesM/
bal P.A l
owersuppl
yofr
ealmoneybal
ancesshi
ft
sthe LM cur
ve
upwar
d(t
othel
eft
),whi
chr
aisest
heequi
l
ibr
ium i
nter
estr
ateandl
ower
sthe
equi
l
ibr
ium l
evel
ofi
ncome, npanel
asshowni (a)
.
• Her
ethepr
icel
evelr
isesf
rom P1 t
oP2,andi
ncomef
all
sfom Y1 t
r oY2.
The
aggr
egat
edemandcur
v npanel(
ei b)pl
otst
hisnegat
iver
elat
ionshi
pbet
ween
nat
ional
incomeandt
hepr
icel
evel
.Inot
herwor
ds,
theaggr
egat
edemandcur
ve
showst
hesetofequi
l
ibr
ium poi
ntst
hatar
isei
ntheI
S–LM modelaswevar
ythe
pr
icel
evel
andseewhathappenst
oincome.

CHAPTER-FOUR
AGGREGATEDEMANDI
NTHEOPENECONOMY

26
 I
nter
nat
ional
FlowsofCapi
talandGoods

• I
nthepr
evi
ouschapt
er,wesi
mpl
i
fiedouranal
ysi
sbyassumi
ngacl
osed
economy
.
• I
nact
ual
i
ty,
howev
er,
mosteconomi
esar
eopen:
– t
heyexpor
tgoodsandser
vicesabr
oad
– t
heyi
mpor
tgoodsandser
vicesf
rom abr
oad,
and
– t
heybor
rowandl
endi
nwor
ldf
inanci
almar
ket
s.
OpenVer
susCl
osedEconomi
es
• Acl
osedeconomy i
sonet
hatdoesnoti
nter
actwi
thot
hereconomi
esi
nthe
wor
ld.
Ther
ear
enoexpor
ts,
noi
mpor
ts,
andnocapi
talf
lows.
• Anopeneconomyi
sonet
hati
nter
act
sfr
eel
ywi
thot
hereconomi
esar
ound
t
hewor
ld.
Anopeneconomyi
nter
act
swi
thot
hercount
ri
esi
ntwoway
s:
I
tbuy sgoodsandser
sandsel
l vicesi
nwor
ldpr
oductmar
ket
s.
I
tbuy scapi
sandsel
l talasset
sinwor
ldf
inanci
almar
ket
s.
I
nter
nat
ionalFl
owsofGoods:(
Expor
ts,
Impor
ts,
andNetExpor
ts)
• Consi
dert
heexpendi
tur
eonanopeneconomy
’sout
putofgoodsandser
vices,
whi
chcanbedi
vi
dedi
ntof
ourcomponent
s:
Cd,
consumpt
ionofdomest
icgoodsandser
vices,
d
I,i
nvest
menti
ndomest
icgoodsandser
vices,
Gd,
gov
ernmentpur
chasesofdomest
icgoodsandser
vices,
EX,
expor
tsofdomest
icgoodsandser
vices.
• Thedi
vi
si
onofexpendi
tur
eint
othesecomponent
sisexpr
essedi
nthei
dent
it
y,
Y =Cd +I
d
+Gd +EX
• Not
ethatdomest
icspendi
ngonal
lgoodsandser
vicesi
sthesum of
domest
icspendi
ngondomest
icgoodsandser
vicesandonf
orei
gngoods
andser
vices.Ther
efor
e,
C =Cd +CfI=I
d f
+I
G =Gd +Gf
• Wesubst
it
utet
heset
hreeequat
ionsi
ntot
hei
dent
it
yabove:andr
ear
rangi
ng
Y =Cd +I
d
+Gd +EX,
• Y =(
C-Cf)+(
I-)+G-
f
I Gf +EX

27
 • Y =C +I+G +EX-
(Cf +I
f
+Gf)
• Y =C +I+G +EX-
IM
Thenat
ionali
ncomei
dent
it
yinanopeneconomyi
sther
efor
e:
Y =C +I+G +Nx
Or Nx=Y-
( ,
C +I+G)
NetExpor
ts=Out
put−Domest
icSpendi
ng
• I
tshowst
hati
nanopeneconomy
,domest
i ngneednotequal
cspendi theout
put
ofgoodsandser
vices.
• I
fout
putexceedsdomest
icspendi
ng(
consumpt
ion)
,weexpor
tthedi
ff
erence:
netexpor
tsar
eposi
ti
ve.
• I
fout
putf
all
s shor
tofdomest
ic spendi
ng (
consumpt
ion)
,we i
mpor
tthe
di
ff
er netexpor
ence: tsar
enegat
ive.
Itshowst
hati
nanopeneconomy
,domest
ic
spendi
ngneednotequal
theout
putofgoodsandser
vices.
• Expor
ts:
aredomest
ical
l
ypr
oducedgoodsandser
vicest
hatar
esol
dabr
oad.
• I
mpor
ts:ar
efor
eignpr
oducedgoodsandser
vicest
hatar
esol
ddomest
ical
l
y.
• Netexpor
ts(
NX)
:-
also cal
l he t
ed t radebal
ance:r
efer
stot
hev
aluesofa
nat
ion’
sexpor
tsmi
nust
hev
alueofi
tsi
mpor
ts.
I
nter
nat
ionalCapi
tal
Flows
• Netf
orei
gni
nvest
ment
/Netcapi
talout
fl
ow/
-ref
erst
othepur
chaseoff
orei
gn
asset
s bydomest
icr
esi s mi
dent nus t
he pur
chase ofdomest
ic asset
s by
f
orei
gner
s.
• Fori
nst
ance,
theEt
hiopi
anr
esi
dentbuy
sst
ocki
ntheChi
nesecor
por
ati
onanda
Chi
nesebuy
sst
ocki
ntheEt
hiopi
ancor
por
ati
on.
WhenEt
hiopi
anr
esi
dentbuy
s
st
ocki
nTel
mex,
theMexi
canphonecompany
,t chaser
hepur aisest
heEt
hiopi
an
netf
orei
gni
nvest
ment
.
• WhenaJapaneser
esi
dentbuy
sabondi
ssuedbyt
heEt
hiopi
angov
ernment
,the
chaser
pur educest
heEt
hiopi
annetf
orei
gni
nvest
ment
.
• Fi
nanci
al/
Capi
talmar
ket
sandgoodsmar
ket
sar
ecl
osel
yrel
ated.
• Begi
nwi
tht
hei
dent
it
y:Y =C +I +G +NX.
Subt
ractCandGf
rom bot
hsi
dest
oobt
ain:
Y -C -G =I +NX
Not
e:Y -C -G i
snat
ionalsavi
ngS,t
hesum ofpr
ivat
esavi
ng,Y -T -C,and
publ
i
csavi
ng,
T -G.

28
• Ther
efor
e, S =I +NX.
• Subt
ract
ing If
rom bot
hsi
desoft
heequat
ion,wecanwr
it
ethenat
ionali
ncome
account
sident
it
yas
S -I =NX⟹

t
(radebal
ance= netcapi
talout
fl
ow)
• Thi
sident
it
yshowst
hataneconomy’
snetexpor
tsmustal
waysequalt
he
di
ff
erencebet
weeni
tssavi
ngandi
tsi
nvest
ment
.
• S-I
,i
ster
medasnetcapi
talout
fl
ow/
netf
orei
gni
nvest
ment(
domest
icsavi
ng
l
essdomest
ici
nvest
ment
).
• I
fnetcapi
talout
fl
ow i
sposi
ti
ve,oursavi
ngexceedsouri
nvest
ment
,and
wear
elendi
ngt
heexcesst
ofor
eigner
s/I
.e.
,WhenS >I,t
hecount
ryi
sa
netl
ender
/
• I
fthenetcapi
talout
fl
ow i
snegat
ive,ouri
nvest
mentexceedsoursavi
ng,
andwear
efi
nanci
ngt
hisext
rai
nvest
mentbybor
rowi
ngf
rom abr
oad/I
.e.
,
WhenS <I,t
hecount
ryi
sanetbor
rower
/.
• Thus,netcapi
taloutf
low equal
stheamountt
hatdomest
icr
esi
dent
sar
e
l
endi
ngabr
oadmi
nust
heamountt
hatf
orei
gner
sar
elendi
ngt
ous.
• Thenat
ionali
ncomeaccount
sident
it
yshowst
hatt
hei
nter
nat
ionalf
low of
f
undst
ofi
nancecapi
talaccumul
ati
onandt
hei
nter
nat
ionalf
low ofgoodsand
ser
vicesar
etwosi
desoft
hesamecoi
n.
• Ont
heonehand,i
foursav
ingexceedsouri
nvest
ment
,thesav
ingt
hati
snot
i
nvest
eddomest
ical
l
yisusedt
omakel
oanst
ofor
eigner
s.For
eigner
srequi
re
t
hesel
oansbecausewear
epr
ovi
dingt
hem wi
thmor
egoodsandser
vicest
han
t
heyar
epr
ovi
dingus.Thati
s,wear
er ngat
unni radesur
plus.
• Ont
heot
herhand,i
fouri
nvest
mentexceedsoursav
ing,t
heext
rai
nvest
ment
mustbef
inancedbybor
rowi
ngf
rom abr
oad.Thesef
orei
gnl
oansenabl
eust
o
i
mpor
tmor
egoodsandser
vicest
hanweexpor
t.Thati
s,wear
er ngat
unni rade
def
ici
t.
Fact
orst
hatI
nfl
uenceNetFor
eignI
nvest
ment
:
• Ther
eal
int
erestr
atesbei
ngpai
donf
orei
gnasset
s.
• Ther
eal
int
erestr
atesbei
ngpai
dondomest
icasset
s.
• Theper
cei
vedeconomi
candpol
i
tical
risksofhol
dingasset
sabr
oad.
• Thegov
ernmentpol
i
ciest
hataf
fectf
orei
gnowner
shi
pofdomest
icasset
s.

29
Savi
ngandi
nvest
menti
nasmal
lopeneconomy
Basi
cAssumpt
ions:
• Smal
lopeneconomy-
iti
stomeant
hatt
heeconomyi
sasmal
lpar
toft
hewor
ld
mar
ketandt
hus,byi
tsel
f,canhaveonl
yanegl
i
gibl
eef
fectont
hewor
ldi
nter
est
r
ate.
• Per
fectcapi
talmobi
li
ty-r
esi
dent
soft
hecount
ryhav
eful
laccesst
o wor
ld
f
inanci
almar
ket
s.Meani
ng t
he gov
ernmentdoes noti
mpede i
nter
nat
ional
bor
rowi
ng/l
endi
ng.
• Owi
ngt
otheabov
eassumpt
ions,t
hei
nter
estr
ater
,mustequalt
he wor
ld
i
nter
estr
ater* (
ther
eali
nter
estr
atepr
evai
l
ingi
nwor
ld f
inanci
almar
ket
s):
r =r*
• Resi
dent
soft
hesmal
lopeneconomyneednev
erbor
row atanyi
nter
estr
ate
abov
er*
,becauset
heycan al
way
sgetal
oan atr
*fr
om abr
oad.Si
mil
arl
y,
r
esi
dent
soft
hiseconomyneednev
erl
endatanyi
nter
estr
atebel
owr*because
t
heycan al
way
s ear
n r*byl
endi oad.Thus,t
ng abr he wor
ldi
nter
estr
ate
det
ermi
nest
hei
nter
estr
atei
noursmal
lopeneconomy.
Whatdet
ermi
nest
hewor
ldr
eali
nter
estr
ate?
• Theequi
l
ibr
ium ofwor
ldsav
ingandwor
ldi
nvest
mentdet
ermi
nest
hewor
ld
i
nter
estr
ate.
• Oursmal
lopeneconomyhasanegl
i
gibl
eef
fectont
hewor
ldr
eali
nter
estr
ate
because,bei
ngasmal
lpar
toft
hewor
ld,i
thasanegl
i
gibl
eef
fectonwor
ld
sav
ingandwor
ldi
nvest
ment
.
• Hence,oursmal
lopeneconomyt
akest
hewor
ldi
nter
estr
ateasexogenousl
y
gi
ven.
• TheModel
:Tobui
l
dthemodeloft
hesmal ,wemaket
lopeneconomy hree
assumpt
ions,
̅ ̅̅
• Pr
oduct
ionf
unct
ion: Y =Y =F(K,
L) :Theeconomy
’s out
putYi
s
f
ixedbyt
hef
act
orsofpr
oduct
ion.
Consumpt
ionf
unct
ion: C =C(
Y-T)
I
nvest
mentf
unct
ion: I=I
(r
)
• Wecannowr
etur
ntot
heaccount
ingi
dent
it
yandwr
it
eitas
Nx=(
Y -C -G)-I

30
 Nx=S -I
• Subst
it
uti
ngourt
hreeassumpt
ionsandt
hecondi
ti
ont
hatt
hei
nter
estr
ate
equal
sthewor
ldi
nter
estr
ate,
weobt
ain
̅ ̅
Y -C(Y -T) -G] -I
Nx=[ (r*
)
̅
Nx=S -I
(r*
)
• Thi
sequat
ionshowswhatdet
ermi
nessavi
ngSandi
nvest
mentI
,andt
hust
he
t
radebal
ance-
Nx.
• Sav
ingdependsonf
iscalpol
icy:l
owergover
nmentpur
chasesGorhi
ghert
axes
Tr
aisenat
ionalsavi
ng.I
nvest
mentdependsont
hewor
ldr
eali
nter
estr
ater
*:
hi
ghi
nter
estr
atesmakesomei
nvest
mentpr
oject
sunpr
ofi
tabl
e.Ther
efor
e,t
he
t
rade bal
ance depends on t
hese var
iabl
es as wel
l
.The t
rade bal
ance i
s
det
ermi
ned byt
he di
ff
erence bet
ween sav
ing and i
nvest
mentatt
he wor
ld
i
nter
estr
ate.(
pleaser
efert
othegr
aph)
• I
nacl
osedeconomy
,ther
eali
nter
estr
ateadj
ust
stoequi
l
ibr
atesav
ingand
i
nvest
ment
.But
,inasmal
lopeneconomy,t
hei
nter
estr
atei
sdet
ermi
nedi
nwor
ld
f
inanci
almar
ket
s.Thedi
ff
erencebet
weensav
ingandi
nvest
mentdet
ermi
nest
he
t
r ance.Her
adebal ether
eisat
radesur
plus,becauseatt
hewor
ldi
nter
estr
ate,
savi
ngexceedsi
nvest
ment
.
HowPol
ici
esI
nfl
uencet
heTr
adeBal
ance
• Supposet
hatt
heeconomybegi
nsi
naposi
ti
onofbal
ancedt
rade.Thati
s,att
he
wor
ldi
nter
estr
ate,
inv mentIequalsav
est ing,
S,andnetexpor
tsNxequalzer
o.
Let
’suseourmodelt
opr
edi
ctt
heef
fect
sofgover
nmentpol
i
ciesathomeand
abr
oad.
Fi
scalPol
i
cyatHome:
• Whathappenst
othesmal
lopeneconomyi
fthegov
ernmentexpandsdomest
ic
spendi
ng byi
ncr
easi
ng gov
ernmentpur
chases?Thei
ncr
easei
nG r
educes
nat
ionalsav
i becauseS =Y -C -G.Wi
ng, thanunchangedwor
ldr
eali
nter
est
r
ate,i
nvest
mentr
emai
nst
hesame.Ther
efor
e,sav
ingf
all
sbel
ow i
nvest
ment
,
and some i
nvest
mentmustnow be f
inanced by bor
rowi
ng f
rom abr
oad.
BecauseNX =S -I
,thef
alli
n Si
mpl
i
esaf
al nNx.Theeconomynowr
li unsa
t
radedef
ici
t.(
pleaser
efert
othegr
aph)
• BecauseNx i
sthedi
stancebet
weent
hesav
ingschedul
eandt
hei
nvest
ment

31
 schedul
eatt
hewor
ldi
nter
estr
ate,t
hisshi
f educesNx.Hence,st
tr art
ingf
rom
bal
ancedt
rade,achangei
nfi
scalpol
icyt
hatr
educesnat
ionalsavi
ngl
eadst
o
at
radedef
ici
t.
Fi
scalPol
i
cyAbr
oad
• Whathappenst
oasmal
lopeneconomywhenf
orei
gngov
ernment
sincr
ease
t
hei
rgov
ernmentpur
chases?Assumi
ngt
hesef
orei
gncount
ri
esar
eal
arge
par
toft
hewor
ldeconomy
,andt
hust
hei
rincr
easei
ngov
ernmentpur
chases
r
educeswor
ldsav
ingandcausest
hewor
ldi
nter
estr
atet
ori
se.
• Thei
ncr
easei
nthewor
ldi
nter
estr
ater
aisest
hecostofbor
rowi
ngand,t
hus,
r
educesi
nvest
menti
noursmal
lopeneconomy
.

Shi
ft
sinI
nvest
mentDemand
• Whathappenst
ooursmal
lopeneconomyi
fit
sinv
est eshi
mentschedul ft
s
out
war
d—t
hati
s,i
fthedemandf
ori
nvest
mentgoodsatev
eryi
nter
estr
ate
i
ncr
eases?
• Anout
war
dshi
fti
nthei
nvest
mentschedul
efr
om I
(r
1)t
o(I
(r
2)i
ncr
easest
he
amountofi
nvest
mentatt
hewor
ldi
nter
estr
ater
*.
• Asar
esul
t,i
nvest
mentnow exceedssavi
ng,whi
chmeanst
heeconomyi
s
bor
rowi
ngf
rom abr
oadandr
unni
ngat
radedef
ici
t.

ExchangeRat
es
• Hav
ingexami
nedt
hei
nter
nat
ionalf
lowsofcapi
talandofgoodsandser
vices,
we
now ext
end t
he anal
ysi
s by consi
der
ing t
he pr
ices t
hatappl
ytot
hese
t
ransact
i Theexchanger
ons. ate(
E)i
sther
ateatwhi
chonecur
rencyexchanges
f
oranot
her
.
• Onemayv
iewt
heex
changer
ateasi
ndi
cat
iveoft
her
elat
ivepr
iceofgoodsand
ser
vicesdenomi
nat
edi
nthecur
renci
esoft
het
wocount
ri
esconcer
ned.Ther
e
et
ar woconvent
ionsf
ormeasur
ingt
heexchanger
ate,t
hedi
sti
nct
ionbet
ween
whi
chcanbet
hesour
ceofser
iousconf
usi
on:

32
 1)Domest
iccur
rencyuni
tsperuni
toff
orei
gncur
rency
• Forexampl
e,i
fthebi
rri
sthehomecur
rencyandt
hedol
l
ar(
$)i
sthef
orei
gn
Cur
rency
,and 20 bi
rrexchangesf
or$1,t
hent
heexchanger
atei
s20.The
domest
iccur
rencyi
sont
henumer
atoroft
her
ati
o.
• Her
e,wheneverEr
isest
hehomecur
rencyget
sweaker
;itdepr
eci
ates.
• Forex
ampl
e,ar
isef
rom 20t
o21meanst
hat21bi
rrexchangedf
or$1,l
esst
han
bef
ore.
• Conv
ersel
y,whenEf
all
s,t
hedomest
iccur
rencyget
sst
ronger
,itappr
eci
ates.
2)For
eigncur
rencyuni
tsperuni
tofdomest
iccur
rency
• Thi
sisexact
lyt
heconv
erseoft
hef
ir
stconv
ent
ion.
• Thedomest
iccur
rencyi
sont
hedenomi
nat
or.When20bi
rri
sexchangedf
or$1,
t
heexchanger
atei
s0. I
05.fEr
ises,t
hehomecur
rencyget
sst
ronger
,andvi
ce
ver
sa.
RealandNomi
nal
ExchangeRat
es
• The Nomi
nalExchangeRat
e(e)i
sther
elat
ivepr
iceoft
hecur
rencyoft
wo
count
ri
es.
• Forexampl
e,i
ftheexchanger
atebet
weent
heEt
hiopi
anbi
rrandt
heU.
Sdol
l
ari
s
20bi
rrperdol
l
ar,t
heny
oucanexchangeonedol
l
arf
or20bi
rri
nthewor
ld
mar
ket
sforf
orei
gncur
rency
.TheRealExchangeRat
eist
her
elat
ivepr
iceoft
he
goodsoft
wocount
ri
es.
• Thati
s,t
her
ealexchanger
atet
ell
sust
her
ateatwhi
chwecant
radet
hegoods
ofonecount
ryf
ort
hegoodsofanot
her
.I
tmeasur
esacount
ry’
scompet
it
iveness
i
nthei
nter
nat
ional
trade.
• Ther
eal
exchanger
ateR,
isusual
l
ydef
inedas
Pf/
R =e. P
• Wher
ePandPfar
ethepr
icel
evel
sher
eandabr
oad,
respect
ivel
yandei
sthebi
rr
pr
iceoff
orei
gnexchange(
thenomi
nalexchanger
ate)
.Ther
ateatwhi
chwe
exchangef
orei
gnanddomest
icgoodsdependsont
hepr
icesoft
hegoodsi
nthe
l
ocalcur
renci
esandont
her
ateatwhi
cht
hecur
renci
esar
eexchanged.
Ift
her
eal
exchanger
ateequal
s1,cur
renci eatpur
esar chasi
ngpowerpar
it
y(PPP)
.Ar
eal
exchanger
ateabove1means,
thatgoodsabr
oadar
emor
eexpensi
vet
hangoods
athome.
• Ot
hert
hingsequal
,thi
simpl
i
est
hatpeopl
e-bot
hathomeandabr
oad-ar
eli
kel
y

33
 t
oswi
tchsomeoft
hei
rspendi
ngt
ogoodspr
oducedathome.Thi
sisof
ten
descr
ibedasani
ncr
easei
nthecompet
it
ivenessofourpr
oduct ongasRi
s.Asl s
gr
eat
ert
han1,weex
pectt
her
elat
ivedemandf
ordomest
ical
l
ypr
oducedgoods
t
ori
se.

Exchanger
ateDet
ermi
nat
ion/
Fixedv
ersusFl
exi
bleExchanger
ateRegi
mes/
Fl
exi
bleExchangeRat
es:
• Undert
hissy
stem t
heexchanger
atei
scompl
et ymar
el ket
-det
ermi
ned,wi
thout
anyi
nter
fer
encef
rom gov
ernmentaut
hor
it
ies(
thecent
ral
bank)
.
• Thebal
anceofpayment
sbal
ances:sur
plusesar
eel
i
minat
edv
iaexchanger
ates
appr
eci
ati
on;
def
ici
tsar
ecur
edbyexchanger
atedepr
eci
ati
on.
• I
not
herwor
ds,
bal
anceofpayment
sdi
sequi
l
ibr
iaar
esel
f-
cor
rect
ing.
Fi
xedExchangeRat
es:
• Her
ether
ateofexchangei
sapol
i
cypar
amet
erf
ixedbyt
heaut
hor
it
ies.
• Theyhav
etomeetexcessdemandf
oraf
orei
gncur
rency(
notf
inancedbysal
es
i
nthatf
orei
gncount
ry)f
rom t
hei
rreser
vesoff
orei
gncur
rency.
• Neti
nfl
owsoff
orei
gncur
rencyswel
lthedomest
icmoneysuppl
y,aspr
ivat
e
economi
cagent
swhodon’
tusei
ttopur
chasegoodsabr
oadconv
ertf
orei
gn
cur
rencyt
odomest
icmoneyatt
hef
ixedr
ateofexchange.
• Ther
e i
s no sel
f-
cor
rect
ing mechani
sm t
o bal
ance of payment
s
di
sequi
li
bri
a.Bet
ween t
wo ext
remes we hav
e:Managed f
loat(
consi
dert
he
Et
hiopi
ancase)
.
Depr
eci
ati
onver
susAppr
eci
ati
ons
• Acur
rencyi
ssai
dtobedepr
eci
atewhenunderf
loat
ingr
atesi
tbecomesl
ess
expensi
vei
nter
msoff
orei
gncur
rency
.Bycont
rast
,cur
rencyappr
eci
ateswhen
i
tbecomesmor
eex
pensi
vei
nter
msoff
orei
gnmoney
.
Deval
uat
ionVer
susReval
uat
ion
• Dev
aluat
ion t
akes pl
ace when t
he pr
ice off
orei
gn cur
renci
es underf
ixed
exchange r
ater
egi
me i
sincr
eased byof
fi
cial
.To pr
omot
e expor
ter
s and
di
scour
agei
mpor
ter
s.
• Dev
aluat
iont
husmeanst
hatf
orei
gner
spayl
essf
ordev
aluedcur
rencyandt
hat
r
esi
dent
s oft
he dev
alui
ng count
ry pay mor
eforf
orei
gn cur
renci
es.The
opposi
teofdev
aluat
ioni
srev
aluat
ion.

34
TheMundel
l-
Flemi
ngModel
• Themodeldev
elopedi
nthi
schapt
er,
cal
l
edt
heMundel
l
–Fl
emi
ngmodel
,i
san
open-
economyv
ersi
onoft
heI
S–LM model
.Thi
smodelowesi
tsor
igi
nst
o
paper
spubl
i
shed byJamesFl
emmi
ng (
1962)and Rober
tMundel
l(1962,
1963)
.
• Thei
rmaj
orcont
ri
but
i oi
onwast ncor
por
atei
nter
nat
ionalcapi
talmovement
s
i
ntof
ormal
macr
oeconomi
cmodel
sbasedont
heKey
nesi
anI
S-LM f
ramewor
k.
• Thei
rpaper
sledt
osomedr
amat
ici
mpl
i
cat
ionsconcer
ningt
heef
fect
iveness
off
iscal
andmonet
arypol
i
cyonnat
ional
income.
• TheMundel
l–Fl
emi
ngmodelmakesonei
mpor
tantandext
remeassumpt
ion:
i
tassumest
hatt
heeconomybei
ngst
udi
edi
sasmal
lopeneconomywi
th
per
fectcapi
tal
mobi
l
ity
.
• Thati
s,t
heeconomycanbor
row orl
endasmuchasi
twant
sinwor
ld
f
inanci
almar
ket
sand,asar
esul
t,t
heeconomy
’si
nter
estr
atei
sdet
ermi
ned
byt
hewor
ldi
nter
estr
ate.
• Onev
irt
ueoft
hisassumpt
ioni
sthati
tsi
mpl
i
fiest
heanal
ysi
s:oncet
he
i
nter
estr
atei
sdet
ermi
ned,
wecanconcent
rat
eourat
tent
ionont
her
oleoft
he
exchanger
ate.
• I
nthi
ssect
ion,wewi
l
lbui
l
dtheMundel
l–Fl
emi
ngmodel
,anduset
hemodel
t
o exami
net
hei
mpactofvar
iouspol
i
ciest
o di
scer
n how t
heeconomy
oper
atesunderf
loat
ingandf
ixedexchanger
ater
egi
mesandnot
icewhet
hera
f
loat
ingorf
ixedexchanger
atei
sbet
ter
.

Smal
lOpenEconomywi
thPer
fectCapi
tal
Mobi
li
ty
• ri
sdet
ermi
nedbyt
hewor
ldi
nter
estr
at t
er* -hesmal
lopeneconomybei
ng
underconsi
der
ati
ondonotaf
fectwor
ldi
nter
estr
ate.Mat
hemat
ical
l
y:r =r*
• Ther =r*equat
ionr
epr
esent
stheassumpt
iont
hatt
hei
nter
nat
ionalf
lowof
capi
tali
srapi
denought
okeept
hedomest
ici
nter
estr
ateequalt
othewor
ld
i
nter
estr
ate.
• Si
nceri
sfi
xed,f
iscalandmonet
arypol
i
cieswi
l
laf
fectt
heI
SandLM cur
ves
t
hr heexchanger
ought ates.

TheGoodsMar
ketandtheI
S*Cur
ve
• TheMundell–Fl
emingmodeldescr
i hemar
best ketf
orgoodsandser
vices
muchast
heI
S–LM modeldoes,
buti
taddsanewt
er ornetexpor
mf ts.
35
• I
npar
ti
cul
ar,
thegoodsmar
keti
srepr
esent
edwi
tht
hef
oll
owi
ngequat
ion:
Y =C(
Y -T) +I
(r*
) +G +Nx(
e)
• Thenetexpor
tsdependont
her
ealexchanger
ate.
• TheMundel
l
-Fl
emi
ngmodel
,howev
er,assumest hepr
hatt icel
evel
sathome
andabr ef
oadar i
xed,sot
her
ealandnomi
nalexchanger
atesar
epr
opor
ti
onal
(
R=e*
pf/
pd)
• Whent
henomi
nalexchanger
ateappr
eci
atesf
orei
gngoodsbecomecheaper
compar
edt
odomest
icgoods,andt
hiscausesexpor
tst
ofal
landi
mpor
tst
o
r
ise,
andl
ower
stheaggr
egat
eincome.(
seef
igur
ebel
ow)
.
• Ther
elat
ionoft
heexchanger
ateandaggr
egat
eincomei
scal
l
edt S*cur
heI ve.
Fi
gur
e:TheNet
-Expor
tsFunct
ion
Ani
ncr
easei
ntheexchanger
atef
rom e1t
oe2l
ower
snetexpor
tsf
r e1)t
om Nx( o
e2)
Nx(

Howchangesi
ntheexchanger
atedoaf
fecti
ncome?
Fi
gur
e:TheKeynesi
anCr
oss
(
PleaseRef
ert
opl
anned-
expendi
tur
eFi
gur
e!)
• A decr
ease i
n netexpor
tsf
rom Nx(
e1) t
o Nx(
e2)shi
ft
sthe pl
anned-
expendi
tur
eschedul
edownwar
dandr
educesi
ncomef
rom Y1t
o Y2as
i
ndi
cat
edabov
e.
• TheI
S*cur
vesummar
izi
ngt
hisr
elat
ionshi
pbet
weent
heexchanger
ateand
i
ncome:t
hehi
ghert
heexchanger
ate,
thel
owert
hel
evelofi
ncome.
Fi
gur
e:The I
S*Cur
ve

36
TheMoneyMar
ketandtheLM*Cur
ve
• LM cur
veisderi
vedfrom M/
P =L(
r,Y)
• ThemodelassumesM asf
ixedpol
i
cyv
ari
abl
echosenbycent
ralbanksandPi
s
al
sof
ixedi
ntheshor
t-
run,andt
husLM cur
vedr
awscombi
nat
ionsofrandY
sat
isf
yingt
heequat
ionwr
it
tenabov
e.Si
nceri
sfi
xedbyt
hewor
ldi
nter
estr
ate
i
nanopeneconomy
,theequat
ionf
indsaf
ixedamountofi
ncomeY,i
.e.t
osay
Yi
snotaf
fect
edbyt
heexchanger
ate.
• Hence,t
he LM cur
ve,whi
ch dr
awst
he r
elat
ion oft
he exchange r
ate and
aggr
egat
eincome,
isver
ti
cal
.
• (
PleaseRef
ert
otheLM Fi
gur
e!)
TheEqui
li
bri
um/
Combi
ningt
heI
S*andLM*Cur
ves

Monet
aryandFi
scal
Pol
icyAnal
ysi
sinanOpenEconomywi
thPer
fectCapi
talMobi
li
ty
TheSmal
lOpenEconomyunderFl
oat
ingExchangeRat
es
Fi
scalPol
icyunderFl
oat
ingExchangeRat
es
Suppose t
hat t
he gov
ernment st
imul
ates domest
ic spendi
ng by i
ncr
easi
ng
gov
ernmentpur
chasesorbycut
ti
ngt
axes.Becausesuchexpansi
onar
yfi
scalpol
i
cy
i
ncr
easespl
annedexpendi
tur
e,i
tshi
ft
stheI
S*cur
vet
other
ight
,asi
nFi
gur
ebel
ow.
Asar
esul
t,t
heexchanger
ateappr
eci
ates,wher
east
hel
evelofi
ncomer
emai
nst
he
same.
(Pl
easeRef
ert
otheFi
gur
e!)
Not
ethemechani
sm:
• Wheni
ncomer
isesi
nasmal
lopeneconomy
,duet
othef
iscal
expansi
on,
the
i
nter
estr
atet
ri
est
ori
sebutcapi
tal
inf
lowsf
rom abr
oadputdownwar
dpr
essur
e
ont
hei
nter
estr
ate.Thi
sinf
lowcausesani
ncr
easei
nthedemandf
ort
he
domest
iccur
rencypushi
ngupi
tsv
alue(
thecur
rencyappr
eci
ates)
.The
appr
eci
ati
onoft
heexchanger
atemakesdomest
icgoodsexpensi
vef
or
f
orei
gner
s,andt
hisr
educesnetexpor
t Thef
s. alli
nnetexpor
tsof
fset
sthe
ef
fect
soft
heexpansi
onar
yfi
scalpol
i
cyoni
ncome.
• Ani
ncr
easei
ngover
nmentpur
chasesoradecr
easei
ntaxesshi
ft
stheI
S*cur
ve
t
other
ight
.Thi
srai
sest
heexchanger
atebuthasnoef
fectoni
ncome.
(Fi
scal
37
 pol
i
cyi
nthi
scasei
sinef
fect
iveher
e)
AFi
scalExpansi
onUnderFl
oat
ingExchangeRat
es(
PleaseRef
ert
otheFi
gur
e!)
Monet
aryPol
icyunderFl
oat
ingExchangeRat
es
• Supposenowt
hatt
hecent
r banki
al ncr
easest
hemoneysuppl
y.
• Becauset
hepr
icel
eveli
sassumedt
obef
ixed,t
hei
ncr
easei
nthemoney
suppl
ymeansani
ncr
easei
nreal
bal
ances.
• Thei
ncr
easei
nrealbal
ancesshi
ft
stheLM*cur
vet
other
ight
,asi
nFi
gur
e
bel
ow.
• Hence,an i
ncr
ease i
nthe moneysuppl
yrai
ses i
ncome and l
ower
sthe
exchanger
ate.
• (
PleaseRef
ert
otheFi
gur
e!)

Not
ethemechani
sm:

• Wheni
ncr
easei
nthemoneysuppl
yput
sdownwar
dpr
essur
eont
he
domest
ici
nter
estr
ate.Hence,
capi
talf
lowsoutoft
heeconomyas
i
nvest
orsseekahi
gherr
etur
nel
sewher
e.Thi
scapi
talout
fl
owpr
event
s
t
hedomest
ici
nter
estr
atef
rom f
all
i
ng.
• I
naddi
ti
on,becauset
hecapi
talout
fl
ow i
ncr
easest
hesuppl
yoft
he
domest
iccur
rencyi
nthe mar
ketf
orf
orei
gn-
cur
rencyexchange,t
he
exchanger
atedepr
eci
ates.
• Thef
alli
ntheexchanger
atemakesdomest
icgoodscheapr
elat
ivet
o
f
orei
gngoodsand,
ther
eby,
sti
mul
atesnetexpor
ts.
• Hence,
inasmal
lopeneconomy,monet
arypol
icyi
nfl
uencesi
ncomeby
al
ter
ingt
heexchanger
ate.
• Ani
ncr
easei
nthemoneysuppl
yshi
ft
stheLM*cur
vet
other
ight
,
l
ower
ingt
heexchanger
ateandr
aisi
ngi
ncome.(
MPi
sef
fect
ivei
nthi
s
case)
.
TheSmal
lOpenEconomyunderFi
xedExchangeRat
es
• Underaf
ixedexchanger
ate,t
hecent
ralbankannouncesav
aluef
ort
he
exchanger
ateandst
andsr
eadyt
obuyandsel
lthedomest
iccur
rencyata
pr
edet
ermi
nedpr
icet
okeept
heexchanger
ateati
tsannouncedl
evel
.
• i
.e.
,thesol
eobj
ect
iveofmonet
arypol
i
cyi
stokeept
heexchanger
ateatt
he
announcedl
evel
.

38
 HowaFi
xed-
Exchange-
Rat
eSyst
em Wor
ks
• Supposet
hatt
heEt
hiopi
annat
ionalbankannouncest
hati
tisgoi
ngt
ofi
xthe
exchanger
ateat32bi
rrperdol
l
ar(
I.
e.,
$0.
03125perbi
rr
).
• I
twoul
dthenst
andr
eadyt
ogi
ve32bi
rri
nexchangef
or$1ort
ogi
ve$1i
n
exchangef
or32bi
rr
.
• Hence,t
heNBwoul
dneedar
eser
veofbi
rr(
whi
chi
tcanpr
int
)andar
eser
ve
ofdol
l
ars(
whi
chmusthav
ebeenpur
chasedpr
evi
ousl
y)
• Suppose i
nthe cur
rentequi
l
ibr
ium wi
tht
he cur
rentmoney suppl
y,t
he
exchanger
atei
s20bi
rrperdol
l
ar(
$0.
05perbi
rr
)thati
shi
ghert
han32bi
rr
perdol
l
ardet
ermi
nedbyt
hecent
ral
bank.
• Ar
bit
rageur
s use t
hei
rbi
rrt
o buy f
orei
gn cur
rency i
nfor
eign-
exchange
mar
ket
sandsel
li
ttot
hedomest
icnat
ional
bankf
orapr
ofi
t.
• Thi
spr
ocessaut
omat
ical
l
yincr
easest
hemoneysuppl
y(t
hebasemoney)
-
shi
ft
i heLM * cur
ngt vet
other
ightandl
ower
stheexchanger
ateast
het
abl
e
bel
owpr
esent
s.
Fi
gur
e:Whent
heequi
l
ibr
ium exchanger
atei
sgr
eat
ert
hant
hef
ixedexchange
r
ate

(
Rev
ersi
ng)
• Supposet
heequi
l
ibr
ium exchanger
atei
slowert
hant
hef
ixedexchanger
ate.
• Ar
bit
rageur
swi
l
lbuybi
rri
nfor
eign-
exchangemar
ket
sanduset
hem t
obuy
f
orei
gncur
rencyf
rom nat
ional
bankofEt
hiopi
a.
• Thi
spr
ocessaut
omat
ical
l
yreducest
hemoneysuppl
y,shi
ft
i heLM *cur
ngt ve
t
othel
eftandr
aisest
heexchanger
ateasf
igur
e,pr
esent
s.
Whent
heequi
li
bri
um exchanger
atei
slesst
hant
hef
ixedexchanger
ate
• (
PleaseRef
ert
otheFi
gur
e!)
Fi
scalPol
i
cyunderFi
xedExchangeRat
es
• Supposet
hatt
hegov
ernmentst
imul
atesdomest
icspendi
ngbyi
ncr
easi
ng
gov
ernmentpur
chasesorbycut
ti
ngt
axes.

39
• Thi
spol
i
cyshi
ft
stheI
S*cur
vet
other
ight
,asi
nFi
gur
e,put
ti
ngupwar
d
pr
essur
eont
heexchanger
ate.
• Butbecauset
hecent
ralbankst
andsr
eadyt
otr
adef
orei
gnanddomest
ic
cur
rencyatt
hef
ixedexchanger
ate,
arbi
tr
ageur
squi
ckl
yrespondt
other
isi
ng
exchanger
atebysel
l
ingf
orei
gncur
rencyt
othecent
ralbank,l
eadi
ngt
o
anaut
omat
icmonet
aryexpansi
on.
Ther
isei
nthemoneysuppl
y(i
nthebase
money
)shi
ft
stheLM *cur
vet
other
ight
.Thus,
underaf
ixedexchanger
ate,
a
f
iscal
expansi
onr
aisesaggr
egat
eincome.(
PFi
sef
fect
ivei
nthi
scase)
.

• Af
iscalexpansi
onshi
ft
stheI
S*cur
vet
other
ight
.
• Tomai
ntai
nthef
ixedexchanger
ate,t
hecent
ralbankmusti
ncr
easet
he
moneysuppl
y,t
her
ebyshi
ft
ingt
heLM*cur
vet
other
ight
.
• Hence,i
n cont
rastt
othe case off
loat
ing exchange r
ates,underf
ixed
exchanger
atesaf
iscalexpansi
onr
aisesi
ncome.
Monet
aryPol
icyunderFi
xedExchangeRat
es
• I
magi
net
hatacent
ralbankoper
ati
ngwi
thaf
ixedexchanger
atewer
etot
ry
t
oincr
easet
hemoneysuppl
y—f
orexampl
e,bybuy
ingbondsf
rom t
hepubl
i
c.
What
woul
dhappen?Thei
nit
iali
mpactoft
hispol
i
cyi
stoshi
ftt
heLM*cur
ve
t
other
ight
,lower
ingt
heexchanger
ate,
asi
nFi
gur
ebel
ow.
• Hence,
monet
arypol
i
cyi
sinef
fect
ualunderaf
ixedexchanger
ate.Byagr
eei
ng
t
ofi
xtheexchanger
ate,t
hecent
ralbankgi
vesupi
tscont
rolovert
hemoney
suppl
y.
• (
PleaseRef
ert
otheFi
gur
e!)
• I
ftheNat
ionalbankt
ri
est
oincr
easet
hemoneysuppl
y-f
orexampl
e,bybuyi
ng
bondsf
rom t
hepubl
i
c—i
twi
l
lputdownwar
dpr
essur
eont
heexchanger
ate.
• Tomai
ntai
nthef
ixedexchanger
ate,t
hemoneysuppl
yandt
heLM*cur
ve
mustr
etur
ntot
hei
rini
ti
alposi
ti
ons.Hence,underf
ixed exchanger
ates,
monet
arypol
i
cyi
sinef
fect
ual
.

40
TheMundel
l-
FlemingModelwi
thaChangi
ngPri
ceLevel
* *
• TheIS- LM model i
sconstr
uctedf
orfi
xedpricel
evel
.
• Howev
er,achangei
nthepr
icel
evelshi
ft
stheLM * cur
veandchangest
he
equi
l
ibr
ium i
ncome.
• Consi
derr
educt
ioni
nthepr
icel
evel
.Whent
hepr
icel
evelf
all
s,heLM*cur
t ve
shi
ft
stot
her
ight
.Theequi
l
ibr
ium l
evel
ofi
ncomer
ises.

TheShor
t-
RunandLong-
Run
Equi
li
bri
ainaSmal
lOpenEconomy
• Nowl
et’
scompar
etheshor
t-
runandt
hel
ong-
runequi
l
ibr
ium oft
heeconomy
usi
ngt S*-
heI LM *andaggr
egat
edemand-
aggr
egat
esuppl
ymodel
s.
• Poi
ntKi
nbot
hpanel
sshowst
heequi
l
ibr
ium undert
heKey
nesi
anassumpt
ion
t
hatt
hepr
icel
evel
isf
ixedatP1.
• Poi
ntCi
nbot
hpanel
sshowst
heequi
l
ibr
ium undert
hecl
assi
calassumpt
ion
̅
t
hatt
hepr
icel
evel
adj
ust
stomai
ntai
nincomeati
tsnat
ural
r e Y.
at

CHAPTERFI
VE:AGGREGATESUPPLY
1Th
5. eCl
assi
calappr
oacht
oaggr
egat
esuppl
y
• I
npr
evi
oussect
ionwehav
eanal
yzedt
hedemandsi
deoft
heeconomyt
aki
ng
t
hepr
icel
evelpasexogenousl
ydet
ermi
ned.Thi
ssect
iondev
elopst
hesuppl
y
si
deofmacr
oeconomy
.
• Byequat
ingSSandDDi
ntheeconomyweobt
ainendogenousl
ydet
ermi
ned
equi
l
ibr
ium v
alues ofout
putand t
he pr
ice l
evel
.we f
ocus on di
ff
erent
aggr
egat
esuppl
ymodel
s.

41
 • Aggr
egat
esuppl
yist
her
elat
ionshi
pbet
weenquant
it
yofgoodsandser
vices
suppl
iedandt
hepr
icel
evel
.
• Weneedt
odi
scusst
wodi
ff
erentaggr
egat
esuppl
ycur
ves:
• l
ongr
unaggr
egat
esuppl
ycur
veLRAS(
thecl
assi
cal
suppl
ycur
ve)and
• shor
t-
runaggr
egat
esuppl
ycur
veSRAS(
theKey
nesi
ansuppl
ycur
ve)
• Fi
nal
l
yanat
temptwi
l
lbemadet
opr
esentf
ourpr
omi
nentmodel
sofshor
t-
run
aggr
egat
esuppl
ycur
ve.

TheLongRun:t
heVer
ti
cal
Aggr
egat
eSuppl
yCur
ve
 Cl
assi
calmodeldescr
ibeshowt
heeconomybehav
esi
nthel
ongr
un;
weder
ive
t
hel
ong-
runaggr
egat
esuppl
ycur
vef
r hecl
om t assi
calmodel
.
 Thecl
assi
cal
aggr
egat
esuppl
ycur
vei
sver
ti
cal
,
 i
tisi
ndi
cat
ing t
hatt
he same amountofgoods wi
l
lbe suppl
i
ed
what
evert
hepr
icel
evel
or
 out
putdoesnotdependont
hepr
icel
evel
 Thecl
assi
cal
suppl
ycur
vei
sbasedont
heassumpt
ion
 l
abormar
keti
sinequi
l
ibr
ium wi
thf
ull
empl
oymentofl
abor

 I
ftheaggr
egat
esuppl
ycur
vei
sver
ti
cal
,thenchangesi
naggr
egat
edemand
af
fectpr
icesbutnotout
put
.Forexampl
e,i
fthemoneysuppl
yfal
l
s,t
he
aggr
egat
edemandcur
veshi
ft
sdownwar
ds.Theeconomymov
esf
rom poi
ntA
t
opoi
ntB.
 I
fiti
sani
ncr
easei
nmoneysuppl
y,t
heeconomymov
esf
rom At
oC.
Theshi
ft
i
naggr
egat
edemandaf
fect
sonl
ypr
ices.

42
 Thecl
assi
calmodelandt
hev
ert
icalaggr
egat
esuppl
ycur
veappl
yonl
yint
he
l
ongr
un.
 I
ntheshor
trun,somepr
icesar
est
ickyand,t
her
efor
e,do notadj
ustt
o
changesi
ndemand.
 Becauseoft
hispr
icest
icki
ness,shor
trunaggr
egat
esuppl
ycur
vei
snot
v
ert
ical
 Thi
siswhatwecal
ltheKey
nesi
anaggr
egat
esuppl
ycur
ve.
 I
ntheext
remeKey
nesi
ancaseAggr esuppl
egat ycur
vei
shor
izont
al.

 Thei
deaunder
lyi
ngt
heKey
nesi
anaggr
egat
esuppl
ycur
vei
sthatbecause
t
her
eisunempl
oyment
,fi
rmscanobt
ainasmuchl
aborast
heywantatt
he
cur
rentwage.
 Thei
rav
eragecost
sofpr
oduct
iont
her
efor
ear
eassumednott
ochangeas
t
hei
rout
putl
evel
s change.The shor
trun equi
l
ibr
ium oft
he economyi
s
obt
ainedatt
hei
nter
sect
ionoft
heAD cur
veandt
hehor
izont
alAScur
ve.
Supposecent
ralbankr
educest
hemoneysuppl
yandaggr
egat
edemandcur
ve
shi
ft
sdownwar
d.
 I
ntheshor
trun,
pri
cesar
est
icky
,sot
heeconomymov
esf
rom poi
ntAt
opoi
nt
B.

43
 Out
putand empl
oymentf
allbel
ow t
hei
rnat
urall
evel
s,whi
ch means t
he
economy
,isi
nrecessi
on.Ov
ert
ime,i
nresponset
othel
ow demand,wages
andpr
icesf
all
.
 Thegr
adualr
educt
ioni
nthepr
icel
evelmov
est
heeconomydownwar
dal
ong
t
heaggr
egat
edemandcur
vet
opi
ntC,whi
chi
sthenewl
ongr
unequi
l
ibr
ium.

2Th
5. eKeynesi
anappr
oacht
oaggr
egat
esuppl
y
5.
2.1TheFourModel
sofAggr
egat
eSuppl
y
 I
nthepr
evi
oussect
iont
heI
S-LM modelshowshowchangesi
nmonet
aryand
f
iscal
pol
i
cyt
othemoneyandgoodsmar
ketshi
ftt
heaggr
egat
edemandcur
ve.
 I
nthel
ongr
un,
pri
cesar
efl
exi
ble,
andt
heaggr
egat
esuppl
ycur
vei
sver
ti
cal
.
 Whent
heaggr
egat
esuppl
ycur
vei
sver
ti
cal
,shi
ft
sint
heaggr
egat
edemand
cur
veaf
fect
sthepr
icel
evel
,butout
putr
emai
nsunchanged.
 I
ntheshor
trun,
pri
cesar
est
icky
,andt
heaggr
egat
esuppl
ycur
vei
snotv
ert
ical
.
 I
nthi
scase,
shi
ft
sint
heaggr
egat
edemanddocausef
luct
uat
ionsi
nout
put
.
 I
nthi
ssect
ionwest
udyf
ourmodel
sofshor
t-
runAScur
ve.
 Al
thought
hesemodel
sdi
ff
eri
nsomesi
gni
fi
cantdet
ail
s,butwi
thcommon
concl
usi
ont
hatshor
t-
runaggr
egat
esuppl
ycur
vei
supwar
dsl
opi
ng.

Aggr
egat
esuppl
yequat
ionoft
hef
orm:
 Wher
eYi
sout
put
, i
sthenat
uralr
ateofout
put
,pi
sthepr
icel
evel
,andpei
s
t
heexpect
edpr
icel
evel
.
 Thi
sequat
ionst
atest
hatout
putdev
iat
esf
rom i
tsnat
uralr
atewhent
hepr
ice
l
evel
dev
iat
esf
rom t
heexpect
edpr
icel
evel
.
 Thepar
amet
erαi
ndi
cat
eshowmuchout
putr
espondst
ounexpect
edchanges
i
nthepr
icel
evel
.
 Eachoft
hesemodel
stel
l
sdi
ff
erentst
oryaboutwhatl
i
esbehi
ndt
hisshor
t-
run
aggr
egat
esuppl
yequat
ion.

44
  Di
ff
erentmodel
sofaggr
egat
esuppl
y:
 TheSt
icky–Pri
ceModel  TheSti
cky-WageModel
 TheI
mper f
ectI
nfor
mat
ion  The wor
ker
s-
Model misper
cepti
onmodel

Cour
seTi
tl
e:Macr
oeconomi
csI
I
Cour
seCode:Econ1032
Cour
seObj
ect
ive:
Thi
s cour
se has t
he obj
ect
ive of pr
ovi
ding st
udent
s wi
th t
he basi
cs of
macr
oeconomi
canal
ysi
s.Thecour
sei
sthussupposedt
oletst
udent
sunder
stand
t
hef
undament
alsoft
hei
nter
act
ionsofeconomi
cagent
satt
heaggr
egat
elev
el.Wi
th
t
hisper
spect
ive,st
udent
sar
eexpect
edt
oacqui
reatl
eastt
hef
ramewor
ktof
urt
her
anal
yzet
heaggr
egat
eint
eract
ionsamongeconomi
cagent
sthemsel
vesandt
he
out
comes t
hatt
hese i
nter
act
ions gener
atei
nthe economy atsome l
evelof
aggr
egat
ion.Thi
sisf
undament
all
ybasedont
heweal
thofmacr
oeconomi
ctheor
ies
t
hatcanbeascr
ibedt
othecl
assi
cal
andKey
nesi
anschool
soft
hought
.

Chapt
erOne

Behav
iour
alFoundat
ions:Theor
iesofConsumpt
ion
Topi
csunderdi
scussi
on:
 JohnMay
nar
dKey
nesandt
heConsumpt
ionFunct
ion
 I
rvi
ngFi
sherandI
nter
tempor
alChoi
ce
 Fr
ancoModi
gli
ani
andt
hel
i
fe-
cycl
eHy
pot
hesi
s
 Mi
l
tonFr
iedmanandt
hePer
manent
-I
ncomeHy
pot
hesi
s
 Rober
tHal
landt
heRandom-
Wal
kHy
pot
hesi
s
Thi
schapt
erpr
esent
sthevi
ewsoff
ivepr
omi
nenteconomi
stst
oshowt
hedi
ver
se
appr
oachest
oexpl
aini
ngconsumpt
ion.

JohnMay
nar
dKey
nesandt
heConsumpt
ionFunct
ion
Theconsumpt
ionf
unct
ionexhi
bist
t hr
eepr
oper
ti
est
hatKey
nesconj
ect
ured.
 Themar
ginal
propensi
tyt
oconsumeci
sbet
weenzer
oandone.
b/
c,whenaper
sonear
nsanext
radol
l
ar,het
ypi
cal
l
yspendssomeofi
t
andsav
essomeofi
t.

45
  Theav
eragepr
opensi
tyt
oconsumef
all
sasi
ncomer
ises.
Hebel
i
evedt
hatsav
ingwasal
uxur
y,soheexpect
edt
her
icht
osav
ea
hi
gherpr
opor
ti
onoft
hei
rincomet
hant
hepoor
 Consumpt
ioni
sdet
ermi
nedbycur
renti
ncome.
 i
ncomei
sthepr
imar
ydet
ermi
nantofconsumpt
ion
Key
nesi
anconsumpt
ionf
unct
ioni
sof
tenwr
it
tenas:

eCi
 wher sconsumpt
ion,Yi
sdi
sposabl
eincome,Ci
saconst
ant
,andci
sthe
mar
ginal
propensi
tyt
oconsume.
 Thi
sconsumpt
ionf
unct
ion,
showni
nFi
gur
e1.
1,i
sgr
aphedasast
rai
ghtl
i
ne.
 Not
ice t
hatt
his consumpt
ion f
unct
ion exhi
bit
sthe t
hree pr
oper
ti
es t
hat
Key
nesposi
ted.
 I
tsat
isf
ies1stpr
oper
tyb/
ctheMPCi
sbet
weenzer
oandone,
 sot
hathi
gheri
ncomel
eadst
ohi
gherconsumpt
ionandal
sot
ohi
gher
sav
ing
 I
tsat
isf
ies2ndpr
oper
tyb/
ctheAPCi
s

 AsYr
ises,
C/Yf
all
s,andsot
heAPCi
.e.C/
Yfal
l
s.And
 Fi
nal
l
y,t
hisconsumpt
ionf
unct
ionsat
isf
ies3rd pr
oper
tyb/
c
 t
hei
nter
estr
atei
snoti
ncl
udedi
nthi
sequat
ion
TheEar
lyEmpi
ri
calSuccesses
 Soonaf
terKey
neseconomi
stsbegancol
l
ect
ingandexami
ningdat
atot
est
hi
sconj
ect
ures.
 Theear
li
estst
udi
esi
ndi
cat
edt
hatt
heKey
nesi
anconsumpt
ionf
unct
ionwasa
goodappr
oxi
mat
ionofhowconsumer
sbehav
e.
 Theyf
oundt
hatHHswi
thhi
gheri
ncomeconsumedmor
e,whi
chconf
ir
ms
t
hatt
heMPCi
sgr
eat
ert
hanzer
o.
 Theyal
sof
oundt
hatHHswi
thhi
gheri
ncomesav
edmor
e,whi
chconf
ir
ms
t
hatt
heMPCi
slesst
hanone.
 I
naddi
ti
on,t
heyf
oundt
hathi
gher
-i
ncomeHHssav
edal
argerf
ract
ionof
t
hei
rincome,
whi
chconf
ir
mst
hatt
heAPCf
all
sasi
ncomer
ises.
 Thus,t
hesedat
aver
if
iedKey
nes’
sconj
ect
uresaboutt
hemar
ginalandav
erage

46
 pr
opensi
ti
est
oconsume.
 I
not
herst
udi
es,r
esear
cher
sexami
nedaggr
egat
edat
aonconsumpt
ionand
i
ncomef
ort
heper
iodbet
weent
het
wowor
ldwar
s.
 Thesedat
aal
sosuppor
tedt
heKey
nesi
anconsumpt
ionf
unct
ion.
 I
nyear
swheni
ncomewasunusual
l
ylow,suchasdur
ingt
hedept
hsoft
he
Gr
eatDepr
essi
on,
bot
hconsumpt
ionandsav
ingwer
elow,
 i
ndi
cat
ingt
hatt
heMPCi
sbet
weenzer
oandone.
 I
naddi
ti
on,
dur
ingt
hosey
ear
sofl
owi
ncome,
 t
her
ati
oofconsumpt
iont
oincomewashi
gh,conf
ir
ming2nd
conj
ect
ure.
 Fi
nal
l
y,becauset
hecor
rel
ati
onbet
weeni
ncomeandconsumpt
ionwasso
st
rong,
 noot
herv
ari
abl
eappear
edt
obei
mpor
tantf
orexpl
aini
ngconsumpt
ion.
Ther
efor
e,i
tconf
ir
medKeynes’
sthi
rdconj
ect
uret
hati
ncomei
sthepr
imar
y
det
ermi
nantofhowmuchpeopl
echooset
oconsume.

Secul
arSt
agnat
ion,
SimonKuznet
s,andt
heConsumpt
ionPuzzl
e
Al
thought
heKey
nesi
anconsumpt
ionf
unct
ionmetwi
thear
lysuccesses,t
wo
anomal
i
essoonar
ose.
Bot
hconcer
nKey
nes’
sconj
ect
uret
hatt
heAPCf
all
sasi
ncomer
ises.
Thef
ir
stanomal
ysomeeconomi
stsmadeer
roneous—pr
edi
cti
ondur
ingWor
ld
WarI
I.
 Theyr
easonedt
hat
:
 as i
ncomes i
nthe economy gr
ew ov
ert
ime,househol
ds woul
d
consumeasmal
l
erandsmal
l
erf
ract
ionoft
hei
rincomes.
 Theyf
ear
ed t
hatt
her
emi
ghtnotbeenough pr
ofi
tabl
einv
est
ment
pr
oject
stoabsor
bal
lthi
ssav
ing.
 Af
tert
heendofWor
ldWarI
Iincomeswer
emuchhi
gheraf
tert
hewart
han
bef
ore,t
hesehi
gheri
ncomesdi
dnotl
eadt
olar
gei
ncr
easesi
nther
ateof
sav
ing.
Keynes’
sconj
ect
uret
hatt
heaver
agepr
opensi
tyt
oconsumewoul
dfal
lasi
ncome
r
oseappear
ednott
ohol
d.
Thesecondanomal
yar
osewheneconomi
stSi
monKuznet
discov
eredt
hatt
her
ati
o

47
ofconsumpt
iont
oincomewasr
emar
kabl
yst
abl
efr
om decadet
odecade,despi
te
l
argei
ncr
easesi
nincomeov
ert
heper
iodhest
udi
ed.
 Agai
n,Key
nes’
sconj
ect
uret
hatt
heav
eragepr
opensi
tyt
oconsumewoul
dfal
l
asi
ncomer
oseappear
ednott
ohol
d.
 Thef
ail
ureoft
hesecul
ar-
stagnat
ionhy
pot
hesi
sandt
hef
indi
ngsofKuznet
s
 bot
hindi
cat
edt
hatt
heaver
agepr
opensi
tyt
oconsumei
sfai
rl
yconst
ant
overl
ongper
iodsoft
ime.
 Concl
usi
on,t
woconsumpt
ionf
unct
ions:
 Theshor
tti
me-
ser
ies,t
heKey
nesi
anconsumpt
ionf
unct
ionappear
edt
o
wor
kwel
l
.
 Yetf
ort
hel
ongt
ime-
ser
ies,
theconsumpt
ionf
unct
ionappear
edt
oexhi
bit
aconst
antav
eragepr
opensi
tyt
oconsume.
 Theset
wor
/psb/
nconsumpt
ionandi
ncomear edt
ecal
l heshor
t-
runandl
ong
-
runconsumpt
ionf
unct
ions.
Economi
stsneededt
oexpl
ainhow t
heset
woconsumpt
ionf
unct
ionscoul
d
beconsi
stentwi
theachot
her
.
I
nthe 1950s,Fr
anco Modi
gli
aniand Mi
l
ton Fr
iedman each pr
oposed
expl
anat
ionsoft
heseseemi
ngl
ycont
radi
ctor
yfi
ndi
ngs.

I
rvi
ngFi
sherandI
nter
tempor
alChoi
ce
 Theconsumpt
ionf
unct
ioni
ntr
oducedbyKey
nesr
elat
escur
rentconsumpt
ion
t
ocur
renti
ncome.
 Thi
srel
ati
onshi
p,howev
er,
isi
ncompl
eteatbest
.
 Whenpeopl
edeci
dehow mucht
oconsumeandhow mucht
osav
e,t
hey
consi
derbot
hthepr
esentandt
hef
utur
e.
 Themor
econsumpt
iont
heyenj
oyt
oday
,thel
esst
heywi
l
lbeabl
etoenj
oy
t
omor
row.
 I
nmaki
ngt
hist
radeof
f,HHsmustl
ookaheadt
othei
ncomet
heyexpectt
o
r
ecei
vei
nthef
utur
eandt
otheconsumpt
ionofgoodsandser
vicest
hey
hopet
obeabl
etoaf
for
d.
 Theeconomi
stI
rvi
ngFi
sherdev
elopedt
hemodelwi
thwhi
checonomi
sts
anal
yze how r
ati
onal
,for
war
d-l
ooki
ng consumer
s make i
nter
tempor
al
choi
ces—t
hati
s,choi
cesi
nvol
vi
ngdi
ff
erentper
iodsoft
ime.

48
 Fi
sher
’smodeli
ll
umi
nat
es
heconst
 t rai
ntsconsumer
sface,t
hepr
efer
encest
heyhave,and
how t
heseconst
rai
ntsandpr
efer
encest
oget
herdet
ermi
net
hei
r
choi
cesaboutconsumpt
ionandsav
ing
1.
1.1 TheI
nter
tempor
alBudgetConst
rai
nt
 Mostpeopl
ewoul
dpr
efert
oincr
easet
hequant
it
yorqual
i
tyoft
hegoodsand
ser
vicest
heyconsumet
owearni
cercl
othes,eatatbet
terr
est
aur
ant
s,orsee
mor
emov
ies.
 Ther
easonpeopl
econsumel
esst
hant
heydesi
rei
sthat
thei
rconsumpt
ioni
s
const
rai
nedbyt
hei
rincome, edabudgetconst
cal
l rai
nt.
 Ourf
ir
stst
epi
ndev
elopi
ngFi
sher
’smodeli
stoexami
net
hisconst
rai
nti
n
somedet
ail
.
 Tokeept
hingssi
mpl
e,weexami
net
hedeci
sionf
aci
ngaconsumerwhol
i
ves
f
ort
woper
iods.
Per
iodoner
epr
esent
stheconsumer
’sy
out
h,and
per
iodt
wor
epr
esent
stheconsumer
’sol
dage
 Theconsumerear ncomeY1andconsumesC1i
nsi nper
iodone,andear
ns
i
ncomeY2andconsumesC2i
nper
iodt
wo.
 (
Allvar
iabl
esar
ereal
—thati
s,adj
ust
edf
ori
nfl
ati
on.
)
 Becauset
heconsumerhast
heoppor
tuni
tyt
obor
rowandsav
e,consumpt
ion
i
nanysi
ngl
eper
iodcanbeei
thergr
eat
erorl
esst
hani
ncomei
nthatper
iod.
 Consi
der how t
he consumer
’si
ncome i
nthe t
wo per
iods const
rai
ns
consumpt
ioni
nthet
woper
iods.
 I
nthef
ir
stper
iod,
savi
ngequal
sincomemi
nusconsumpt
ion.Thati
s,

eSi
 wher ssavi
ng. -
--
--
--
--
--
--
--
--
--
--
--
--
-1
I
nthesecondper
iod,consumpt
ionequal
stheaccumul
atedsavi
ng,i
ncl
udi
ng
t
hei
nter
estear
nedont
hatsav
ing,
plussecond-
per
iodi
ncome.

Thati
s, -
--
--
--
--
--
--
--
--
--
--
--
2

Forex
ampl
e,i
fther
eali
nter
estr
atei
s5per
cent
,thenf
orev
ery$1ofsav
ingi
n
per
iodone,
theconsumerenj
oysanext
ra$1.
05ofconsumpt
ioni
nper
iodt
wo.
Becauset
her
eisnot
hir
dper
iod,t
heconsumerdoesnotsav
eint
hesecond

49
 per
iod.
Not
ethatt
hev
ari
abl
eScanr
epr
esentei
thersav
ingorbor
rowi
ng.
I
ffi
rst
-per
iodconsumpt
ioni
slesst
hanf
ir
st-
per
iodi
ncome,t
heconsumeri
s
sav
ing,
andSi
sgr
eat
ert
hanzer
o.
I
ffi
rst
-per
iod consumpt
ion exceedsf
ir
st-
per
iod i
ncome,t
he consumeri
s
bor
rowi
ng,
andSi
slesst
hanzer
o.
 Forsi
mpl
i
cit
y,weassumet
hatt
hei
nter
estr
atef
or(
bor
rowi
ng=sav
ing)
.
Toder
ivet
hebudgetconst
rai
nt,
combi
net
het
woequat
ions.
Subst
it
utet
he1stequat
ionf
orSi
ntot
he2ndequat
iont
oobt
ain
C2=(
1+r
)(Y1−C1)+Y2
Tomaket
heequat
ioneasi
ert
oint
erpr
et,
wemustr
ear
ranget
erms.
Topl
aceal
ltheconsumpt
iont
ermst
oget
her
,br
ing(
1+r
)C1f
rom t
her
ight
-
handsi
det
othel
eft
-handsi
deoft
heequat
iont
oobt
ain(
1+r
)C1+C2=(
1+
r
)Y1+Y2.
Nowdi
vi
debot
hsi
desby1+rt
oobt
ain
Thi
sequat
ionr
elat
esconsumpt
ioni
nthet
woper
iodst
oincomei
nthet
wo
per
iods.
I
tist
hest
andar
dwayofexpr
essi
ngt
heconsumer
’si
nter
tempor
albudget
const
rai
nt.1.
3.2ConsumerPr
efer
ences
Theconsumer
’spr
efer
encesr
egar
dingconsumpt
ioni
nthet
woper
iodscanbe
r
epr edbyi
esent ndi
ff
erencecur
ves.
Ani
ndi
ff
erencecur
veshowst
hecombi
nat
ionsof1st
-per
iodand2nd-
per
iod
consumpt
iont
hatmaket
heconsumerequal
l
yhappy
.
Theconsumeri
sindi
ff
erentamongcombi
nat
ionsW,X,andY,becauset
hey
ar
eal
lont
hesamecur
ve.
i
ftheconsumer
’sf
ir
st-
per
iodconsumpt
ioni
sreduced,sayf
rom poi
ntW t
o
poi
ntX,
second-
per
iodconsumpt
ionmusti
ncr
easet
okeephi
m equal
l
yhappy
.
Theconsumeri
sequal
l
yhappyatal
lpoi
ntsonagi
veni
ndi
ff
erencecur
ve,
but
hepr
efer
ssomei
ndi
ff
erencecur
vest
oot
her
s.
Because he pr
efer
s mor
e consumpt
ion t
oless,he pr
efer
s hi
gher
i
ndi
ff
erencecur
vest
olowerones.
Thesetofi
ndi
ff
erencecur
vesgi
vesacompl
eter
anki
ngoft
heconsumer
’s
pr
efer
ences.

50
 I
ttel
l
sust
hatt
heconsumerpr
efer
spoi
ntZt
opoi
ntW,
butt
hatshoul
d
beobv
iousbecausepoi
ntZhasmor
econsumpt
ioni
nbot
hper
iods.
1.
1.2 Opt
imi
zat
ion
Theconsumerwoul
dli
ket
o end up wi
tht
hebestpossi
blecombi
nat
ion of
consumpt
ioni
nthet
woper
iods—t
hati
s,ont
hehi
ghestpossi
blei
ndi
ff
erence
cur
ve.
Thehi
ghesti
ndi
ff
erencecur
vet
hatt
heconsumercanobt
ainwi
thoutv
iol
ati
ngt
he
budgetconst
rai
nti
sthei
ndi
ff
erencecur
vet
hatj
ustbar
elyt
ouchest
hebudget
l
i
ne,
whi
chi
scur
veI
C3i
nthef
igur
e.
Thepoi
ntatwhi
cht
hecur
veandl
i
net
ouch—poi
ntO,f
or“
opt
imum”
—ist
hebest
combi
nat
ionofconsumpt
ioni
nthet
woper
iodst
hatt
heconsumercanaf
for
d.
Not
icet
hat
,att
heopt
imum,t
hesl
opeoft
hei
ndi
ff
erencecur
veequal
sthesl
ope
oft
hebudgetl
i
ne.
Thei
ndi
ff
erencecur
vei
stangentt
othebudgetl
ine.
Thesl
opeoft
hei
ndi
ff
erencecur
vei
sthemar
ginalr
ateofsubst
it
utonMRS,and
i
t
hesl
opeoft
hebudgetl
i
nei
s1pl
ust
her
eal
int
erestr
ate.
Weconcl
udet
hatatpoi
ntO MRS=1+r
.
Theconsumerchoosesconsumpt
ioni
nthet
woper
iodssucht
hatt
hemar
ginal
r
ateofsubst
it
uti
onequal
s1pl
ust
her
eal
int
erestr
ate.

Fr
ancoModi
gli
aniandt
hel
if
e-cycl
eHypot
hesi
s
 I
nthe1950’
s,Fr
ancoModi
gli
ani
,AndoandBr
umber
gusedFi
sher
’smodelof
consumerbehav
iort
ost
udyt
heconsumpt
ionf
unct
ion.
 Oneoft
hei
rgoal
swast
ost
udyt
heconsumpt
ionpuzzl
e.
 Accor
dingt
oFi
sher
’smodel
,consumpt
iondependsonaper
son’
sli
fet
ime
i
ncome.
 Modi
gli
aniemphasi
zedt
hat
incomev
ari
essy
stemat
ical
l
yov
erpeopl
e’
sli
ves
andsav
ingal
l
owsconsumer
stomov
eincomef
rom t
hoset
imesi
nli
fewhen
i
ncomei
shi
ght
othoset
imeswheni
ncomei
slow.

51
 TheHy
pot
hesi
s
 Mostpeopl
epl
ant
ost
opwor
kingataboutage65,andt
heyexpectt
hei
r
i
ncomest
ofal
lwhent
heyr
eti
re,butdon’
twantadr
opi
nst
andar
dofl
i
ving
char
act
eri
zedbyconsumpt
ion.
Supposeaconsumerexpect
stol
i
veanot
herT
y
ear
s,hasweal
thofW andexpect
stoear
nincomeYunt
ilsher
eti
resRy
ear
s
f
rom now.
 Whatl
evelofconsumpt
ionwi
l
ltheconsumerchooset
o hav
easmoot
h
consumpt
ionov
erherl
i
fe?
TheLi
fe-
cycl
eConsumpt
ionFunct
ion
 TheLi
fet
imer
esour
cesofconsumerf
orTy
ear
sar
eweal
thW andl
i
fet
ime
ear
ningsofRxY(
assumi
ngi
nter
estr
atet
obezer
o).
 Tohav
esmoot
hestconsumpt
ionov
erl
i
fet
ime,
shedi
vi
dessucht
hat
C=(
W +RY)/T or
C=(
1/T)
W +(
R/T)
Y
 I
fsheexpect
sT=50andR=30,
thent
heconsumpt
ionf
unct
ionwi
l
lbe
C=1/50W +30/
50Y or
C=0.
02W +0.
6Y
 Thi
sequat
ionsay
sthatconsumpt
iondependsonbot
hincomeandweal
th.
 Anext
ra$1ofi
ncomepery
earr
aisesconsumpt
ionby$0.
60per
y
ear
,andanext
ra$1ofweal
thr
aisesconsumpt
ionby$0.
02per
y
ear
.
 Gener
ali
zi
ngf
orAggr
egat
eConsumpt
ionf
unct
ionoft
heeconomy
:
C=αW +βY
Wher
e,α=MPCoutofWeal
th
β=MPCoutofI
ncome
 Thel
i
fe-
cycl
emodelsay
sthatconsumpt
iondependsonweal
thaswel
las
i
ncome.
 Asar
esul
t,t
hei
nter
ceptoft
heconsumpt
ionf
unct
ionαW dependsonweal
th.
 Accor
dingt
oLi
fe-
cycl
econsumpt
ionf
unct
ion,
APC=C/
Y=α(
W/Y)+β
 Because,i
nshor
tper
iods,
weal
thdoesnotv
arypr
opor
ti
onat
elywi
thi
ncomes,
Hi
ghi
ncomescor
respondst
oLowAPC.
 Butov
erl
ongerper
iods,
weal
th and i
ncomes gr
ow t
oget
her
,resul
ti
ng i
n

52
 const
antW/
Yrat
ioandhenceaconst
antAPC.

Mi
lt
onFr
iedmanandt
hePer
manent
-I
ncomeHypot
hesi
s
 I
n1957,Mi
l
tonFr
iedmanpr he per
oposed t manent
-i
ncomehypot
hesi
sto
expl
ainconsumerbehav
ior
.
 I
tsessencei
sthatcur
rentconsumpt
ioni
spr
opor
ti
onal
toper
manenti
ncome.
 Fr
iedman’
s per
manent
-i
ncome hy
pot
hesi
s compl
ement
s Modi
gli
ani
’
sli
fe-
cy
clehy
pot
hesi
s:
 bot
huseFi
sher
’st
heor
yofconsumpt
ionshoul
dnotdependoncur
rent
i
ncomeal
one.
 Butunl
iket
hel
i
fe-
cycl
ehy
pot
hesi
s,
 whi
chemphasi
zest
hati
ncomef
oll
owsar
egul
arpat
ter
nov
eraper
son’
s
l
i
fet
ime,
 per
manent
-i
ncomehy
pot
hesi
semphasi
zest
hatpeopl
eexper
iencer
andom
andt
empor
arychangesi
nthei
rincomesf
rom y
eart
oyear
.
 Fr
iedmansuggest
edt
hatcur
renti
ncomeYast
hesum oft
wocomponent
s,
per ncomeYPandt
manenti ransi
tor
yincomeYT.
Y=YP +YT
 Per
manentI
ncomei
sthepar
tofi
ncomet
hatpeopl
eexpectt
oper
sisti
nthe
f
utur
e.
 Tr
ansi
tor
yincomei
sthepar
tofi
ncomet
hatpeopl
edonotexpectt
oper
sist
.
 Fr
iedmanr
easonedt
hatconsumpt
ionshoul
ddependpr
imar
il
yonper
manent
i
ncome
 b/
c consumer
s use sav
ings and bor
rowi
ngs t
o smoot
h consumpt
ion i
n
r
esponset
otr
ansi
tor
ychangesi
nincome.
 Fr
iedmanappr
oxi
mat
ionofconsumpt
ionf
unct
ioni
s:
C=αYP
 Whi
l
eAv
eragepr
opensi
tyt
oconsumei
s:
APC=C/
Y=αYP/
Y,WhenY>YP,
APCFal
l
s,WhenY<YP,
APCr
ises

Rober
tHal
landt
heRandom-
Wal
kHypot
hesi
s
 Rober
tHal
lwasf
ir
stt
oder
ivet
hei
mpl
i
cat
ionsofr
ati
onalexpect
ati
onsf
or
consumpt
ion.

53
  He showed t
hati
fthe per
manent
-i
ncome hy
pot
hesi
sis cor
rect
,and i
f
consumer
shav
erat
ionalexpect
ati
ons,t
henchangesi
nconsumpt
ionov
er
t
imeshoul
dbeunpr
edi
ctabl
e.
 Whenchangesi
nav
ari
abl
ear
eunpr
edi
ctabl
e,t
hev
ari
abl
eissai
dtof
oll
owa
r
andom wal
k.
 Accor
ding t
o Hal
l
,the combi
nat
ion oft
he per
manent
-i
ncome hy
pot
hesi
s
andr
ati
onal
expect
atonsi
i mpl
iest
hatconsumpt
ionf
oll
owsar
andom wal
k.
CHAPTERTWO

I
NVESTMENTTHEORY
 I
nvest
menti
sthemostv
olat
il
ecomponentofGDP.
 Whenexpendi
tur
eongoodsandser
vicesf
alldur
ingar
ecessi
on,
muchoft
he
decl
i
nei
susual
l
yduet
oadr
opi
ninv
est
mentspendi
ng.
 Themodel
sofGDP,
suchasI
S-LM model
,wer
ebasedonasi
mpl
einv
est
ment
f
unct
ionr
elat
ingi
nvest
mentt
oreal
int
erestr
at I=I
e: (r
)
 Thatf
unct
ion st
ates t
hatan i
ncr
ease i
nthe r
eali
nter
estr
ater
educes
I
nvest
ment
.
 Her
ewel
ookmor
ecl
osel
yatt
het
heor
ybehi
ndt
hisi
nvest
mentf
unct
ion.

Thr
eet
ypesofI
nvest
mentSpendi
ng
1)Busi
ness f
ixed i
nvest
ment
:incl
udes t
he equi
pmentand st
ruct
ures t
hat
busi
nessesbuyt
ousei
npr
oduct
ion.
2)Resi
dent
iali
nvest
ment
:incl
udest
henew housi
ngt
hatpeopl
ebuyt
oli
vei
n
andt
hatl
andl
ordsbuyt
orentout
.
3)I
nvent
oryi
nvest
ment
:incl
udest
hosegoodst
hatbusi
nessesputasi
dei
n
st
orage,i
ncl
udi
ng mat
eri
alsand suppl
i
es,wor
kin pr
ogr
ess,and f
ini
shed
goods.
 Weshal
lbui
l
dmodel
sofeacht
ypeofi
nvest
mentt
oexpl
aint
hef
luct
uat
ionsi
n
t
heeconomy
.
 Al
sot
hesemodel
swi
l
lshedl
i
ghtont
hequest
ionssuchas:
Whyi
nvest
menti
snegat
ivel
yrel
atedt
othei
nter
estr
ate?
Whatcausesi
nvest
mentf
unct
iont
oshi
ft
?
Whydoesi
nvest
mentr
isedur
ingboomsandf
all
dur
ingr
ecessi
ons?
2.
1.1Busi
nessFi
xedI
nvest
ment
 Thel
argestpi
eceofi
nvest
mentspendi
ng(
about¾oft
otal
)isbusi
nessf
ixed

54
 i
nvest
ment
.
Busi
ness:t
hesei
nvest
mentgoodsar
eboughtbyf
ir
msf
orusei
nfut
ure
pr
oduct
ion.
 Busi
ness Fi
xed i
nvest
ment i
ncl
udes ev
ery
thi
ng f
rom f
ax machi
nes t
o
f
act
ori
es,
comput
erst
ocompanycar
s.
 Thest
andar
dmodel
ofbusi
nessf
ixedi
nvest
menti
scal
l heneocl
edt assi
cal
modelofi
nvest
ment
.
 I
texami
nest
hebenef
it
sandcost
sofowni
ngcapi
tal
goods.
 Her
e ar
e t
hree v
ari
abl
es t
hat shi
fti
nvest
ment
: or t
he l
evel of
i
nvest
ment
/theaddi
ti
ont
othest
ockofcapi
tal
rel
atedt
o:
 mar
ginal
productofcapi
tal
 i
nter
estr
ate
 t
axr
ulesaf
fect
ingf
ir
ms
 To dev
elop t
hemodel
,imagi
net
hatt
her
ear
etwo ki
ndsoff
ir
msi
nthe
economy
:
pr
oduct
ionf
ir
mst
hatpr
oducegoodsandser
vicesusi
ngt
hecapi
talt
hat
t
heyr
ent
Rent
alf
ir
mst
hatmakeal
lthei
nvest
ment
sint
heeconomy
.theybuy
capi
tal
andr
enti
toutt
othepr
oduct
ionf
ir
ms.
i
. TheRent
alPr
iceofCapi
tal
 At
ypi
cal
product
ionf
ir
m deci
deshowmuchcapi
tal
tor
entbycompar
ingt
he
costandbenef
itofeachuni
tofcapi
tal
.
 Thef
ir
mrent
sCapi
tal
atar
ent
alr
ateRandsel
l
sit
sout
putatapr
iceP
 Ther
ealcostofauni
tofcapi
tal
tot
hepr
oduct
ionf
ir
misR/
P
 Ther
ealbenef
itofauni
tofcapi
tal
ist
hemar
ginal
productofcapi
tal
,MPK
(
theext
raout
putpr
oducedwi
thonemor
euni
tofcapi
tal
)
 MPKf
all
sast
heamountofcapi
tal
rises.
 Tomaxi
mizepr
ofi
t,t
hef
ir
mrent
scapi
tal
unt
ilt
hemar
ginal
productofcapi
tal
f
all
stoequal
ther
eal
rent
alpr
ice.
(seef
igur
ebel
ow)
MPK=R/
P
 HenceMPKdet
ermi
nest
hedownwar
dsl
opi
ngdemandcur
vef
orcapi
tal
fora
f
ir
m
 Whi
l
eatpoi
nti
nti
me,
theamountofcapi
tal
inaneconomyi
sfi
xed,
sosuppl
y

55
 cur
vei
sfi
xed.
 So,
tomaxi
mizepr
ofi
t,t
hef
ir
mrent
scapi
tal
unt
ilt
heMPKf
all
sto:
 Ther
ealr
ent
alpr
iceofcapi
tal
adj
ust
stoequi
l
ibr
atet
hedemandf
orcapi
tal
(
det
ermi
nedbyt
hemar
ginal
productofcapi
tal
)andt
hef
ixedsuppl
y.
 TheCobb-
Dougl
aspr
oduct
ionf
unct
ionser
vesasagoodappr
oxi
mat
ionofhow
t
heact
ual
economyt
urnscapi
tal
andl
abori
ntogoodsandser
vices

 TheCobb-
Dougl
aspr
oduct
ionf
unct
ioni
s:
wher
e
Y i
sout
put
,K capi
tal
,L l
abor
 A apar
amet
ermeasur
ingt
hel
evel
oft
echnol
ogy
 α apar
amet
erbet
ween0and1t
hatmeasur
escapi
tal
’
sshar
eofout
put
.
 Themar
ginal
productofcapi
tal
(MPK)f
ort
heCobb-
Dougl
aspr
oduct
ion
f
unct
ioni
s:
1-
α
 MPK=αA(
L/K)
 Becauset
her
eal
rent
alpr
ice(
R/P)equal
sMPKi
nequi
l
ibr
ium,
wecanwr
it
e:
1-
α
R/
P=αA(
L/K)
 Thi
sexpr
essi
oni
dent
if
iest
hev
ari
abl
est
hatdet
ermi
net
her
eal
rent
alpr
ice.I
t
showst
hef
oll
owi
ng:
 Thel
owert
hest
ockofcapi
tal
,thehi
ghert
her
eal
rent
alpr
iceofcapi
tal
 Thegr
eat
ert
heamountofl
aborempl
oyed,
thehi
ghert
her
eal
rent
alpr
iceof
capi
tal
s
 Thebet
tert
het
echnol
ogy
,thehi
ghert
her
eal
rent
alpr
iceofcapi
tal
.
 Ev
ent
sthatr
educet
hecapi
tal
stock,
orr
aiseempl
oyment
,ori
mpr
ovet
he
t
echnol
ogy
,rai
set
heequi
l
ibr
ium r
eal
rent
alpr
iceofcapi
tal
.
i
. TheCostofCapi
tal
 TheRent
alf
ir
ms,j
ustl
i
kecarr
ent
alf
ir
msmer
elybuycapi
talgoodsandr
ent
t
hem out
.
 Let
’sconsi
dert
hebenef
itandcostofowni
ngcapi
tal
.
 Thebenef
itofowni
ngcapi
tali
sther
ealr
ent
alpr
iceofcapi
talR/
Pforeachuni
t
ofcapi
tal
itownsandr
ent
sout
.
 Foreachper
iodoft
imet
hataf
ir
mrent
soutauni
tofcapi
tal
,ther
ent
alf
ir
m
bear
sthr
eecost
s:

56
 I
nter
estont
hei
rloans,whi
chequal
sthepur
chasepr
iceofauni
tofcapi
talPK
t
imest
hei
nter
estr
ate,
i,soi
PK
 Thecostoft
hel
ossorgai
nont
hepr
iceofcapi
tal
denot
edas-
PK
 Themi
nussi
gni
sher
ebecausewear
emeasur
ingcost
s,notbenef
it
s.
 Depr
eci
ati
ondef
inedast
hef
ract
ionofv
aluel
ostperper
iodbecauseoft
he
wearandt
ear
,so
PK
Tot
alcostofcapi
tal
=iPK-PK+
PK
=PK(
i-PK/
PK+
)
 Thecostofcapi
taldependsupont
hepr
iceofcapi
tal
,thei
nter
estr
ate,r
ateof
changeofcapi
tal
pri
cesandt
hedepr
eci
ati
onr
ate.
 Exampl
e:ACarr
ent
alcompany
 Buy
scar
sfor$1,
000,
000eachandr
ent
sthem outt
oot
herbusi
nesses
 I
fitf
acesani
nter
estr
atei
of10%pery
ear
,sot
hei
nter
estcost
,iPk=
$100,
000pery
earf
oreachcart
hecompanyowns.
 Carpr
icesar
eri
si
ngat6%pery
ear
,soexcl
udi
ngmai
ntenancecost
sthef
ir
m
get
sacapi
tal
gai
n,Pk=$60,
000pery
ear
 Car
sdepr
eci
ateat20%pery
earso,
l
ossduet
owearandt
ear
,Pk=$200,
000
 So,
Tot
alcostofcapi
tal
=iPK-PK+
PK
=100,
000–60,
000+200,
000
=$240,
000
 Thecostt
othecar
-r
ent
alcompanyofkeepi
ngacari
nit
scapi
tal
stocki
s
$2,
400/y
ear
.
 Tomaket
heexpr
essi
onf
ort
hecostofcapi
tal
simpl
erandeasi
ert
oint
erpr
et,
weassumet
hatt
hepr
iceofcapi
tal
goodsr
iseswi
tht
hepr
icesofot
hergoods.
 I
nthi PK/
scase, PKequal
stheover
allr
ateofi
nfl
ati
onp.Becausei
-πequal
s
t
her
eal
int
erestr
ater
,wecanwr
it
ethecostofcapi
talas
CostofCapi
t =PK(
al r+)
.
 Thi
sequat
ionst
atest
hatt
hecostofcapi
tal
dependsont
he
 pr
iceofcapi
tal
,
 t
her
eal
int
erestr
ate,
and
 t
hedepr
eci
ati
onr
ate.
 Fi
nal
l
y,wewantt
oexpr
esst
hecostofcapi
tal
rel
ati
vet
oot
hergoodsi
nthe

57
 economy
.
Ther
ealcostofcapi
tal
—thecostofbuy
ingandr
ent
ingoutauni
tofcapi
tal
measur
edi
nuni
tsoft
heeconomy
’sout
put
—is
 RealCostofCapi
t PK/
al=( P)(
r+)
.
Thi
sequat
ionst
atest
hatt
her
eal
costofcapi
tal
dependsont
her
elat
ivepr
ice
ofacapi
t goodPK/
al P,t
her
eali
nter
estr
ater
,andt
hedepr
eci
ati
onr
ate.
TheDet
ermi
nant
sofI
nvest
ment
 Nowconsi
derar
ent
alf
ir
m’sdeci
sionaboutwhet
hert
oincr
easeordecr
ease
i
tscapi
tal
stock.
 Foreachuni
tofcapi
tal
,thef
ir
m ear
nsr
ealr
evenueR/
Pandbear
sther
eal
cost(
PK/
P)(
r+
).
 Ther
eal
prof
itperuni
tofcapi
tal
is
Pr
ofi
trat
e=Rev
enue–Cost=R/
P -(
PK/
P)(
r+
)
 Becauser
ealr
ent
alpr
iceequal
sthemar
ginalpr
oductofcapi
tal
,wecanwr
it
e
t
hepr
ofi
trat
eas: Pr
ofi
trat
e=MPK-(
PK/P)
(r+
)
Thechangei
nthecapi
tal
stock,
cal
l
edneti
nvest
mentdependsont
he
di
ff
erencebet
weent
heMPKandt
hecostofcapi
tal
.
I
ftheMPKexceedst
hecostofcapi
tal
,fi
rmswi
l
laddt
othei
rcapi
tal
st
ock.
I
ftheMPKf
all
sshor
toft
hecostofcapi
tal
,theyl
ett
hei
rcapi
tal
stock
shr
ink.
Thus:
K=I
n[MPK-(
PK/P)
(r+
)]
wher
eIn()i
sthef
unct
ionshowi
nghowmuchneti
nvest
mentr
espondst
o
t
hei
ncent
ivet
oinv
est
.
Wecannowder
ivet
hei
nvest
mentf
unct
ioni
ntheneocl
assi
cal
model
of
i
nvest
ment
.
Tot
alspendi
ngonbusi
nessf
ixedi
nvest
menti
sthesum ofneti
nvest
ment
andt
her
epl
acementofdepr
eci
atedcapi
tal
.

Thi
s model
shows why

58
 i
nvest
mentdependsont
her
eal
int
erestr
ate.
Adecr
easei
nther
eali
nter
estr
atel
ower
sthecostofcapi
tal
.Itt
her
efor
e
r
aisest
he amountofpr
ofi
tfr
om owni
ng t
he capi
taland i
ncr
easest
he
i
ncent
ivet
oaccumul
atemor
ecapi
tal
.
Si
mil
arl
yani
ncr
easei
nreali
nter
estr
ater
aisescostofcapi
talandl
eadst
he
f
ir
mst
oreducet
hei
rinv
est
ment
.
TheSt
ockMar
ketand Tobi
n’sq
 Thet
erm st
ockr
efer
stot
heshar
esi
ntheowner
shi
pofcor
por
ati
ons
 Thest
ockmar
keti
sthemar
keti
nwhi
cht
heseshar
esar
etr
aded.
 TheNobel
-Pr
ize-
winni
ngeconomi
stJamesTobi
npr
oposedt
hatf
ir
msbaset
hei
r
i
nvest
mentdeci
si
onsont
hef
oll
owi
ngr
ati
o,whi
chi edTobi
snowcal
l n’sq:

 Thenumer
atorofTobi
n’
sqi
sthev
alueoft
heeconomy
’scapi
tal
asdet
ermi
ned
byt
hest
ockmar
ket
.
 Thedenomi
nat
ori
sthepr
iceofcapi
tal
asi
fitwer
epur
chasedt
oday
.
 Tobi
nconv
eyedt
hatneti
nvest
mentshoul
ddependonwhet
herqi
sgr
eat
eror
l
esst
han1.
fqi
 I sgr
eat
ert
han1,t
hent
hest
ockmar
ketval
uesi
nst
all
edcapi
talat
mor
ethani
tsr
epl
acementcost
,thef
ir
msr
aiset
hev
alueoft
hei
rst
ock
byi
ncr
easi
ngcapi
tal
.
fqi
 I slesst
han1,t
he st
ockmar
ketv
aluescapi
talatl
esst
hani
ts
r
epl
acementcost
.Int
hiscase,manager
swi
l
lnotr
epl
acecapi
talasi
t
wear
sout
.

Resi
dent
ialI
nvest
ment
 Wewi
l
lnowconsi
dert
hedet
ermi
nant
sofr
esi
dent
ial
inv
est
mentbyl
ooki
ngata
si
mpl
emodel
oft
hehousi
ngmar
ket
.
 Resi
dent
ial
inv
est
menti
ncl
udest
hepur
chaseofnewhousi
ngbot
hbypeopl
e
whopl
ant
oli
vei
nitt
hemsel
vesandbyl
andl
ordswhopl
ant
orenti
ttoot
her
s.
 Tokeept
hingssi
mpl
e,weshal
lassumet
hatal
lhousi
ngi
sowner
-occupi
ed.
 Ther
ear
etwopar
tst
othemodel
:
1)Themar
ketf
ort
heexi
sti
ngst
ockofhousesdet
ermi
nest
heequi
l
ibr
ium

59
 housi
ngpr
ice
2)Thehousi
ngpr
icedet
ermi
nest
hef
lowofr
esi
dent
ial
inv
est
ment
 Ther
elat
ivepr
iceofhousi
ngadj
ust
stoequi
l
ibr
atesuppl
yanddemandf
ort
he
exi
sti
ngst
ockofhousi
ngcapi
tal
.
 Const
ruct
ionf
ir
msbuymat
eri
alsandhi
rel
abort
obui
l
dthehousesandt
hensel
l
t
hem atmar
ketpr
ice.
 Thei
rcost
sdependont
heov
eral
lpr
icel
evelPwhi
l
ethei
rrev
enuedependson
t
hepr
iceofhousesPH.TheHi
ghert
hePH,
thegr
eat
eri
ncent
ivet
obui
l
dhouse.
 Thi
smodelofr
esi
dent
iali
nvest
menti
smuchsi
mil
art
oqt
heor
yofbusi
ness
f
ixedi
nvest
ment
,whi
chst
atest
hatbusi
nessf
ixedi
nvest
mentdependsont
he
mar
ketpr
iceofi
nst
all
edcapi
talr
elat
ivet
oit
srepl
acementcost
,whi
chi
ntur
n
dependsonexpect
edpr
ofi
tsf
rom owni
ngi
nst
all
edcapi
tal
 Ther
esi
dent
iali
nvest
mentdependsont
her
elat
ivepr
iceofhousi
ng,whi
chi
n
t
urn dependson demand f
orhousi
ng,dependi
ng on t
hei
mput
ed r
entt
hat
i
ndi
vi
dual
sexpectt
orecei
vef
rom t
hei
rhousi
ng
 Whent
hedemandf
orhousi
ngshi
ft
s,t
heequi
l
ibr
ium pr
iceofhousi
ngchanges,
andt
hischangei
ntur
naf
fect
sresi
dent
iali
nvest
ment
.Ani
ncr
easei
nhousi
ng
demand,per
hapsduet
oaf
alli
nthei
nter
estr
ate,r
aiseshousi
ngpr
icesand
r
esi
dent
ial
inv
est
ment
.
3I
2. nvent
oryI
nvest
ment
• I
nvent
oryi
nvest
ment
,thegoodst
hatbusi
nessesputasi
dei
nst
orage,
isatt
he
samet
imenegl
i
gibl
eandofgr
eatsi
gni
fi
cance.
• I
tisoneoft
hesmal
l
estcomponent
sofspendi
ng,
yeti
tsv
olat
il
it
ymakesi
t
cr
it
ical
int
hest
udyofeconomi
cfl
uct
uat
ions.
• I
nrecessi
on,
fir
msst
opr
epl
eni
shi
ngt
hei
rinv
ent
oryasgoodsar
esol
d,and
i
nvent
oryi
nvest
mentbecomesnegat
ive
Reasonsf
orHol
dingI
nvent
ori
es
pr
oduct
ionsmoot
hing st
ock-
outavoi
dance
i
nvent
ori
esasaf
act
orof wor
kinpr
ocess
pr
oduct
ion
TheAccel
erat
orModelofI
nvent
ori
es
 Theaccel
erat
ormodelassumest
hatf
ir
mshol
dast
ockofi
nvent
ori
est
hati
s
pr
opor
ti
onal
tot
hef
ir
m’sl
evel
ofout
put
.

60
  Whenout
puti
shi
gh,manuf
act
uri
ngf
ir
msneedmor
emat
eri
alsandsuppl
i
es
onhand,
andmor
egoodsi
npr
ocessofcompl
eti
on.
 WhenEconomyi
sboomi
ng,r
etai
lfi
rmswantt
ohav
emor
emer
chandi
seon
t
hei
rshel
vest
oshowcust
omer
s.
 Thus,
ifNi
stheeconomy
’sst
ockofi
nvent
ori
esandYi
sout
put
,then
N=bY
 Wher
e,bi
sapar
amet
err
efl
ect
inghowmuchi
nvent
oryf
ir
mswi
sht
ohol
dasa
pr
opor
ti
onofout
put
.
 I
nvent
oryi
nvest
mentIi
sthechangei
nthest
ockofi
nvent
ori
esDN.
Ther
efor
e,I=DN=bDY
 Theaccel
erat
ormodelpr
edi
ctst
hati
nvent
oryi
nvest
menti
spr
opor
ti
onalt
o
t
hechangei
nout
put
 Whenout
putr
ises,
fir
mswantt
ohol
dal
argerst
ockofi
nvent
ory
,soi
nvent
ory
i
nvest
menti
shi
gh
 Whenout
putf
all
s,f
ir
mswantt
ohol
dasmal
l
erst
ockofi
nvent
ory
,sot
hey
al
l
owt
hei
rinv
ent
oryt
orundown,
andi
nvent
oryi
nvest
menti
snegat
ive.
 Themodelsay
sthati
nvent
oryi
nvest
mentdependsonwhet
hert
heeconomy
i
sspeedi
nguporsl
owi
ngdown.
Chapt
er3:MoneyDemandandMoneySuppl
y
1Ba
3. nks’
rol
eint
heMoneySuppl
y
 Themoneysuppl
yequal
scur
rencypl
usdemand(
checki
ngaccount
)deposi
ts:
M=C+D
 Si
ncet
hemoneysuppl
yincl
udesdemanddeposi
ts,
thebanki
ngsy
stem pl
aysan
i
mpor
tantr
ole.
Af
ewpr
eli
minar
ies:
 Reser
v R)
es( :t
hepor
ti
onofdeposi
tst
hatbankshav
enotl
ent
.
 Abank’
sli
abi
l
iti
esi
ncl
udedeposi
ts,
asset
sincl
uder
eser
vesandout
standi
ng
l
oans.
 100-
per
cent
-r
eser
vebanki
ng:asy
stem i
nwhi
chbankshol
dal
ldeposi
tsas
r
eser
ves.
 Fr
act
ional
-r
eser
vebanki
ng:
asy
stem i
nwhi
chbankshol
daf
ract
ionoft
hei
r
deposi
tsasr
eser
ves.
Tounder
standt
her
oleofbanks,
wewi
llconsi
dert
hreescenar
ios:

61
a)Nobanks
b)100-
per
centr
eser
vebanki
ng(
bankshol
dal
ldeposi
tsasr
eser
ves)
c)Fr
act
ional
-r
eser
vebanki
ng(
bankshol
daf
ract
ionofdeposi
tsasr
eser
ves,
use
t
her
estt
omakel
oans)
 I
neachscenar
i weassumeC=$1000.
o,
SCENARI
O1:Nobankswi
thnobanks, D=0 and M =C=$1000.

62
63
Thr
eei
nst
rument
sofmonet
arypol
icy
1)Open-
mar
ketoper
ati
ons
2)Reser
ver
equi
rement
s
3)Thedi
scountr
ate
Open-
mar
ketoper
ati
ons

64
  Def
ini
ti
on:
Thepur
chaseorsal
eofgov
ernmentbondsbyt
heFeder
alReser
ve.
 howi
twor
ks:
I
fFedbuy
sbondsf
rom t
hepubl
i
c,i
tpay
swi
thnewdol
l
ars,i
ncr ngB and
easi
t
her
ef eM.
or
Reser
ver
equi
rement
s
 Def
ini
ti
on:
Fedr
egul
ati
onst
hatr
equi
rebankst
ohol
dami
nimum r
eser
ve-
deposi
trat
io.
 howi
twor
ks:
Reser
ver
equi
rement
saf
fectr
randm:I
fFedr
educesr
eser
ver
equi
rement
s,
t
henbankscanmakemor
eloansand“
creat
e”mor
emoneyf
rom each
deposi
t.
Thedi
scountr
ate
 Def
ini
ti
on:
Thei
nter
estr
atet
hatt
heFedchar
gesonl
oansi
tmakest
obanks.
 howi
twor
ks:
 Whenbanksbor
rowf
rom t
heFed,
thei
rreser
vesi
ncr
ease,
all
owi
ngt
hem t
o
makemor
eloansand“
creat
e”mor
emoney
.TheFedcani easeB by
ncr
l
ower
ingt
hedi
scountr
atet
oinducebankst
obor
rowmor
ereser
vesf
rom t
he
Fed.
Whi
chi
nst
rumenti
susedmostof
ten?
 Open-
mar
ketoper
ati
ons:
mostf
requent
lyused.
 Changesi
nreser
ver
equi
rement
s:l
eastf
requent
lyused.
 Changesi
nthedi
scountr
ate:
lar
gel
ysy
mbol
i
c.
TheFedi
sa“
lenderofl
astr
esor
t,
”doesnotusual
l
ymakel
oanst
obankson
demand.
NewI
nst
rument
sofMonet
aryPol
icy
 Fi
nanci
alCr
isi
sledFedt
ouseNewTool
s
 Ter
m Auct
ionFaci
li
ty:
 Al
l
owsbankst
obor
rowr
eser
vest
hroughanauct
ionmechani
sm.
 Af
fect
sthemonet
arybasej
ustl
i
kebor
rowi
ngt
hrought
hedi
scount
wi
ndow.
 Pay
ingI
nter
estonReser
ves:

65
  Hi
gheri
nter
estr
ateonr
eser
veshel
dondeposi
tatt
heFedl
eads
bankst
ohol
dmor
ereser
ves.
 Af
fect
sther
eser
ve-
deposi
trat
ioand,
int
urn,
themoneymul
ti
pli
er.
MoneyDemand
Twot
ypesoft
heor
ies
 Por
tfol
i
otheor
ies
 emphasi
ze“
stor
eofv
alue”f
unct
ion
 r
elev orM2,
antf M3
 notr
elev orM1.(
antf Asast
oreofv
al M1i
ue, sdomi
nat
edbyot
her
asset
s.)
 Tr
ansact
ionst
heor
ies
 emphasi
ze“
medi
um ofexchange”f
unct
ion
 al
sor
elev orM1
antf
Asi
mpl
epor
tfol
iot
heor
y

wher
e
r
s=expect
edr
eal
ret
urnonst
ocks
r
b=expect
edr
eal
ret
urnonbonds
πe=expect
edi
nfl
ati
onr
ate
W=r
eal
weal
th
TheBaumol
-Tobi
nModel
 at
ransact
ionst
heor
yofmoneydemand
 not
ati
on:
Y=t
otal
spendi
ng,
donegr
adual
l
yov
ert
hey
ear
i
=int
erestr
ateonsav
ingsaccount
N=numberoft
ri
psconsumermakest
othebankt
owi
thdr
awmoneyf
rom sav
ings
account
F=costofat
ri
ptot e.
hebank( g.
,i
fat
ri
ptakes15mi
nut
esandconsumer
’swage
=$12/
hour
,thenF=$3)
.
Chapt
er4:TheLabourMar
ket
Chapt
erObj
ect
ives:
Att
heendoft
hischapt
ery
ouwi
llbeabl
eto:

66
  El
abor
atehowpeopl
emakechoi
cesbet
weenl
eisur
eandhour
sofwor
k
 I
dent
if
ythei
ncomeandsubst
it
uti
onef
fect
sofawagei
ncr
easeonl
abour
suppl
y
 Ment
ionanddi
scusst
hedet
ermi
nant
sofl
abourdemand
 Show how t
hei
nter
act
ionb/
nsuppl
yofanddemandf
orl
abourdet
ermi
nes
wager
ateandempl
oymenti
ntheneocl
assi
cal
model
ofl
abourmar
ket
 Di
sti
ngui
shbet
weent
heNeocl
assi
cal
,Key
nesi
anandNewKey
nesi
anv
iewof
t
hel
abourmar
ketandt
hei
rimpl
i
cat
ions
 Ment
ionandexpl
aint
hecausesofunempl
oyment
 Di
scuss how gov
ernmentpol
i
cy i
nter
vent
ions & f
ir
ms deci
sion af
fect
s
empl
oyment
4.
1Int
roduct
ion
 We hav
elear
ntaboutt
wo maj
orcomponent
s ofGDP,consumpt
ion and
i
nvest
ment
.Wedi
scussedt
heexpor
ts,
andi
mpor
tsi
nthef
ir
sthal
foft
hecour
se.
Anot
herwayofmeasur
ingGDPi
sthr hei
ought ncomeappr
oach,whi
chi
nvol
ves
f
act
orsofpr
oduct
ion.
 Labormar
keti
s wher
e an i
mpor
tantf
act
orofpr
oduct
ion i
str
aded wi
th
i
mpl
i
cat
ionsf
ort
hel
evel
ofout
putpr
oduced.

I
nthi
ssect
ion,
ther
efor
e,wewi
l
lat
temptt
olear
nhowt
hel
abormar
ketwor
ksby
l
ooki
ngatneocl
assi
calmi
croeconomi
csmodelandt
heNew Key
nesi
anv
iew of
t
hel
abourmar
ket
.

Neocl
assi
calMi
croeconomi
csModelOfTheLabourMar
ket
TheNeocl
assi
calTheor
yofLaborSuppl
y
Tohol
dapai
djob,
youmustf
ir
sthav
edeci
dedt
odoso.Thi
sist
hest
art
ingpoi
ntof
t
heso-
cal
l
ed‘
‘
Neocl
assi
cal
’
’theor
yofl
aboursuppl
y.I
tposi
tst
hateachi
ndi
vi
dual
di
sposesofal
i
mit
edamountoft
ime,whi
chs/
hechoosest
oal
l
ocat
ebet
weenpai
d
wor
kandl
eisur
e.
 Assuch,t
heNeocl
assi
calt
heor
yofl
aboursuppl
yisbasedonamodelofa
consumermaki
ngachoi
cebet
weenconsumi
nggoodsandl
eisur
e.
 Choi
ceBet
weenConsumpt
ionandLei
sur
e
I
tisassumedt
hatconsumerder
ivesut
il
it
yfr
om t
wosour
ces:
Thequant
it
yofconsumergoods(
aggr
egat
edt
oCwi
thpr
icenor
mal
i
zedt
ouni
ty)
and

67
 t
heamountofl
eisur
e(t
imedevot
edt
oot
heract
ivi
ti
est
hanwor
k,denot
edbyL)
Twokeyassumpt
ionsusedbyt
hemodel
:
i
.Peopl
eactt
omaxi
mizet
hei
rwel
far
e,orut
il
it
y(i
.e.peopl
edot
hebestt
heycanwi
th
whatt
heyhav
e).
i
i
.Peopl
eexper
iencedi
mini
shi
ngmar
ginalbenef
itt
oconsumi
ngext
raconsumpt
ion
goodsorext
ral
eisur
e(i
.e.t
hei
rwel
far
egoesupbutatadi
mini
shi
ngr
ate)
.
Weassumet
hatawor
kerwant
stoachi
evet
hemi
xofr
eali
ncomeandl
eisur
ethati
s
mostsat
isf
act
oryt
ohi
m orher
.Todev
elopt
hel
aboursuppl
ymodel
,weuset
he
mi
croeconomi
csmodelofconsumerbehav
iorwher
etheconsumermaxi
mizesut
il
it
y
subj
ectt
ohi
s/herbudgetconst
rai
nt.
A.Consumer
’sPr
efer
ences
The t
rade-
offb/
n consumpt
ion and l
eisur
e can be depi
cted by t
he hel
p of
i
ndi
ff
erencecur
veanal
ysi
sofaut
il
it
yfunct
ion,U(
C,L)
,wher
eCandLdesi
gnat
e,
r
espect
ivel
ytheconsumpt
ionofgoodsandt
heconsumpt
ionofl
eisur
e.
Thesl
opeoft
hei
ndi
ff
erencecur
veatagi
venpoi
ntdef
inest
hemar
ginalr
ateof
subst
it
uti
onb/
nconsumpt
ionandl
eisur
e(MRSCL)
.
I
trepr
esent
sthehour
sofl
eisur
ewhi
chaconsumermustgi
veupi
nexchangef
oran
hourofwor
korconsumpt
iongoods,f
orhi
s/herl
evelofsat
isf
act
iont
oremai
n
unchanged.
B.Consumer
’sBudgetConst
rai
nt
 Nowl
et’
sconsi
deral
lther
esour
cesav
ail
abl
etoaper
son.Theconsumerhasnon
-
labori
ncome(
R)and24hour
sadaywhi
chs/
hecanuset
owor
kandgeti
ncome
( ewT i
wher sthewagei
ncomef
rom wor
kingal
lthepossi
blehour
sav
ail
abl
e).
Peopl
ecant
henuset
hisi
ncomet
obuyconsumpt
iongoods(
C)orl
eisur
ehour
s
wL)
( .Thi
sgi
vesusabudgetconst
rai
ntoft
hef
orm:
C +wL =wT +R
Thi
s equat
ion st
ates t
hata per
son can use hi
s/heri
ncome t
o ei
therbuy
consumpt
iongoods,ort
o“buy
”lei
sur
eti
me.Her
ethepr
iceoft
hel
eisur
eti
mewe
“
buy
”ist
heoppor
tuni
tycostoft
hatt
ime,whi
chsi
mpl
yequal
sthewagei
ncomewe
di
dnotear
n,butcoul
dhav
e.
C.Consumer
’sChoi
ce-
Opt
imalAl
locat
ionOfTi
meb/
nWor
kandLei
sur
e
Sof
ar,
wehav
edev
elopedt
heconsumer
’sconsumpt
ion-
lei
sur
epr
efer
encecur
veand
t
he Consumer
’s Consumpt
ion-
Lei
sur
e BudgetLi
ne.Now,l
et’
s def
ine consumer

68
equi
l
ibr
ium.
D.Ef
fectofWageI
ncr
easeonLaborSuppl
y
Nowconsi
derwhathappenst
olaborsuppl
ywhent
hewager
ater
ises.Achangei
n
Wager
atecausest
woef
fect
s:
1.Subst
it
uti
onEf
fect
—ast
hepr
iceofl
eisur
eincr
eases,t
heamountofl
eisur
e
consumedgoesdown,andt
heamountofl
aborser
vicessuppl
i
edi
ncr
eases,
hol
dingut
il
it
yconst
ant
.
2.I
ncomeEf
fect
—aspeopl
e’
sincomei
ncr
eases,t
heamountofl
eisur
econsumed
i
ncr
eases,andt
heamountofl
aborser
vicessuppl
i
eddecr
eases.Wecanshow
t
heset
woef
fect
sgr
aphi
cal
l
yasf
oll
ow:
Summar
y:Thenetef
fect
sofawagei
ncr
easeonl
aboursuppl
y:
 Hi
gherwage wi
l
lincr
ease l
aboursuppl
y(decr
ease demand f
orl
eisur
e)i
f
subst
it
uti
onef
fecti
sst
rongert
hani
ncomeef
fect
:
 Hi
gherwagewi
l
ldecr
easel
aboursuppl
y(i
ncr
easedemandf
orl
eisur
e)i
fincome
ef
fecti
sst
rongert
hansubst
it
uti
onef
fect
:
. LaborDemandi
ntheNeocl
assi
calModel
Sof
ar,wehav
econsi
der
edt
hesuppl
ysi
deoft
hel
abormar
keti
ntheneocl
assi
cal
cont
ext
.Now,
let
’sconsi
dert
heot
herpar
toft
hel
abourmar
ket
-(
I.
e.,
Labordemand)-
t
oaddt
ooursuppl
yfunct
ionoft
hel
abourmar
ket
.
 Twokeyassumpt
ionsusedbyt
hemodel
:
1.Fi
rmsactt
omaxi
miset
hei
rpr
ofi
ts.
2.Ther
eexi
stdi
mini
shi
ngmar
ginalbenef
it
stoempl
oyi
ngext
rar
esour
ces
(
i.
e.out
putgoesupbutatadi
mini
shi
ngr
ate)
.
 Thepr
obl
em t
husf
aci
ngf
ir
msi
stodeci
dehowmuchofeachi
nputt
oempl
oyt
o
maxi
mizepr
ofi
tssubj
ectt
othet
echnol
ogi
est
heyhav
eandpr
icest
heyf
ace.
 Thedemandf
orl
abouri
sademandf
orf
act
orsofpr
oduct
ionder
ivedf
rom
demandf
orf
inalgoods.Fi
rmsi
naper
fect
lycompet
it
ivemar
ketuseashor
trun
pr
oduct
ionf
unct
ion(
wit
hpr
edet
ermi
nedcapi
talst
ockandgi
vent
echnol
ogy
)to
maxi
mizepr
ofi
ts:
Y =AF(
L,K)
Wher
eY–r
ealout
put
,K–gi
vencapi
talst
ock,
L–amountofl
abourempl
oyed,–
A t ogy.
echnol
w =MPL

69
WhatDet
ermi LD)
nesLabourDemand( ?
Fr
om t
heabovemat
hexpr
essi
onwecancl
aimt
hat
: ↑)=f
LD( [w(
↓) ↑)
,A( ↑)
,K( ]
.
i
.Ani
ncr
easei
nrealwager
educesdemandf
orl
abour(
SinceFLL <0)
.
I
fthe r
ealwage r
atei
ncr
eases t
hen t
his means t
he MC t
o empl
oyi
ng l
abour
i
ncr
eases.I
fthef
ir
m wasi
nequi
l
ibr
ium bef
oret
hewagei
ncr
ease,i
twi
l
lnow be
maki
ngl
ossesont
hel
astuni
tsofl
abouri
templ
oysast
hei
rMBwi
l
lbel
owert
han
t
hei
rMC.
Thi
stel
l
sust
hatt
her
eisanegat
iver
elat
ionshi
pb/
nther
ealwageandt
hequant
it
y
ofl
abourempl
oyedandcanbechar
act
eri
zedast
henor
maldownwar
dsl
opi
ng
l
abourdemandcur
ve,
andi
nfactt
hel
abourdemandcur
vei
sj heMPL.
ustt
a. Ani
ncr
easei
ncapi
talst
ocki
ncr
easesdemandf
orl
abour(
Since
FLK >0)
b.Ani
mpr
ovementi
ntechnol
ogyi
ncr
easesdemandf
orl
abour
( nceFL >
Si 0)
Howchangesi
ncapi
talst
ockandt
echnol
ogyaf
fectdemandf
orl
abour
?
I
fki
ncr
easesorpr
oduct
iont
echnol
ogyget
sbet
tert heMPL i
hent ncr
eases,t
hati
s,
eachuni
tofl
abourempl
oyedbecomesmor
epr
oduct
ive.Thi
sisshowngr
aphi
cal
l
y
byanout
war
dshi
f heMPL schedul
toft e,(
orequi
val
ent
ly,byout
war
dshi
ftoft
he
l
abourdemandcur
ve)
.

TheNeocl
assi
calLaborMar
ket
 Thedemandf
orl
abouri
sadecr
easi
ngf
unct
ionoft
her
ealwager
ate(
indi
cat
ing
t
hati
tisbyr
educi
ngt
her
ealwager
atet
hatmor
ewor
ker
scanbeempl
oyed)
.
Cont
rar
ytot
his,t
hesuppl
yofl
abouri
sani
ncr
easi
ngf
unct
ionoft
her
ealwage
r
ate(
showi
ngt
hati
tisbyi
ncr
easi
ngt
her
ealwager
atet
hatmor
ewor
ker
scanbe
empl
oyed)
.

 I
ngener
al,t
hef
orcesi
nthi
smar
ketactt
odet
ermi
nebot
htheamountofl
abour
t
radedandt
hel
eveloft ealwage.I
her tisal
sowor
thnot
ingt
hatt
her
eisno
i
nvol
unt
aryunempl
oymenti
nthi
smodel
.Peopl
emaybe“
unempl
oyed”
,buti
tis
onl
ybecauset
heychoosenott
owor
katt
hegoi
ngr
ealwage.

Accor
dingt
othi
smodel
,ful
lempl
oymenti
sanor
malsi
tuat
ionandanydevi
ati
on
f
rom t
hisr
egar
dedassomet
hingabnor
mal
,andt
het
endencyoft
heeconomi
c
syst
em i
stoaut
omat
ical
l
ypr
ovi
def
ullempl
oymenti
nthel
abormar
ket
.

70
Unempl
oymenti
ntheNeocl
assi
cal
Model
Recal
lthatNeocl
assi
cal
labourmar
keti
schar
act
eri
zedby
:
o Per
fectcompet
it
ionandPer
fecti
nfor
mat
ion
o Mar
ketcl
ear
ing,
flexi
blewages
o Homogenouswor
ker
s
o Noi
nvol
unt
aryunempl
oyment
I
stheNeocl
assi
calmodelenought
oexpl
aint
heper
for
manceoft
hel
abormar
ket
t
oday?
Possi
bleExpl
anat
ionsf
orUnempl
oyment

oIfwagesdon’tclearthemarket,sothatthereexistunemployment,whydon’tthey
f
all
?
 Wager
igi
dit
y(especi
all
ydownwar
d)–mi
nimum wagel
egi
slat
ion
 Ef
fi
ciencywages–i
tmaybepr
ofi
tabl
eforf
ir
mst
opayhi
gherwaget
han
mar
ket
-cl
ear
ingwage.
 Bar
gai
ningpowerofl
aboruni
ons
 Het
erogenei
tyofwor
ker
sandj
obs–sear
chf
orj
obsandmat
chi
ngawor
ker
wi
thsui
tabl
ejobi
scost
lyandt
akest
ime.
Unempl
oymentmayr
esul
tfr
om t
her
igi
dit
yint
hewagest
ruct
ureandi
nter
fer
encei
n
t
hewor
kingoff
reemar
ketsyst
em i
nthef
orm ofl
aboruni
on,mi
nimum wage
l
egi
slat
ionet
c.

Keynesi
anvi
ewsoftheLaborMar
ket
I
twasKey nesthatfir
stacknowledgest
heexi
stenceofdi
sequi
l
ibr
iai
nthel
abor
mar
ket
.He emphasi
zes t
he possi
bil
i
tyofdownwar
d nomi
nalwage st
icki
ness.
Howev
er,concer
ningt
hecapaci
tyofnomi
nalwagesr
educt
ionsi
nrest
ori
ngf
ull
empl
oyment
,Key
nesdi
dnotbel
i
evet
hatnomi
nalwager
igi
dit
ywast
hemai
nsour
ce
ofunempl
oyment
.Asaconsequence,heasser
tedt
hatnomi
nalwagecut
swer
enot
t
hepr
opercur
eforunempl
oyment
.
Asar
esul
t,Key
nesadv
ocat
edt
hemai
ntenanceofast
abl
elev
elofnomi
nalwages
andt
hataut
hor
it
ies/
gov
ernment
swoul
dtakeposi
ti
veact
ioni
nor
dert
orest
oref
ull
empl
oyment
.
Thei
mpl
icat
ioni
sthatgover
nmentt
hroughmonet
aryandf
iscalpol
ici
escanal
ter
aggr
egat
edemand,andt
her
ebyempl
oyment
.Consi
dert
heI
S-LM modelofKey
nes

71
t
ounder
standhowt
hiswor
ks.
I
S(I
nvest
ment
-Savi
ng)
:Y =C(
Y-T(
↓))+I
(r
(↓)
)(↑)+G(
↑)
M(
↑)
LM (
Liqui
dit
yPr
efer
ences-
MoneySuppl
y): =L(
r( ,
↓)Y)
P
Not
e:Ar
rowsi
ndi
cat
eexpansi
onar
ypol
i
cies.
Expansi
onar
ypol
i
ciesshi
ft
sISandLM cur
vest
other
ightwhatpr
ovokesashi
fti
n
t
hesamedi
rect
ionoft
heaggr
egat
edemandf
ixi
nganewandhi
gherl
evelofout
put
and empl
oymentata gi
ven pr
ice l
evel
.The f
oll
owi
ng di
agr
am pr
esent
s how
expansi
onar
y pol
i
cies i
nfl
uences aggr
egat
e demand whi
ch t
hen det
ermi
nes
empl
oyment
.
a.NewKeynesi
anVi
ewoft
heLaborMar
ket
New Key
nesi
an Economi
sts(
NKE)whi
ch obt
ains t
hei
rinspi
rat
ion f
rom Key
nes
accept
edt
heexi
stenceofwagesandpr
icer
igi
dit
y.Howev
er,unl
i
keKey
nes,NKE
ar
guedt
hatwager
igi
dit
ycanbet
hesour
ceofunempl
oyment
.Asar
esul
t,f
orNKE
f
lex
ibl
ewageswoul
dal
l
owt
heeconomyt
omai
ntai
nful
lempl
oyment
.
Thus,NKEat
tempt
stopr
ovi
demi
crof
oundat
ionsf
ort
hephenomenaofwagesand
pr
icessl
uggi
shadj
ust
ment
s.Fori
nst
ance,NKEdev
eloped ef
fi
ciencywagesand
i
nsi
der
-out
sidert
heor
iest
oexpl
ainwhyf
ir
msdonotcutwageswhent
her
ear
e
unempl
oyedwor
ker
s.
i
.Ef
fi
ciencywages:NewKeynesi
aneconomi
stsof
tent
urnt
otheor
iesofwhatt
hey
cal
lef
fi
ciencywagest
oexpl
ainwhyl
abourmar
ket
-cl
ear
ingmechani
sm mayf
ail
.
I
n an asy
mmet
ri
cinf
ormat
ion f
ramewor
k,ef
fi
ciency wage model
s descr
ibe
sev
eralr
easons f
orwhi
ch cut
ti
ng a wage adv
ersel
y af
fectt
he qual
i
ty or
pr
oduct
ivi
tyofl
aborandi
ncr
easeatt
heendt
hef
ir
m’scost
.
Theset
heor
ieshol
dthathi
ghwagesmakewor
ker
smor
epr
oduct
ive.Hence,t
he
i
nfl
uenceofwagesonwor
keref
fi
ciencymayexpl
aint
hef
ail
ureoff
ir
mst
ocut
wagesdespi
teanexcesssuppl
yofl
abor
.
i
i
.Insi
der
-Out
siderTheor
y:i
nthi
stheor
y,i
tisar
guedt
hatt
hei
nsi
der
s(empl
oyed
wor
ker
s)hav
esomepoweri
ndet
ermi
ningf
ir
m’swageandempl
oymentdeci
sion
duet
othepr
esenceoft
urnov
ercost
s.Si
ncef
oraf
ir
miti
scost
lyt
oexchange
i
nsi
der
sforout
sider
s(unempl
oyedwor
ker
s),t
hei
nsi
der
scanext
ractashar
eof
t
heeconomi
crentgener
atedbysucht
urnov
ercost
s.
b.Labour
-Mar
ketSear
chandUnempl
oyment

72
Empi
ri
calev
idence has shown t
hatt
he l
abourmar
keti
n many count
ri
es i
s
char
act
eri
zed by huge gr
oss f
lows of wor
ker
sleav
ing a j
ob and ent
eri
ng
unempl
oymentandv
icev
ersa.I
nthi
ssect
ion,wedevel
opasi
mpl
emodelofl
abor
-
f
orcedynami
cst
hatshowswhatdet
ermi
nest
henat
uralr
ateofunempl
oyment
.
Becauseev
ery
wor
keri
sei
therempl
oyedorunempl
oyed,t
hel
aborf
orcei
sthesum
oft
heempl
oyedandt
heunempl
oyed:
i
.e.
,
L =E +U
3.
5.TypesandCausesofUnempl
oyment
.JobSe
I ar
chandFr
ict
ionalUnempl
oyment
Oner
easonf
orunempl
oymenti
sthati
ttakest
imet
omat
chwor
ker
sandj
obs.
Asa
mat
teroff
act
,wor
ker
shav
edi
ff
erentpr
efer
encesand abi
l
iti
es,and j
obshav
e
di
ff
erentat
tri
but
es.Fur
ther
mor
e,t
hef
low ofi
nfor
mat
ionaboutj
obcandi
dat
esand
j
ob v
acanci
es i
simper
fect
,and t
he geogr
aphi
c mobi
l
ity of wor
ker
sis not
i
nst
ant
aneous.
Theunempl
oymentcausedbyt
het
imei
ttakeswor
ker
stosear
chf
oraj
obi
scal
l
ed
f
ri
cti
onalunempl
oyment
.
Economi
stscal
lachangei
nthecomposi
ti
onofdemandamongi
ndust
ri
esorr
egi
ons
asect
oralshi
ft
.Becausesect
oralshi
ft
sar
eal
way
soccur
ri
ng,andbecausei
ttakes
t
imef
orwor
ker
stochangesect
ors,
ther
eisal sf
way r
ict
ionalunempl
oyment
.
I
I.Cycl
icalUnempl
oyment
I
tist
heunempl
oymentt
hataccompani
esf
luct
uat
ionsi
nrealGDPandsomet
imes
cal
l Demanddef
ed“ ici
entunempl
oyment
”.
 Ref
lect
sbusi
nesscy
clecondi
ti
ons
 Whent
her
eisagener
aldownt
urni
nbusi
nessact
ivi
ty,cy
cli
calunempl
oyment
r
ises.
I
II
.SeasonalUnempl
oyment
Apr
oductofr
egul
ar,r
ecur
ri
ngchangesi
nthehi
ri
ngneedsofcer
tai
nindust
ri
eson
amont
hlyorseasonal
basi
s.
I
V.Real
-WageRi
gidi
tyandSt
ruct
uralUnempl
oyment
Wager
igi
dit
yref
erst
othef
ail
ureofwagest
oadj
ustunt
ill
aborsuppl
yequal
slabor
demand.The unempl
oymentr
esul
ti
ng f
rom wage r
igi
dit
yis cal
l
ed st
ruct
ural
unempl
oy .Mi
ment nimum-
WageLaws

73
The gov
ernmentcauses wage r
igi
dit
ywhen i
tpr
event
s wages f
rom f
all
i
ng t
o
equi
l
ibr
ium l
evel
s.Mi
nimum-
wagel
awssetal
egalmi
nimum ont
hewagest
hatf
ir
ms
payt
hei
rempl
oyees.Formostwor
ker
s,t
hismi
nimum wagei
snotbi
ndi
ng,because
t
heyear
nwel
labov
ethemi
nimum.Yetf
orsomewor
ker
s,especi
all
yteenager
sand
unski
l
led wor
ker
s,mi
nimum-
wage l
aws hav
e si
gni
fi
cantunempl
oymenti
mpact
s
si
ncei
trai
sest
hei ePol
rwageabov icyOpt
ionst
oSol
veUnempl
oymentcaused
byMi
nimum wageLaws
i
.Taxcr
edi
ts:Mi
nimum wagei
ncr
easesar
edesi
gnedt
ohel
pthewor
kingpoor
.
Howev
er,
itcausesunempl
oyment
.
i
i.Subsi
dizi
ngunski
ll
edl
abor
:thegov
ernmentbysubsi
dizi
ngunski
l
ledl
aborcoul
d
pusht
hel
abordemandupsot
hatempl
oymentwoul
dbebet
ter
.
i
i
i.The gover
nment can di
rect
ly empl
oy some unski
ll
ed wor
ker
s at t
he
goi
ngmi
nimum wage.Agai
n,t
hedemandf
orunski
l
ledl
aborshi
ft
stot
her
ight
andunempl
oymenti
sreduced.
 N.
B:Foral
lthet
hreeopt
ionsdi
scussedabove,t
her
eisar
evenuer
equi
rement
ont
hepar
toft
hegover
nment
.
A.Pr
ovi
sion oft
rai
ning t
o unski
ll
ed wor
ker
s by t
he gover
nment
:By maki
ng
unski
l
ledl
abormor
epr
oduct
ive,i
tispossi
blet
ost
imul
atet
hedemandf
ort
hose
wor
ker
sandempl
oyment
.
B.Uni
onsandCol
lect
iveBar
gai
ning
Anot
hercauseofwager
igi
dit
yist ypowerofuni
hemonopol ons.I
nSweden84
per
centofwor
ker
s,andi
ntheUni
tedSt
ates,onl
y18per
centofwor
ker
sbel
ongt
o
uni
ons.Of
ten,uni
oncont
ract
ssetwagesabov
etheequi
l
ibr
ium l
evelandal
l
ow t
he
f
ir
mtodeci
dehowmanywor
ker
stoempl
oy.
C.Ef
fi
ciencyWages
Ef
fi
ciency
-wage t
heor
ies pr
opose a t
hir
d cause ofwage r
igi
dit
yin addi
ti
on t
o
mi
nimum-
wagel
awsanduni
oni
zat
ion.Theset
heor
ieshol
dthathi
ghwagesmake
wor
ker
smor
epr
oduct
ive.Thei
nfl
uenceofwagesonwor
keref
fi
ciencymayexpl
ain
t
hef
ail
ureoff
ir
mst
ocutwagesdespi
teanexcesssuppl
yofl
abor
.Event
hougha
wage r
educt
ion woul
dlowera f
ir
m’s wage bi
l
l,i
twoul
d al
so l
owerwor
ker
pr
oduct
ivi
tyandt
hef
ir
m’spr
ofi
ts.
 Economi
stshavepr
oposedvar
iousr
easonst
oexpl
ainhowwagesaf
fect

74
 wor
kerpr
oduct
ivi
ty
1.Wagesi
nfl
uencenut
ri
ti
on(
whi
chi
sappl
i
edmost
lyt
opoor
ercount
ri
es)
2.Hi
ghwagesr
educel
abort
urnover
3.Theaver
agequal
i
tyofaf
ir
m’swor
kfor
cedependsont
hewagei
tpaysi
ts
empl
oyees
4.Hi
ghwagei
mpr
oveswor
keref
for
t

CHAPTERFI
VE

Macr
oeconomi
cPol
icyDebat
es:St
abi
li
zat
ionPol
icy
 I
nthi
schapt
erweaskt
woquest
ionst
hatar
isei
nthi
sdebat
e.
 Fi
rst
,shoul
d monet
aryand f
iscalpol
i
cyt
akean act
iver
olei
ntr
ying t
o
st
abi
l
izet
heeconomy
,orshoul
dpol
i
cyr
emai
npassi
ve?
 Second,shoul
dpol
i
cymaker
sbef
reet
ouset
hei
rdi
scr
eti
oni
nrespondi
ngt
o
changi
ngeconomi
ccondi
ti
ons,orshoul
dtheybecommi
tt
edt
oaf
ixedpol
i
cy
r
ule?
 Quest
ion1:
Shoul
dpol
i
cybeact
iveorpassi
ve?
Ar
gument
sforact
ivepol
icy
 Recessi
onscauseeconomi
char
dshi
pformi
l
li
onsofpeopl
e.
 Themodelofaggr
egat
edemandandsuppl
yshowshowf
iscalandmonet
ary
pol
i
cycanr
espondt
oshocksandst
abi
l
izet
heeconomy
.
I
ntheabsenceofanact
ivegov
ernmentr
olei
ntheeconomy
,ev
ent
sli
ke
t
heGr
eatDepr
essi
oncoul
doccurr
egul
arl
y.
 I
tal
soshowshow monet
aryandf
iscalpol
i
cycanpr
eventr
ecessi
onsby
r
espondi
ngt
otheseshocks.
Ar
gument
sagai
nstact
ivepol
icy
 Ot
hereconomi
stscr
it
icsar
guest
hatgov
ernmentshoul
dtakeahands-
off
appr
oacht
omacr
oeconomi
cpol
i
cy.
Pol
i
ciesactwi
thl
ong&v
ari
abl
elags,
incl
udi
ng:
 i
nsi
del
ag:t
het
imebet
weent
heshockandt
hepol
i
cyr
esponse.
 t
akest
imet
orecogni
zeshock
 t
akest
imet
oimpl
ementpol
i
cy,
especi
all
yfi
scal
pol
i
cy
 out
sidel
ag: t
het
imei
ttakesf
orpol
i
cyt
o af
fecteconomy
. i
.e
Monet
arypol
i
cy

75
  I
fcondi
ti
onschangebef
orepol
i
cy’
simpacti
sfel
t,t
hepol
i
cymay
dest
abi
l
izet
heeconomy
.
Aut
omat
icst
abi
li
zer
s
Somepol
i
cies,cal
l
edaut
omat
icst
abi
l
izer
s,ar
edesi
gnedt
oreducet
hel
ags
associ
atedwi
thst
abi
l
izat
ionpol
i
cy.
Aut
omat
icst
abi
l
izer
sar
epol
i
ciest
hatst
imul
ateordepr
esst
heeconomywhen
necessar
y wi
thoutany del
i
ber
ate pol
i
cy change.Exampl
es:i
ncome t
ax ,
unempl
oymenti
nsur
ance/Wel
far
e
Whyt
hei
ncomet
axi
sanaut
omat
icst
abi
l
izer
: Eachper
son’
staxbi
l
ldepends
onheri
ncome.I
n r
ecessi
on,
aver
agei
ncomesf
all
,sot
heav
erageper
sonpay
s
f
ewert
axes.
Whyunempl
oymenti
nsur
ance/
wel
far
eisanaut
omat
icst
abi
l
izer
For
ecast
ingt
hemacr
oeconomy
Becausepol
i
ciesactwi
thl
ags,
pol
i
cymaker
smustpr
edi
ctf
utur
econdi
ti
ons.
Twoway
seconomi
stsgener
atef
orecast
s:
 Leadi
ngeconomi
cindi
cat
ors:dat
aser
iest
hatf
luct
uat
einadv
anceoft
he
economy
 Macr
oeconomet
ri
c model
s: Lar
ge-
scal
e model
s wi
th est
imat
ed
par
amet
erst
hatcanbeusedt
ofor
ecastt
her
esponseofendogenous
v
ari
abl
est
oshocksandpol
i
cies
TheLucascr
it
ique
 Duet
oRober
tLucaswhowonNobel
Pri
zei
n1995f
orr
ati
onal
expect
ati
ons.
 For
ecast
ingt
heef
fect
sofpol
i
cychangeshasof
tenbeendoneusi
ngmodel
s
est
imat
edwi
thhi
stor
ical
dat
a.
 Lucaspoi
ntedoutt
hatsuchpr
edi
cti
onswoul
dnotbev
ali
dift
hepol
i
cy
change al
ter
s expect
ati
ons i
n a way t
hat changes t
he f
undament
al
r
elat
ionshi
psbet
weenv
ari
abl
es.
Anexampl
eoft
heLucascr
it
ique
 Pr
edi
cti
on(
basedonpastexper
ience)
:Ani
ncr
easei
nthemoneygr
owt
hrat
ewi
l
l
r
educeunempl
oyment
.
 TheLucascr
it
iquepoi
ntsoutt
hati
ncr
easi
ngt
hemoneygr
owt
hrat
emayr
aise
expect
edi
nfl
ati
on,
inwhi
chcaseunempl
oymentwoul
dnotnecessar
il
yfal
l
.
 An i
ncr
easei
n moneygr
owt
h and i
nfl
ati
on onl
yreducesunempl
oymenti
f

76
 expect
edi
nfl
ati
onr
emai
nsunchanged.Per
hapst
hatwast
hecasei
nthepast
.
 But now,i
fthe money gr
owt
hincr
ease causes peopl
etor
aise t
hei
r
expect
ati
onsofi
nfl
ati
on,
thenunempl
oymentwon’
tfal
l
.
Quest
ion2:Shoul
dpol
icybeconduct
edbyr
uleordi
scr
eti
on?
Rul
esanddi
scr
eti
on:Basi
cconcept
s
 Pol
i
cyconduct
edbyr
ule:Pol
i
cymaker
sannouncei
nadv
ancehowpol
i
cywi
l
l
r
espondi
nvar
ioussi
tuat
ions,
andcommi
tthemsel
vest
ofol
l
owi
ngt
hrough.
Pol
i
cyconduct
edbydi
scr
eti
on:Asev
ent
soccurandci
rcumst
anceschange,
pol
i
cymaker
s use t
hei
rjudgment and appl
y what
ever pol
i
cies seem
appr
opr
iat
eatt
het
ime.
Ar
gument
sforr
ules:
1. Di
str
ustofpol
i
cymaker
sandt
hepol
i
tical
process
 mi
si
nfor
medpol
i
tici
ans
 pol
i
tici
ans’
int
erest
ssomet
imesnott
hesameast
hei
nter
est
sof
soci
ety
:pol
i
tical
busi
nesscy
cle?
2.Thet
imei
nconsi
stencyofdi
scr
eti
onar
ypol
i
cy
 Def
:Ascenar
ioi
nwhi
chpol
i
cymaker
shav
eani
ncent
ivet
orenegeona
pr
evi
ousl
yannouncedpol
i
cyonceot
her
shav
eact
edont
hatannouncement
.
 Dest
roy
spol
i
cymaker
s’cr
edi
bil
i
ty,
ther
ebyr
educi
ngef
fect
ivenessoft
hei
r
pol
i
cies.
Monet
arypol
icyr
ules
Const
a. antmoneysuppl
ygr
owt
hrat
e
b.
Tar
getgr
owt
hrat
eofnomi
nal
GDP
 Aut
omat
ical
l
yincr
easemoneygr
owt
hwhenev
ernomi
nal
GDPgr
owssl
ower
t
hant
arget
ed.
 Decr
easemoneygr
owt
hwhennomi
nal
GDPgr
owt
hexceedst
arget
.
c.
Tar
gett
hei
nfl
ati
onr
ate
 Aut
omat
ical
l
yreducemoneygr
owt
hwhenev
eri
nfl
ati
onr
isesabov
ethet
arget
r
ate.
 Manycount
ri
es’
cent
ral
banksnowpr
act
icei
nfl
ati
ont
arget
ing,
butal
l
ow
t
hemsel
vesal
i
ttl
edi
scr
eti
on.
Cent
ralbanki
ndependence
 Apol
i
cyr
uleannouncedbycent
ralbankwi
l
lwor
konl
yift
heannouncementi
s

77
 cr
edi
ble. Cr
edi
bil
i
tydependsi
npar
tondegr
eeofi
ndependenceofcent
ral
bank.
Chapt
erSi
x

Model
sofMacr
oeconomi
cGr
owt
h
 Theneo-
Key
nesi
anHar
rod–Domarmodel
 TheSol
ow–Swanneocl
assi
cal
model
;and
 TheRomer
–Lucas-
inspi
redendogenousgr
owt
hmodel
s

TheHar
rod-DomarGr
owt
hModel
Har
rod(
1939,1948)andEv
sey
Domar(
1946,1947)i
ndependent
lydev
eloped
t
heor
iest
hatr
elat
eaneconomy
’sr
ateofgr
owt
htoi
tscapi
tal
stock.
Themodelassumes:
anexogenousr
ateofl
abourf
orcegr
owt
h(n)agi
ven
t
echnol
ogyexhi
bit
ingf
ixedf
act
orpr
opor
ti
ons i
.e.-const
antcapi
tal
–labour
r
ati
o,K/
L)andaf
ixedcapi
tal
–out
putr
ati
o(K/
Y).
Assumi
ngat
wo-
sect
oreconomy(
househol
dsandf
ir
ms)
wecanwr
it
ethe
si
mpl
enat
ional
incomeequat
ionas:
Yt=Ct+St-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
6.1
eYt=GDP,
wher Ct=consumpt
ionandSt=savi
ng.
 Equi
l
ibr
ium i
nthi
ssi
mpl
eeconomyr
equi
res:
I
t=St-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-6.
2
Subst
it
uti
ng(
6.2)i
nto(
6.1)y
iel
ds(
6.3)
:
Yt=Ct+I
t--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
6.3
 Wi
thi
ntheHar
rod–Domarf
ramewor
kthegr
owt
hofr
eal
GDPi
sassumedt
obe
pr
opor
ti
onal
tot
heshar
eofi
nvest
mentspendi I
ng()i
nGDPandf
oran
economyt
ogr
ow,
netaddi
ti
onst
othecapi
tal
stockar
erequi
red.
 Thecapi
tal
stockov
ert
imei
sgi
veni
nequat
ionas
Kt
+1=(
1−δ)
Kt+I
t--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-6.
4
wher
eδi
sther
ateofdepr
eci
ati
onoft
hecapi
tal
stock.
 Ther
elat
ionshi
pbet
weent
hesi
zeoft
het
otal
capi
tal
st K)andt
ock( otalGDP(
Y)
i
sknownast
hecapi
tal
–out
putr
ati
o(K/
Y=v)andi
sassumedf
ixed.
 Gi
vent
hatwehav
edef
inedv=K/
Y,i
tal
sof
oll
owst
hatv=ΔK/
ΔY
 Assumet
hatt
otal
sav
ingi
ssomepr
opor
ti
on(
s)ofGDP(
Y)
St=sYt-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-6.
5
 Si
nceK=v
YandI
t=St
,itf
oll
owst
hatwecanr
ewr
it
eequat
ion(
6.4)asequat
ion

78
 vYt
+1=(
1−δ)
vYt+sYt-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-6.
6
 Di
vi
dingbyv
,andsubt
ract
ingYt
from bot
hsi
desofequat
ion(
6.6)y
iel
dsequat
ion
(
6.7)
:Yt
+1−Yt=[
s/v−δ]
Yt-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
6.7
 Di
vi
dingt
hroughbyYtgi
vesusequat
ion:
[
Yt+1−Yt]
/Yt=(
s/v
)−δ-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-6.
8
 Her
e[Yt+1–Yt
]/Yti
sthegr
owt
hrat
eofGDP.Let
ti
ngG=[
Yt+1–Yt
]/Yt
,
Wecanwr
it
etheHar
rod–Domargr
owt
hequat
ionas:
G=s/
v−δ-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
6.9
ssi
NB:Thi mpl
yst
atest
hatt
hegr
owt
hrat
e(G)ofGDPi
sjoi
ntl
ydet
ermi
nedby
 t
hesav
ingsr
ati
o(s)di
vi
dedbyt
hecapi
tal
–out
putr
ati
o(v)
 Thehi
ghert
hesavi
ngsr
ati
oandt
hel
owert
hecapi
tal
–out
putr
ati
oand
depr
eci
ati
onr
ate,
thef
ast
erwi
l
laneconomygr
ow.
 Byi
gnor
ingdepr
eci
ati
onr
ateHar
rod–Domarmodel
as
G=s/
v--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-6.
10
 Forexampl
e,i
fadev
elopi
ngcount
rydesi
redt
oachi
eveagr
owt
hrat
eofper
capi
tai
ncomeof2percentperannum andpopul
ati
oni
sest
imat
edt
obe
gr
owi
ngat2percent
,theneconomi
cpl
anner
swoul
dneedt
osetat
argetr
ate
ofGDPgr
owt
h(G*
)equal
to4percent
.
G/pop%=Per
capi
tai
ncome
4%/
2%=2%
 I
fv=4,
thi
simpl
i
est
hatG*canonl
ybeachi
evedwi
thadesi
redsav
ingsr
ati
o
(
s*)of0.
16,
or16percentofGDP.
 I
fs*>s,
ther
eisa‘
sav
ingsgap’
,andpl
anner
sneededt
odev
isepol
i
ciesf
or
pl
uggi
ngt
hisgap.
 Si
ncet
her
ateofgr
owt
hint
heHar
rod–Domarmodel
 i
sposi
ti
vel
yrel
atedt
othesavi
ngsr
ati
o
 I
fdomest
icsour
cesoff
inancewer
einadequat
etoachi
evet
hedesi
redgr
owt
h
t
arget
,
 t
henf
orei
gnai
dcoul
dfi
l
lthe‘
savi
ngsgap’
 Ai
drequi
rement
s(Ar
)woul
dsi
mpl
ybecal
cul
at s*–s=Ar
edas:

TheSol
owNeocl
assi
cal
Growt
hModel
 I
nSol
owmodel
:capi
tal
,l
abor
,andt
echnol
ogyar
ekeydet
ermi
nant
sof
pr
oduct
ionofgoods&ser
vices.

79
 Wedev
elopedt
heSol
owmodel
toshow: ncapi
howchangesi tal(
thr
oughSandI
)
&changesi
nthel
aborf
orce(
pongr
owt
h)af
fecteconomy
’sout
put
 Wear
enowr
eadyt
oaddt
het
hir
dsour
ceofgr hchangesi
owt ntechnol
ogy—t
o
t
hemi
x.
 TheSol
owmodel
doesnotexpl
aint
echnol
ogi
cal
progr
essbut
,
 i
nst
ead,
takesi
tasexogenousl
ygi
venand
 showshowi
tint
eract
swi
thot
herv
ari
abl
esi
nthepr
ocessofeconomi
c
gr
owt
h
TheSol
ow gr
owt
hmodeli
sdesi
gnedt
oshow how gr
owt
hint
hecapi
talst
ock,
gr
owt
hint
hel
aborf
orce,andadv
ancesi
ntechnol
ogy-
aff
ectanat
ion’
stot
alout
put
ofgoodsandser
vices.
Ourf
ir
stst
epi
stoexami
nehow t
hesuppl
yanddemandf
orgoodsdet
ermi
nest
he
accumul
ati
onofcapi
tal
.
 I
nthi
sfi
rstst
ep,
weassumet
hat
(thel
aborf
orceandt
echnol
ogyar
efi
xed)
.
 Wet
henr
elaxt
heseassumpt
ionsbyi
ntr
oduci
ngchangesi
nthel
aborf
orce
l
ateri
nthi
schapt
erandbyi
ntr
oduci
ngchangesi
ntechnol
ogyi
nthenext
.
 Thesuppl
yofgoodsi
ntheSol
owmodel
isbasedont
hepr
oduct
ionf
unct
ion,
 whi
chst
atest
hatout
putdependsoncapi
talst
ockandl
aborf
orce:
Y=F(
K,L)
 TheSol
owgr
owt
hmodel
assumest
hatt
hepr
oduct
ionf
unct
ion
 hasconst
antr
etur
nst e.zY=F(
oscal zK,
zL)
Pr
oduct
ionf
unct
ionswi
thconst
antr
etur
nst
oscal
eal
l
owust
oanal
yzeal
l
quant
it
iesi
ntheeconomyr
elat
ivet
othesi
zeoft
hel
aborf
orce.
Toseet
hatt
hisi
str
ue, Li
setz=1/ nt
hepr
ecedi
ngequat
iont
oobt
ain
Y/
L=F(
K/L,
1)
 Thi
sequat
ionshowst
hatt
heamountofout kerY/
putperwor L
 i
saf
unct
ionoft
heamountofcapi
tal kerK/
perwor L.
 (
Thenumber1i
sconst
antandt
huscanbei
gnor
ed.
)
 Theassumpt
ionofconst
antr
etur
nst
oscal
eimpl
i
est
hat
 t
hesi
zeoft edbyt
heeconomyasmeasur henumberofwor
ker
sdoes
notaf
fectt
her
elat
ionshi
pbet
weenout
putperwor
kerandcapi
talper
wor
ker
 y=Y/
Lisout
putperwor
ker
,andk=K/
Liscapi
talperwor
ker
.

80
  Wecant
henwr
it
ethepr
oduct
ionf
unct
i y=f(
onas, k)
 t
hepr
oduct
ionf
unct
ionbecomesf
lat
ter
,indi
cat
ingt
hatt
hepr
oduct
ion
f
unct
ionexhi
bisdi
t mini
shi
ngmar
ginalpr
oductofcapi
tal
.
 Whenki
slow,
theaver
agewor
kerhasonl
yal
i
ttl
ecapi
tal
towor
kwi
th,
soan
ext
rauni
tofcapi
tal
isv
eryusef
ulandpr
oducesal
otofaddi
ti
onal
out
put
.
 Whenki
shi
gh,
theaver
agewor
kerhasal
otofcapi
talal
ready
,soanext
rauni
t
i
ncr
easespr
oduct
iononl
ysl
i
ght
ly.(
Ref
ert
othef
igur
e!)
TheDemandf
orGoodsandt
heConsumpt
ionFunct
ion
 Thedemandf
orgoodsi
ntheSol
owmodel
comesf
rom consumpt
ionand
i
nvest
ment
.
 I
not
herwor
ds,
out keryi
putperwor sdi
vi
dedbet
weenconsumpt
ionper
wor
kercandi
nvest
mentperwor
keri
:y=c+i
 TheSol
owmodel
assumest
hateachy
earpeopl
esav
eaf
ract
ionsoft
hei
r
i
ncomeandconsumeaf
ract
i 1–s)
on(
 Wecanexpr
esst
hisi
deawi
tht
hef
oll
owi
ngconsumpt
ionf
unct
ion:
c=(
1−s)
y es,
wher thesavi
ngr
ate
Toseewhatt
hisconsumpt
ionf
unct
ioni
mpl
i
esf
ori
nvest
ment
,
subst
it
ut 1–s)
e( yforci
nthenat
ional
incomeaccount
sident
it
y:y=(
1−s)
y
+i
Rear
ranget
het
ermst
oobt
ain i=sy
Foranygi
vencapi
tal
stockk,
thepr
oduct
ionf
unct
iony=f
(k)
 det
ermi
neshowmuchout
putt
heeconomypr
oduces,
and
Thesav
ingr
atesdet
ermi
nest
heal
l
ocat
ionoft
hatout
putbet
ween
consumpt
ionandi
nvest
ment
.

Gr
owt
hint
heCapi
talSt
ockandt
heSt
eadySt
ate
 Atanymoment
,thecapi
tal
stocki
sakeydet
ermi
nantoft
heeconomy
’s
out
put
,butt
hecapi
tal
stockcanchangeov
ert
ime,
andt
hosechangescan
l
eadt
oeconomi
cgr
owt
h
 I
npar
ti
cul
ar,
twof
orcesi
nfl
uencet
hecapi
t ock:i
alst nvest
mentand
depr
eci
ati
on.
 I
nvest
menti
sexpendi
tur
eonnewpl
antandequi
pment
,andi
tcausest
he
capi
talst
ockt
ori
se.

81
  Depr
eci
ati
oni
sthewear
ingoutofol
dcapi
tal
,andi
tcausest
hecapi
talst
ock
t
ofal
l.
 Thi
sequat
ionr
elat
est
heexi
sti
ngst
ockofcapi
t kt
al ot
heaccumul
ati
onofnew
capi
t i
al.
 Thepr
oduct
ionf
unct
ionf
(k)
,andt
heal
l
ocat
ionoft
hatout
putbet
ween
consumpt
ionandsav
ingwhi
chi
sdet
ermi
nedbyt
hesavi
ngr
ates.
 Toi
ncor
por
atedepr
eci
ati
oni
ntot
hemodel
,weassumet
hatacer
tai
nfr
act
ion
oft
hecapi
tal
stockwear
souteachy
ear
.
 Forexampl
e,i
fcapi
tall
ast
sanaver
ageof25year
s,t
hent
hedepr
eci
ati
onr
atei
s
4per
centpery =0.
ear( 04)
.
 Theamountofcapi
tal
thatdepr
eci
ateseachy s
eari k.
Changei
nCapi
tal
Stock=I
nvest
ment−Depr
eci
ati
on
k=i
−k
eki
 wher sthechangei
nthecapi
talst
ockbet
weenoneyearandt
henext
.
Becausei
nv menti
est equal
ssf
(k)
,wecanwr
it
ethi
sask=sf(
k)−k.
Let
’sconsi
dereachoft
hesef
orcesi
ntur
n.Aswehav
eal
readynot
ed,
i
nvest
mentperwor equal
keri ssy.
Bysubst
it
uti
ngt
hepr
oduct
ionf
unct
ionf
ory
,wecanexpr
essi
nvest
mentper
wor
kerasaf
unct
ionoft
hecapi
tal
stockperwor
ker
:i=sf
(k)
.
 Regar
dlessoft
hel
evelofcapi
tal
wit
hwhi
cht
heeconomybegi i
ns,tendsup
wi
tht
hest
eady-
stat
elevelofcapi
tal
.
 Toseewhyaneconomyal
way
sendsupatt
hest
eadyst
ate,
supposet
hatt
he
economyst
art
swi
thl
esst
hant
hest
eady
-st
atel
evelofcapi
tal
,suchasl
evelk1
i
nFi
gur
e6.
2.
 I
nthi
scase,
thel
evel
ofi
nvest
mentexceedst
heamountofdepr
eci
ati
on.
 Ov
ert
ime,
thecapi
talst
ockwi
l
lri
seandwi
l
lcont
inuet
ori
se-al
ongwi
th
putf
out (k)
—unt
ili
tappr
oachest
hest
eadyst
atek*
.
 Si
mil
arl
y,supposet
hatt
heeconomyst
art
swi
thmor
ethant
hest
eady
-st
ate
l
evelofcapi
tal
,such as l
evelk2.I
nthi
s case,i
nvest
menti
sless t
han
depr
eci
ati
on:capi
tal
iswear
ingoutf
ast
ert
hani
tisbei
ngr
epl
aced.Thecapi
tal
st
ockwi
l
lfal
l
,agai
nappr
oachi
ngt
hest
eady
-st
atel
evel
.
 Once t
he capi
talst
ock r
eaches t
he st
eady st
ate,i
nvest
ment equal
s

82
 depr
eci
ati
on,andt
her
eisnopr
essur
efort
hecapi
talst
ockt
oei
theri
ncr
ease
ordecr
ease.
Thehi
ghert
hecapi
talst
ock,
thegr
eat
ert
heamount
sofout
putandi
nvest
ment
.
Yett
hehi
ghert
hecapi
tal
stock,
thegr
eat
eral
sot
heamountofdepr
eci
ati
on.
I
ftheeconomyf
indsi
tsel
fatt
hisl
eveloft
hecapi
talst
ock,t
hecapi
talst
ockwi
l
l
notchangebecauset
het
wof
orcesact
ingoni
ti
nvest
mentanddepr
eci
ati j
on-ust
bal
ance.
s,atk*
 Thati ,k=0,sot
hecapi
t ockkandout
alst putf
(k)ar
est
eadyovert
ime
(
rat
hert
hangr
owi
ngorshr
inki
ng)
.
 Wet
her
efor
ecal
lk*t
hest
eady-
stat
elevelofcapi
tal
.(
Ref
ert
oFi
gur
e6.
2)
TheSol
owmodel
showst hesav
hatt ingr
atei
sakeydet
ermi
nantoft
hest
eady
-
st
atecapi
tal
stock.
I
fthesavi
ngr
atei
shi
gh,
theeconomywi
l
lhaveal
argecapi
talst
ockandahi
gh
l
evelofout
puti
nthest
eadyst
ate.
I
fthesavi
ngr
atei
slow,
theeconomywi
l
lhaveasmal
lcapi
talst
ockandal
ow
l
evelofout
puti
nthest
eadyst
ate.
TheGol
denRul
eLevelofCapi
tal
 Sof
ar,wehav
eusedt
heSol
ow modelt
oexami
nehow aneconomy
’sr
ateof
sav
ingandi
nvest
mentdet
ermi
nesi
tsst
eady
-st
atel
evel
sofcapi
tal
andi
ncome.
 Yetsupposeanat
ionhadasav
ingr
ateof100per
cent
.Thatwoul
dleadt
othe
 l
argestpossi
blecapi
tal
stockandt
hel
argestpossi
blei
ncome.
 Buti
fal
loft
hisi
ncomei
ssavedandnonei
severconsumed,
whatgoodi
sit
?
 Thi
ssect
ionusest
heSol
ow modelt
odi heopt
scusst imalamountofcapi
tal
accumul
ati
onf
rom t
hest ntofeconomi
andpoi cwel
l
-bei
ng.
 So,
howdowef
i hesandk*t
ndt hatmaxi
mizec*?
K*golden= the Gol den Rulelevelofcapit
al,
the st
eadyst
atev
alue ofkt
hat
maxi mi zesconsumpt i
on.
 Tof indi t,f
irstexpressc*int
ermsofk*:
c*= y*i *

= f( k*) i*

=f( k*) k*

 Ingener al
:
i=k+k
 Int hest eadyst ate:

83
 *
i k*becausek=0.
=
(
Ref
ert
othef
igur
e!)
Popul
ati
onGr
owt
h
 Assumet
hatt
hepopul
ati
on-
-andl
aborf
orce-
-gr
owatr
aten. (
nis
exogenous)
 EX:SupposeL=1000i
nyear1andt
hepopul
ati
oni
sgr
owi
ngat2%/
year
n=0.
( 02)
.
 Then L=nL=0. soL=1020i
021000=20, nyear2.
Br
eak-
eveni
nvest
ment
 (
+n)
k=br
eak-
eveni
nvest
ment
,theamountofi
nvest
mentnecessar
yto
keepkconst
ant
.
 Wi
thpopul
ati
ongr
owt
h,t
heequat
ionofmot
i orki
onf s
k=sf
(k)
(+n)k

Act
ual
inv
esment
breakev
eni
nvest
ment
TheEf
fect
sofPopul
ati
onGr
owt
h
 Ani
ncr nn=br
easei eak-
eveni
nvest
ment
,leadi
ngt
oal
owerst
eady
-st
atel
evel
ofk.
owerk*.Andsi owerk* l *
ghernl
 Hi ncey=f
(k),l owery.
 Thus,
Sol
owmodel
predi
ctst
hatcount
ri
eswi
thhi
gherpopngr
owt
hwi
l
lhav
e
l
owerl
evel
sofcapi
tal
andi
ncomeperwor
keri
nthel
ongr
un.
(Ref
ert
othefi
gure!
)
TheGol
denRul
ewithPopul
ati
onGr
owt
h
 Tof
indt
heGol
denRul
ecapi
tal
stock,
weagai essc*i
nexpr nt msofk*:
er
c*= y*i
*

=f
(k*)
(+n)k*
c*i
smaxi
mizedwhen
MPK=
+norequi
val
ent
lyMPK=n
,
Technol
ogi
calPr
ogr
essi
nSol
owModel
Pr
evi
ousl
y,i
ntheSol
ow model
thepr
oduct
iont
echnol
ogywashel
dconst
ant
income
percapi
tawasconst
anti
nthest
eadyst
ate.
Tech.pr
ogr
essi
ntheSol
owmodel

84
  Anewv ari e:E=l
abl aboreff
ici
ency
 Assume: Technol
ogicalpr
ogressisl
abor
-augment
ing: i
tincr
easesl
abor
ef
fici
encyatt
heexogenousr eg:
at

 Wenowwr
it
ethepr
oduct
ionf
unct
ionas
 whereLE=t henumberofef
fectiveworker
s
 Hence,incr
eases i
nlaboreffi
ciency havethe same ef
fecton out
putas
i
ncreasesi nt hel aborf or ce.
 Not ation:
y=Y/ LE =out putperef fect iveworker
k=K/ LE =capi tal pereffect ivewor ker
 Pr oductionf unct i
onperef fectivewor ker:y=f (k)
 Sav ingandi nv est mentperef fectivewor ker
:sy=sf (
k)
(+n +g) k=br eak- eveni nv estment :
 Theamountofi nvestmentnecessar yt okeepkconstant .Consi
stsof:
  kt or epl acedepr eci atingcapi tal
 nkt opr ov idecapi t al fornewwor kers
 gk t o pr ov i
de capi talf ort he new “ eff
ect
ive”wor kers cr
eated by
technol ogi cal progr ess
Poli
ciest opr omot egr owth
Fourpol i
cyquest ions:
 Ar ewesav ingenough?Toomuch? Whatpol ici
esmi ghtchanget hesav i
ng
rate?How shoul dweal l
ocat eouri nv est mentbet weenpr i
vatel
yownedphy sical
capital,publici nfrast ructur e, and“ humancapi tal
”?Whatpolici
esmightencourage
fastertechnol ogi cal progr ess?
Evaluatingt heRat eofSav ing
UsetheGol denRul etodet erminewhet heroursav i
ngr
ateandcapit
alst
ockare
toohigh,toolow, oraboutr i
ght.Todot hi
s,weneedt ocompare(MPK )t
o(n
+g).
Toest i
mat MPK
e( ),weuset hreefactsaboutaneconomy ;
1. k=2. 5y
Thecapitalstocki sabout2.5t i
mesoney ear’
sGDP.
2.  k=0. 1y
About10%ofGDPi susedt oreplacedepreciat
ingcapi
tal
.
3. MPKk=0. 3y
Capitali
ncomei sabout30%ofGDP
1.k=2. 5y 2.k=0. 1y 3.
MPKk=0. 3y

Todet
er ne
mi ,di
vi
ded2by1:

85
 Todet
ermi
neMPK,
div
ided3by1:

Hence,MPK=0. 120.04=0. 08
Fr
om t hel
astslde:MPK=0.
i 08,RealGDPgr
owsanav
erageof3%/
year
,
so n+g =0. 03.Thus,
int
hiseconomy,MPK=0.08>0.03=n+g
Conclusi
on:
Theeconomyi
sbel
owt
heGol
denRul
est
eadyst
ate:i
fwei
ncr
easesav
ingr
ateof
t
hiseconomy
,theeconomywi
l
lhav
efast
ergr
owt
hunt
ili
treachest
oanew
st
eadyst
atewi
thhi
gherconsumpt
ionpercapi
ta.

EndogenousGr
owt
hTheor
y
 Solowmodel :
 Sust ainedgr owthinlivi
ngstandardsisduetotechprogress,
therateof
techpr ogressisexogenous.
 Endogenousgr owththeory:
 asetofmodel sinwhichthegrowthr at
eofproduct
ivi
tyandlivi
ng
standar dsisendogenous
 Abasi cmodel
 Pr oductionf uncton:Y =AK
i
 wher e, YisOutput,Ki sthecapit
alst
ock,Ameasur estheamount
ofout putproducedforeachunitofcapit
al(Aisexogenous&
const ant)
 Keydi ff
erencebet weenthismodel&Sol ow:MPKi sconstanthere,di
mini
shes
i
nSol ow
 Investment :sY
 Depr eci
ation: K

86
 Equat
ionofmoti
onfort
otalcapi
tal
:
ΔK =sY K
 ΔK =sY K
 Div
idet oughbyK anduseY =AK,
hr get
:

Chapt
er7:Macr
oeconomi
cTheor
iesandAf
ri
canEconomi
es

Macr
oeconomi
cTheor
iesandAf
ri
canEconomi
es:Anover
view
7.
1TheAppl
icabi
li
tyofConv
ent
ional
Theor
iest
oAf
ri
canEconomi
es

7.
1.1I
ntr
oduct
ion
Ther
ewer
eal
somuchmor
edebat
eont
heappl
i
cabi
l
ityofconv
ent
ionalmacr
omodelt
o
Af
ri
caneconomi
esi
npar
ti
cul
aranddev
elopi
ngcount
ri
esi
ngener
al.Butt
hemaj
or
v
iewscanbecat
egor
izedi
ntot
wo:
a)TheOr
thodoxVi
ew
Accor
dingt
othi
svi
ewsuchmacr
omodel
sar
eappl
i
cabl
eel
sewher
ebei
tdev
elopedor
dev
elopi
ngcount
ri
es.Thesol
uti
onf
orwar
dedbyt
hisv
iew i
sthatt
olett
hemar
kett
o
al
l
ocat
eresour
cesandl
i
mitgov
ernmenti
nter
vent
ion.Thegui
dingpr
inci
pleofeconomi
c
deci
si
oni
s“pr
iceandmar
ketsyst
em i
sri
ght
”.

b)TheSt
ruct
ural
istVi
ew
Thest
ruct
ural
istv
iewcanbecl
assi
fi
edas:

 Ear
lyVi
ew:i
tar
guest
hatt
hest
ruct
ureofdev
elopi
ngcount
ri
esi
sdi
ff
erentf
rom t
hatof
dev
eloped count
ri
es.Thi
s schooli
sthe pr
oponentofi
nfanti
ndust
ryar
gumentwhi
ch
f
ocusesonpr
otect
ingt
hei
ndust
ri
esandoni
mpor
tsubst
it
uti
onst
rat
egy
.
 TheRecentVi
ew:t
hisv
iew f
ocusesonshor
tter
m adj
ust
ment
s.Fort
hisschoolmonet
ary
and f
iscalpol
i
cypr
escr
ipt
ionst
hatmaybeappl
i
cabl
eto dev
eloped count
ri
esar
enot
r
elev
antf
ordev
elopi
ngcount
ri
es.
 Remov
ingst
ruct
uralr
igi
dit
ies,
creat
ingwel
l
-funct
ioni
ngandi
ntegr
atedmar
ket
stoel
i
minat
e
suppl
ysi
der
igi
dit
iesshoul
dther
efor
ebei
nthepr
ior
it
iesofdev
elopmentst
rat
egi
es.
7.
1.2Char
act
eri
sti
csofDev
elopi
ngCount
ri
es
Thesechar
act
eri
sti
csi
ncl
udet
henat
ureofopennesst
otr
adewi
tht
her
estoft
hewor
ldi
nbot
h
commodi
ti
es and asset
s,t
he pr
oper
ti
es oft
he economy
’sl
ong-
run and shor
t-
run suppl
y
f
unct
ions,t
henat
ureoff
inanci
almar
ket
s,t
hechar
act
eri
sti
csoft
hegov
ernment
’sbudgetand
t
hei
rimpl
i
cat
ionf
orf
iscal
pol
i
cy,
etc.
Dev
elopi
ngcount
ri
est
endt
obemor
eopenandhav
eli
tt
lecont
rolov
ert
hepr
icesoft
he

87
 goodst
heyexpor
tand i
mpor
t.Hencet
heconv
ent
ionalcl
osed economymodeli
snot
appl
i
cabl
e.
I
ncont
rastt
othemaj
ori
ndust
ri
alcount
ri
es,t
hev
astmaj
ori
tyofdev
elopi
ngcount
ri
eshav
e
notadopt
edf
lexi
bleex
changer
ates.
Dev
elopi
ngcount
ri
est
endt
obecapi
tali
mpor
ter
s,andt
heser
vici
ngofext
ernaldebti
sa
cent
ral
pol
i
cyi
ssuei
nmanyoft
hem.
Theext
entofext
ernalt
radei
nasset
stendst
obemor
eli
mit
edi
ndev
elopi
ngcount
ri
est
han
i
nindust
ri
alones.
Theaggr
egat
edemandcur
vei
sdownwar
dsl
opi
ngj
ustl
i
kedev
elopedcount
ri
esbutmuch
st
eeper
.
7.
1.3Dev
aluat
ionandDev
elopi
ngCount
ri
es
Thedi
ff
erencebet
weent
heMDCandLDCmodel
sar
eper
hapsmostev
identwhenconsi
der
ing
dev
aluat
ion. I
ntheMDC,dev
aluat
ioni
mpr
ovest
hebal
anceoft
radeshi
ft
ingt
heI
Sandt
he
aggr
egat
edemandcur
v YD)t
es( other
ight
,resul
ti
ngi
nani
ncr
easei
nbot
hout
putandt
hepr
ice
l
evel
;rest
ri
cti
vemonet
aryandf
iscalpol
i
cyar
eli
kel
ytobet
heappr
opr
iat
est
abi
l
izat
ionpol
i
cies
t
oaccompanydev
aluat
ion.
7.
1.4Rest
ri
cti
veMonet
arypol
icyandDev
elopi
ngCount
ri
es
Ani
ncr
easei
nther
eser
ver
ati
o,r
educi
ngt
hemoneysuppl
y,hasal
argei
mpactont
heLM cur
ve
(
foragi
venpr
icel
evel
)becauseoft
hei
nter
estel
ast
ici
tyofmoneydemand.Thedecr
easei
nthe
av
ail
abi
l
ityofl
ow i
nter
estcommer
cialbankl
oansal
sor
educesr
etai
nedear
ningsomewhat
shi
ft
ingt
heI
Scur
vedown.
7.
1.5Rest
ri
cti
veFi
scal
pol
icyandDev
elopi
ngCount
ri
es
Whi
l
erest
ri
cti
vemonet
arypol
i
cyi
sli
kel
ytoi
ncr
easebot
hunempl
oymentandi
nfl
ati
oni
nthe
LDCi
ntheshor
trun,
rest
ri
cti
vef
iscalpol
i
cyi
sli
kel
ytobemor
esuccessf
uli
nreduci
ngt
hepr
ice
l
evel
wit
houtt
hecost
sofamaj
orr
ecessi
on.
7.
1.6I
ncomepol
icyandDev
elopi
ngCount
ri
es
Anincomepoli
cyt
hatl
ower
sthenomi
nalwageaf
fect
sthest
andar
dLDC economi
esi
na
numberofway
s.
Shi
ft
stheI
Scur
vet
othel
eft(
sincegov
ernmentspendi
ngi
sdecr
easi
ng)
TheLM cur
veshi
ft
stot
her
ightduet
oadecr
easei
nmoneydemand
I
tdecr
easesbot
hwageandi
nter
estcost
sshi
ft
ingaggr
egat
esuppl
ydown

END

88
 DEVELOPMENTECONOMI
CSMODULE
DEVELOPMENTECONOMI
CSI
CHAPTERONE

Economi
csofdevel
opment
:concept
sandappr
oaches
Dev
elopmenteconomi
csdeal
swi
thdev
elopmentpr
obl
emsofdev
elopi
ngcount
ri
es.I
n
ot
herwor
ds,i
tisaboutt
hecausesandcur
esofmasspov
ert
yint
hel
essdev
eloped
nat
ions.Att
heout
set
,ther
efor
e,weshoul
dbeawar
eoft
her
elev
antconcept
sand
measur
ingmet
hodsofdev
elopmentdev
isedbydi
ff
erenti
nst
it
uti
onsandper
sons.Thus,
t
hedi
scussi
onoft
hehi
stor
icalev
olut
ionoft
heconceptdev
elopmentandt
hemet
hods
empl
oyed i
n measur
ing dev
elopmentar
evi
tal
.Dearst
udent
s,we wi
l
lbegi
n our
di
scussi
on dev
elopmenteconomi
csbydef
ini
ng t
heconcept
sofdev
elopmentand
economi
cgr
owt
h.

Themeani
ngofeconomi
cgr
owt
hisunambi
guous. Al
mostal
leconomi
stswoul
d
acceptt
hei
ncr
easei
ntheout
putofgoodsandser
vicesofacount
ryperuni
tti
meas
i
tsdef
ini
ti
on. Out
puti
smeasur
ed byt
hegr
ossnat
ionalpr
oduct(
GNP)orgr
oss
domest
icpr
oduct(
GDP)
.Gr
owt
hinGNP/
GDPcanbecal
cul
atedei
theratmar
ketpr
ice
orf
act
orcost
.Inor
dert
omeasur
etheef
fectofgr
owt
hont
hest
andar
dofl
i
vingoft
he
popul
ati
on,
theGNP/
GDPpercapi
tal
ist
aken,
whi
chi
sal
soknownaspercapi
tal
income.
Percapi
tali
ncomecanbemeasur
edi
nter
msofhomecur
rencyandf
ori
nter
nat
ional
compar
isonsi
nter
msofUSdol
l
ar.Howev
er,t
heUSdol
l
arhasdi
ff
erentpur
chasi
ng
poweri
nthemar
ketofdi
ff
erentcount
ri
esespeci
all
yfornon-
tr
adedgoods.

Ot
hert
ri
edt
oexpl
aindev
elopmenti
nter
msoft
hepr
ocessofst
ruct
uralt
ransf
ormat
ion
oft
heeconomy
.Thusi
t’
sthepl
annedal
ter
ati
onoft
hest
ruct
ureofpr
oduct
ionand
empl
oyment
.Lat
eronconcer
nar
eaccor
dedt
opov
ert
y,unempl
oyment
,inequal
i
tiesof
i
ncome,andot
hereconomi
c,i
nst
it
uti
onal
,soci
alandpol
i
ticalf
act
orsowi
ngt
othe
f
ail
ureofdev
elopi
ngcount
ri
est
oimpr
ovet
hest
andar
dofl
i
vingoft
hepoor
.

89
Dudl
eySeer
sar
guesont
heneedofl
ooki
ngonwhathasbeenhappeni
ngt
opov
ert
y,
unempl
oyment
,and i
nequal
i
tyasa det
ermi
nantofdev
elopmentr
athert
han mer
e
gr
owt
hofpercapi
tai
ncome.Af
terhi
mInaddi
ti
ont
othesei
ssues,
dev
elopmenthast
o
i
ncor
por
ateot
hereconomi
candnon-
economi
cfact
ors.Aconceptofdev
elopmenti
n
gener
ali
srequi
redwhi
chembr
acest
hemaj
oreconomi
candsoci
alobj
ect
ivesand
v
aluest
hatsoci
eti
esst
ri
vef
or.

Cur
rent
ly,byPodar
o dev
elopmenti
s“concei
ved as a mul
tidi
mensi
onalpr
ocess
i
nvol
vi
ng maj
or changes i
n soci
alst
ruct
ures,popul
ar at
ti
tudes,and nat
ional
i
nst
it
uti
ons,as wel
las t
he accel
erat
ion ofeconomi
c gr
owt
h,t
he r
educt
ion of
i
nequal
it
y(andunempl
oyment
),andt
heer
adi
cat
ionofabsol
utepover
ty”
.Deni
sGoul
et
di
sti
ngui
shes t
hree basi
c component
s orcor
eval
ues i
nthi
s wi
dermeani
ng of
dev
elopment
.Li
fe-
sust
enance:i
sconcer
nedwi
tht
hepr
ovi
sionofbasi
cneeds.No
count
rycanber
egar
dedasf
ull
ydev
elopedi
fitcannotpr
ovi
dei
tsent
ir
epeopl
ewi
th
suchbasi
cneedsashousi
ng,
clot
hing,
foodandmi
nimum educat
ion.Amaj
orobj
ect
ive
ofdev
elopmentmustbet
orai
sepeopl
eoutofpr
imar
ypov
ert
yandt
opr
ovi
debasi
c
needssi
mul
taneousl
ywi
thoutwhi
ch t
her
eisabsol
ute underdev
elopment
.Hence,
economi
cdev
elopmenti
sanecessar
ycondi
ti
on(
butnotsuf
fi
cientcondi
ti
on)f
ort
he
i
mpr
ovementoft
hequal
i
tyofl
i
fei
npr
ovi
dingt
hesel
i
fesust
enanceneedsandbr
ingi
ng
dev
elopment
.

Sel
f-
Est
eem: sel
f-
est
eem i
s concer
ned wi
th t
he f
eel
i
ng of sel
f-
respect and
i
ndependence.I
tmeanst
obeaper
son,asenseofwor
thandsel
f-
respect
,ofnotbei
ng
usedasat
oolbyot
her
sfort
hei
rownends.Ev
erysoci
etyori
ndi
vi
dualst
ri
vest
owar
ds
sel
f-
est
eem.Wi
thoutdev
elopmentt
hepr
ideoft
hepeopl
esoft
hedev
elopi
ngcount
ri
es
ont
hei
rcul
tur
ali
dent
it
yanddi
gni
tyar
ebei
nger
oded.Nocount
rycanber
egar
dedas
f
ull
ydev
elopedi
fiti
sexpl
oit
edbyot
her
sanddoesnothav
ethepowerandi
nfl
uencet
o
conductr
elat
ionsonequalt
erms.Nowday
s,economi
cweal
thandt
echnol
ogi
calpower
hav
e become al
most uni
ver
salmeasur
es of wor
th.Dev
elopi
ng count
ri
es seek
dev
elopmentf
orsel
f-
est
eem;t
oer
adi
cat
ethef
eel
i
ngofdomi
nanceanddependence
whi
chi
sassoci
atedwi
thi
nfer
ioreconomi
cst
atus.

Fr
eedom f
rom ser
vit
ude:Fr
eedom i
sabi
l
ityofpeopl
etodet
ermi
net
hei
rdest
iny
.It
i
nvol
vesanexpandedr
angeofchoi
cesf
orsoci
eti
esandt
hei
rmember
stoget
herwi
tha
mi
nimi
zat
ionofext
ernalconst
rai
ntsi
nthepur
sui
tofdev
olv
ement
.Nomani
sfr
eei
f

90
s/
hecannotchoose;
ifs/
hei
simpr
isonedbyl
i
vingont
hemar
ginofsubsi
stencewi
thno
educat
ionandnoski
l
ls.

Economi
cpr
osper
it
yexpandst
her
angeofchoi
cest
hatpeopl
emayhav
e.I
tenabl
est
o
gai
ngr
eat
ercont
rolov
ernat
ureandphy
sicalenv
ironment
.Itgi
vest
hef
reedom t
o
choosegr
eat
erl
eisur
e,t
o hav
emor
egoodsandser
vicesordenymat
eri
alwant
s.
Ther
efor
e,dev
elopmenti
s har
dlypossi
ble wi
thoutgr
owt
h,butgr
owt
his possi
ble
wi
thoutdev
elopment
.Di
ff
erentmet
hods ofmeasur
ing dev
elopmentand maki
ng
i
nter
nat
ional
compar
isonshav
esof
arbeendev
ised.Amongt
hese:
-

1.
1.Conv
ent
ionalMeasur
esofDev
elopment
:

The domi
nantconv
ent
ionalmeasur
es ofgr
owt
h and dev
elopmentar
ethe Gr
oss
Nat
ionalPr
oduct(
GNP)orGr
ossDomest
icPr
oduct(
GDP)andt
hei
rcor
respondi
ngper
capi
talv
alues.GNPi
scal
cul
atedast
het
otaldomest
icandf
orei
gnv
alueaddedcl
aimed
byacount
ry’
sresi
dent
swi
thoutmaki
ngdeduct
ionsf
ordepr
eci
ati
onoft
hedomest
ic
capi
tal
stock.

1.
2.Al
ter
nat
ivedev
elopmenti
ndi
cat
ors:

Asi
def
rom t
heaf
orement
ioneddef
ici
enci
esencount
eredi
nmeasur
ingi
ncomei
tsel
f,
t
hissear
chhasbeenpr
ompt
edbyt
hef
oll
owi
ngconsi
der
ati
ons:

i
. Thef
ail
ureoft
heGNP/
GDPmeasur
est
oref
lectt
hei
mpactofgr
owt
hont
he
pat
ter
nofi
ncomedi
str
ibut
ion
i
i
. Thei
nabi
l
ityoft
heGNP/
GDPmeasur
est
oref
lectt
hewel
far
eimpactoft
hegoods
andser
vicespr
oducedaswel
last
hel
i
kel
ycost
stosoci
etyofcer
tai
npat
ter
nsof
gr
owt
h.
i
i
i. Thei
nval
i
dit
yoft
heGNP/
GDPi
ndi
cat
orasameasur
eofwel
lbei
ngi
nsi
tuat
ions
wher
egr
owt
hhasact
ual
l
ydeepenedpov
ert
yandi
ncomei
nequal
i
ties,i
ncr
eased
unempl
oymentandaf
fect
edt
heenv
ironmentadv
ersel
y.
Ther
efor
e,t
hemosti
mpor
tantf
act
ori
nfl
uenci
ngt
hesear
chf
oral
ter
nat
ivei
ndi
ctor
shas
beent
hemar
kedshi
fti
nthi
nki
ngamongdev
elopmenteconomi
sts,or
gani
zat
ionsand
pr
act
it
ioner
ssi
ncet
hebegi
nni
ngoft
he1970saboutt
hemeani
ngofdev
elopmentand
t
hepr
ocessesl
eadi
ngt
oit
.Amongt
hedev
elopedal
ter
nat
ivei
ndi
cat
orst
hemaj
orar
e
t
he phy
sicalqual
i
tyofl
i
fei
ndex (
PQLI
)dev
eloped byMor
ri
s(1979)
,the Human

91
Dev
elopmentI
ndex(
HDI
)dev
elopedbyUNDP,
andt
heHumanPov
ert
yIndex.Thesear
e
t
obedi
scussedonebyonebel
ow:
PQLI=Li
feexpec.i
ndex+i
nfantmor
t.i
ndex+l
i
ter
acyi
ndex

ThePQLIi
ndi
rect
lyr
efl
ect
stheef
fect
sonhumandev
elopmentofi
nvest
menti
nheal
th
ser
vice,wat
erandsewagesy
stems,qual
i
tyoff
oodandnut
ri
ti
on,educat
ion,housi
ng,
andchangesi
nincomedi
str
ibut
ion.Oneposi
ti
veaspectoft
hePQLIi
s,t
her
efor
e,t
hati
t
hel
pedr
edi
rect
ingat
tent
ionawayf
rom gr
owt
h,t
owar
dabr
oaderconceptofhuman
dev
elopment
.

Howev
er,t
hePQLIhasbeencr
it
ici
zedasani
ndi
cat
orofsoci
aldev
elopmenti
nrel
ati
on
t
o bot
hthe choi
ce ofi
ndi
cat
orsaswel
last
he wei
ghtassi
gned t
othe di
ff
erent
i
ndi
cat
ors.

 I
tishandi
cappedbyt
hel
i
mit
eddat
aav
ail
abi
l
ity
 I
tgi
vesdi
spr
opor
ti
onat
ewei
ghtt
olongev
ityast
wooft
het
hreei
ndi
cat
ors,
i
nfantmor
tal
i
tyandl
i
feexpect
ancyar
erel
atedt
oit
.
 I
tgi
vesequal
wei
ghtt
oeachi
ndi
cat
orar
bit
rar
il
ywi
thoutobv
iousr
ati
onal
e
 I
ttr
eat
seconomi
candsoci
ali
ndi
ctor
ssepar
atel
y,i
nst
eadofcombi
ningt
hem
i
nacomposi
tei
ndex
.
HDIi
sranki
ngv
ari
ouscount
ri
esaccor
dingt
other
elat
ivesuccesst
heyhav
ehadwi
th
t
hehumandev
elopmentoft
hei
rpopul
ati
on.UNDPi
sof
fer
ingt
heHDIasanal
ter
nat
ive
t
otheGNPf
ormeasur
ingt
her
elat
ivesoci
o-economi
cpr
ogr
essofnat
ions.HDIhas
al
soat
tempt
edt
otakeaccountofsomeoft
hel
i
mit
ati
onsoft
hePQLI
.HDIi
sbasedon
t
hreev
ari
abl
es:

 l
ongev
ity
:-asmeasur
edbyl
i
feexpect
ancyatbi
rt
h
 educat
ionalat
tai
nment
:-asmeasur
edbyacondi
ti
onofadul
tli
ter
acy(
two
t
hir
d wei
ght
)and a combi
ned pr
imar
y,secondar
y,and t
ert
iar
y school
enr
oll
mentr
ati
os(
onet
hir
dwei
ght
)
 St
andar
dofl
i
vingmeasur
edbyr
ealpercapi
tai
ncomeatPPP.Themar
ginal
v
alueofmoneyi
ncomeabov
ethewor
ldav
eraget
hreshol
dof$5120r
eal
GDP
percapi
tai
sassumedt
ober
api
dlydi
mini
shi
ng
Foranycomponentoft
heHDI
,thei
ndi
vi
duali
ndi
cescanbecomput
edaccor
dingt
othe

92
gener
alf
ormul
aof
:

I
ndex=Act
ual
val
ue–Mi
nimum v
alue

Maxi
mum v
alue–Mi
nimum v
alue

 Li
feExpect
ancyI
ndex=

 Educat
ionI
ndex=

 Adul
tLi
ter
acyI
ndex(
ALI
)=

 Gr
ossEnr
olmentI
ndex(
GEI
)=

 GDPI
ndex=

Wher
e:LE:
Lif
eexpect
ance ALR: Adul
tli
ter
acyr
ate

CGER:
Combi
nedgr
ossenr
olmentr
ati
o GDPpc:
GDPpercapi
taatPPPi
nUSD

Thei
ndext
husr
angesf
rom 0t
o1.I
ftheact
ualv
aluei
sequalt
omaxi
mum t
hei
ndexi
s
one.TheHDIr
ankscount
ri
esi
ntot
hreegr
oups:l
owhumandev
elopment(
0.0t
o0.
49)
,
medi
um humandev
elopment(
0.50t
o0.
79)andhi
ghhumandev
elopment(
0.80t
o1.
00)
.
Foranygi
veny
ear
,HDImeasur
esr
elat
ivenotabsol
utel
evelofhumandev
elopmentand
t
hati
tsf
ocusi
sont
heendsofdev
elopment(
longev
ity
,educat
ionalachi
evementand
st
andar
dofl
i
ving)
.

TheUni
tedNat
ionshasconst
ruct
edhumanpov
ert
yindi
cesf
ordev
elopi
ngcount
ri
es.
The composi
te measur
efocuses on di
mensi
ons of depr
ivat
ions.The HPIf
or
dev
elopi
ngcount
ri
esi
sbasedont
hreemai
nindi
ces:

 Theper
cent
ageoft
hepopul
ati
onnotexpect
edt
osur
viv
etot
heageof40(
P1)
 Theadul
til
l
iter
acyr
ate(
P2)
 Adepr
ivat
ioni
ndexbasedonanav
erageoft
hreev
ari
abl
es:t
heper
cent
ageoft
he
popul
ati
onwi
thoutaccesst
o saf
ewat
er;t
heper
cent
ageofpopul
ati
onwi
thout
accesst
oheal
thser
vice;andt
heper
cent
ageoft
heunder
wei
ghtchi
l
drenunderf
ive
y
ear
sol
d(P3)
.Thef
ormul
aisgi
venby
: HPI=[
1/ P13+P23+P33)
3( ]1/3

93
Quest
ion1.
1.Whyi
sast
ri
ctl
yeconomi
cdef
ini
ti
onofdev
elopmenti
nadequat
e?Use
empi
ri
calev
idences as exampl
es ofcount
ri
es dev
elopi
ng economi
cal
l
y butar
e
under
dev
eloped.

Chapt
ert
wo

St
ruct
uralf
eat
uresandcommonchar
act
eri
sti
csofdev
elopi
ngcount
ri
es

Thi
schapt
erpor
tray
sthest
ruct
ural
div
ersi
tyofdev
elopi
ngnat
ions.Wi
tht
hisi
ntent
ion
wewi
l
lmakeanexami
nat
ionofei
ghtcr
it
ical
component
s.Thesear
e:

Thesi
zeoft
hecount
ry(
geogr
aphi
car
ea,
sizeofpopul
ati
on,
andi
ncomel
evel
s)
Ev
ident
ly,
economi
cpot
ent
ialofacount
ryi
ssi
gni
fi
cant
lydet
ermi
nedbyi
tsphy
sicaland
popul
ati
onsi
ze,andi
tsl
evelofnat
ionali
ncomepercapi
ta. Thesear
eal
somaj
or
f
act
orsdi
ff
erent
iat
ingonedev
elopi
ngcount
ryf
rom anot
her
.Thi
ssi
zepr
ovi
desbot
h
adv
ant
agesanddi
sadv
ant
ages. Lar
gesi
zeusual
l
ypr
esent
sadv
ant
agesofdi
ver
se
r
esour
ce endowment
,lar
ge pot
ent
ialmar
ket
s,and l
esserdependence on f
orei
gn
sour
cesofmat
eri
alsandpr
oduct
s. Buti
tal
socr
eat
espr
obl
emsofadmi
nist
rat
ive
cont
rol
,nat
ional
cohesi
on,
andr
egi
onal
imbal
ances.

Howev
er,
iti
stobebor
nthatt
her
eisnonecessar
yrel
ati
onshi
pamongacount
ry’
ssi
ze,
i
tsl
evelofpercapi
tai
ncome,
andt
hedegr
eeofequal
i
tyori
nequal
i
tyi
nthedi
str
ibut
ion
oft
hati
ncome.Forexampl
e,ascompar
edt
oEt
hiopi
a,t
henei
ghbor
ingcount
ry,Keny
a
i
ssmal
l
eri
ngeogr
aphi
candpopul
ati
onsi
ze. ButKeny
ahasabout3t
imest
heper
capi
tai
ncomeofEt
hiopi
aatof
fi
cialexchanger
ate.ButKeny
ahasal
sol
esserpercapi
ta
i
ncomet
hanBr
azi
landsomeot
herl
argerdev
elopi
ngcount
ri
es.

I
tshi
stor
icalandeconomi
calbackgr
ound
Theot
hersour
cesofdi
ver
sit
yamongt
hedev
elopi
ngcount
ri
esar
ethei
rtr
adi
ti
onaland
col
oni
alher
it
ages.Appar
ent
ly,count
ri
eshav
ethei
rowndi
ff
erentcul
tur
albackgr
ound
accumul
ated i
nthei
rhi
stor
ymaki
ng t
hem t
o hav
e di
ff
erentsoci
aland economi
c
i
nst
it
uti
ons.Mor
eov
er,dev
elopi
ng nat
ions wer
e atone t
ime orot
hercol
oni
es of
West
ernEur
opeancount
ri
es.TheEur
opeancol
oni
alpower
shadadr
amat
icandl
ong-
l
ast
ingi
mpactont
heeconomi
es,pol
i
ticalandi
nst
it
uti
onalst
ruct
uresoft
hei
rAf
ri
can
and Asi
an col
oni
es. The economi
cst
ruct
uresoft
hese nat
ions,aswel
last
hei
r

94
educat
ionalandsoci
ali
nst
it
uti
onshav
ety
pical
l
ybeenmodel
edont
hoseoft
hei
rfor
mer
economi
crul
ers.
Hence,t
he di
ver
sit
yin col
oni
alher
it
age t
oget
her wi
tht
he i
ndi
genous cul
tur
al
di
ff
erenceshav
eresul
teddi
ff
erentst
ruct
ural
probl
emsi
nthesecount
ri
es.Dependi
ngon
t
hei
rcol
oni
alher
it
aget
her
efor
ethecount
ri
esar
erequi
redt
otakedi
ff
erentmeasur
es.
Count
ri
esl
i
ket
hosei
nAf
ri
cat
hatonl
yrecent
lygai
nedt
hei
rindependencear
eli
kel
yto
bemor
econcer
nedwi
thconsol
i
dat
ingandev
olv
ingt
hei
rownnat
ionaleconomi
cand
pol
i
tical
str
uct
urest
hanwi
thsi
mpl
ypr
omot
ingr
api
deconomi
cdev
elopment
.
Thei
rpol
i
ciesmayconsequent
ly,r
efl
ectagr
eat
eri
nter
esti
nthesei
mmedi
atepol
i
tical
i
ssues.Lat
inAmer
icancount
ri
eshav
eal
ongerhi
stor
yofpol
i
ticali
ndependencepl
usa
mor
eshar
edcol
oni
alher
it
age. Ther
efor
e,i
nspi
teofgeogr
aphi
canddemogr
aphi
c
di
ver
sit
ythe count
ri
es possess r
elat
ivel
y si
mil
areconomi
c,soci
al,and cul
tur
al
i
nst
it
uti
onsandf
acesi
mil
arpr
obl
ems. I
nAsi
a,ont
heot
herhand,di
ff
erentcol
oni
al
her
it
agesandt
hedi
ver
secul
tur
alt
radi
ti
onsoft
hei
ndi
genouspeopl
eshav
ecombi
ned
t
ocr
eat
edi
ff
erenti
nst
it
uti
onal
andsoci
alpat
ter
ns.

I
tendowment
sofphysi
calandunmanr
esour
ces
Endowment
sofphy
sicalandhumanr
esour
cesar
eot
hersour
cesofdi
spar
it
iesi
n
economi
cgr
owt
hpot
ent
ialoft
hecount
ies.I
fwest
artwi
tht
hephy
sicalr
esour
ce
endowment
s,ont
heonehandt
her
ear
ecount
ri
eswhi
char
eext
remel
yandf
avor
abl
y
endowedi
nresour
cessuchasmi
ner
als,r
aw mat
eri
als,andf
ert
il
eland.Ont
heot
her
hand,t
her
ear
eal
sopoor
lyendowednat
ionswher
eendowment
sofr
awmat
eri
alsand
mi
ner
alsandev
enf
ert
il
elandar
erel
ati
vel
ymi
nimal
.

Mor
eov
er,geogr
aphyandcl
i
mat
ecanal
sopl
ayani
mpor
tantr
olei
nthesuccessor
f
ail
ure ofdev
elopmentef
for
ts. Ot
hert
hings bei
ng equal
,iti
s sai
dthati
sland
economi
esseem t
odobet
tert
hanl
andl
ockedeconomi
es.Wi
thr
espectt
ocl
i
mat
eal
so
t
emper
atezonecount
ri
esdobet
tert
hant
ropi
calzonenat
ions.Dev
elopi
ngcount
ri
es
ar
eal
sodi
sti
ngui
shedonef
rom t
heot
heri
nthei
rhumanr
esour
ceendowment
s.The
humanr
esour
ceendowment
sincl
udesnotonl
ythenumberofpeopl
eandt
hei
rski
l
l
l
evel
sbutsoal
sot
hei
rcul
tur
alout
looks,at
ti
tudest
owar
dwor
k,accesst
oinf
ormat
ion,
wi
l
li
ngnesst
oinnov
ate,
anddesi
ref
orsel
f-
impr
ovement
.

95
I
tset
hni
candr
eli
giouscomposi
ti
on
Et
hni
cit
yandr
eli
gionof
tenpl
ayamaj
orr
olei
nthesuccessorf
ail
ureofdev
elopment
ef
for
ts.Ev
ident
ly,t
hegr
eat
ert
heet
hni
candr
eli
giousdi
ver
sit
yofacount
ryt
hemor
e
l
i
kel
yiti
sthatt
her
e wi
l
lbe i
nter
nalst
ri
fe and pol
i
ticali
nst
abi
l
ity
.Ther
eis al
so
di
sti
nct
ioni
net
hni
candr
eli
giouscomposi
ti
onamongnat
ions.
Pr
esent
lymor
ethan40%oft
hewor
ld’
snat
ionshav
emor
ethanf
ivesi
gni
fi
cantet
hni
c
popul
ati
ons.I
nmostcases,oneormor
eoft
hesegr
oupsf
aceser
iouspr
obl
emsof
di
scr
imi
nat
ion. Ov
erhal
foft
he wor
ld’
sless dev
eloped count
ri
es hav
erecent
ly
exper
iencedsomef
orm ofi
nter
ethni
cconf
li
ct.Justi
nthef
ir
sthal
foft
he1990s,
ethni
c
andr
eli
giousconf
li
ctsl
eadi
ngt
owi
despr
eaddeat
handdi
sti
nct
iont
ookpl
acei
nmany
Af
ri
cancount
ri
esandsomecount
ri
esofot
herr
egi
ons.
Butnei
therov
ertphy
sicalconf
li
ctnorwi
despr
eadv
iol
encei
snecessar
ytodi
sruptan
economyorcausepol
i
ticali
nst
abi
l
ity
.Ifdev
elopmenti
sabouti
mpr
ovi
nghumanl
i
ves
andpr
ovi
dingawi
deni
ngr
angeofchoi
cet
oal
lpeopl
es,r
aci
al,et
hni
c,orr
eli
gious
di
scr
imi
nat
ionscanbeequal
l
ydest
ruct
ive.Forexampl
ethr
oughoutLat
inAmer
ica,
i
ndi
genouspopul
ati
onshav
esi
gni
fi
cant
lyl
aggedbehi
ndot
hergr
oupsonal
mostev
ery
measur
eofeconomi
candsoci
alpr
ogr
ess.I
nthesecount
ri
es,bei
ngi
ndi
genousmakes
i
tmuchmor
eli
kel
ythatani
ndi
vi
dualwi
l
lbel
esseducat
ed,i
npoor
erheal
th,andi
na
l
owersoci
o economi
c st
ruct
uret
han ot
herci
ti
zens. Thi
sis par
ti
cul
arl
ytr
ue f
or
i
ndi
genouswomen.Et
hni
candr
eli
giousdi
ver
sit
yneednot
,howev
er,
necessar
il
yleadt
o
i
nequal
i
ty,
tur
moi
l
,ori
nst
abi
l
ity
.

Ther
elat
ivei
mpor
tanceofi
tspubl
icandpr
ivat
esect
or
Mostdev
elopi
ngcount
ri
eshav
emi
xedeconomi
csy
stems,f
eat
uri
ngbot
hpubl
i
cand
pr
ivat
eowner
shi
panduseofr
esour
ces.Thedi
vi
sionbet
weent
het
woandt
hei
rrel
ati
ve
i
mpor
tancear
emost
lydet
ermi
nedbyt
hehi
stor
icalandpol
i
ticalci
rcumst
ancesoft
he
count
ri
es.Thus,i
ngener
al,Lat
inAmer
icanandSout
hEastAsi
annat
ionshav
elar
ger
pr
ivat
esect
orst
hanSout
hAsi
aandAf
ri
cannat
ions.
Thedegr
eeoff
orei
gnowner
shi
pont
hepr
ivat
esect
ori
sanot
heri
mpor
tantv
ari
abl
eto
consi
derwhendi
ff
erent
iat
ingamongl
essdev
elopedcount
ri
es.Al
argef
orei
gnowned
pr
ivat
esect
orusual
l
ycr
eat
eseconomi
candpol
i
ticaloppor
tuni
ti
esaswel
laspr
obl
ems
notf
oundi
ncount
ri
eswher
efor
eigni
nvest
orsar
elesspr
eval
ent
.
Economi
cpol
i
cies,
suchast
hosedesi
gnedt
opr
omot
emor
eempl
oyment
,wi
l
lnat
ural
l
y
bedi
ff
erentf
orcount
ri
eswi
thl
argepubl
i
csect
orsandoneswi
thsi
zeabl
epr
ivat
e

96
sect
ors.Di
rectgov
ernmenti
nvest
mentpr
oject
sandl
arger
ural
wor
kpr
ogr
amsmayt
ake
pr
ecedencei
neconomi
esdomi
nat
edbyt
hepubl
i
csect
ors. I
nthepr
ivat
eor
ient
ed
economi
es,
howev
er,
speci
alt
axal
l
owancesdesi
gnedt
oinducepr
ivat
ebusi
nessest
hat
canempl
oymor
ewor
ker
smi
ghtbemor
ecommon.Ther
efor
e,al
thought
hepr
obl
em t
o
besol
vedmaybesi
mil
ar,
thesol
uti
oncandi
ff
eri
ncount
ri
eswi
thsi
gni
fi
cantdi
ff
erences
i
nther
elat
ivei
mpor
tanceoft
hepubl
i
candpr
ivat
esect
ors.

Thenat
ureofi
tsi
ndust
ri
alst
ruct
ure
Dev
elopi
ng count
ri
es ar
e pr
edomi
nant
lyagr
ari
an i
n economi
c,soci
al,and cul
tur
al
out
look.Labourf
orce i
n mostoft
hese count
ri
es i
s ov
erwhel
mingl
y engaged i
n
agr
icul
tur
e.Theagr
icul
tur
alsect
orcont
ri
but
essi
gni
fi
cant
lyal
sot
otheGDPofmanyof
t
hepoornat
ions.Far
mingi
snotmer
elyanoccupat
ionbutawayofl
i
fef
ormostpeopl
e
i
nAsi
a,Af
ri
ca,andLat
inAmer
ica. Nev
ert
hel
ess,t
her
ear
egr
eatdi
ff
erencesbet
ween
t
hest
ruct
ureofagr
ari
ansy
stemsandpat
ter
nsofl
andowner
shi
pinLat
inAmer
icaand
Af
ri
ca.Asi
aagr
ari
ansy
stemsar
esl
i
ght
lycl
osert
othoseofLat
inAmer
icai
nter
msof
pat
ter
nsofl
andowner
shi
p.Butev
ent
hent
hesi
mil
ari
ti
esar
elessenedbysubst
ant
ialby
cul
tur
aldi
ff
erences.
I
tisi
nther
elat
ivei
mpor
tanceofbot
hthemanuf
act
uri
ngandser
vicesect
orst
hatwe
f
indt
hewi
destv
ari
ati
onamongdev
elopi
ngnat
ions. MostLat
inAmer
icancount
ri
es
possessmor
eadv
ancedi
ndust
ri
alsect
ors.Buti
nthe1970sand1980scount
ri
esl
i
ke
Tai
wan,
Sout
hKor
ea,
andSi
ngapor
ear
erapi
dlybecomi
ngi
ndust
ri
ali
zedst
ates.

I
tsdegr
eeofdependenceonext
ernal
economi
candpol
it
icalf
orces
Thedegr
eet
owhi
chacount
ryi
sdependentonf
orei
gneconomi
c,soci
al,andpol
i
tical
f
orcesi
srel
atedt
oit
ssi
ze,r
esour
cesendowment
,andpol
i
ticalhi
stor
y. Formost
dev
elopi
ngcount
ri
es,
thi
sdependencei
ssubst
ant
ial
.Insomecases,
itt
ouchesal
most
ev
eryf
acetofl
i
fe. Mostsmal
lnat
ionsar
ehi
ghl
ydependentonf
orei
gnt
radewi
tht
he
dev
elopedwor
ld.Al
mostal
lsmal
lnat
ionsar
edependentont
hei
mpor
tat
ionoff
orei
gn
and of
ten i
nappr
opr
iat
etechnol
ogi
es of pr
oduct
ion.Thi
sfactal
one exer
ts an
ext
raor
dinar
yinf
luenceont
hechar
act
eroft
hegr
owt
hpr
ocessi
nthesedependent
nat
ions.
Acount
ry’
sabi
l
ityt
ochar
tit
sowneconomi
candsoci
aldest
inyi
ssi
gni
fi
cant
lyaf
fect
ed
byi
tsdegr
eeofdependenceont
heseandot
herext
ernal
for
ces

Thedi
str
ibut
ionofpowerandt
hei
nst
it
uti
onal
andpol
it
icalst
ruct
urewi
thi
nthenat
ion.
I
nthef
inalanal
ysi
s,i
tisof
tennott
hecor
rect
nessofeconomi
cpol
i
ciesal
onet
hat

97
det
ermi
nest
heout
comeofnat
ionalappr
oachest
ocr
it
icaldev
elopmentpr
obl
ems.The
pol
i
ticalst
ruct
ureandt
hev
est
edi
nter
est
sandal
l
egi
ancesofr
uli
ngel
i
tes(
e.g.
,lar
ge
l
andowner
s,ur
bani
ndust
ri
ali
sts,banker
s,f
orei
gnmanuf
act
urer
s,t
hemi
l
itar
y,andt
rade
uni
oni
sts)wi
l
lty
pical
l
ydet
ermi
newhatst
rat
egi
esar
epossi
bleandwher
ethemai
n
bar
ri
erst
oef
fect
iveeconomi
candsoci
alchangemayl
i
e.
Theconcent
rat
ionofi
nter
est
sandpoweramongdi
ff
erentsegment
soft
hepopul
ati
ons
ofmostdev
elopi
ngcount
ri
esi
sit
sel
fther
esul
toft
hei
reconomi
c,soci
al,andpol
i
tical
hi
stor
iesandi
sli
kel
ytodi
ff
erf
rom onecount
ryt
othenext
.Nev
ert
hel
ess,
what
evert
he
speci
fi
cdi
str
ibut
ion ofpoweramong t
hemi
l
itar
y,t
hei
ndust
ri
ali
sts,and t
hel
arge
l
andowner
sofLat
inAmer
ica;
thepol
i
tici
ansandhi
ghl
evelci
vi
lser
vant
sinAf
ri
ca;
theoi
l
Shei
ksandf
inanci
almogul
soft
heMi
ddl
eEast
;ort
hel
andl
ords,moneyl
ender
s,and
weal
thyi
ndust
ri
ali
stsofAsi
a–mostdev
elopi
ngcount
ri
esar
erul
eddi
rect
lyori
ndi
rect
ly
bysmal
landpower
ful
eli
test
oagr
eat
erext
entt
hant
hedev
elopednat
ionsar
e.
Ef
fect
ivesoci
alandeconomi
cchangest
husr
equi
reei
thert
hatt
hesuppor
tofel
i
te
gr
oupsbeenl
i
stedort
hatt
hepoweroft
heel
i
tebeof
fsetbymor
epower
fuldemocr
ati
c
f
orces.Ei
therwayeconomi
candsoci
aldev
elopmentwi
l
lof
tenbei
mpossi
blewi
thout
cor
respondi
ngchangesi
nthesoci
al,pol
i
tical
,andeconomi
cinst
it
uti
onsofanat
ion.
Suchi
nst
it
uti
onalchangesmayi
ncl
ude:l
andt
enur
esy
stems,f
ormsofgov
ernance,
educat
ionalst
ruct
ures,l
abourmar
ketr
elat
ionshi
ps,pr
oper
tyr
ight
s,t
hedi
str
ibut
ionand
cont
rolofphy
sicalf
inanci
alasset
,lawsoft
axat
ionandi
nher
it
anceandpr
ovi
sionof
cr
edi
t.

CommonChar
act
eri
sti
csofDevel
opi
ngCount
ri
es
Thef
oregoi
ngdi
scussi
onshav
edemonst
rat
edwhyi
tissomet
imesr
iskyt
ogener
ali
ze
t
oo much aboutsuch a di
ver
se setofnat
ions.Nev
ert
hel
ess common economi
c
f
eat
uresofdev
elopi
ngcount
ri
esper
mitust
ovi
ewt
hem i
nabr
oadl
ysi
mil
arf
ramewor
k.

Thi
ssect
ionpor
tray
svar
iousdi
mensi
onsoft
hedev
elopmentgapbet
weenr
ichand
poorcount
ri
esandsi
mil
ari
ti
esofpoornat
ions.Thesei
ncl
udel
evelandgr
owt
hrat
eof
i
ncome,unempl
oymentand under
empl
oyment
,popul
ati
on gr
owt
hrat
e,economi
c
st
ruct
ure,
pol
i
tical
andi
nst
it
uti
onal
fact
ors,
anddegr
eeofdependence.Forconv
eni
ence,
wecancl
assi
fyt
hesecommonchar
act
eri
sti
csi
ntosev
enbr
oadcat
egor
ies.

98
Lowlevel
sofl
iv
ing,
char
act
eri
zedbyl
owi
ncome,
inequal
it
y,poorheal
th,
andi
nadequat
e
educat
ion
I
ndev
elopi
ngnat
ions,
gener
all
evel
sofl
i
vingt
endt
obev
eryl
owf
ort
hev
astmaj
ori
tyof
peopl
e.Thi
sist
ruenotonl
yinr
elat
iont
othei
rcount
erpar
tsi
nri
chnat
ionsbutof
ten
al
soi
nrel
ati
ont
osmal
lel
i
tegr
oupswi
thi
nthei
rownsoci
eti
es.Thesel
ow l
evel
sof
l
i
vingar
emani
fest
edquant
it
ati
vel
yandqual
i
tat
ivel
yint
hef
orm ofl
owi
ncome(
pov
ert
y),
i
nadequat
ehousi
ng,poorheal
th,l
i
mit
edornoeducat
ion,hi
ghi
nfantmor
tal
i
ty,l
owl
i
fe
andwor
kexpect
anci
es,
andi
nmanycaseagener
alsenseofmal
aiseandhopel
essness.

PerCapi
taNat
ionalI
ncome:Asy
ouhav
eseeni
tinchapt
erone,t
heGNPpercapi
tai
s
of
tenusedassummar
yindexoft
her
elat
iveeconomi
cwel
l
-bei
ngofpeopl
eindi
ff
erent
nat
ions.Onecommondi
sti
ngui
shi
ngf
eat
ureofdev
elopi
ngcount
ri
esascompar
edt
o
dev
elopednat
ionsi
stheext
remel
ylow l
evelofi
ncome.Thedi
ff
erencei
nincome
bet
ween r
ich and poornat
ions wi
l
lbe appar
entwhen one t
akes accountoft
he
di
str
ibut
ionofwor
ldpopul
ati
on.I
ntheset
erms,t
hismeanst
hatal
most80% oft
he
wor
ld’
sincomei
spr
oducedi
ntheeconomi
cal
l
ydev
elopedr
egi
onsby20%oft
hewor
ld’
s
peopl
e.Thust
her
emai
ningf
our
-f
if
thsoft
hewor
ld’
spopul
ati
oni
spr
oduci
ngonl
yone-
f
if
thoft
otal
wor
ldout
put
.
Gr
owt
hRat
esofI
ncome:Manydev
elopi
ngcount
ri
esnotonl
yhav
emuchl
owerl
evel
sof
percapi
tai
ncomebutal
sohav
eexper
iencesl
owerGNPgr
owt
hthant
hedev
eloped
nat
ions Di
str
ibut
ion ofNat
ionalI
ncome:t
he gr
owi
ng gap i
n percapi
tai
ncomes
bet
weenr
ichandpoornat
ionsi
snott
heonl
ymani
fest
ati
onoft
hewi
deni
ngeconomi
c
di
spar
it
ybet
weent
hewor
ld'
sri
chandpoor
.Toappr
eci
atet
hebr
eadt
handdept
hof
Thi
rdWor
ldpov
ert
y,i
tisal
sonecessar
ytol
ookatt
hegr
owi
nggapbet
weenr
ichand
poorwi
thi
nindi
vi
dualLDCs.Al
lnat
ionsoft
hewor
ldshow somedegr
eeofi
ncome
i
nequal
i
ty.Ther
ear
elar
gedi
spar
it
iesbet
weent
hei
ncomeoft
her
ichandoft
hepoori
n
bot
hdev
elopedandunder
dev
elopedcount
ri
es.Nev
ert
hel
ess,t
hegapbet
weenr
ichand
poori
sgener
all
ygr
eat
eri
nlessdev
elopednat
ionst
hani
ndev
elopednat
ions.
Ext
entofPov
ert
y:Themagni
tudeandext
entofpov
ert
yinanycount
rydependont
wo
f
act
ors:t
he av
erage l
evelofnat
ionali
ncome and t
he degr
ee ofi
nequal
i
tyi
nit
s
di
str
ibut
ion.Buthowi
sonet
omeasur
epov
ert
yinanymeani
ngf
ulquant
it
ati
vesense?
Heal
th:i
naddi
ti
ont
ost
ruggl
i
ngonl
owi
ncome,
manypeopl
eindev
elopi
ngnat
ionsf
ight
aconst
antbat
tl
eagai
nstmal
nut
ri
ti
on,
disease,
andi
l
lheal
th.

I
nthe mi
d-1970s,mor
ethan 1 bi
l
¬li
on peopl
e,al
mosthal
fthepopul
ati
on oft
he

99
dev
elopi
ngwor
ld(
excl
udi
ngChi
na)
,wer
eli
vi
ngondi
etsdef
ici
enti
nessent
ialcal
ori
es.
One-
thi
rdoft
hem wer
echi
l
drenunder2y
ear
sofage.I
nbot
hAsi
aandAf
ri
ca,
over60%
oft
hepopul
ati
onbar
elymetmi
nimum cal
ori
crequi
rement
snecessar
ytomai
ntai
n
adequat
eheal
th.Tomakemat
ter
swor
se,number
sofdoct
ors,medi
calf
aci
l
iti
esar
e
concent
rat
edi
nur
banar
easwher
eonl
y25% oft
hepopul
ati
onr
esi
des;t
hewoef
ull
y
i
nadequat
epr
ovi
si
onofheal
thcar
etot
hemassesofpoorpeopl
ebecomesst
ri
ki
ngl
y
cl
ear
.Mostpr
obabl
ythesev
ict
ims66%oft
hem wer
eresi
dingi
nAf
ri
cawhi
l
eAsi
aand
Lat
inAmer
icahad21%and4.
3%r
espect
ivel
y.

Educat
ion:t
hespr
eadofeducat
ionaloppor
tuni
ti
esi
sthef
inali
ndi
cat
oroft
hev
eryl
ow
l
evel
sofl
i
vingt
hati
sper
vasi
vei
ndev
elop¬i
ngnat
ions.Theat
temptt
opr
o¬v
idepr
imar
y
schooleducat
ionaloppor
tuni
ti
eshaspr
obabl
ybeent
hemostsi
gni
f¬i
cantofal
lLDC
dev
elopmentef
for
ts.I
n mostcount
ri
es,educat
ion t
akes si
gni
fi
cantshar
e oft
he
gov
ernment
s’budget
.

Yeti
nspi
teofsomei
mpr
essi
vequant
it
a¬t
iveadv
ancesi
nschoolenr
oll
ment
s,l
i
ter
acy
l
evel
sremai
nst
ri
ki
ngl
ylowcom¬par
edwi
tht
hedev
elopednat
ions.Forexampl
e,among
t
hel
eastdev
elopedcoun¬t
ri
es,
li
ter
acyr
atesav
erageonl
y45%oft
hepopul
ati
on.

Lowl
evelofpr
oduct
ivi
ty
I
naddi
ti
ont
olowl
evelofl
i
ving,LDCsar
echar
act
eri
zedbyr
elat
ivel
ylowl
evelofl
abor
pr
oduct
ivi
ty.Si
ncepr
oduct
ionf
unct
iondescr
ibest
hewayi
nwhi
chsoci
eti
esgoabout
pr
ovi
dingf
ort
hei
rmat
eri
alneeds.Thr
oughoutt
hedev
elopi
ngwor
ld,l
evel
sofl
abor
pr
oduct
ivi
tyar
eext
remel
ylowcompar
edwi
tht
hosei
ndev
elopedcount
ri
es.Thi
scanbe
expl
ainedbypr
inci
pleofdi
mini
shi
ngmar
ginalpr
oduct
ivi
tyt
hati
fincr
easi
ngamount
sof
av
ari
abl
efact
or(
labor
)ar
eappl
i
edt
ofi
xedamount
sofot
herf
act
ors(
e.g.
,capi
tal
,l
and,
mat
eri
als)
,theext
raormar
ginalpr
oductoft
hev
ari
abl
efact
ordecl
i
nesbey
ondacer
tai
n
number
.

Low l
evel
sofl
aborpr
oduct
ivi
tycant
her
efor
ebeexpl
ainedbyt
heabsenceorsev
ere
l
ack of"
compl
ement
ary
"fac¬t
ori
nput
s such as phy
sicalcapi
talorexper
ienced
management
.Tor
aisepr
oduct
ivi
ty,accor
dingt
othi
sar
gument
,domest
icsav
ingsand
f
orei
gnf
inancemustbemobi
l
ized.Thi
sist
ogener
atenew i
nvest
menti
nphy
sical
capi
talgoodsandbui
l
dupt
hest
ockofhumancapi
tal(
e.g.
,manager
ialski
l
ls)t
hrough
i
nvest
¬menti
neducat
ionandt
rai
ning.

100
Popul
ati
onGr
owt
handDependencyBur
dens
St
ati
sti
csondemogr
aphi
cev
olut
ionbycount
ryshowt
hatt
hepr
esentr
hyt
hm ofgl
obal
popul
ati
ongr
owt
hisl
argel
yther
esul
toft
heaccel
erat
ionofgr
owt
hint
hedev
elopi
ng
r
egi
ons.The cr
ude bi
rt
hrat
eis pr
obabl
y one of t
he mostef
fi
¬ci
entway
s of
di
sti
ngui
shi
ngt
hel
essdev
elopedf
rom t
hedev
elopedcount
ri
es.Deat
hrat
es(
they
ear
ly
numberofdeat
hsper1,
000popul
ati
ons)i
nThi
rdWor
ldcount
ri
esar
eal
sohi
ghr
elat
ive
t
othedev
elopednat
ions.

Howev
er,t
hesepoornat
ionshav
ebenef
it
edf
rom t
hepr
ogr
essofmedi
cinef
ort
he
massesandt
hecampai
gnsagai
nstendemi
cdi
sease.Thi
swasf
oll
owedbyf
alli
n
mor
tal
i
ty.Hence,t
hedi
ff
erencesi
ndeat
hrat
ebet
weendev
elopi
ng and dev
eloped
count
ri
esar
esubst
ant
ial
l
ysmal
l
ert
hant
hecor
respondi
ngdi
ff
erencesi
nbi
rt
hrat
es.
Thusi
nmostdev
elopi
ngcount
ri
es,t
heact
ivel
aborf
orcehast
osuppor
tpr
opor
ti
onal
l
y
al
mostt
wiceasmanychi
l
drenasi
tdoesi
nri
chercount
ri
es.

Wemayconcl
ude,t
her
efor
e,t
hatnotonl
yar
eThi
rdWor
ldcount
ri
eschar
act
er¬i
zedby
hi
gherr
atesofpopul
ati
ongr
owt
h,butt
heymustal
socont
endwi
thgr
eat
erdependency
bur
denst
hanr
ichnat
ions.

Hi
ghUnempl
oymentandUnder
empl
oyment
Oneoft
hepr
inci
palmani
fest
ati
onsofandcont
ri
but
orst
othel
ow l
evel
sofl
i
vingi
n
dev
elopi
ngnat
ionsi
sthei
rrel
ati
vel
yinadequat
eori
nef
fi
cientut
il
izat
ionofl
abori
n
compar
isonwi
tht
hedev
elopednat
ions.Unempl
oymenti
ncr
easedasar
esul
toft
hef
act
t
hatempl
oymenthasbeengr
owi
ngdur
ingt
hepastatar
atewhi
chi
smuchsl
owert
han
t
her
ateofgr
owt
hoft
hel
abourf
orce;st
agnat
ingeconomi
cgr
owt
handal
sohi
ghr
ural
t
our
banmi
grat
ion.Theunempl
oyedexhi
bitt
woi
mpor
tantchar
act
eri
sti
cs,namel
ythei
r
y
out
hful
nessandt
hei
rhi
ghl
evelofeducat
ion.Andal
socr
eepi
ngupt
heeducat
ion
l
adder

Subst
ant
ialDependenceonAgr
icul
tur
alPr
oduct
ionandPr
imar
y-Pr
oductExpor
ts
Thev
astmaj
ori
ti
esofpeopl
einLDCsl
i
veandwor
kinr
uralar
eas.Ov
er65%ar
erur
all
y
based,compar
edt
olesst
han27%i
neconomi
cal
l
ydev
elopedcount
ri
es.Si
mil
arl
y,58%
oft
hel
aborf
orcei
sengagedi
nagr
icul
tur
e,compar
edt
oonl
y5%i
ndev
elopednat
ions.
Agr
icul
tur
econt
ri
but
esabout14%oft
heGNPofdev
elopi
ngnat
ionsbutonl
y3%oft
he
GNPofdev
elopednat
ions.

101
Ther
eis st
ri
ki
ng di
ff
erence bet
ween t
he pr
opor
ti
onat
e si
ze of t
he agr
icul
tur
al
pop¬ul
ati
oni
nAf
ri
ca,whi
chconst
it
utes(
68%)andSout
hAsi
a(64%)v
ersusNor
th
Amer
ica(
3%)
.Butt
heav
eragepr
oduct
ivi
tyofagr
icul
tur
all
abori
sal
most35t
imes
gr
eat
eri
nNor
thAmer
icat
hani
nAsi
aandAf
ri
cacombi
ned.Agr
icul
tur
alpr
oduct
ivi
tyi
s
l
ow notonl
ybecauseoft
hel
argenumber
sofpeopl
einr
elat
iont
oav
ail
abl
elandbut
al
sobecauseLDC agr
icul
tur
eisof
tenchar
act
eri
zedbypr
imi
ti
vet
echnol
ogi
es,poor
or
gani
zat
ion,
andl
i
mit
edphy
sical
andhumancapi
tal
input
s.

Mosteconomi
esofl
essdev
elopedcount
ri
esar
eor
ient
edt
owar
dthepr
oduct
ionof
pr
imar
ypr
oduct
s.Thesepr
imar
ycommodi
ti
esf
ormt
hei
rmai
nexpor
ts.Andal
somost
poorcount
ri
esneedt
oobt
ainf
orei
gnexchangei
naddi
ti
ont
odomest
icsav
ingsi
nor
der
t
ofi
nancepr
ior
it
ydev
elop¬mentpr
oject
s.

I
mper
fectMar
ket
sandI
ncompl
eteI
nfor
mat
ion
St
art
ing f
rom t
he 1980s al
mostev
ery dev
elopi
ng count
ryi
s mov
ing t
owar
dthe
est
abl
i
shmentofamar
keteconomyf
ormanyr
easons.Ther
eseemedt
obeagr
owi
ng
consensust
hatt
her
ehadbeent
oomuchgov
ernmenti
nter
vent
ioni
nthewor
kingsof
Thi
rdWor
ldeconomi
es.Thi
sgov
ernmenti
nter
vent
ioni
ssi
ght
edbymanyast
hemaj
or
cause oft
he pr
obl
ems i
nthe poornat
ions.Hence,f
ree mar
ketand unf
ett
ered
compet
it
ionar
econsi
der
edast
hekeyt
orapi
deconomi
cgr
owt
h.

Domi
nance,
Dependence,
andVul
ner
abi
li
tyi
nInt
ernat
ionalRel
ati
ons
FormanyLDCs,
afi
nalsi
gni
fi
cantf
act
orcont
ri
but
ingt
otheper
sist
enceofl
owl
evel
sof
l
i
ving,r
isi
ng unempl
oyment
,and gr
owi
ng i
ncome i
nequal
i
tyi
sthe hi
ghl
yunequal
di
str
ibut
ionofeconomi
candpol
i
ticalpowerbet
weenr
ichandpoornat
ions.These
unequalst
rengt
hsar
emani
fest
ed economi
cal
l
yand non-
economi
caspect
soft
he
r
elat
ionshi
p.Economi
cal
l
ythedomi
nantpower
sofr
ichnat
ionscont
rolt
hepat
ter
nof
i
nter
nat
ionalt
rade.Theyhav
eal
sot
heabi
l
ityt
odi
ctat
ethet
ermswher
ebyt
echnol
ogy
,
f
orei
gnai
d,andpr
ivat
ecapi
tal
aret
ransf
err
edt
odev
elopi
ngcoun¬t
ri
es.

Fi
nal
l
y,t
hepenet
rat
ionofr
ich-
count
ryat
ti
tudes,v
alues,andst
andar
dsal
socont
ri
but
es
t
oapr
obl
em wi
del
yrecogni
zedandr
efer
redt
oast
hei
nter
nat
ional
brai
ndr
ain(
migr
ati
on
ofpr
ofessi
onal
andski
l
ledper
sonnel
).

Quest
ion2.
1.Di
scusst
hechar
act
eri
sti
csofEt
hiopi
athatmakei
ttobecat
egor
ized
asoneoft
hedevel
opi
ngcount
riesbyt
aki
ngact
ualf
igur
eswhenappr
opr
iat
e.

102
 CHAPTERTHREE
Gr
owt
hModel
sandTheor
iesofDev
elopment
I
nthepr
evi
ouschapt
er,wehavedi
scussedt
hedi
mensi
onsoft
hepr
obl
emsof
devel
opi
ng count
ri
es, whi
ch may be cal
led t
hei
r di
ver
sit
ies and common
char
act
eri
sti
cs.Gener
all
y,wehavet
ri
edt
omakeanassessmentoft
hef
act
orst
hat
maket
hesecount
ri
est
obecat
egor
izedaspoorcount
ri
es.Wehaveal
soassessed
t
hedi
ffer
encesamongt
hem t
hatshoul
dbeobser
vedi
nfor
mul
ati
ngdevel
opment
pol
ici
esandst
rat
egi
es.

Now i
tist
ime t
olook atsome oft
he avai
labl
etool
s usef
uli
n expl
aini
ng
devel
opment pr
obl
ems and f
ormul
ati
ng r
elevant devel
opment pol
ici
es and
st
rat
egi
es.These hel
pfuli
nst
rument
s ar
ethe gr
owt
h model
s and devel
opment
t
heor
ies.Ther
ear
edi
ffer
entt
heor
iesexpl
aini
ngt
hedi
ver
sedevel
opmentpr
obl
ems
ofcount
ri
esatdi
ffer
entsoci
al,economi
c,pol
it
ical
,andi
nst
it
uti
onalci
rcumst
ances.
Chapt
erdi
vided i
ntwo maj
orpar
tst
hese ar
e gr
owt
h modeland devel
opment
t
heor
ies.

Gr
owt
hModel
s
TheHar
rod-
DomarGr
owt
hModel
Thegr
owt
hmodelt
hatwaspar
ti
cul
arl
ypopul
arwi
theconomi
cpl
anner
sjustaf
ter
Wor
ldWarI
Icamet
obeknownast
heHar
rod-
Domarmodel
,si
ncei
twasbasedon
i
ndependent
lypubl
ishedar
ti
clesbyRoyHar
rodandEvseyDomar
.Thef
actt
hatt
he
t
woaut
hor
sindependent
lypr
oducedi
dent
icalmodel
swasnotsur
pri
sing. Thei
r
model
s wer
e si
mpl
e ext
ensi
ons of John May
nar
d Key
nes’
s wel
l-
known
macr
oeconomi
c model
,whi
ch domi
nat
ed economi
cthi
nki
ng i
nthe 1940s.The
Har
rod-
Domarmodelmakessi
mil
arassumpt
ionst
otheKey
nesi
anmacr
oeconomi
c
model
:

o Unl
imi
tedamountofunempl
oyedl
abour
,out
putcanbei
ncr
easedwi
thout
t
ri
gger
ingpr
icei
ncr
eases.
o Duet
ofi
rstassumpt
ionmar
ginalpr
oductofcapi
tal(
capi
talout
putr
ati
o).
o Duet
o second assumpt
ion out
putgr
owt
hisdi
rect
lypr
opor
ti
onalt
o new
i
nvest
menti
nnewcapi
tal
.

103
 o Pr
oduct
ivei
nvest
menti
sal
way
sequalt
osavi
ng.
Har
rodsmodeldy
nami
cext
ensi
onofkey
nes'st
ati
cequi
li
bri
um anal
ysi
s.Fi
rst
lyi
n
Key
ens'
Gener
alTheor
y,t
hecondi
ti
onf
ori
ncomeandout
putt
obei
nequi
li
bri
um (
in
acl
osedeconomy
)ist
hatpl
anst
oinvestequal
spl
anst
osave.Hence,
Har
rodasked
i
fchangesi
nincomei
nducei
nvest
ment
,whatmustbet
her
ateofgr
owt
hofi
ncome
f
orpl
anst
oinvestt
oequalpl
anst
osavei
nor
dert
oensur
eamovi
ngequi
li
bri
um i
n
agr
owi
ngeconomyt
hrought
ime?

Secondl
y,i
nst
ati
cKey
nesi
ant
heor
y,i
fequi
l
ibr
ium bet
weensav
ingandi
nvest
menti
s
di
stur
bed,t
he economycor
rect
sit
sel
fand a new equi
l
ibr
ium i
sachi
eved v
iat
he
mul
ti
pli
erpr
ocess.Thent
hesecondquest
ioni
sifgr
owt
hequi
l
ibr
ium i
sdi
stur
bed,
wil
lit
besel
f-
cor
rect
ingorsel
f-
aggr
avat
ing?Andl
ast
ly,wi
l
lthi
sequi
l
ibr
ium r
atebeequalt
o
t
hemaxi
mum r
ateofgr
owt
hthatt
heeconomyi
sabl
etosust
aingi
vent
her
ateof
gr
owt
hofpr
oduct
ivecapaci
ty?I
fnotwhatwi
l
lhappen?

Toexpl
aint
hiscondi
ti
on,
Har
roddi
sti
ngui
shedt
hreedi
ff
erentgr
owt
hrat
es.Thesear
e

Act
ual
growt
hrat
e(g)def
inedas

G=s/
c--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
1

Wher
eass=t
her
ati
oofsav
ingt
oincome(
S/Y)
,c=act
uali
nvest
mentcapi
talout
putr
ati
o,
t
hati
sther
ati
oofext
racapi
tal
accumul
ati
onori
nvest
mentt
othegr
owt
hofout
put

(
K/
Y=I
/Y)

g=s/
c=(
S/Y)
/(I
/Y)

=(
S/Y)(
Y/
I)

=Y/
Y(r
ateofgr
owt
hofout
put
),gi
venS=I

War
rant
edgr
owt
hrat
e(gw)
:rat
eofgr
owt
hwhi
ch,i
fitoccur
s,wi
l
lleav
eal
lpar
ti
es
sat
isf
ied.Att
hisr
atepr
oducer
shav
epr
oducednei
thermor
enorl
esst
hant
her
ight
amount
.Iti
sdet
ermi
nedas:pl
anst
osav
eatanyt
imear
egi
venbyt
heKey
nesi
an
sav
ingf
unct
ion

S=sY-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
2

104
Thedemandf
ori
nvest
menti
sgi
venbyt
heaccel
erat
ionpr
inci
ple.Thi
siswher
ecri
sthe
accel
erat
orcoef
fi
ci
entmeasur
edast
her
equi
redamountofext
racapi
talori
nvest
ment
t
opr
oduceauni
tfl
owofout
putatagi
venr
ateofi
nter
est
,det
ermi
nedbyt
echnol
ogi
cal
condi
ti
on.Thus

Cr=Kr
/Y=I
/Y

I=Cr
Y-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-3

Forpl
annedsav
ingst
oequal
plannedi
nvest
mentt
her
efor
e,wehav
e

sY=Cr
Y-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-4

Andt
her
equi
redr
ateofgr
owt
hforamov
ingequi
l
ibr
ium t
hrought
imei
s

Y/
Y=s/
cr=gw-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
5

Thi
sist
hewar
rant
edr
ateofgr
owt
hs(
gw)
.Fordy
nami
cequi
l
ibr
ium,out
putmustgr
ow
att
hisr
ate.Thecondi
ti
onf
orequi
l
ibr
ium i
sthat

g=gw

Fr
om e5andel
,thi
smeans

gc=gwcr (
g/gw=cr
/c)

Supposet
her
eisdi
sequi
l
ibr
ium g>gwt
henc<cri
mpl
i
esi
nvest
mentf
allbel
owt
hel
evel
r
equi
redt
omeett
hei
ncr
easei
nout
put
.Ther
ewi
l
lbeashor
tageofequi
pment
,a
depl
eti
onofst
ocksandani
ncent
ivet
oinv
estmor
e.Theact
ualgr
owt
hrat
ewi
l
lthen
depar
tev
enf
urt
herf
rom t
hewar
rant
edr
ate.Ther
iver
str
uef
orsur
plusofgoodsand
i
nvest
mentwi
l
lbedi
scour
aged,
causi
ngt
heact
ual
growt
hrat
etof
all
evenf
urt
herbel
ow
t
heequi
l
ibr
ium r
ate.Thus,
asHar
rodpoi
ntsout
,int
hedy
nami
cfi
eldwehav
eacondi
ti
on
opposi
tet
othati
nst
ati
cfi
eld.

Nat
ural
growt
hrat
e(go)
:der
ivedf
rom t
hei
dent
it
y

Fi
nal
l
y,t
her
eisnol
i
mitt
ohow muchgr
owt
hcanbehad!Al
thought
heHar
rodDomar
modelwasi
nit
ial
l
ycr
eat
edt
ohel
panal
yzet
hebusi
nesscy
cle,i
twasl
ateradapt
edt
o
expl
aineconomi
cgr
owt
h.I
tsi
mpl
i
cat
ionswer
ethatgr
owt
hdependsont
hequant
it
yof
l
aborandcapi
tal
;mor
einv
est
mentl
eadst
ocapi
talaccumul
ati
on,whi
chgener
ates

105
economi
cgr
owt
h.Themodelal
sohadi
mpl
i
cat
ionf
orl
esseconomi
cal
l
ydev
eloped
count
ri
es;l
abori
sinpl
ent
if
ulsuppl
yint
hesecount
ri
esbutphy
sicalcapi
tali
snot
,
sl
owi
ngeconomi
cpr
ogr
ess.LDCSdonothav
esuf
fi
cientav
eragei
ncomest
oenabl
e
hi
gh r
ates ofsav
ing,and t
her
efor
e accumul
ati
on oft
he capi
talst
ock t
hrough
i
nvest
menti
slow.

TheSol
owModel
TheSol
ow modeli
sbui
l
tar
oundt
woequat
ions,apr
oduct
ionf
unct
ionandacapi
tal
accumul
ati
onequat
ion.Thepr
oduct
ionf
unct
iondescr
ibeshowi
nput
sar
ecombi
nedt
o
pr
oduceout
put
.Tosi
mpl
i
fyt
hemodel
,wegr
oupt
hesei
nput
sint
otwocat
egor
ies,
capi
tal
,K,
andl
abour
,L,
anddenot
eout
putasY.Thepr
oduct
ionf
unct
ioni
sassumedt
o
hav
ethe
Cobb-
Dougl
asf
orm andi
sgi
venby

Y=F(
K,L)=KαL1-α….
…..
(1)
wher
eαi
ssomenumberbet
ween0and1.Not
icet
hatt
hispr
oduct
ionf
unct
ionexhi
bit
s
const
antr
etur
nst
oscal
e:i
fal
loft
hei
nput
sar
edoubl
ed,
out
putwi
l
lexact
lydoubl
e-i
.e.
apr
oduct
ionf
unct
ionhasconst
antr
etur
nst
oscal
eif

zY=F(
zK,
zL)

f
oranyposi
ti
venumberz.Thati
s,i
fwemul
ti
plybot
hcapi
talandl
abourbyz,weal
so
mul
ti
plyt
heamountofout
putbyz.I
nli
newi
tht
heabov
est
yli
sed f
act
s,wear
e
i
nter
est
edi
nexpl
aini
ngout
putperwor
kerorpercapi
taout
put
.Wi
tht
hisi
nter
esti
nmi
nd,
wecanr
ewr
it
ethepr
oduct
ionf
unct
ioni
nequat
ion[
1]i
nter
msofout
putperwor
ker
,y≡
Y/
L,andcapi
tal
perwor
ker
,k≡K/
L-i
.e.set
ti
ngz=1/
L
Y/
L=F(
K/L,
1)
y
=f(
k)wher
ef(
k)=F(
k,1)

Equat
ion[
1]can,
thus,
bewr
it
tenas

α
y= k……….
.(
2)

Thi
spr
oduct
ionf
unct
ioni
sgr
aphedbel
ow.Wi
thmor
ecapi
talperwor
ker
,fi
rmspr
oduce
mor
eout
putperwor
ker
.Howev
er,t
her
ear
edi
mini
shi
ngr
etur
nst
ocapi
talperwor
ker
:
eachaddi
ti
onaluni
tofcapi
talwegi
vet
oasi
ngl
ewor
keri
ncr
easest
heout
putoft
hat

106
wor
kerbyl
essandl
ess.

Theor
iesofDevel
opment
Rost
ow’
sSt
ageofEconomi
cgr
owt
h
Wal
tW.Rost
ow usest
hehi
stor
icalappr
oacht
oexpl
aint
hepr
ocessofeconomi
c
dev
elopment
.It
sessencei
sthatl
ogi
cal
l
yandpr
act
ical
l
ypossi
blet
oident
if
yst
agesof
dev
elopmentand t
o cl
assi
fysoci
eti
es.Accor
ding t
o hi
m,t
her
ear
efi
vest
agesof
economi
cgr
owt
h;

TheTr
adi
ti
onalSoci
ety
:thet
radi
ti
onalsoci
etyi
sdef
inedasonewhosest
ruct
urei
s
dev
elopedwi
thi
nal
i
mit
edpr
oduct
ionandbackwar
dtechnol
ogy
.The“
Pre-
condi
ti
onf
or
Take-
off
”

Hecal
l
sthest
agebet
weenf
eudal
i
sm andt
ake-
offt
het
ransi
ti
onst
age.Dur
ingt
he
t
ransi
ti
onper
iodal
lthepr
e-condi
ti
onsf
orsust
ainedeconomi
cdev
elopmentar
ecr
eat
ed.
I
nthi
sst
agel
eveloneconomi
cfr
ont
;inv
est
mentr
aised,
sel
f-
sust
aini
nggr
owt
hensur
ed,
mai
ndi
rect
ionofi
nvest
mentbui
l
despeci
all
ytr
anspor
tat
ionandt
elecommuni
cat
ion,
t
echnol
ogi
calr
evol
uti
oni
nagr
icul
tur
alsect
or,i
mpor
texpansi
on.Onsoci
alf
ront
;new
el
i
teemer
ged,sur
pluschannel
edbynew el
i
tef
rom agr
icul
tur
etoi
ndust
ry.I
naddi
ti
on,
pol
i
tical
l
yef
fect
ivemoder
ngov
ernmenti
svi
tal
.

Take-
off
:isdef
ined byRost
ow as“
an i
ndust
ri
alr
evol
uti
on t
ied di
rect
lyt
oradi
cal
changesi
nthemet
hodsofpr
oduct
ionhav
ingt
hei
rimpactov
erashor
tper
iodoft
ime
whi
chl
ast
sfort
wodecades.
”Ithast
hreenecessar
ycondi
ti
ons:ar
isei
nther
ateof
pr
oduct
ivei
nvest
ment
,dev
elopmentofsubst
ant
ialmanuf
act
uri
ng sect
or,and t
he
exi
stence ofpol
i
tical
,soci
al,and i
nst
it
uti
onalf
ramewor
kinf
ost
eri
ng economi
c
dev
elopment
.

Ther
ear
etwoappr
oachesf
ort
ake-
off
:Aggr
egat
eappr
oachbasedonH-
Dmodelof
gr
owt
handl
eadi
ngsect
orappr
oachesbasedonunbal
ancedgr
owt
htheor
y.Thet
ake-
of
fper
iodi
sdi
ff
erentf
ordi
ff
erentcount
ri
es.Thet
ake-
offst
agesf
orsomeoft
he
dev
elopedcount
ri
esar
e

Dr
ivet
omat
uri
tyst
age:aper
iodwhenasoci
etyhasef
fect
ivel
yappl
i
edt
her
angeof
moder
ntechnol
ogyt
odev
elopt
hebul
kofi
tsr
esour
ces.I
nthi
sst
age,t
hreesi
gni
fi
cant
changes t
ake pl
ace: char
act
erofwor
kfor
ce become ski
l
led and or
gani
zed)
,

107
ent
repr
eneur
shi
p,i
ndust
ri
ali
zat
ion.AgeofHi
ghMassConsumpt
ions:dur
ingt
hisst
age,
t
hebal
anceofat
tent
ionofsoci
etyi
sshi
ft
edf
rom suppl
ytodemandf
orgoodsand
ser
vicesandf
rom pr
obl
emsofpr
oduct
iont
oconsumpt
ionandwel
far
e.

Cr
it
ici
sms of Rost
ow’
s model
:too r
igi
d,uni
ver
salappl
i
cabi
l
ity cl
aimed,l
i
near
concept
ionofhi
stor
yint
hest
agesofgr
owt
hisa-
hist
ori
cal
.

2.
1.1.Sur
plusLabourTheor
y

Pr
of.Ar
thurLewi
shasdev
elopedav
erysy
stemat
ict
heor
yofeconomi
cdev
elopment
wi
thunl
i
mit
edsuppl
yofl
abour
.It
sfocuswasst
ruct
uralt
ransf
ormat
ionofapr
imar
y
subsi
stenceeconomy
.Themodelst
art
swi
tht
heassumpt
ionofadualeconomywi
tha
moder
nindust
ri
alsect
orandat
radi
ti
onal
subsi
stencesect
or.

2.
1.2.Dual
ist
icTheor
ies

Dual
i
sm i
ndi
cat
esasi
tuat
ionwher
ety
pesofpar
all
elphenomenaco-
exi
st.I
trepr
esent
s
t
heexi
stenceandper
sist
enceofi
ncr
easi
ngdi
ver
gencesbet
weenr
ichandpoornat
ions
and r
ich and poorpeopl
eson v
ari
ousl
evel
s.Speci
fi
cal
l
y,t
heconceptofdual
i
sm
embr
acesf
ourkeyel
ement
ssuchas;super
iorandot
her
sinf
eri
orcanco¬-
exi
sti
na
gi
venspace,Thi
sco-
exi
stencei
schr
oni
candnotmer
elyt
ransi
ti
onal
,Notonl
ydot
he
degr
eesofsuper
ior
it
yori
nfer
ior
it
yfai
ltoshow anysi
gnofdi
mini
shi
ng,butt
heyev
en
hav
eani
nher
entt
endencyt
oincr
easeandThei
nter
rel
ati
onsbet
weent
hesuper
iorand
i
nfer
iorel
ement
s

Dual
ism hasbeenper
cei
vedi
ndi
ffer
entway
ssuchas:soci
al,t
echnol
ogi
cal(
useof
di
ffer
entpr
oduct
ionf
unct
ionsi
ntheadvancedsect
orandt
het
radi
ti
onalsect
orof
t
heeconomi
esofunder
devel
opedcount
ri
es)
,fi
nanci
al(
co-
exi
stenceofdi
ffer
ent
i
nter
estr
atesi
ntheor
gani
zedandunor
gani
zedmoneymar
ket
sint
heLDCs)
,and
geogr
aphi
cdual
ism.

108
 CHAPTERFOUR

Hi
stor
icGr
owt
handCont
emporar
yDevel
opment
:Lessonand
cont
rov
ersi
es
Today
,count
ri
esoft
hewor
ldar
edi
vi
dedi
ntor
ich(
dev
eloped)count
ri
esandpoor
(
dev
elopi
ng)count
ri
es.Ther
eisawi
degapbet
weent
her
ichandt
hepoorcount
ri
es.
Thest
atementt
hat“
ther
ichnat
ionsgetr
icherandt
hepoorcount
ri
esgetpoor
er”has
becomepopul
ari
nthel
i
ter
atur
einwor
ldpov
ert
y.Butwhatar
etheexpl
anat
ionsf
ort
he
poorper
for
manceoft
hedev
elopi
ngcount
ri
es? Ther
ear
etwoappr
oachest
oexpl
ain
t
he det
ermi
nant
s of economi
c dev
elopment t
he t
radi
ti
onalappr
oach and t
he
i
nst
it
uti
onal
appr
oach.

4.
1Tr
adi
ti
onalAppr
oach(
Economi
cFact
ors)t
oDevel
opment
The t
radi
ti
onalappr
oach t
o dev
elopmentassumes t
hateconomi
c dev
elopmenti
s
det
ermi
nedbyeconomi
cfact
ors,l
i
kenat
uralr
esour
ces,capi
tal
,technol
ogy
,et
c.Let
’s
seeeachoft
hemaj
oreconomi
cfact
ors

a)Nat
uralResour
ces:Thepr
inci
pal
s’f
act
oraf
fect
ingt
hedev
elopmentofaneconomy
i
sthenat
uralr
esour
cesorl
and.“
Land”asusedi
neconomi
cincl
udesnat
uralr
esour
ces
suchasf
ert
il
it
yofl
and,i
tssi
tuat
ionandcomposi
ti
on,f
orestweal
th,mi
ner
als,cl
i
mat
e,
wat
err
esour
ces,sear
esour
ces,geogr
aphi
calpr
oxi
mit
ywi
thr
ichcount
ri
eset
c. For
gr
owt
h,t
heexi
stenceofnat
ural
resour
cesi
nabundancei
sessent
ial
.Acount
rywhi
chi
s
def
ici
enti
nnat
uralr
esour
ceswi
l
lnotbei
naposi
ti
ont
odev
elopr
api
dly
.Aspoi
ntedout
byLewi
s,“
Othert
hingsbei
ngequal
,mencanmakebet
teruseofr
ichr
esour
cest
han
t
heycanofpoor
.”

I
nLDCsnat
uralr
esour
cesar
eunut
il
ized,under
uti
l
izedormut
ual
i
zed.Thesear
eoneof
t
her
easonsf
ort
hei
rbackwar
dness.Thepr
esenceofnat
uralr
esour
cesi
snotsuf
fi
cient
f
oreconomi
cgr
owt
h.Whati
srequi
redi
sthei
rpr
operexpl
oit
ati
on.

I
tisof
tensai
dthateconomi
cgr
owt
hispossi
bleev
enwhenaneconomi
cisdef
ici
enti
n
nat
uralr
esour
ces.Aspoi
ntedoutbyLewi
s,“
Acount
rywhi
chi
sconsi
der
edt
obepoori
n
r
esour
cest
odaymaybeconsi
der
edv
eryr
ichi
nresour
cesatsomel
atert
ime,
notmer
ely
because unknown r
esour
ces ar
e di
scov
ered,butequal
l
y because new uses ar
e
di
scov
eredf
ort
heknownr
esour
ces.
”Japani
sonesuchcount
rywhi
chi
sdef
ici
enti
n
nat
uralr
esour
cesbuti
tisoneoft
headv
ancedcount
ri
esoft
hewor
ldbecausei
thas

109
beenabl
etodi
scov
ernewusesf
orl
i
mit
edr
esour
ces.

b)Capi
talAccumul
ati
on
Capi
talmeanst
hest
ockofphy
sicalr
epr
oduci
blef
act
orsofpr
oduct
ion.Whencapi
tal
st
ocki
ncr
easeswi
tht
hepassageoft
ime,i
tiscal
l
edcapi
talaccumul
ati
onorcapi
tal
f
ormat
ion.Capi
talf
ormat
ioni
sinv
est
menti
ncapi
talgoodst
hatl
eadst
oincr
easei
n
capi
tal
stock,
nat
ional
out
putandi
ncome.

Capi
talf
ormat
ioni
sthekeyt
oeconomi
cdev
elopment
. Ont
heonehandi
tref
lect
s
ef
fect
ivedemandandont
heot
herhand,
itcr
eat
espr
oduct
iveef
fi
ciencyf
orpr
oduct
ion.
Capi
talf
ormat
ionpossessesspeci
ali
mpor
tancet
o LDCs. Thepr
ocessofcapi
tal
f
ormat
ionl
eadst
othei
ncr
easei
nnat
ionalout
puti
nanumberofway
s. Capi
tal
f
ormat
ioni
sessent
ialt
omeett
her
equi
rement
sofani
ncr
easi
ngpopul
ati
oni
nsuch
economi
es.I
nvest
menti
n capi
talgoods notonl
yrai
ses pr
oduct
ion butal
so
empl
oymentoppor
tuni
ti
es.I
tiscapi
talf
ormat
iont
hatl
eadst
otechnol
ogi
calpr
ogr
ess.
Technol
ogi
cali
ntur
nleads t
o speci
ali
zat
ion and t
he economi
es ofl
arge scal
e
pr
oduct
ion. Thepr
ovi
sionofsoci
alandeconomi
cov
erheads,l
i
ket
ranspor
t,power
educat
ionet
cinacount
ryi
spossi
blet
hroughcapi
talf
ormat
ion. I
tisal
socapi
tal
f
ormat
ion t
hatl
eadst
otheexpl
oit
ati
on ofnat
uralr
esour
ces,i
ndust
ri
ali
zat
ion and
expansi
onofmar
ket
swhi
char
eessent
ial
foreconomi
cpr
ogr
ess.

c)Or
gani
zat
ion

Or
gani
zat
ioni
sani
mpor
tantpar
toft
hegr
owt
hpr
ocess.I
trel
atest
otheopt
imum use
off
act
orofpr
oduct
ioneconomi
cact
ivi
ti
es.Or
gani
zat
ioni
scompl
ementt
ocapi
taland
l
abourandhel
psi
nincr
easi
ngt
hei
rpr
oductact
ivi
ti
es.I
nmoder
neconomi
cgr
owt
h,t
he
ent
repr
eneurhasbeenper
for
mingt
het
askofanor
gani
zerandunder
taki
ngr
isksand
uncer
tai
nti
es.

Theunder
dev
elopedcount
ri
esl
ackent
repr
eneur
ialact
ivi
ty.Suchf
act
orsast
hesmal
l
si
zeoft
hemar
ket
,capi
taldef
ici
ency
,absenceofpr
ivat
epr
oper
tyandcont
ract
,lackof
ski
l
ledandt
rai
nedl
abour
,non-
avai
l
abi
l
ityofadequat
erawmat
eri
alsandi
nfr
ast
ruct
ural
f
aci
l
iti
esl
i
ket
ranspor
t,power
,et
cincr
easer
iskanduncer
tai
nti
es.Thati
swhysuch
count
ri
esl
ackent
repr
eneur
s.

d)Technol
ogi
calPr
ogr
ess:Technol
ogi
calchar
gesar
eregar
dedast
hemosti
mpor
tant

110
f
act
ori
nthepr
ocessofeconomi
cgr
owt
h.Theyar
erel
atedt
ochangesi
nthemet
hods
ofpr
oduct
ionwhi
char
ether
esul
tofsomenew t
echni
quesofr
esear
chori
nnov
ati
on.
Changesi
nTechnol
ogyl
eadt
oincr
easei
npr
oduct
ivi
tyofl
abour
,capi
talandot
her
f
act
orsofpr
oduct
ion.

e)Di
vi
sionofl
abourandscal
eofpr
oduct
ion:Speci
ali
zat
ionanddi
vi
sionofl
abourl
ead
t
oincr
easei
npr
oduct
ivi
ty.Theyl
eadt
oeconomi
esofl
argescal
epr
oduct
ionwhi
ch
f
urt
herhel
pini
ndust
ri
aldev
elopment
. Adam Smi
thgav
emuchi
mpor
tancet
othe
di
vi
sionofl
abouri
neconomi
cdev
elopment
.Di
vi
sionofl
abourl
eadst
oimpr
ovementi
n
t
hepr
oduct
ivecapaci
ti
esofl
abour
.Ev
eryl
abor
erbecomesmor
eef
fi
cientt
hanbef
ore.
S/
hesav
est
ime.S/
hei
scapabl
eofi
nvent
ingnewmachi
nesandpr
ocessi
npr
oduct
ion.
Ul
ti
mat
elypr
oduct
ioni
ncr
easesmani
fol
d.Butdi
vi
sionofl
abourdependsupont
hesi
ze
oft
hemar
ket
.Thesi
zeoft
hemar
ket
,int
urn,
dependsuponeconomi
cpr
ogr
ess,
i.
e.t
he
ext
entt
owhi
cht
hesi
zeofdemand,t
hegener
all
evelofpr
oduct
ion,t
hemeansof
t
ranspor
tet
car
edev
eloped.Whent
hescal
eofpr
oduct
ioni
slar
get
her
eisgr
eat
er
speci
ali
zat
ionanddi
vi
si
onofl
abour
.Asar
esul
tpr
oduct
ioni
ncr
easesandt
her
ateof
economi
cpr
ogr
essi
saccel
erat
ed.

Under
dev
elopedcount
ri
esar
eunabl
etot
akeadv
ant
ageoft
heeconomi
csofdi
vi
sionof
l
abourandl
argescal
epr
oduct
ionduet
othepr
esenceofmar
keti
mper
fect
ions,
whi
chi
n
t
urnkeept
hesi
zeoft
hemar
ketsmal
l
.

4.
2Inst
it
uti
onalAppr
oacht
oDevel
opment
Thei
nst
it
uti
onalappr
oacht
odev
elopmenti
sar
ecentphenomenon. I
tar
guest
hat
expl
anat
ionsoft
hepooreconomi
cdev
elopmentar
efoundnotonl
yineconomi
cfact
ors
butal
sonon-
economi
cfact
ors. I
nfactmostoft
hesef
act
orsar
eexpl
ainedbynon-
economi
cfact
orsori
nst
it
uti
onal
fact
ors.

Thei
nst
it
uti
onalappr
oacht
odev
elopmentemphasi
zesi
mpor
tanceoft
hei
nst
it
uti
onal
f
act
orsmor
ethant
heeconomi
cfact
orsusi
ngt
hecaseofamet
ropol
i
tanci
ty. The
cent
ralci
tyi
n a met
ropol
i
tan ar
ea,whi
l
e gai
ning some hi
gh-
ri
se bui
l
dings,has a
st
agnantpopul
ati
onandani
ncr
easi
ngpr
opor
ti
onofpoorpeopl
e.Ont
heot
herhand
subur
bsar
epr
osper
ousandgr
owi
ngr
api
dly
.Toacer
tai
ndegr
ee,
moder
neconomi
csi
s
l
i
kesuchamet
ropol
i
tanar
ea.Thet
radi
ti
onaleconomi
csi
satt
hecent
eroft
heci
ty.At
t
hesamet
ime,
thesubur
bsofeconomi
csar
eexpandi
ngr
api
dlyi
nal
ldi
rect
ions.

111
Thei
nst
it
uti
onappr
oacht
odev
elopmenti
sacasei
npoi
nt. Forexampl
e,consi
der
shi
ft
ingt
hef
ocusf
rom capi
tal
andot
herr
esour
cest
owar
dthequal
i
tyofgov
ernance.I
n
t
hesubur
bsofeconomi
cs,gov
ernancei
saf
ocus,butnoti
ntheci
tycent
erwher
e
capi
tali
sthef
ocus.Thei
nst
it
uti
onalf
act
orf
urt
herar
guest
hatmostoft
heeconomi
c
f
act
orscanbeobt
ainedi
nthegl
obal
i
zemar
ket
.Forexampl
e,manyMNCsar
ereadyt
o
i
nvestasi
gni
fi
cantamountofcapi
tali
fcondi
ti
onsar
efav
orabl
e.Besi
desLDCscanal
so
bor
rowt
echnol
ogi
esf
rom DCS.

Thei
nst
it
uti
onal
fact
orst
hatdet
ermi
neeconomi
cper
for
mancei
ncl
ude.

a)TypeofGover
nment
Acount
rywi
thamonar
chysy
stem i
slessl
i
kel
ytodev
elopascompar
edwi
thacount
ry
wi
thademocr
ati
cgov
ernment
.Thenat
ureofdemocr
acydependsont
hel
evelof
educat
ion,
disci
pli
ne,
cul
tur
eet
coft
hepeopl
e.I
nmai
ntai
ningr
ules,
gov
ernment
scoul
d
besof
torst
rong.Tomai
ntai
nrul
esandt
her
ebypr
epar
ethegr
oundf
ordev
elopment
,
gov
ernment
s need be st
rong.To pr
ovi
de f
ort
he enf
orcementofcont
ract
s,t
he
pr
event
ionofanar
chy
,andt
hepr
ovi
sionofot
herpubl
i
cgood,t
hecoer
civ
epowerof
gov
ernmenti
snecessar
y.
Good gov
ernance i
s anot
her i
mpor
tant f
act
or whi
ch det
ermi
nant
s economi
c
per
for
mance of count
ri
es.Accor
ding t
o Ol
son M. “
Gov
ernance i
s a deci
siv
e
det
ermi
nantofeconomi
cper
for
manceandt
hatwi
tht
her
ighteconomi
cpol
i
cyand
i
nst
it
uti
ons,
poorcount
ri
escangr
owatav
eryr
api
drat
e.”Goodgov
ernancei
sref
lect
ed
byl
ongt
em v
isi
on,
cor
rectpol
i
ciesandef
fect
ivei
mpl
ement
ati
on.Forexampl
e,i
nJapan
t
hegov
ernmentdeci
dedwhatt
ypeofi
ndust
ri
est
odev
elopaf
terWor
ldWarI
I.I
tgav
e
emphasi
stot
ext
il
e,i
ronandst
eel
,shi
pbui
l
dinget
c.I
nrecenty
ear
s,t
hegov
ernment
shi
ft
edt
owar
dsel
ect
roni
csi
nresponset
oachangei
nwor
ldmar
ket
.

Anot
heraspectofgoodgov
ernancei
sthedev
elopmentofi
nfr
ast
ruct
ure.Count
ri
esl
i
ke
HongKong,
Singapor
e,Mal
aysi
a,et
cdev
elopi
nfr
ast
ruct
ureandat
tr
actf
orei
gncapi
tal
.

I
b)nst
it
uti
ons:Avai
l
abi
l
ityoft
echnol
ogyl
i
ket
hecapi
talgood,compl
ement
aryf
act
ors
l
i
kei
nfr
ast
ruct
ure,hi
ghl
yski
l
ledl
abor
,innov
ati
onet
car
erequi
redf
oraneconomyt
o
gr
ow.Tohav
esucht
echnol
ogi
calchangesr
equi
resagoodi
nst
it
uti
on.Forexampl
e,i
n
maki
ngi
nnov
ati
ons,t
her
ecoul
dber
esi
stance.Tocal
m suchr
esi
stance,gov
ernment
ef
for
tisr
equi
red.Thus,i
nst
it
uti
ons t
hatencour
age t
echnol
ogi
cali
nnov
ati
on and

112
sui
tabi
l
ityofi
nst
it
uti
onf
orsuccessf
uladopt
ionofnewi
deasi
sani
mpor
tantquest
ion.
Pol
i
ticalandcul
tur
aldy
nami
sm hel
pinadopt
ionofnew t
echnol
ogyandt
henegat
ive
f
orces such as l
abouruni
on or
thodoxy shoul
d be managed pr
oper
ly by good
gov
ernance.Spr
eadofeducat
ion,sci
ent
if
iccul
tur
ear
enecessar
yforadopt
ionofnew
t
echnol
ogy

Reser
vat
ion/
Aff
ir
mat
iveAct
ion/
.Soci
alj
ust
icer
equi
rest
hati
fsomesect
ionsoft
he
soci
etyar
edepr
ived,
theymustbegi
venspeci
alat
tent
ioni
.e.r
eser
vat
ioni
sneeded.The
suppor
ter
sofr
eser
vat
ionj
ust
if
yit
susei
nter
msofsoci
alj
ust
ice,equi
tyandt
orect
if
y
hi
stor
ical
mist
akes.Howev
er,
from t
hepoi
ntofv
iewofef
fi
ciency
,iti
snotj
ust
if
ied.

c) Soci
alSt
ruct
ureofPopul
ati
on:I
nsomecount
ri
es,wegetahomogenoust
ypeof
popul
ati
on.Homogenei
tyoft
he popul
ati
on l
eads t
othe dev
elopmentofnat
ional
f
eel
i
ngs,
whi
chi
shel
pfulf
oreconomi
cdev
elopment–f
orexampl
eChi
na,
Japan,
Kor
ea,
Russi
a.Ont
heot
herhand,popul
ati
onofacount
rycoul
dal
sobehet
erogeneous-
di
vi
dedont
hebasi
sofl
anguage,r
eli
gion,et
hni
ci
ty,cast
eet
c.I
nsuchsoci
eti
es,some
gr
oupspl
ayent
repr
eneur
ial
rol
e.Forexampl
e,t
heJewsi
nUSA.

d)
Human Capi
taland Cul
tur
alTr
ait
s:Thedi
ff
erencei
npercapi
tai
ncomeamong
count
ri
escoul
dbeexpl
ainedbyhumancapi
talandcul
tur
alt
rai
ts.I
ntheDCs,human
capi
talandcul
tur
alt
rai
tsi
nthef
orm ofwor
kcul
tur
e,di
sci
pli
ne,goodent
repr
eneur
shi
p
et
chav
epl
ayedani
mpor
tantr
ole.Poorcount
ri
esar
epoorbecauset
heyl
ackt
hese
t
rai
ts.Thecul
tur
alt
rai
tst
hatper
pet
uat
epov
ert
yar
ether
esul
tofcent
uri
esofsoci
al
accumul
ati
onandt
heycan’
tbechangedqui
ckl
y.Cul
tur
aladv
ancementaccor
dingt
oM.
Ol
sonr
esul
tsi
ntwot
ypesofhumancapi
tal
:
a)Mar
ket
abl
ehumancapi
tal-t
hesei
ncl
udemor
eski
l
l,pr
opensi
tyt
owor
khar
der
,
mor
eent
repr
eneur
ialper
sonal
i
ty-t
hesequal
i
tiesr
esul
tini
ncr
easei
nthequal
i
ty
andquant
it
yofpr
oduct
iveout
put
s. Theser
esul
tsi
nincr
easei
nincomeof
per
sons,
groupsaswel
lasofnat
ions.
b)Ci
vi
ccul
tur
e.A ci
vi
ccul
tur
eleadst
otheel
ect
ionofgoodgov
ernmentwhi
ch
adopt
sgoodpol
i
cy.I
tal
sor
esul
tsi
nadi
sci
pli
nedsoci
ety
.Cor
rupt
ionwi
l
lbel
ess.
Peopl
epayt
ax.
I
tisi
mpossi
blet
ost
udyt
heeconomi
cgr
owt
hoft
hedevel
opi
ngcount
ri
esi
nmoder
n
t
imeswi
thoutconsi
der
ingt
hemut
uali
nter
act
ionsbet
weent
heseeconomi
esand
t
hoseoft
headvanced count
ri
es.When West
ern Eur
opean Capi
tal
ism began t
o

113
expand i
ts pr
oduct
ion and t
rade on a wor
ld-
wide scal
e,i
tawakened t
he l
ess-
devel
opedar
easoft
hewor
ldt
omoder
neconomi
cdevel
opment
.Thi
sar
ti
clewi
ll
t
akeupt
heAsi
anaf
ea,i
ncl
udi
ngJapan,asobj
ectofexami
nat
ion.Economi
cgr
owt
h
i
ntheAsi
anar
eawasbr
oughtaboutbyt
heeast
war
dadvanceofWest
ernEur
opean
capi
tal
ism.I
nthi
sint
ermi
ngl
ingofWest
ernEur
opeanandAsi
aneconomi
est
he
f
oll
owi
nghi
stor
icalst
agescanbeobser
ved.

Thef
ir
stst
agei
stheper
iodwhennat
iveAsi
ani
ndust
rydevel
opedasar
esul
toft
he
exchangeofnat
iveAsi
anpr
oduct
sforWest
ernEur
opeani
ndust
ri
alpr
oduct
s.

The second st
age i
sthe per
iod when t
he nat
ive handi
craf
tindust
rycr
umbl
ed
because manuf
act
ured consumergoods f
lowed i
ntot
he Asi
an ar
ea af
tert
he
I
ndust
ri
alRevol
uti
oni
nWest
ernEur
ope.Thet
hir
dst
agei
stheper
iodwhenWest
ern
Eur
opeancapi
talandt
echni
quesi
nfi
lt
rat
edt
heAsi
anar
eaf
ort
hel
arge-
scal
ein
consequence;t
her
ewasaconspi
cuouschangef
rom consumergoodst
ocapi
tal
goodsi
nthei
mpor
tst
ruct
ure.

Thesi
xthst
agei
stheper
iodwhenmanuf
act
uredgoodsi
ngener
albegant
obe
pr
oduced by nat
ive i
ndust
ri
es,whet
hert
he r
aw mat
eri
als wer
e domest
ical
ly
avai
labl
eornot
.Thecapi
talgoodsr
equi
redbyt
hesei
ndust
ri
eswer
eimpor
tedatt
he
expenseoft
hei
nduct
ionoff
orei
gncapi
talandoft
heexpor
tofpr
imar
ypr
oduct
s.
The sevent
h st
age i
sthe per
iod when t
he i
ndust
ri
ali
zat
ion oft
he devel
opi
ng
count
ri
esbecamesoadvancedast
omakepossi
blet
heexpor
tofmanuf
act
ured
consumergoods,and when t
he domest
ic pr
oduct
ion ofsome capi
talgoods
gr
adual
lycamet
othef
ore.

CHAPTERFI
VE

I
NEQUALI
TY,
POVERTYANDDEVELOPMENT
The1970,wi
tnessedar
emar
kabl
echangei
npubl
i
candpr
ivat
eper
cept
ionsaboutt
he
ul
ti
mat
enat
ureofeconomi
cact
ivi
ty.I
nbot
hri
chandpoorcount
ri
es,t
her
ewasa
gr
owi
ngdi
si
ll
usi
onmentwi
tht
hei
deat
hatr
elent
lesspur
sui
tgr
owt
hwast
hepr
inci
pal

114
economi
cobj
ect
iveofsoci
ety
.Int
hedev
elopedcount
ri
es,
themaj
oremphasi
sseemed
t
oshi
ftt
owar
dmor
econcer
nfort
hequal
i
tyofl
i
fe,aconcer
nmani
fest
edmai
nlyi
nthe
env
ironment
almov
ement
.

I
nthi
schapt
er,
wewi
l
lexami
ne:
-

 Whati
stheext
entofr
elat
ivei
nequal
i
tyi
nLDCs

 Whoar
ethepoor
,andt
hei
reconomi
cchar
act
eri
sti
cs?

 Hatdet
ermi
net
henat
ureofeconomi
cgr
owt
h,t
hati
swhobenef
it
s?

 Ar
erapi
deconomi
cgr
owt
handmor
eequi
tabl
edi
str
ibut
ionsofi
ncome?

 Whatki
ndsofpol
i
ciesar
erequi
redt
oreducet
hemagni
tudeandext
entof
absol
utepov
ert
y?

I
ncomei
nequal
i
ty

Bypul
l
ingquest
ion1and2t
oget
hersamer
ecentev
idencef
rom v
ari
etyofsour
ces;we
def
inet
hedi
mensi
onsofi
ncomedi
str
ibut
ionandpov
ert
ypr
obl
emsandi
dent
if
ysome
si
mil
ar el
ement
sthat char
act
eri
ze t
he pr
obl
em i
n many dev
elopi
ng count
ri
es.
Economi
stsusual
l
yli
ket
o di
sti
ngui
shbet
weent
wo pr
inci
palmeasur
esofi
ncome
di
str
ibut
ionf
orbot
hanal
yti
candquant
it
ati
vepur
poses.

1.Theper
sonalorsi
zedi
str
ibut
ionofi
ncome:i
sthemeasur
emostcommonl
yused
byeconomi
sts.I
tsi
mpl
ydeal
swi
thi
ndi
vi
dualper
sonsorhousehol
dsandt
het
otal
i
ncomet
heyr
ecei
ve.Economi
stsandst
ati
sti
cians,t
her
efor
e,l
i
ket
oar
rangeal
l
i
ndi
vi
dual
sbyascendi
ngper
sonali
ncomesandt
hendi
vi
dedt
het
otalpopul
ati
oni
n
t
odi
sti
nctgr
oupsorsi
zes.Acommonmet
hodi
stodi
vi
det
hepopul
ati
oni
nto
successi
vequi
nti
l
es(
fi
ft
hs)ordeci
l
es(
tent
hs)accor
dingt
otheascendi
ngi
ncome
l
evel
sandt
hendet
ermi
newhatpr
opor
ti
onoft
het
otalnat
ionali
ncomei
srecei
ved
byeachi
ncomegr
oup.

Lor
enzCur
ve:Anot
hercommonwayt
oaper
sonali
ncomest
ati
sti
csi
stoconst
ruct
whati
sknown asaLor
enzcur
ve.On t
hehor
izont
alaxi
s,t
henumberofi
ncome
r
eci
pient
sispl
ott
ed,noti
nabsol
utet
ermsbuti
ncumul
ati
veper
cent
ages.Thev
ert
ical
axi
sshowst
heshar
eoft
otali
ncomer
ecei
vedbyeachper
cent
ageoft
hepopul
ati
on;i
t

115
al
soi
scumul
ati
veupt
o100%meani
ngt
hatbot
haxesar
eequal
l
ylong.Theent
ir
efi
gur
e
i
sencl
osed i
n a squar
e and t
he cur
ve showst
he act
ualquant
it
ati
ver
elat
ionshi
p
bet
weent
heper
cent
agesofi
ncomer
eci
pient
sandt
heper
cent
ageoft
heact
uali
ncome
t
heydi
dinf
actr
ecei
vedur
ing,
say
,agi
veny
ear
.

Themor
etheLor
enzl
i
necur
vesi
sawayf
rom t
hedi
agonal
(per
fectequal
i
ty)
,thegr
eat
er
t
hedegr
eeofi
nequal
i
tyr
epr
esent
ed.Theext
remecaseofper
fecti
nequal
i
ty(i
.e.a
si
tuat
ioni
nwhi
choneper
sonr
ecei
vesal
loft
henat
ionali
ncomewhi
l
eev
erbodyel
se
r
ecei
vesnot
hing)woul
dber
epr
esent
edbyt
hecongr
uenceoft
heLor
enzcur
vewi
tht
he
bot
tom hor
izont
alandr
ighthandv
ert
ical
axes.

Gi
niCoef
fi
cientorGi
niconcent
rat
ionr
ati
o:A f
inalandv
eryconv
eni
entshor
thand
summar
ymeasur
eoft
her
elat
ivedegr
eeofi
ncomei
nequal
i
tyi
nacount
rycanbe
obt
ainedbycal
cul
ati
ngt
her
ati
ooft
hear
eabet
weent
hedi
agonalandt
heLor
enzcur
ve
di
vi
dedbyt
het
otal
areaoft
hehal
fsquar
einwhi
cht
hecur
vel
i
es.Thi
sisshownbel
ow.

116
 Fi
gur
e5.
1:Gi
nicoef
fi
cientcur
ve

Gi
ni ShadedAr
eaA
Coef
fi
ci
ent Tot
alAr
eaBCD

2.Thef
unct
ionalordi
str
ibut
ivef
act
orshar
edi
str
ibut
ionofi
ncome:

The second common measur

e ofi
ncome di
str
ibut
ion used by economi
sts,t
he
f
unct
ionalorf
act
orshar
edi
str
ibut
ionsofi
ncome,
att
empt
stoexpl
aint
heshar
eoft
otal
nat
ionali
ncome t
hateach oft
he f
act
orsofpr
oduct
ion (
land,l
abourand capi
tal
)
r
ecei
ves.I
nst
ead ofl
ooki
ng ati
ndi
vi
dual
s as separ
ate ent
it
ies,i
nqui
ri
es i
ntot
he
per
cent
aget
hatl
abourr
ecei
vesasawhol
eandcompar
est
hiswi
tht
heper
cent
agesof
t
otali
ncomedi
str
ibut
edi
nthef
orm of r
ent
,int
erest
,and pr
ofi
t(i
.e.t
her
etur
ntol
and
andf
inanci
alandphy
sical
capi
tal
).

I
nequal
it
yandAbsol
utPover
ty
I
nequal
it
y:v
ari
ati
onsamongcount
ri
es

Quest
i 1whati
on5. sther
elat
ionshi
pbet
weenl
evel
sofpercapi
tai
ncomeanddegr
eeof
i
nequal
i
ty? Ar
ehi
gheri
ncomesassoci
atedwi
thgr
eat
erorl
esseri
nequal
i
tyorcanno
def
ini
ti
vest
atementbemade?

Absol
utepov
ert
y:Ext
entandmagni
tude
Nowl
et'
sswi
tchourat
tent
ionf
rom r
elat
ivei
ncomeshar
esofv
ari
ousper
cent
il
egr
oups
wi
thi
nagi
venpopul
ati
ont
othemor
esi
gni
fi
cantquest
ionoft
heext
entandmagni
tude
ofabsol
utepov
ert
yindev
elopi
ngcount
ri
es.Absol
utepov
ert
yismeantt
orepr
esenta
speci
fi
cmi
nimum l
evelofi
ncomeneededt
osat
isf
ythebasi
cphy
sicalneedsoff
ood,
cl
othi
ngandshel
teri
nor
dert
oensur
econt
inuedsur
viv
alext
entofobsol
etepov
ert
yis

117
t
her
efor
ethe numberofpeopl
ewhoar
eunabl
etocommandsuf
fi
cientr
esour
cest
o
sat
isf
ybasi
cneeds.

A pr
obl
em,howev
er,ar
iseswhenoner
ecogni
zest
hatt
hosemi
nimum subsi
stence
l
evel
s wi
l
lvar
yfr
om count
ryt
o count
ryand r
egi
on t
oregi
on,r
efl
ect
ing di
ff
erent
phy
siol
ogi
calaswel
lassoci
alandeconomi
crequi
rement
s.Economi
stshav
ether
efor
e
t
ended t
o make consul
tat
ive est
imat
es of wor
ld pov
ert
yin or
der t
o av
oid
unsubst
ant
iat
ed exagger
ati
onsoft
hepr
obl
em.Si
ncet
hei
nter
nat
ionalpov
ert
yli
ne
knowsnoboundar
ies,i
sindependentoft
hel
evelofnat
ionalpercapi
tai
ncome,and
t
akesi
ntoaccountdi
ff
eri
ngpr
icel
evelbymeasur
ingpov
ert
yasanyonel
i
vingonl
ess
t
han$1adayi
nPPPdol
l
ars.

Quest
ion5.
2let
’sassumet
hatt
hepov
ert
yli
nei
ssetat$360.I
ftwoi
ndi
vi
dual
sAandB
ear
n$350and$300r
espect
ivel
y,t
het
woar
ebel
ow t
hepov
ert
yli
neAr
etwoequal
l
y
poor

Quest
ion5.
3"Hi
gherpercapi
tai
ncomes perse do notguar
ant
ee t
he absence of
si
gni
fi
cantnumber
sofabsol
utepoor
.Iti
spossi
blef
oracount
rywi
thahi
gherpercapi
ta
i
ncomet
ohav
eal
argeper
cent
agel
i
neandal
argerpov
ert
ygapt
hanacount
rywi
tha
l
owerpercapi
tai
ncome “
Argue on t
his st
atementby r
elat
ing y
ouranswer
sto
quest
ion5.
1

Whypov
ert
yper
sisti
nLDCs?Theansweri
sbasi
cal
l
ybecauseofl
argei
nequal
i
tyl
evel
wi
thi
nanat
ionandacr
osscount
ri
es.Consi
dert
hef
oll
owi
ngf
act
s:amongf
ourpoi
nt
f
ourbi
l
li
onpeopl
eli
vei
ndev
elopi
ngcount
ri
es.Thr
ee-
fi
ft
hsl
ackbasi
csani
tat
ion,
almost
onet
hir
dhav
enoaccesst
ocl
eanwat
erandquar
ter(
25%)donothav
eadequat
e
housi
ng.Twent
yper
centhav
enoaccesst
omoder
nheal
thser
vices.I
n1997t
her
ichest
f
if
thoft
hewor
ld’
spopul
ati
onhad74t
imest
hei
ncomeoft
hepoor
estf
if
th.Thet
op
t
hreebi
l
li
onai
reshav
easset
sgr
eat
ert
hant
hecombi
nedGNPofal
lleastdev
eloped
count
ri
esandt
hei
r600mi
l
li
onpeopl
e.

Whyshoul
dwebeconcer
nedwi
thi
nequal
it
yamongt
hoseabov
ethepov
ert
yli
ne?
Ther
ear
ethr
eemaj
oranswer
stot
hisquest
ion.Fi
rst
,ext
remei
ncomei
nequal
i
tyl
eads
t
oeconomi
cinef
fi
ciency
.Thi
sdi
spar
it
yunder
minessoci
alst
abi
l
ityandsol
i
dar
it
y.Hi
gh
i
nequal
i
tyf
aci
l
it esr
at entseeki
ng,i
ncl
udi
ngact
ionssuchasexcessi
vel
obby
ingand
br
iber
y.Thesecanbegener
all
yvi
ewedasunf
air
. Gener
all
y,ourassumpt
ioni
sthat

118
soci
alwel
far
edependsposi
ti
vel
yont
hel
evelofi
ncomepercapi
tabutnegat
ivel
yon
pov
ert
yandnegat
ivel
yont
hel
evel
ofi
nequal
i
ty.

Fact
orsDr
ivi
ngHi
gherI
ncomeI
nequal
it
y

Technol
ogi
cal change: el
i
minat
ing many j
obs t
hrough aut
omat
ion, f
inanci
al
dev
elopmentcoul
dbenef
itt
her
ichi
ntheear
lyst
agesofdev
elopment
,changesi
nlabor
mar
keti
nst
it
uti
ons(
adecl
i
nei
ntr
adeuni
onmember
shi
pcoul
dreducet
her
elat
ive
bar
gai
ningpowerofl
abor
),r
edi
str
ibut
ivepol
i
cies,f
alsePr
ogr
essi
vet
axat
ion&soci
al
t
ransf
ers.

Causesofpov
ert
yint
hir
dwor
ldcount
ri
es(
LDCs

Tr
ade:t
hir
d wor
ld count
ri
es l
ose outt
hrough unf
airt
rade agr
eement
s,l
ack of
t
echnol
ogyandi
nvest
ment
,andr
api
dlychangi
ngpr
icesf
ort
hei
rgoods.

Wor
kandgl
obal
isat
ion:Bet
tercommuni
cat
ionsandt
ranspor
thav
eledt
oa“
global
i
sed”
economy
.Compani
esl
ookf
orl
ow-
costcount
ri
est
oinv
esti
n.Thi
scanmeant
hat
,
t
hought
her
ear
ejobs,
theyar
elow-
pai
d.

Warorconf
li
ct:Whenacount
ryi
satwar(
incl
udi
ngci
vi
lwar
)basi
cser
vicesl
i
ke
educat
ionar
edi
srupt
ed.Peopl
eleav
ethei
rhomesasr
efugees.Cr
opsar
edest
roy
ed

Pol
icyOpt
ion:Fourbr
oadar
easofpossi
blegov
ernmentpol
i
cyi
nter
vent
ioncanbe
i
dent
if
ied:

1) Al
ter
ingt
hef
unct
ional
dist
ri
but
iont
hroughandchangi
ngr
elat
ivef
act
orpr
ices.

I
tisar
guedt
hatmeasur
esdesi
gnedt
oreducet
hepr
iceofl
aborr
elat
ivet
ocapi
tal(
e.g.
,
t
hroughpubl
i
cwagesubsi
diest
oempl
oyer
s)wi
l
lcauseempl
oyer
stosubst
it
utel
abor
f
orcapi
tali
nthei
rpr
oduct
ionact
ivi
ti
esSuchf
act
orsubst
it
uti
oni
ncr
easest
heov
eral
l
l
evel
ofempl
oymentandul
ti
mat
elyr
aisest
hei
ncomesoft
hepoor
.

2)Mi
ti
gat
ing t
he si
ze di
str
ibut
ion:t
hrough pr
ogr
essi
ver
edi
str
ibut
ion ofasset
owner
shi
p

3)Moder
ati
ng(
reduci
ng)t
hesi
zedi
str
ibut
ionatupperl
evel
s:t
hroughpr
ogr
essi
ve
t
axat
ionofper
sonali
ncomeandweal
th.Pr
ogr
essi
vei
ncomet
axi
sat
axwhose
r
atei
ncr
eases wi
thi
ncr
easi
ng per
sonali
ncomes.Such t
axat
ion i
ncr
eases

119
 gov
ernmentr
evenuest
hatdecr
easet
heshar
eofdi
sposabl
eincomeoft
hev
ery
r
ich

4) Moder
ati
ng(
incr
easi
ng)t
hesi
zedi
str
ibut
ionatl
owerl
evel
s:t
hrought
ransf
er
pay
ment
sandpubl
i
cpr
ovi
sionofgoodsandser
vices.

DEVELOPMENTECONOMI
CS-
II
CHAPTERONE

Popul
ati
onGr
owt
handt
heQual
it
yofLi
fe
Ev
eryy
earappr
oxi
mat
ely80mi
l
li
onpeopl
ear
ebei
ngaddedt
othewor
ld’
spopul
ati
on.
Al
mostal
loft
hisnetpopul
ati
oni
ncr
ease(
97%)i
sindev
elopi
ngcount
ri
es.I
ncr
easesof
suchmagni
tudear
eunpr
ecedent
ed.Butt
hepr
obl
em ofpopul
ati
ongr
owt
hisnotsi
mpl
y
apr
obl
em ofnumber
s.I
tisapr
obl
em ofhumanwel
far
eandofdev
elopment
.Rapi
d
popul
ati
ongr
owt
hcanhav
eser
iousconsequencesf
ort
hewel
l
-bei
ngofal
lofhumani
ty.
I
fdev
elopmentent
ail
sthei
mpr
ovementi
npeopl
e’
slev
elsofl
i
ving,t
hent
her
eal
l
y
i
mpor
tantquest
ion aboutpopul
ati
on gr
owt
hist
his:How does t
he cont
empor
ary
popul
ati
onsi
tuat
ioni
nmanydev
elopi
ngcount
ri
escont
ri
but
etoordet
ractf
rom t
hei
r
chancesofr
eal
i
zingt
hegoal
sofdev
elopment
,notonl
yfort
hecur
rentgener
ati
onbut
al
so f
orf
utur
e gener
ati
ons?Conv
ersel
y,how does dev
elopmentaf
fectpopul
ati
on
gr
owt
h?

Amongt
hemaj
ori
ssuesr
elat
ingt
othi
sbasi
cquest
ionar
ethef
oll
owi
ng:
Wil
ldev
elopi
ng
count
ri
esbecapabl
eofi
mpr
ovi
ngt
hel
evel
sofl
i
vingf
ort
hei
rpeopl
ewi
tht
hecur
rent
andant
ici
pat
edl
evel
sofpopul
ati
ongr
owt
h?Towhatext
entdoesr
api
dpopul
ati
on
i
ncr
easemakei
tmor
edi
ff
icul
ttopr
ovi
deessent
ialsoci
alser
vices,i
ncl
udi
nghousi
ng,
t
ranspor
t,sani
tat
ion,
andsecur
it
y?

How wi
l
lthedev
elopi
ngcount
ri
esbeabl
etocopewi
tht
hev
asti
ncr
easesi
nthei
r
l
aborf
orcesov
ert
hecomi
ngdecades?Wi
l
lempl
oymentoppor
tuni
ti
esbepl
ent
if
ul,
orwi
l
litbeamaj
orachi
evementj
ustt
okeepunempl
oymentl
evel
sfr
om r
isi
ng?
Whatar
ethei
mpl
i
cat
ionsofhi
gherpopul
ati
ongr
owt
hrat
esamongt
hewor
ld’
spoor
f
ort
hei
rchancesofov
ercomi
ngt
hehumanmi
ser
yofabsol
utepov
ert
y?Wi
l
lwor
ld
f
ood suppl
yand i
tsdi
str
ibut
ion besuf
fi
cientnotonl
yto meett
heant
ici
pat
ed
popul
ati
oni
ncr
easei
nthecomi
ngdecadesbutal
sot
oimpr
ovenut
ri
ti
onall
evel
sto
t
hepoi
ntwher
eal
lhumanscanhav
eanadequat
edi
et?

120
Gi
vent
heant
ici
pat
edpopul
ati
ongr
owt
h,wi
l
ldev
elopi
ngcount
ri
esbeabl
etoext
end
t
hecov
erageandi
mpr
ovet
hequal
i
tyoft
hei
rheal
thandeducat
ional
syst
emssot
hat
ev
ery
onecanatl
easthav
ethechancet
osecur
eadequat
eheal
thcar
eandabasi
c
educat
ion?Towhatext
entar
elowl
evel
sofl
i
vingani
mpor
tantf
act
ori
nli
mit
ingt
he
f
reedom ofpar
ent
stochooseadesi
redf
ami
l
ysi
ze?I
sther
ear
elat
ionshi
pbet
ween
pov
ert
yandf
ami
l
ysi
ze?

Towhatext
enti
sthegov
erni
ngaf
fl
uenceamongt
heeconomi
cal
l
ymor
edev
eloped
nat
ionsani
mpor
tantf
act
orpr
event
ingpoornat
ionsf
rom accommodat
ingt
hei
r
gr
owi
ngpopul
ati
ons?I
sthei
nev
itabl
epur
sui
tofi
ncr
easi
ngaf
fl
uenceamongt
her
ich
mor
edet
ri
ment
alt
othegl
obalenv
ironmentandt
ori
singl
i
vingst
andar
dsamongt
he
poort
hant
heabsol
utei
ncr
easei
nthei
rnumber
s?Wewi
l
ltr
ytoexpl
oreandexpl
ain
t
heseandot
herpr
obl
emsi
nthi
scour
se.

Wor
ldPopul
ati
onGr
owt
hthr
oughHi
stor
y
Gi
vencur
rentpopul
ati
ongr
owt
hrat
esi
ndi
ff
erentpar
tsoft
hewor
ld,t
her
egi
onal
di
str
ibut
ionoft
hewor
ld’
spopul
ati
onwi
l
linev
itabl
ychangeby2050.Byt
hatt
ime,i
tis
l
i
kel
ythatt
her
ewi
l
lbe6.
6bi
l
li
onmor
epeopl
eont
heear
tht
hani
n1950and3.
1bi
l
li
on
mor
ethani
n2000.Af
ri
cawi
l
lexper
iencet
hel
argestper
cent
agei
ncr
ease(
184%)
,and
i
tspr
oject
edpopul
ati
onof2.
1bi
l
li
onwi
l
lbeal
mostt
hreet
imesi
ts1998popul
ati
onand
al
most10t
imesi
ts1950popul
ati
on.

Fer
ti
li
tyand Mor
tal
i
tyTr
ends:t
he r
ate ofpopul
ati
on i
ncr
ease i
s quant
it
ati
vel
y
measur
edast
heper
cent
agey
ear
lynetr
elat
ivei
ncr
easei
npopul
ati
onsi
zeduet
o
nat
urali
ncr
easeandneti
nter
nat
ionalmi
grat
ion.Nat
urali
ncr
easesi
mpl
ymeasur
es
t
heexcessofbi
rt
hsov
erdeat
hsor
,inmor
etechni
calt
erms,
thedi
ff
erencebet
ween
f
ert
il
it
yandmor
tal
i
tyr
ates.

Thedi
ff
erencebet
weendev
elopi
nganddev
elopednat
ionsi
nter
msofr
atesof
popul
ati
ongr
owt
hcanbeexpl
ainedsi
mpl
ybyt
hef
actt
hebi
rt
hrat
es(
fer
ti
li
tyr
ates)
i
n dev
elopi
ng count
ri
esar
e gener
all
ymuch hi
ghert
han i
nthe r
ich nat
ions.I
n
Dev
elopi
ngcount
ri
es,deat
hrat
es(
mor
tal
i
tyr
ates)ar
eal
sohi
gher
.Howev
er,t
hese
deat
hrat
edi
ff
erencesar
esubst
ant
ial
l
ysmal
l
ert
hant
hedi
ff
erencesi
nbi
rt
hrat
es.
AgeSt
ruct
ureanddependencyBur
dens:Wor
ldpopul
ati
ont
odayi
sver
yyout
hful
,

121
par
ti
cul
arl
yint
hedev
elopi
ngwor
ld.Chi
l
drenundert
heageof15const
it
utemor
e
t
han31%oft
het
otalpopul
ati
onofdev
elopi
ngcount
ri
esbutj
ust18%ofdev
eloped
nat
ions.

TheHi
ddenMoment
um ofPopul
ati
onGr
owt
h
Per
haps t
he l
eastunder
stood aspectofpopul
ati
on gr
owt
hisi
tst
endencyt
o
cont
inueev
enaf
terbi
rt
hrat
eshav
edecl
i
nedsubst
ant
ial
l
y.Popul
ati
ongr
owt
hhasa
bui
l
t-i
ntendencyt
ocont
inue,
apower
fulmoment
um t
hat
,li
keaspeedi
ngaut
omobi
l
e
whent
hebr
akesar
eappl
i
ed,
tendst
okeepgoi
ngf
orsomet
imebef
orecomi
ngt
oa
st
op.I
nthecaseofpopul
ati
ongr
owt
h,t
hismoment
um canper
sistf
ordecadesaf
ter
bi
rt
hrat
esdr
op.Ther
ear
etwobasi
creasonsf
ort
his.Fi
rst
,hi
ghbi
rt
hrat
escannotbe
al
ter
edsubst
ant
ial
l
yov
erni
ght
.Thesoci
al,economi
c,andi
nst
it
uti
onalf
orcest
hat
hav
einf
luencedf
ert
il
it
yrat
esov
ert
hecour
seofcent
uri
esdonotsi
mpl
yev
apor
ateat
t
heur
gingofnat
ionall
eader
s.Thesecondandl
essobv
iousr
easonf
ort
hehi
dden
moment
um ofpopul
ati
ongr
owt
hrat
eisr
elat
edt
otheagest
ruct
ureofLDC.

Thecausef
orhi
ghf
ert
il
it
yinLDCs
Mal
thusi
anPopul
ati
onTr
ap
Twocent
uri
esago,t
heRev
erendThomasMal
thusputf
orwar
dat
heor
yoft
he
r
elat
ionshi
p bet
ween popul
ati
on gr
owt
h and economi
c dev
elopmentt
hatst
il
l
sur
viv
est
oday
.TheMal
thusi
anpopul
ati
ont
rappr
ovi
desat
heor
yoft
her
elat
ionshi
p
bet
weenpopul
ati
ongr
owt
handeconomi
cdev
elopment
.Unf
ort
unat
ely
,iti
sbasedon
anumberofsi
mpl
i
sti
cassumpt
ionsandhy
pot
hesest
hatdonotst
andt
het
estof
empi
ri
cal
ver
if
icat
ion.
Wecant
husl
argel
yrej
ectt
heMal
thusi
anandneo-
Mal
thusi
ant
heor
iesasappl
i
edt
o
cont
empor
arydev
elopi
ngnat
ionsont
hef
oll
owi
nggr
ounds:f
ir
stt
heydonott
ake
adequat
eaccountoft
her
oleandi
mpactoft
echnol
ogi
calpr
ogr
ess.Secondt
heyar
e
basedonahy
pot
hesi
saboutamacr
orel
ati
onshi
pbet
weenpopul
ati
ongr
owt
hand
l
evel
sofpercapi
tai
ncomet
hatdoesnotst
andupt
oempi
ri
calt
est
ing.Thi
rdt
hey
f
ocusont
hewr
ongv
ari
abl
e,percapi
tai
ncome,ast
hepr
inci
paldet
ermi
nantof
popul
ati
ongr
owt
hrat
es.Thus,amuchbet
terand mor
eval
i
d appr
oacht
othe
quest
ionofpopul
ati
onanddev
elopmentcent
ersont
hemi
croeconomi
csoff
ami
l
y
si
zedeci
sionmaki
ngi
nwhi
chi
ndi
vi
dual
,andnotaggr
egat
e,l
evel
sofl
i
vingbecome
t
hepr
inci
pal
det
ermi
nantofaf
ami
l
y’sdeci
siont
ohav
emor
eorf
ewerchi
l
dren.

122
TheMi
croeconomi
cHousehol
dTheor
yofFer
ti
li
ty
I
nrecenty
ear
s,economi
stshav
ebegunt
olookmor
ecl
osel
yatt
hemi
croeconomi
c
det
ermi
nant
soff
ami
l
yfer
ti
li
tyi
nanat
temptt
opr
ovi
deabet
tert
heor
eti
caland
empi
ri
calex
planat
ionf
ort
heobser
vedf
all
i
ngbi
rt
hrat
esassoci
atedwi
thst
age3of
t
he demogr
aphi
ctr
ansi
ti
on.I
n doi
ng t
his,t
heyhav
e dr
awn on t
he t
radi
ti
onal
neocl
assi
calt
heor
yofhousehol
dandconsumerbehav
iorf
ort
hei
rbasi
canal
yti
cal
modelandhav
eusedt
hepr
inci
plesofeconomyandopt
imi
zat
iont
oexpl
ainf
ami
l
y
si
zedeci
sions.Speci
fi
cal
l
y,bi
rt
hrat
esamongt
hev
erypoorar
eli
kel
ytof
allwher
e
t
her
eis:Ani
ncr
easei
ntheeducat
ionofwomenandaconsequentchangei
nthei
r
r
oleandst
atus.

Ani
ncr
easei
nfemal
enonagr
icul
tur
alwageempl
oymentoppor
tuni
ti
es,whi
chr
aises
t
hepr
iceorcostoft
hei
rtr
adi
ti
onalchi
l
d-r
ear
ingact
ivi
ti
es;ar
isei
nfami
l
yincome
l
evel
sthr
ought
hei
ncr
easeddi
rectempl
oymentandear
ningsofahusbandandwi
fe
ort
hrought
her
edi
str
ibut
ionofi
ncomeandasset
sfr
om r
icht
opoor
;ar
educt
ioni
n
i
nfantmor
tal
i
tyt
hrough expanded publ
i
c-heal
th pr
ogr
amsand bet
ternut
ri
ti
onal
st
atusf
orbot
hmot
herandchi
l
dandbet
termedi
cal
car
e;t
hedev
elopmentofol
d-age
andot
hersoci
alsecur
it
ysy
stemsout
sidet
heext
endedf
ami
l
ynet
wor
ktol
essent
he
economi
c dependence ofpar
ent
s,especi
all
y women,on t
hei
rof
fspr
ing and
Expandedschool
i
ngoppor
tuni
ti
essopar
ent
scanbet
tersubst
it
utechi
l
d“qual
i
ty”f
or
l
argenumber
sofchi
l
dren.

1.
1.1.SomePol
icyAppr
oaches

I
nvi
ew oft
hesebr
oadgoal
sandobj
ect
ives,whatki
ndsofeconomi
candsoci
al
pol
i
cies mi
ghtt
he dev
elopi
ng count
ryand dev
eloped-
count
rygov
ernment
s and
i
nter
nat
ionalassi
stanceagenci
esconsi
derbr
ingi
ngaboutl
ong-
ter
mreduct
ionsi
n
t
he ov
eral
lrat
e ofwor
ld popul
ati
on gr
owt
h?Thr
ee ar
eas ofpol
i
cycan hav
e
i
mpor
tantdi
rectandi
ndi
recti
nfl
uencesont
hewel
l
-bei
ngofpr
esentandf
utur
ewor
ld
popul
ati
ons:

Gener
alandspeci
fi
cpol
i
ciest
hatLDCgov
ernment
scani
nit
iat
etoi
nfl
uenceand
per
hapsev
encont
rolt
hei
rpopul
ati
ongr
owt
handdi
str
ibut
ion.Gener
alandspeci
fi
c
pol
i
ciest
hatdev
eloped-
count
rygov
ernment
scani
nit
iat
eint
hei
rowncount
ri
est
o
l
essent
hei
rdi
spr
opor
ti
onat
econsumpt
ionofl
i
mit
edwor
ldr
esour
cesandpr
omot
ea

123
mor
eequi
tabl
edi
str
ibut
ionoft
hebenef
it
sofgl
obal
economi
cpr
ogr
ess.

Cer
tai
ndev
elopmentpol
i
ciesar
epar
ti
cul
arl
ycr
uci
ali
nthet
ransi
ti
onf
rom ahi
gh-
gr
owt
htoal
ow-
growt
h popul
ati
on.Thesepol
i
ciesai
m atel
i
minat
ing absol
ute
pov
ert
y;l
esseni
ng i
ncome i
nequal
i
ties; expandi
ng educat
ional oppor
tuni
ti
es,
especi
all
yforwomen;pr
ovi
ding i
ncr
eased j
ob oppor
tuni
ti
esf
orbot
h men and
women;br
ingi
ng t
hebenef
it
sofmoder
n pr
event
ivemedi
cineand publ
i
c-heal
th
pr
ogr
ams,especi
all
ythepr
ovi
sionofcl
eanwat
erandsani
tat
ion,t
other
uraland
ur
banpoor
;impr
ovi
ngmat
ernalandchi
l
dheal
tht
hroughmor
efood,
bet
terdi
ets,
and
i
mpr
ovednut
ri
ti
ont
oloweri
nfantmor
tal
i
ty;andcr
eat
ingamor
eequi
tabl
epr
ovi
sion
ofot
hersoci
alser
vicest
owi
desegment
soft
hepopul
ati
on.

1.
1.2.How Dev
eloped Count
ri
es Can Assi
stDev
elopi
ng Count
ri
es wi
th Thei
r
Popul
ati
onPr
ogr
ams

Ther
ear
eal
soanumberofway
sinwhi
cht
hegov
ernment
sofr
ichcount
ri
esand
mul
ti
lat
eraldonoragenci
escanhel
pthegov
ernment
sofdev
elopi
ngcount
ri
esachi
eve
t
hei
rpopul
ati
onpol
i
cyobj
ect
ivesi
nshor
terper
iodsoft
ime.Themosti
mpor
tantof
t
heseconcer
nst
hewi
l
li
ngnessofr
ichcount
ri
est
obeofgenui
neassi
stancet
opoor
count
ri
esi
nthei
rdev
elopmentef
for
ts.Suchgenui
nesuppor
twoul
dconsi
stnotonl
yof
expandedpubl
i
candpr
ivat
efi
nanci
alassi
stancebutal
soofi
mpr
ovedt
rader
elat
ions,
suchast
ari
ff
-andquot
a-f
reeaccesst
odev
eloped-
count
rymar
ket
s,mor
eappr
opr
iat
e
t
echnol
ogy t
ransf
ers,and assi
stance i
n dev
elopi
ng i
ndi
genous sci
ent
if
icr
esear
ch
capaci
ti
es,
bet
teri
nter
nat
ional
commodi
ty-
pri
cingpol
i
cies,
andamor
eequi
tabl
eshar
ing
oft
hewor
ld’
sscar
cenat
ural
resour
ces.

Ther
ear
etwoot
heract
ivi
ti
esmor
edi
rect
lyr
elat
edt
ofer
ti
li
tymoder
ati
oni
nwhi
chr
ich-
count
ry gov
ernment
s,i
nter
nat
ionaldonoragenci
es,and pr
ivat
e non-
gov
ernment
al
or
gani
zat
ions(
NGOs)canpl
ayani
mpor
tantassi
sti
ngr
ole.

Thef
ir
sti
sthewhol
ear
eaofr
esear
chi
ntot
het
echnol
ogyoff
ert
il
it
ycont
rol
,the
cont
racept
ivepi
l
l,moder
nint
raut
eri
nedev
ices(
IUDs)
,vol
unt
aryst
eri
l
izat
ionpr
ocedur
es,
and,
par
ti
cul
arl
yforAf
ri
cai
ntheageofAI
Ds,
eff
ect
ivebar
ri
ercont
racept
ion.

Thesecondar
eai
ncl
udesf
inanci
alassi
stancef
rom dev
elopedcount
ri
esf
orf
ami
l
y-
pl
anni
ng pr
ogr
ams,publ
i
c educat
ion,and nat
ionalpopul
ati
on pol
i
cy r
esear
ch

124
act
ivi
ti
esi
nthedev
elopi
ngcount
ri
es.Thi
shast
radi
ti
onal
l
ybeent
hepr
imar
yar
eaof
dev
eloped-
count
ryassi
stancei
nthef
iel
dofpopul
ati
on.

UNI
T TWO

HumanCapi
tal
:Educat
ionandHeal
thi
nEconomi
cDevel
opment
I
nthe t
hir
d uni
t,we exami
ne t
he r
oles ofeducat
ion and heal
thi
n economi
c
dev
elopment
.Theset
wohumancapi
tali
ssuesar
etr
eat
edt
oget
herbecauseoft
hei
r
cl
oser
elat
ionshi
p.Weconsi
dert
her
elat
ionshi
psbet
weeni
ncomeont
heonehand
andheal
thandeducat
ionont
heot
her
.

1.
2. Educat
ionandHeal
thasJoi
ntI
nvest
ment
sfor
Dev
elopment

Heal
thandeducat
ionar
ecl
osel
yrel
atedi
neconomi
cdev
elopment
.Ont
heonehand,
gr
eat
erheal
thcapi
talmayi
mpr
ovet
her
etur
ntoi
nvest
menti
neducat
ion,i
npar
t
becauseheal
thi
san i
mpor
tantf
act
ori
n schoolat
tendanceand i
nthef
ormal
l
ear
ning pr
ocess ofa chi
l
d.A l
ongerl
i
fer
aises t
he r
etur
ntoi
nvest
ment
sin
educat
ion;bet
terheal
thatanypoi
ntdur
ingwor
kingl
i
femayi
nef
fectl
owert
her
ate
ofdepr
eci
ati
onofeducat
ioncapi
tal
.Ont
heot
herhand,gr
eat
ereducat
ioncapi
tal
mayi
mpr
ovet
her
etur
ntoi
nvest
ment
sinheal
th,
becausemanyheal
thpr
ogr
amsr
ely
onbasi
cski
l
lsof
tenl
ear
nedatschool
,i
ncl
udi
ngper
sonal
hygi
eneandsani
tat
ion,
not
t
oment
ionbasi
cli
ter
acy
;educat
ioni
sal
soneededf
ort
hef
ormat
ionandt
rai
ningof
heal
thper
sonnel
.Fi
nal
l
y,ani
mpr
ovementi
npr
oduct
iveef
fi
ciencyf
rom i
nvest
ment
s
i
neducat
ionr
aisest
her
etur
nonal
i
fesav
ingi
nvest
menti
nheal
th.

WhyI
ncr
easi
ngI
ncomeI
sNotSuf
fi
cient
?Heal
thandeducat
ionl
evel
sar
emuch
hi
gheri
nhi
gh-
incomecount
ri
es.Ther
ear
egoodr
easonst
obel
i
evet
hatt
hecausal
i
ty
r
unsi
nbot
hdi
rect
ions:Wi
thhi
gheri
n-come,peopl
eandgov
ernment
scanaf
for
dto
spendmor
eoneducat
ionandheal
th;wi
thgr
eat
erheal
thandeducat
ion,hi
gher
pr
oduct
ivi
tyandi
ncomesar
epossi
ble.Becauseoft
heser
elat
ionshi
ps,
dev
elopment
pol
i
cyneedst
ofocusoni
ncome,
heal
th,
andeducat
ionsi
mul
taneousl
y.

125
Chi
ldLabor
:Chi
l
dlabori
sawi
despr
eadpr
obl
em i
ndev
elopi
ngcount
ri
es.Whenachi
l
d
underage14wor
k,t
hei
rlabort
imedi
srupt
sthei
rschool
i
ngandi
namaj
ori
tyofcases
pr
event
sthem f
rom at
tendi
ngschool
.Compoundi
ngt
his,t
heheal
thofchi
l
dwor
ker
sis
si
gni
fi
cant
lywor
se,ev
enaccount
ingf
ort
hei
rpov
ert
yst
atus,t
hant
hatofchi
l
drenwho
donotwor
k;phy
sicalst
unt
ingamongchi
l
dlabor
ersi
sver
ycommon.I
naddi
ti
on,
alar
ge
f
ract
ionofl
abor
ingchi
l
dreni
ssubj
ectt
oespeci
all
ycr
uelandexpl
oit
ati
vewor
king
condi
ti
onst
hatwi
l
laf
fectt
hei
rheal
thandt
hei
rpr
oduct
ivi
tydur
ingt
hei
rol
daget
hatwi
l
l
hav
edi
recti
mpactont
hedev
elopmentoft
hedev
elopi
ngcour
ti
ers.

Ther
ear
efourmai
nappr
oachest
ochi
l
dlaborpol
i
cycur
rent
lyi
ndev
elopmentpol
i
cy:
Thef
ir
str
ecogni
zeschi
l
dlaborasanexpr
essi
onofpov
ert
yand r
ecommendsan
emphasi
sonel
i
minat
ingpov
ert
yrat
hert
handi
rect
lyaddr
essi
ngchi
l
dlabor
;thi
sposi
ti
on
i
sgener
all
yassoci
atedwi
tht
heWor
ldBank.

Thesecondappr
oachemphasi
zesst
rat
egi
est
ogetmor
echi
l
dreni
ntoschool
,i
ncl
udi
ng
expandedschoolpl
aces,suchasnewv
il
lageschool
s,andi
ncent
ivest
oinducepar
ent
s
t
osendt
hei
rchi
l
drent
oschool
.Thet
hir
dappr
oachconsi
der
schi
l
dlabori
nev
itabl
e,at
l
easti
ntheshor
trun,andst
ressespal
l
iat
ivemeasur
essuchasr
egul
ati
ngi
ttopr
event
abuseandt
opr
ovi
desuppor
tser
vicesf
orwor
kingchi
l
dren.Thef
our
thappr
oachf
avor
s
banni
ngchi
l
dlabor
.Ift
hisi
snotpossi
ble,
howev
er,
andr
ecogni
zi
ngt
hatchi
l
dlabormay
notal
way
sresul
tfr
om mul
ti
pleequi
l
ibr
ia,
thi
sappr
oachf
avor
sbanni
ngchi
l
dlabori
nit
s
mostabusi
vef
orms.Thel
att
erappr
oachhasr
ecei
vedmuchat
tent
ioni
nrecenty
ear
s.

Fi
nal
l
y,manyact
ivi
stsi
ndev
elopedcount
ri
eshav
epr
oposedt
hei
mposi
ti
onoft
rade
sanct
ionsagai
nstcount
ri
est
hatper
mitchi
l
dlabororatl
eastbanni
ngt
hegoodson
whi
chchi
l
drenwor
k.Thi
sappr
oachi
swel
li
ntent
ioned,
buti
ftheobj
ect
ivei
sthewel
far
e
ofchi
l
dren,i
tneedst
obeconsi
der
edcar
eful
l
y,becausei
fchi
l
drencannotwor
kint
he
expor
tsect
or,t
heywi
l
lal
mostcer
tai
nlybef
orcedt
owor
kint
hei
nfor
malsect
or,wher
e
wagesandot
herwor
kingcondi
ti
onsar
egener
all
ywor
se.

1.
3. Pol
ici
esf
orHeal
th,Educat
ion,andI
ncome
Gener
ati
on

I
nthecomi
ngy
ear
s,t
hecl
earev
idencet
hatheal
thandeducat
ionar
ejoi
nti
n-
v
est
ment
smayof
ferscopef
oramor
eint
egr
atedpol
i
cyappr
oach.I
tmaybet
hat

126
oneoft
hemostef
fect
ivei
nvest
ment
swecanmakei
neducat
ionqual
i
tyi
sto
i
mpr
ovechi
l
dheal
th.Si
mil
arl
y,oneoft
hemostef
fect
ivei
nvest
ment
swecoul
dmake
i
nheal
thmaybet
oimpr
ovet
hequal
i
tyofeducat
ion.I
nfact
,anumberofpr
omi
nent
pov
ert
ypr
ogr
amsi
ndev
elopi
ngcount
ri
esnowexpl
i
cit
lyi
ntegr
atei
ncent
ivesf
ort
he
dev
elopmentofheal
thandeducat
ionhumancapi
talamongl
ow i
ncomef
ami
l
ies.
I
ntegr
atedst
rat
egi
esseekl
i
nki
nghi
ghl
ysuccessf
ulmi
crocr
edi
tsy
stemswi
thheal
th
andeducat
ion.

I
ntegr
ati
ngpr
ogr
am oneducat
ion,heal
thandnut
ri
ti
oni
sanot
hergoodst
rat
egyt
o
r
efert
o.I
nthi
sint
egr
atedst
rat
egy
,ther
eiscasht
ransf
ert
opoorf
ami
l
y,f
ami
l
ycl
i
nk
v
isi
t,andot
heri
nki
ndnut
ri
ti
onalsuppl
ement
,andot
herheal
thbenef
it
sforpr
egnant
andl
act
ati
ngwomenandt
hei
rchi
l
drenunderaspeci
fi
edage.Someoft
hebenef
it
s
canbemadecondi
ti
onalonchi
l
d’sr
egul
arschoolat
tendance.I
nthi
smanneri
tis
possi
blet
oint
egr
atedheal
th,
educat
ionandbenef
itpackagest
othehousehol
ds.

Chapt
ert
hree

Rur
al-
urbani
nter
sect
ion,
migr
ati
on,
andunempl
oyment
Af
tercompl
eti
ngt
hisuni
t,y
ouwi
l
lcl
ear
lyunder
standt
hepot
ent
ialr
olesofci
ti
est
o
enhanceeconomi
cdev
elopmenti
nthecont
empor
arydev
elopi
ngeconomi
esy
oube
f
ami
l
iarwi
tht
hewel
l
-knownt
heor
eti
calmodelofr
ural
-ur
banmi
grat
ion(t
heTodar
o
ModelofMi
grat
ion)y
ouwi
l
lbeabl
eexami
net
headv
ant
agesanddi
sadv
ant
agesoft
he
i
nfor
malsect
ori
nthemoder
nci
ti
esoft
hecont
empor
arydev
elopi
ngcount
ri
esy
ouwi
l
l
beabl
etoev
aluat
edi
ff
erentpol
i
cyopt
ionst
hatt
hecont
empor
arydev
elopi
ngcount
ri
es
shoul
d pur
suet
o sol
vepr
obl
emsassoci
ated wi
thheav
yinf
low ofr
uralt
o ur
ban
mi
grat
ion

1.
4. Ther
oleci
ti
es

Whatexpl
ainst
hest
rongassoci
ati
onbet
weenur
bani
zat
ionanddev
elopment
?Toa
l
argedegr
ee,
cit
iesar
efor
medbecauset
heypr
ovi
decostadv
ant
agest
opr
oducer
sand
consumer
s t
hrough what ar
e cal
l
ed aggl
omer
ati
on economi
es. Aggl
omer
ati
on
economi
escomei
ntwof
orms.Ur
bani
zat
ioneconomi
esar
eef
fect
sassoci
atedwi
tht
he
gener
algr
owt
h ofa concent
rat
ed geogr
aphi
cregi
on.Local
i
zat
ion economi
es ar
e
ef
fect
scapt
uredbypar
ti
cul
arsect
orsoft
heeconomy
,suchasf
inanceoraut
omobi
l
es,

127
ast
heygr
owwi
thi
nanar
ea.

1.
5. TheUr
banGi
ant
ism Pr
obl
em

I
nthecaseofdev
elopi
ngcount
ri
es,
themai
ntr
anspor
tat
ionr
out
esar
eof
tenal
egacyof
col
oni
ali
sm.Theor
ist
soft
hedependencyschoolhav
ecompar
edcol
oni
alt
ranspor
tat
ion
net
wor
kst
odr
ainagesy
stems,emphasi
zi
ngeaseofext
ract
ionoft
hecount
ry'
snat
ural
r
esour
ces.I
nmanycases,t
hecapi
talci
tywi
l
lbel
ocat
edneart
heout
letoft
hissy
stem
ont
heseacost
.Thi
sty
peoft
ranspor
tat
ionsy
stem i
sal
socal
l
eda"
hub-
and-
spoke
sy
stem,
"whi
chi
sespeci
all
yvi
sibl
ewhent
hecapi
talci
tyi
slocat
edi
nthei
nter
ioroft
he
count
ry.

1.
5.1.CausesofUr
banGi
ant
ism

Whyhav
efi
rstci
ti
es of
ten swel
l
ed t
o such a l
arge mul
ti
ple ofsecond ci
ti
es i
n
dev
elopi
ngcount
ri
es?Ov
eral
l
,ur
bangi
ant
ism pr
obabl
yresul
tsf
rom acombi
nat
ionofa
hub-
and-
spoket
ranspor
tat
ionsy
stem andt
hel
ocat
ionoft
hepol
i
ticalcapi
tali
nthe
l
argestci
ty,t
hus combi
ning t
he ef
fect
s oft
he ur
ban hi
erar
chy modelwi
tht
he
di
ff
erent
iat
ed pl
anemodel
.Thi
sisf
urt
herr
einf
orced byapol
i
ticalcul
tur
eofr
ent
seeki
ngandt
hecapi
talmar
ketf
ail
urest
hatmaket
hecr
eat
ionofnewur
bancent
ersa
t
askt
hatmar
ket
scannotcompl
ete.

TheUr
banI
nfor
malSect
or
Asdi
scussedi
nmodul
eone,amaj
orf
ocusofdev
elopmentt
heor
yhasbeenont
he
dual
i
sti
cnat
ureofdev
elopi
ngcount
ri
es'
nat
ionaleconomi
es-
theexi
stenceofamoder
n
ur
bancapi
tal
i
stsect
orgear
edt
owar
dcapi
tal
-i
ntensi
ve,l
arge-
scal
epr
oduct
ionanda
t
radi
ti
onal r
ural subsi
stence sect
or gear
ed t
owar
d l
abor
-i
ntensi
ve, smal
l
-scal
e
pr
oduct
ion.Thei
nfor
malsect
orcont
inuest
o pl
ayani
mpor
tantr
olei
ndev
elopi
ng
count
ri
es,despi
tedecadesofbeni
gnnegl
ectatbestandout
ri
ghthost
il
it
yatwor
st.I
n
manydev
elopi
ngcount
ri
es,abouthal
foft
heempl
oyedur
banpopul
ati
onwor
ksi
nthe
i
nfor
mal
sect
or.

Thei
nfor
malsect
ori
schar
act
eri
zedbyal
argenumberofsmal
l
-scal
epr
oduct
ionand
ser
viceact
ivi
ti
est
hatar
eindi
vi
dual
l
yorf
ami
l
y-ownedandusesi
mpl
e,l
abor
-i
ntensi
ve

128
t
echnol
ogy
.Theyt
endt
ooper
atel
i
kemonopol
i
sti
cal
l
ycompet
it
ivef
ir
mswi
theaseof
ent
ry,excesscapaci
ty,andcompet
it
iondr
ivi
ngpr
ofi
ts(
incomes)downt
otheav
erage
suppl
ypr
iceofl
aborofpot
ent
ial
newent
rant
s.

Mor
eov
er,wor
ker
sint
hei
nfor
malsect
ordo notenj
oyt
hemeasur
eofpr
otect
ion
af
for
ded by t
he f
ormalmoder
n sect
ori
nter
ms ofj
ob secur
it
y,decentwor
king
condi
ti
ons,and ol
d-age pensi
ons.Manywor
ker
s ent
eri
ng t
his sect
orar
erecent
mi
grant
sfr
om r
uralar
easunabl
etof
ind empl
oymenti
nthe f
ormalsect
or.Thei
r
mot
ivat
ion i
s of
ten t
o obt
ain suf
fi
cienti
ncome f
orsur
viv
al,r
ely
ing on t
hei
rown
i
ndi
genous r
esour
ces t
o cr
eat
e wor
k.Si
nce manymember
s oft
he househol
d as
possi
blear
einv
olv
edi
nincome-
gener
ati
ngact
ivi
ti
es,
incl
udi
ngwomenandchi
l
dren,
and
t
heyof
tenwor
kver
ylonghour
s.

Al
argef
ract
ioni
nhabi
tshackst
hatt
heyt
hemsel
veshav
ebui
l
tinsl
umsandsquat
ter
set
tl
ement
s,whi
chgener
all
ylackmi
nimalpubl
i
cser
vicessuchasel
ect
ri
cit
y,wat
er,
dr
ainage,t
ranspor
tat
ion,andeducat
ionalandheal
thser
vices.Ot
her
sar
eev
enl
ess
f
ort
unat
e.Theyf
indspor
adi
ctempor
aryempl
oymenti
nthei
nfor
malsect
orasday
l
abor
ersandhawker
s,butt
hei
rincomesar
einsuf
fi
cientt
opr
ovi
deev
ent
hemost
r
udi
ment
aryshel
ter
.

2.
2.1.Ar
gument
sinf
avorofUr
banI
nfor
malSect
or

Ther
ear
esev
eral
argument
sthatar
emadei
nfav
orofpr
omot
ingt
hei
nfor
mal
sect
or:

Fi
rst
,scat
ter
edev
idencei
ndi
cat
est
hatt
hei
nfor
malsect
orgener
atessur
plusesev
en
undert
hecur
rent
lyhost
il
epol
i
cyenv
ironment
,whi
chdeni
esi
taccesst
otheadv
ant
ages
of
fer
edt
othef
ormalsect
or,suchascr
edi
t,f
orei
gnexchange,andt
axconcessi
ons.
Thust
hei
nfor
malsect
or'
ssur
pluscoul
dpr
ovi
deani
mpet
ust
ogr
owt
hint
heur
ban
economy
.

Second,
asar
esul
tofi
tsl
owcapi
tal
int
ensi
ty,
onl
yaf
ract
ionoft
hecapi
tal
neededi
nthe
f
ormalsect
ori
srequi
red t
o empl
oy a wor
keri
nthe i
nfor
malsect
or,of
fer
ing
consi
der
abl
esav
ingst
odev
elopi
ngcount
ri
essoof
tenpl
aguedwi
thcapi
tal
shor
tages.

Thi
rd,bypr
ovi
dingaccesst
otr
aini
ngandappr
ent
iceshi
psatsubst
ant
ial
l
ylowercost
s

129
t
hant
hatpr
ovi
dedbyf
ormali
nst
it
uti
onsandt
hef
ormalsect
or;t
hei
nfor
malsect
orcan
pl
ayani
mpor
tantr
olei
nthef
ormat
ionofhumancapi
tal
.

Four
th,
thei
nfor
malsect
orgener
atesdemandf
orsemi
ski
l
ledandunski
l
ledl
aborwhose
suppl
yisi
ncr
easi
ngi
nbot
hrel
ati
veandabsol
utet
ermsandi
sunl
i
kel
ytobeabsor
bed
byt
hef
ormal
sect
orwi
thi
tsi
ncr
easi
ngdemandsf
oraski
l
ledl
aborf
orce.

Fi
ft
h,t
hei
nfor
malsect
ori
smor
eli
kel
ytoadoptappr
opr
iat
etechnol
ogi
esandmakeuse
ofl
ocal
resour
ces,
all
owi
ngf
oramor
eef
fi
ciental
l
ocat
ionofr
esour
ces.

Si
xth,
thei
nfor
malsect
orpl
aysani
mpor
tantr
olei
nrecy
cli
ngwast
emat
eri
als,
engagi
ng
i
nthecol
l
ect
ionofgoodsr
angi
ngf
rom scr
apmet
alst
oci
gar
ett
ebut
ts,manyofwhi
ch
f
indt
hei
rwayt
othei
ndust
ri
alsect
ororpr
ovi
debasi
ccommodi
ti
esf
ort
hepoor
.Fi
nal
l
y,
pr
omot
ionoft
hei
nfor
malsect
orwoul
densur
eani
ncr
easeddi
str
ibut
ionoft
hebenef
it
s
ofdev
elopmentt
othepoor
,manyofwhom ar
econcent
rat
edi
nthei
nfor
malsect
or.
Pr
omot
ionoft
hei
nfor
mal
sect
ori
snot
,howev
er,
wit
houti
tsdi
sadv
ant
ages.

Ur
banUnempl
oyment
One oft
he maj
orconsequences oft
he r
api
d ur
bani
zat
ion pr
ocess has been t
he
bur
geoni
ngsuppl
yofj
obseeker
sint
obot
hthemoder
n(f
ormal
)andi
nfor
malsect
orsof
t
heur
baneconomy
.Inmanydev
elopi
ngcount
ri
es,t
hesuppl
yofwor
ker
sfarexceeds
t
he demand, t
he r
esul
t bei
ng ext
remel
y hi
gh r
ates of unempl
oyment and
under
empl
oymenti
nur
banar
eas.Becauseamaj
orcont
ri
but
ingf
act
ort
obot
hhi
gh
r
atesofur
bangr
owt
handhi
ghr
atesofunempl
oymentandunder
empl
oymenti
srur
al-
ur
banmi
grat
ion,
iti
sessent
ial
toi
nvest
igat
ethi
sissuei
nsomedet
ail
.

Mi
grat
ionandDevel
opment
Aswehav
eseenear
li
eri
ntheuni
t,r
ural
-ur
banmi
grat
ionhasbeendr
amat
ic,andur
ban
dev
elopmentpl
aysani
mpor
tantr
olei
neconomi
cdev
elopment
.Rat
esofr
ural
-ur
ban
mi
grat
ioni
ndev
elopi
ngcount
ri
eshav
eexceededr
atesofur
banj
obcr
eat
ionandt
hus
sur
passedgr
eat
lyt
heabsor
pti
oncapaci
tyofbot
hindust
ryandur
bansoci
alser
vices.
Mi
grat
iont
oday
,par
ti
cul
arl
ytot
hel
argestLDCci
ti
es,
mustbeseenast
hemaj
orf
act
or
cont
ri
but
ing t
othe ubi
qui
tous phenomenon ofur
ban sur
plus l
abor
,a f
orce t
hat
cont
inuest
oexacer
bat
eal
readyser
iousur
banunempl
oymentpr
obl
ems.

130
Mi
grat
ionwor
sensr
ural
-ur
banst
ruct
urali
mbal
ancesi
ntwodi
rectway
s.Fi
rst
,ont
he
suppl
ysi
de,
int
ernalmi
grat
iondi
spr
opor
ti
onat
elyi
ncr
easest
hegr
owt
hrat
eofur
banj
ob
seeker
srel
ati
vet
our
banpopul
ati
ongr
owt
h,whi
chi
tsel
fisathi
stor
ical
l
yunpr
ecedent
ed
l
evel
s,becauseoft
hehi
ghpr
opor
ti
onofwel
l
-educat
edy
oungpeopl
eint
hemi
grant
sy
stem.Thei
rpr
esencet
endst
oswel
ltheur
banl
aborsuppl
ywhi
l
edepl
eti
ngt
her
ural
count
rysi
deofv
aluabl
ehumancapi
tal
.Second,ont
hedemandsi
de,ur
banj
obcr
eat
ion
i
sgener
all
ymor
edi
ff
icul
tandcost
lyt
oaccompl
i
sht
hanr
uralj
obcr
eat
ionbecauseof
t
heneedf
orsubst
ant
ialcompl
ement
aryr
esour
cei
nput
sformostj
obsi
nthei
ndust
ri
al
sect
or.Mor
eov
er,
thepr
essur
esofr
isi
ngur
banwagesandcompul
sor
yempl
oyeef
ri
nge
benef
it
sin combi
nat
ion wi
tht
heunav
ail
abi
l
ityofappr
opr
iat
e,mor
elabor
-i
ntensi
ve
pr
oduct
iont
echnol
ogi
esmeanst
hatar
isi
ngshar
eofmoder
n-sect
orout
putgr
owt
his
account
edf
orbyi
ncr
easesi
nlaborpr
oduct
ivi
ty.Toget
hert
hisr
api
dsuppl
yincr
easeand
l
aggi
ngdemandgr
owt
htendt
oconv
ertashor
t-
runpr
obl
em ofr
esour
cei
mbal
ances
i
ntoal
ong-
runsi
tuat
ionofchr
oni
candr
isi
ngur
bansur
plusl
abor

Towar
danEconomi
cTheor
yofRur
al-
UrbanMi
grat
ion
Theeconomi
cdev
elopmentofWest
ernEur
opeandt
heUni
tedSt
ateswascl
osel
y
associ
atedwi
tht
hemov
ementofl
aborf
rom r
uralt
our
banar
eas.Fort
hemostpar
t,
wi
thar
uralsect
ordomi
nat
edbyagr
icul
tur
alact
ivi
ti
esandanur
bansect
orf
ocusi
ngon
i
ndust
ri
ali
zat
ion,
over
alleconomi
cdev
elopmenti
nthesecount
ri
eswaschar
act
eri
zedby
t
hegr
adualr
eal
l
ocat
ionofl
aboroutofagr
icul
tur
eandi
ntoi
ndust
ryt
hroughr
ural
-ur
ban
mi
grat
ion,bot
hint
ernalandi
nter
nat
ional
.Ur
bani
zat
ionandi
ndust
ri
ali
zat
ionwer
ein
essencesy
nony
mous.

Butt
heov
erwhel
mingev
idenceoft
hepastsev
eraldecades,whendev
elopi
ngnat
ions
wi
tnessedamassi
vemi
grat
ionoft
hei
rrur
alpopul
ati
onsi
ntour
banar
easdespi
ter
isi
ng
l
evel
sofur
banunempl
oymentandunder
empl
oyment
,lessenst
hev
ali
dit
yoft
heLewi
s
t
wo-
sect
ormodelofdev
elopment
.Anexpl
anat
ionoft
hephenomenon,aswel
las
pol
i
ciest
oaddr
esst
her
esul
ti
ngpr
obl
emsmustbesoughtel
sewher
e.Asar
esul
tthe
Todar
omi
grat
ionmodel
wasdev
eloped

2.
2.2.Fi
vePol
icyI
mpl
icat
ionsoft
heModel

131
Al
thought
heTodar
otheor
ymi
ghtatf
ir
stseem t
odev
aluet
hecr
it
icali
mpor
tanceof
r
ural
-ur
banmi
grat
ionbypor
tray
ingi
tasanadj
ust
mentmechani
sm bywhi
chwor
ker
s
al
l
ocat
ethemsel
vesbet
weenr
uralandur
banl
abormar
ket
s,i
tdoeshav
eimpor
tant
pol
i
cyi
mpl
i
cat
ionsf
ordev
elopmentst
rat
egywi
thr
egar
dtowagesandi
ncomes,r
ural
dev
elopment
,andi
ndust
ri
ali
zat
ion.

Fi
rst
,imbal
ancesi
nur
ban-
rur
alempl
oymentoppor
tuni
ti
escausedbyt
heur
banbi
as,
par
ti
cul
arl
yfi
rst
-ci
ty bi
as,ofdev
elopmentst
rat
egi
es mustbe r
educed.Because
mi
grant
sar
eassumedt
orespondt
odi
ff
erent
ial
sinexpect
edi
ncomes,i
tisv
ital
l
y
i
mpor
tantt
hati
mbal
ancesbet
weeneconomi
coppor
tuni
ti
esi
nrur
alandur
bansect
ors
bemi
nimi
zed.Per
mit
ti
ngur
banwager
atest
ori
seatagr
eat
erpacet
hanav
erager
ural
i
ncomeswi
l
lst
imul
atef
urt
herr
ural
-ur
banmi
grat
ioni
nspi
teofr
isi
ngl
evel
sofur
ban
unempl
oyment
.Thi
sheav
yinf
luxofpeopl
eint
our
banar
easnotonl
ygi
vesr
iset
o
soci
oeconomi
cpr
obl
emsi
ntheci
ti
esbutmayal
soev
ent
ual
l
ycr
eat
epr
obl
emsofl
abor
shor
tagesi
nrur
alar
eas,especi
all
ydur
ingt
hebusyseasons.Thesesoci
alcost
smay
exceedt
hepr
ivat
ebenef
it
sofmi
grat
ion.

Second,ur
banj
obcr
eat
ioni
sani
nsuf
fi
cientsol
uti
onf
ort
heur
banunempl
oyment
pr
obl
em. Forev
erynew j
obcr
eat
ed,t
woort
hreemi
grant
swhower
epr
oduct
ivel
y
occupi
edi
nrur
alar
easmaycomet
otheci
ty.Henceapol
i
cydesi
gnedt
oreduceur
ban
unempl
oymentmayl
eadnotonl
ytohi
gherl
evel
sofur
banunempl
oymentbutal
sot
o
l
owerl
evel
s ofagr
icul
tur
alout
putdue t
oinduced mi
grat
ion.Thi
rd,i
ndi
scr
imi
nat
e
educat
ionalexpansi
onwi
l
lleadt
ofur
thermi
grat
ionandunempl
oyment
.Four
th,wage
subsi
diesandt
radi
ti
onal
scar
cit
yfact
orpr
ici
ngcanbecount
erpr
oduct
ive.

Pol
i
ciesofr
uraldev
elopmentar
ecr
uci
alt
othi
sai
m.Manyi
nfor
medobser
ver
sagr
eeon
t
hecent
rali
mpor
tanceofr
uralandagr
icul
tur
aldev
elopmenti
ftheur
banunempl
oyment
pr
obl
em i
stobesol
ved.Mostpr
oposal
scal
lfort
her
est
orat
ionofapr
operbal
ance
bet
weenr
uralandur
bani
ncomesandf
orchangesi
ngov
ernmentpol
i
ciest
hatcur
rent
ly
gi
vedev
elopmentpr
ogr
amsast
rongbi
ast
owar
dtheur
bani
ndust
ri
alsect
or(
e.g.
,
pol
i
ciesi
nthepr
ovi
si
onofheal
th,educat
ion,andsoci
alser
vices)
.Concept
ual
l
y,i
tmay
beusef
ult
othi
nkofci
ti
esandt
hei
rsur
roundi
ngr
uralar
easasi
ntegr
atedsy
stems.
Ther
ear
esi
gni
fi
cantcompl
ement
ari
ti
esbet
weent
ownandcount
ry.Agr
icul
tur
aland

132
r
awmat
eri
alsgr
ownandext
ract
edi
nrur
alar
easar
einput
sforur
bani
ndust
ry.

Al
li
nal
l
,theTodar
omi
grat
ionmodel
hasf
ourbasi
cchar
act
eri
sti
cs:

Mi
grat
ion i
s st
imul
ated pr
imar
il
y by r
ati
onaleconomi
c consi
der
ati
ons ofr
elat
ive
benef
it
sandcost
s,most
lyf
inanci
albutal
sopsy
chol
ogi
cal
.

Thedeci
si
ont
omi
grat
edependsonexpect
edr
athert
hanact
ualur
ban-
rur
alr
eal
-wage
di
ff
erent
ial
swher
etheexpect
eddi
ff
erent
iali
sdet
ermi
nedbyt
hei
nter
act
ionoft
wo
v
ari
abl
es,t
heact
ualur
ban-
rur
alwagedi
ff
erent
ialandt
hepr
obabi
l
ityofsuccessf
ull
y
obt
aini
ngempl
oymenti
ntheur
bansect
or.

UNI
TFOUR

AGRI
CULTUREANDECONOMI
CDEVELOPMENT
Thi
suni
tisaboutagr
icul
tur
eandeconomi
cdev
elopment
.Agr
icul
tur
eanddev
elopment
ofanat
ioni
ngener
alandr
uraldev
elopmenti
npar
ti
cul
arar
ehi
ghl
yint
erconnect
ed.Wel
l
ov
er3.
3bi
l
li
onpeopl
eli
vedi
nrur
alar
easi
n2003.Peopl
eli
vi
ngi
nthecount
rysi
de
compr
iseconsi
der
abl
ymor
ethanhal
fthepopul
ati
onofdev
elopi
ngcount
ri
es.I
nAf
ri
ca,
t
her
ati
osar
emuchhi
gher
,wi
thmostcount
ri
eshav
ingr
uraldwel
l
ersi
nexcessoft
hree-
quar
ter
soft
het
otalpopul
ati
on.Ov
ert
wo-
thi
rdsoft
hewor
ld’
spoor
estpeopl
ear
eal
so
l
ocat
edi
nrur
alar
easandengagedpr
imar
il
yinsubsi
stenceagr
icul
tur
e.I
tisest
imat
ed
t
hatmor
ethan800mi
l
li
onoft
hesepeopl
edonothav
eenoughf
oodt
omeett
hei
rbasi
c
nut
ri
ti
onal
needs.Thei
rbehav
iormayhav
eof
tenseemedi
rr
ati
onal
tomanyobser
ver
s.I
f
dev
elopmenti
stot
akepl
aceandbecomesel
f-
sust
aini
ng,
itwi
l
lhav
etoi
ncl
udet
her
ural
ar
eai
ngener
alandt
heagr
icul
tur
alsect
ori
npar
ti
cul
ar.Si
xmai
nquest
ions,t
her
efor
e,
needt
o beaskedaboutagr
icul
tur
eandr
uraldev
elopmentasi
trel
atest
o ov
eral
l
nat
ional
dev
elopment
:

1.Howcant
otalagr
icul
tur
alout
putandpr
oduct
ivi
typercapi
tabei
ncr
easedi
n
amannert
hatwi
l
ldi
rect
lybenef
itt
heav
eragesmal
lfar
merandt
hel
andl
ess
r
uraldwel
l
erswhi
l
epr
ovi
dingasuf
fi
cientf
oodsur
plust
osuppor
tagr
owi
ng
ur
ban,
indust
ri
alsect
or?
2.Whati
sthepr
ocessbywhi
cht
radi
ti
onal
low-
product
ivi
typeasantf
armsar
e

133
 t
ransf
ormedi
ntohi
gh-
product
ivi
tycommer
cial
ent
erpr
ises?
3.Whent
radi
ti
onalf
ami
l
yfar
mer
sandpeasantcul
ti
vat
orsr
esi
stchange,i
s
t
hei
rbehav
iorst
ubbor
nandi
rr
ati
onal
,orar
etheyact
ingr
ati
onal
l
ywi
thi
n
t
hecont
extoft
hei
rpar
ti
cul
areconomi
cenv
ironment
?
4.Ar
eeconomi
candpr
icei
ncent
ivessuf
fi
cientt
o el
i
citout
puti
ncr
eases
amongpeasantagr
icul
tur
ali
sts,orar
einst
it
uti
onalandst
ruct
uralchanges
i
nrur
alf
armi
ngsy
stemsal
sor
equi
red?
5.I
srai
si
ngagr
icul
tur
alpr
oduct
ivi
tysuf
fi
cientt
oimpr
over
urall
i
fe,ormust
t
her
e be concomi
tant of
f-
far
m empl
oyment cr
eat
ion al
ong wi
th
i
mpr
ovement
sineducat
ional
,medi
cal
,andot
hersoci
alser
vices?I
not
her
wor
ds,whatdo we mean byr
uraldev
elopment
,and how can i
tbe
achi
eved?

TheSt
ruct
ureofAgr
ari
anSy
stemsi
ntheDev
elopi
ngWor
ld
Wor
ldagr
icul
tur
ecompr
isest
wodi
sti
nctt
ypesoff
armi
ng:(
1)t
hehi
ghl
yef
fi
cient
agr
icul
tur
eoft
hedev
elopedcount
ri
es,wher
esubst
ant
ialpr
oduct
ivecapaci
tyand
hi
ghout
putperwor
kerper
mitav
erysmal
lnumberoff
armer
stof
eedent
ir
enat
ions,
and(
2)t
hei
nef
fi
ci
entandl
ow-
product
ivi
tyagr
icul
tur
eofdev
elopi
ngcount
ri
es,
wher
e
i
nmanyi
nst
ancest
heagr
icul
tur
alsect
orcanbar
elysust
aint
hef
arm popul
ati
on,l
et
al
one t
he qui
ckl
yincr
easi
ng ur
ban popul
ati
on,ev
en,ata mi
nimum l
evelof
subsi
stence.Thegapbet
weent
het
wot
ypesofagr
icul
tur
eisi
mmense.

4.
1.1. TheSt
ruct
ureofAgr
ari
anSy
stemsi
nLat
inAmer
icaandAsi
a:

Si
mil
ari
ti
esanddi
ff
erences:

Bot
htheLat
inAmer
icanandAsi
anpeasanti
sar
uralcul
ti
vat
orwhosepr
imeconcer
n
i
ssur
viv
al.Ear
nssubsi
stencei
ncomebyt
il
li
ngi
nadequat
epi
eceofl
andr
ent
edf
rom
orpawnedt
oal
andl
ordormoney
lender
,orbysel
l
inghi
slabourf
orsubst
andar
d
wagest
oacommer
cial
agr
icul
tur
alent
erpr
ise.Empl
oyst
echni
quesr
ati
onal
l
yscal
ed
t
ohi
slev
elofdi
sposabl
ecapi
tal
:
o humanandani
mal
powerr
athert
hanmechani
zedequi
pment
;

o excr
ementr
athert
hanchemi
cal
fer
ti
li
zer
s;

134
 o t
radi
ti
onal
cropsandseedsr
athert
hanexper
iment
alcul
ti
vat
ion
4.
1.1.
3TheSt
ruct
ureofAgr
ari
anSy
stemsi
nAf
ri
ca

Asi
nAsi
aandLat
inAmer
ica,subsi
stencef
armi
ngonsmal
lpl
otsofl
andi
stheway
ofl
i
fef
ort
he v
astmaj
ori
tyofAf
ri
can peopl
e.Howev
er,t
he or
gani
zat
ion and
st
ruct
ure ofAf
ri
can agr
icul
tur
alsy
stems di
ff
ermar
kedl
yfr
om t
hose f
ound i
n
cont
empor
aryAsi
aorLat
inAmer
ica.Thegr
eatmaj
ori
tyoff
armf
ami
l
iesi
ntr
opi
cal
Af
ri
capl
ant
hei
rout
putpr
imar
il
yfort
hei
rownsubsi
stence.Si
ncet
hebasi
cvar
iabl
e
i
nputi
n Af
ri
can agr
icul
tur
eisf
arm f
ami
l
yand v
il
lagel
abor
,Af
ri
can agr
icul
tur
e
sy
stems ar
e domi
nat
ed byt
hree maj
orchar
act
eri
sti
cs:(
1)t
he i
mpor
tance of
subsi
stencef
armi
ngi
nthev
il
lagecommuni
ty;(
2)t
heexi
stenceofsome(
though
r
api
dlydi
mini
shi
ng)l
andi
nexcessofi
mmedi
ater
equi
rement
s,whi
chper
mit
sa
gener
alpr
act
iceofshi
ft
ingcul
ti
vat
ionandr
educest
hev
alueofl
andowner
shi
pasan
i
nst
rumentofeconomi
candpol
i
ticalpower
;and(
3)t
her
ight
sofeachf
ami
l
y(bot
h
nucl
earandext
ended)i
nav
il
laget
ohav
eaccesst
olandandwat
eri
nthei
mmedi
ate
t
err
it
ori
alv
ici
nit
y,excl
udi
ngf
rom suchaccessusebyf
ami
l
iest
hatdonotbel
ongt
o
t
hecommuni
tyev
ent
hought
heymaybeoft
hesamet
ri
be.

Thel
ow-
product
ivi
tysubsi
stencef
armi
ngchar
act
eri
sti
cofmostt
radi
ti
onalAf
ri
can
agr
icul
tur
eresul
tsf
rom acombi
nat
ionoft
hreehi
stor
icalf
orcesr
est
ri
cti
ng t
he
gr
owt
hofout
put
:

1. I
nspiteoftheexi
stenceofsomeunusedandpot
ent
iall
ycul
ti
vabl
eland,only
smallar
eascanbeplantedandweededbyt
hef
armf
amilyatat
imewheni tuses
onlyt
radi
ti
onalt
ool
s.

2.Gi
venthelimitedamountoflandthataf
armfamil
ycancul
ti
vat
einthecontextof
atr
adit
ionaltechnologyandtheuseofpri
mit
ivet
ool
s,t
hesesmallar
eastendt o
bei
ntensiv
elyculti
vated.

3.Labori
sscar
cedur
ingt
hebusi
estpar
toft
hegr
owi
ngseason,
plant
ingand
weedi
ngt
imes.Atot
hert
imes,
muchoft
hel
abori
sunder
empl
oyed.

Thenetr
esul
toft
heset
hreef
orceshadbeenar
elat
ivel
yconst
antl
evel
ofagr
icul
tur
al
t
otal
out
putandl
aborpr
oduct
ivi
tyt
hroughoutmuchofAf
ri
ca.
Ofal
lthemaj
orr
egi
onsof
t
hewor
ld,
Afr
icahassuf
fer
edt
hemostf
rom i
tsi
nabi
l
ityt
oexpandf
oodpr
oduct
ionata

135
suf
fi
cientpacet
okeepupwi
thi
tsr
api
dpopul
ati
ongr
owt
h.

TheEconomi
csofAgr
icul
tur
alDev
elopment
Forexposi
tor
yconv
eni
ence,wecani
dent
if
ythr
eebr
oadst
agesi
ntheev
olut
ionof
agr
icul
tur
alpr
oduct
ion.Thef
ir
standmostpr
imi
ti
vei
sthepur
e,l
ow-
product
ivi
ty,
most
lysubsi
stence-
lev
elpeasantf
arm.Thesecondst
agei
swhatmi
ghtbecal
l
ed
di
ver
sif
iedormi
xedf
ami
l
yagr
icul
tur
e,wher
epar
toft
hepr
oducei
sgr
ownf
or
consumpt
ionandpar
tforsal
etot
hecommer
cialsect
or.Thet
hir
dst
ager
epr
esent
s
t
hemoder
nfar
m,excl
usi
vel
yengagedi
nhi
gh-
product
ivi
tyspeci
ali
zedagr
icul
tur
e
gear
edt
othecommer
cial
mar
ket
.

4.
1.2.Subsi
stenceFar
ming:Ri
skAv
ersi
on,
Uncer
tai
nty
,andSur
viv
al

On t
he cl
assi
c peasantsubsi
stence f
arm,mostout
puti
s pr
oduced f
orf
ami
l
y
consumpt
ion,andaf
ewst
apl
efoods(
usual
l
yincl
udi
ngwheat
,bar
ley
,sor
ghum,r
ice,or
cor
n)ar
ethechi
efsour
cesofnut
ri
ti
on. Out
putandpr
oduct
ivi
tyar
elow,andonl
ythe
si
mpl
estt
radi
ti
onalmet
hodsandt
ool
sar
eused.Capi
tali
nvest
menti
smi
nimal
;land
andl
aborar
ethepr
inci
palf
act
orsofpr
oduct
ion.Thel
aw ofdi
mini
shi
ngr
etur
nsi
sin
oper
ati
onasmor
elabori
sappl
i
edt
oshr
inki
ng(
orshi
ft
ing)par
cel
sofl
and.

Thef
ail
ureoft
her
ains,t
heappr
opr
iat
ionofhi
sland,andt
heappear
anceoft
he
money
lendert
ocol
l
ectout
standi
ngdebt
sar
ethebanesoft
hepeasant
'sexi
stenceand
causehi
mtof
earf
orhi
ssur
viv
al. Labori
sunder
empl
oyedf
ormostoft
hey
ear
,
al
thoughwor
ker
smaybef
ull
yoccupi
edatseasonalpeakper
iodssuchaspl
ant
ingand
har
vest
.Thepeasantusual
l
ycul
ti
vat
esonl
yasmuchl
andashi
sfami
l
ycanmanage
wi
thoutt
heneedf
orhi
redl
abor
,al
thoughmanypeasantf
armer
sint
ermi
tt
ent
lyempl
oy
oneort
wol
andl
essl
abor
ers.

Theenv
ironmenti
shar
shandst
ati
c:Technol
ogi
call
i
mit
ati
ons,
rigi
dsoci
ali
nst
it
uti
ons,
andf
ragment
edmar
ket
sandcommuni
cat
ionnet
wor
ksbet
weenr
uralar
easandur
ban
cent
erst
end t
o di
scour
age hi
gherl
evel
s ofpr
oduct
ion.Anycash i
ncome t
hati
s
gener
atedcomesmost
lyf
rom non-
far
m wagel
abor
.

TheTr
ansi
ti
ont
oMi
xedandDi
ver
sif
iedFar
ming
I
tisnei
therr
eal
i
sti
cnordesi
rabl
etot
hinkofi
nst
ant
lyt
ransf
ormi
ngat
radi
ti
onal

136
agr
ari
ansy
stem t
hathaspr
evai
l
edf
ormanygener
ati
onsi
ntoahi
ghl
yspeci
ali
zed
commer
cialf
armi
ngsy
stem.Di
ver
sif
iedormi
xedf
armi
ngt
her
efor
erepr
esent
sa
l
ogi
cali
nter
medi
ate st
ep,i
nthe t
ransi
ti
on f
rom subsi
stence t
o speci
ali
zed
pr
oduct
ion.

I
nthi
sst
age,t
hest
apl
ecr
opnol
ongerdomi
nat
esf
arm out
put
,andnewcashcr
ops
suchasf
rui
ts,v
eget
abl
es,cof
fee,t
ea,andpy
ret
hrum ar
eest
abl
i
shed,t
oget
herwi
th
si
mpl
eani
malhusbandr
y.Thesenewact
ivi
ti
escant
akeupt
henor
malsl
acki
nfar
m
wor
kloads,
dur
ingt
imesoft
hey
earwhendi
sgui
sedunempl
oymenti
spr
eval
ent
.Thi
s
i
sespeci
all
ydesi
rabl
einmanydev
elopi
ngnat
ionswher
erur
all
abori
sabundant
ly
av
ail
abl
eforbet
terandmor
eef
fi
cientuse.

Thesuccessorf
ail
ureofef
for
tst
otr
ansf
ormt
radi
ti
onalagr
icul
tur
ewi
l
ldependnot
onl
yont
hef
armer
'sabi
l
ityand ski
l
linr
aisi
ng hi
spr
oduct
ivi
tybut
,ev
enmor
e
i
mpor
tant
,ont
hesoci
al,commer
cial
,andi
nst
it
uti
onalcondi
ti
onsunderwhi
chhe
mustf
unct
ion.I
fhecanhav
ereasonabl
eandr
eli
abl
eaccesst
ocr
edi
t,f
ert
il
iz
er,
wat
er,
cropi
nfor
mat
ion,
andmar
ket
ingf
aci
l
iti
es;
ifher
ecei
vesaf
airmar
ketpr
icef
or
hi
sout
put
;andi
fhecanf
eelsecur
ethatheandhi
sfami
l
ywi
l
lbet
hepr
imar
y
benef
ici
ari
esofanyi
mpr
ovement
s,t
her
eisnor
easont
oassumet
hatt
het
radi
ti
onal
f
armerwi
l
lnotr
espondt
onewoppor
tuni
ti
est
oimpr
ovehi
sst
andar
dofl
i
ving.

Ev
idencef
rom suchdi
ver
secount
ri
esasCol
ombi
a,Mexi
co,Ni
ger
ia,Ghana,Keny
a,
I
ndi
a,Paki
stan,Thai
l
and,andt
hePhi
l
ippi
nesshowst
hatunderpr
opercondi
ti
ons,
smal
lfar
mer
sar
eresponsi
vet
opr
icei
ncent
ivesandeconomi
coppor
tuni
ti
esand
wi
l
lmaker
adi
calchangesi
nwhatt
heypr
oduceandhow t
heypr
oducei
t.Lackof
i
nnov
ati
oni
nagr
icul
tur
e,aswehav
eseen,i
susual
l
yduenott
opoormot
ivat
ionor
f
earofchangebutt
oinadequat
eorunpr
ofi
tabl
eoppor
tuni
ti
es.

Thr
oughoutmuchoft
hedev
elopi
ngwor
ld,agr
icul
tur
eisst
il
lint
hissubsi
stence
st
age.Buti
nspi
teoft
her
elat
ivebackwar
dnessofpr
oduct
iont
echnol
ogi
esandt
he
mi
sgui
dedconv
ict
ionsofsomef
orei
gner
swhoat
tr
ibut
ethepeasant
s'r
esi
stancet
o
changeasasi
gnofi
ncompet
enceori
rr
ati
onal
i
ty,t
hef
actr
emai
nst
hatgi
vent
he
st
ati
cnat
ureoft
he

137
Fr
om Di
ver
gencet
oSpeci
ali
zat
ion:Moder
nCommer
cialFar
ming
Thespeci
ali
zedf
armr
epr
esent
sthef
inal
andmostadv
ancedst
ageofi
ndi
vi
dual
hol
ding
i
nami
xedmar
keteconomy
.Iti
sthemostpr
eval
entt
ypeoff
armi
ngi
nadv
anced
i
ndust
ri
alnat
ions.I
thasev
olv
edi
nresponset
oandpar
all
elwi
thdev
elopmenti
not
her
ar
easoft
henat
ional
economy
.Gener
alr
isesi
nli
vi
ngst
andar
ds,
biol
ogi
cal
andt
echni
cal
pr
ogr
ess,andt
heexpansi
onofnat
ionalandi
nter
nat
ionalmar
ket
shav
epr
ovi
dedt
he
mai
nimpet
usf
ori
tsemer
genceandgr
owt
h.

I
nspeci
ali
zedf
armi
ng,pur
ecommer
cialpr
ofi
tbecomest
hecr
it
eri
onofsuccess,and
maxi
mum per
-hect
arey
iel
dsder
ived f
rom sy
nthet
ic(
ir
ri
gat
ion,f
ert
il
izer
,pest
ici
des,
hy
bri
dseeds,
etc.
)andnat
ural
resour
cesbecomet
heobj
ectoff
arm act
ivi
ty.Pr
oduct
ion,
i
nshor
t,i
sent
ir
elyf
ort
hemar
ket
.Speci
ali
zedf
armsv
aryi
nbot
hsi
zeandf
unct
ion.
Theyr
angef
rom i
ntensi
vel
ycul
ti
vat
edf
rui
tandv
eget
abl
efar
mst
othev
astwheatand
cor
nfi
eldsofNor
thAmer
ica.I
nmostcases,sophi
sti
cat
edl
abor
sav
ingmechani
cal
equi
pment
,rangi
ngf
rom huget
ract
orsandcombi
nehar
vest
erst
oai
rbor
nespr
ayi
ng
t
echni
ques,
per
mit
sasi
ngl
efami
l
ytocul
ti
vat
emanyt
housandsofhect
aresofl
and.

Thecommonf
eat
uresofal
lspeci
ali
zedf
arms,t
her
efor
e,ar
ethei
remphasi
sont
he
cul
ti
vat
ionofonepar
ti
cul
arcr
op,t
hei
ruseofcapi
tal
-i
ntensi
veandi
nmanycases
l
abor
sav
ingt
echni
quesofpr
oduct
ion,andt
hei
rrel
i
anceoneconomi
esofscal
eto
r
educeuni
tcost
sandmaxi
mizepr
ofi
ts.

TowardaStrat
egyofAgr
icul
tur
alandRur
alDevel
opment
:SomeMai
n
Requi
rement
s
I
fthemaj
orobj
ect
iveofagr
icul
tur
alandr
uraldev
elopmenti
ndev
elopi
ngnat
ionsi
s
t
hepr
ogr
essi
vei
mpr
ovementi
nrur
all
evel
sofl
i
vingachi
evedpr
imar
il
ythr
ough
i
ncr
easesi
nsmal
l
-far
mincomes,out
put
,andpr
oduct
ivi
ty,i
tisi
mpor
tantt
oident
if
y
t
hepr
inci
palsour
cesofagr
icul
tur
alpr
ogr
essandt
hebasi
ccondi
ti
onsessent
ialt
o
i
tsachi
evement
.Thesear
enecessar
il
yint
err
elat
ed,butf
orpur
posesofdescr
ipt
ion
wemaysepar
atet
hemandf
urt
herdi
vi
deeachi
ntot
hreecomponent
s:

4.
1.3.Sour
cesofsmal
l-
scal
eagr
icul
tur
alpr
ogr
essi
ncl
ude:

Technol
ogi
calchangeandi
nnov
ati
onappr
opr
iat
egov
ernmenteconomi
cpol
i
cies

138
Suppor
ti
ve soci
al i
nst
it
uti
ons Condi
ti
ons f
or Gener
al Rur
al Adv
ancement
:

Moder
nizi
ngf
arm st
ruct
urest
omeetr
isi
ngf
ooddemandscr
eat
inganef
fect
ive
suppor
ti
ngsy
stem changi
ngt
her
uralenv
ironmentt
oimpr
ovel
evel
sofl
i
ving.Letus
l
ookateachoft
hesesi
xint
err
elat
edcomponent
s.

4.
2. Technol
ogyandI
nnov
ati
on
Two maj
or sour
ces of t
echnol
ogi
cali
nnov
ati
on can i
ncr
ease f
arm y
iel
ds.
Unf
ort
unat
ely
,bot
hhav
esomewhatpr
obl
emat
ici
mpl
i
cat
ionsf
orLDCagr
icul
tur
al
dev
elopment
.Thef
ir
sti
sthei
ntr
oduct
ionofmechani
zedagr
icul
tur
etor
epl
acel
abor
.
Thei
ntr
oduct
ionofl
aborsav
ingmachi
ner
ycanhav
eadr
amat
icef
fectont
he
v
olumeofout
putperwor
ker
;especi
all
ywher
elandi
sext
ensi
vel
ycul
ti
vat
edand
l
abori
sscar
ce.Forexampl
e,onemanoper
ati
ngahugecombi
nehar
vest
ercan
accompl
i
sh i
n a si
ngl
e hourwhatwoul
drequi
re hundr
eds ofwor
ker
s usi
ng
t
radi
ti
onal
met
hods.

Buti
nther
uralar
easofmostdev
elopi
ngnat
ions,wher
elandpar
cel
sar
esmal
l
,
capi
tali
sscar
ce,andl
abori
sabundant
,thei
ntr
oduct
ionofheav
il
ymechani
zed
t
echni
ques i
s notonl
y of
ten i
l
l-sui
ted t
othe phy
sicalenv
ironmentbut
,mor
e
i
mpor
tant
,of
tenal
sohast
heef
fectofcr
eat
ingmor
erur
alunempl
oymentwi
thout
necessar
il
ylower
ingper
-uni
tcost
soff
oodpr
oduct
ion.Thesecondmaj
orsour
ces
ar
e bi
ologi
cal(
hybr
id seeds)
,wat
ercont
rol(
ir
ri
gat
ion)
,and chemi
cal(
fer
ti
li
zer
,
pest
ici
des,
insect
ici
des,
etc.
)innov
ati
ons.Theyar
eland-
augment
ing;

CHAPTERFI
VE

I
nter
nat
ionalt
radeandeconomicdevel
opment :t
het
radepol
icydebat
e
andi
ndustr
ial
izat
ion
Ov
ert
he pastsev
eraldecades,t
he economi
es oft
he wor
ld hav
e become
i
ncr
easi
ngl
yli
nked,t
hroughexpandedi
nter
nat
ionalt
radei
nser
vicesaswel
las
pr
imar
y and manuf
act
ured goods, t
hrough por
tfol
i
o i
nvest
ment
s such as
i
nter
nat
ionall
oansandpur
chasesofst
ock,andt
hroughdi
rectf
orei
gni
nvest
ment
,
especi
all
yont
hepar
tofl
argemul
ti
nat
ionalcor
por
ati
ons.Att
hesamet
ime,f
orei
gn

139
ai
dhasi
ncr
easedv
eryl
i
ttl
eandi
ndeedhasbecomedwar
fedbyt
henowmuchl
arger
f
lowsofpr
ivat
ecapi
tal
.Thesel
i
nkageshav
ehadamar
kedef
fectont
hedev
elopi
ng
wor
ld.

Tr
adeTheor
yandDevel
opmentExper
ience
Basi
cQuest
ionsaboutTr
adeandDev
elopment

Ourobj
ect
ivei
nthi
ssect
ioni
stof
ocusont
radi
ti
onalandmor
econt
empor
ary
t
heor
iesofi
nter
nat
ionalt
radei
nthecont
extoff
ivebasi
cthemesorquest
ionsof
par
ti
cul
ari
mpor
tancet
odev
elopi
ngnat
ions.(
1)Howdoesi
nter
nat
ionalt
radeaf
fect
t
her
ate,st
ruct
ure,andchar
act
erofLDC’
seconomi
cgr
owt
h?(
2)How doest
rade
al
tert
hedi
str
ibut
ionofi
ncomeandweal
thwi
thi
nacount
ryandamongdi
ff
erent
count
ri
es?(
3)Howar
ethegai
nsandl
ossesdi
str
ibut
ed,
andwhobenef
it
s?(
4)Under
whatcondi
ti
onscant
radehel
pLDCsachi
evet
hei
rdev
elopmentobj
ect
ives?Can
LDCsbyt
hei
rownact
ionsdet
ermi
nehowmucht
heyt
rade?

(
5)I
nthel
i
ghtofpastexper
ienceandpr
ospect
ivej
udgment
,shoul
dLDCsadoptan
out
war
d-l
ooki
ngpol
i
cy(
freert
rade,
expandedf
lowsofcapi
talandhumanr
esour
ces,
i
deasandt
echnol
ogy
,et
c.)orani
nwar
d-l
ooki
ngone(
prot
ect
ioni
sm i
nthei
nter
estof
sel
f-
rel
i
ance)
,orshoul
dtheypur
suesomecombi
nat
ionofbot
h,f
orexampl
e,i
nthe
f
orm ofr
egi
onaleconomi
ccooper
ati
on?Whatar
ethear
gument
sforandagai
nst
t
heseal
ter
nat
ivet
radest
rat
egi
esf
ordev
elopment
?Thus,cl
ear
lyt
heanswer
sor
suggest
edanswer
stot
hesef
ivequest
ionswi
l
lnotbeuni
for
m t
hroughoutt
he
di
ver
seeconomi
esoft
hedev
elopi
ngwor
ld.

I
mpor
tanceofExpor
tst
oDi
ff
erentDevel
opi
ngNat
ions
Dev
elopi
ng count
ri
es ar
e gener
all
y mor
e dependenton t
rade t
han dev
eloped
count
ri
esar
e.Thi
sisshowncl
ear
lyi
nthecaseoft
radi
ti
onal
l
yexpor
t-
ori
ent
edJapan,
whoseex
por
tsamountt
oroughl
y10%ofGDP,
wher
easLDCswi
thsomewhatl
arger
popul
ati
onssuchasI
ndonesi
a,Bangl
adesh,
andNi
ger
iaexpor
taf
arhi
ghershar
eof
out
put
.

Whi
l
etot
alexpor
tsandt
heshar
eofmanuf
act
uresi
nmer
chandi
seexpor
tshav
e

140
been r
isi
ng f
ormanydev
elopi
ng count
ri
es,i
tisi
mpor
tantt
o keep t
hisr
isei
n
per
spect
ive.A f
ew Newl
yIndust
ri
ali
zed Count
ri
es st
il
lcommand a domi
nant
posi
ti
oni
ndev
elopi
ng-
count
ryex
por
ts.Forexampl
e,i
n2000,Sout
hKor
eaal
one
expor
tedmor
ethanal
lofSout
hAsi
aandsub-
Sahar
anAf
ri
cacombi
ned.AndSout
h
Kor
eaandTai
want
oget
herexpor
tedmor
emanuf
act
uredgoodsi
n2000t
hant
he
ent
ir
eregi
onsofLat
inAmer
ica,t
heCar
ibbean,t
heMi
ddl
eEast
,Nor
thAf
ri
ca,Sout
h
Asi
a,andsub-
Sahar
anAf
ri
cacombi
ned.

2.
1.3.TheTr
adi
ti
onal
Theor
yofI
nter
nat
ionalTr
ade

Whatdet
ermi
neswhi
chgoodsar
etr
adedandwhysomecount
ri
espr
oducesome
t
hingswhi
l
eot
her
spr
oducedi
ff
erentt
hings?Theanswerl
i
esi
nthei
nter
nat
ional
di
ff
erencesi
n cost
sofpr
oduct
ion and pr
icesofdi
ff
erentpr
oduct
s.Thus,t
he
conceptofabsol
uteand/
orr
elat
ivecostandpr
icedi
ff
erencesi
sbasi
ctot
het
heor
y
ofi
nter
nat
ionalt
rade.Themai
nideaofAbsol
ute&Compar
ati
veadv
ant
agel
i
eson
t
henot
ionofspeci
ali
zat
ionandt
rade.I
fthecount
rypr
oduceagoodf
orwhi
chi
thas
anabsol
uteand/
orcompar
ati
veadv
ant
ageov
eranot
hercount
ryandt
radesi
twi
th
t
heot
hercount
ry,
thet
otal
pot
ent
ial
consumpt
ioni
nbot
hcount
ri
escanbei
ncr
eased
bey
ondwhati
spossi
blewi
thoutt
rade.

TheSmi
th’
stheor
yst
atedt
hatweal
thofnat
ionsdependont
hegoodsandser
vices
av
ail
abl
etot
hei
rci
ti
zens,
rat
hert
hant
hei
rgol
dreser
ves.

Tr
adest
imul
ateseconomi
cgr
owt
h:I
tenl
argesacount
ry’
sconsumpt
ioncapaci
ti
es,
i
ncr
easeswor
ldout
put
,andpr
ovi
desaccesst
oscar
cer
esour
ces.Tr
adepr
omot
es
i
nter
nat
ionalanddomest
icequal
i
tybyequal
i
zingf
act
orpr
ices,r
aisi
ngr
eali
ncomes
oft
radi
ngcount
ri
es,&maki
ngef
fi
cientuseofeachnat
ion’
sresour
ceendowment
s.
E.
g.Byr
aisi
ngr
elat
ivewagesi
nlabor
-abundantcount
ri
esandl
ower
ingt
hem i
nlabor
-
scar
cecount
ri
es.

2.
1.4.Bal
anceofPay
ment
s&Macr
oeconomi
cst
abi
li
zat
ion

Thebal
anceofpay
ment
s(BoP)i
sasummar
yst
atementi
nwhi
ch,
inpr
inci
ple,
all
the
economi
ctr
ansact
ionsoft
her
esi
dent
sofanat
ionwi
tht
her
esi
dent
sofal
lot
her

141
nat
ionsar
erecor
deddur
ingapar
ti
cul
arper
iodoft
ime,
usual
l
yacal
endary
ear
.Thus,
BoPi
sthef
low ofgoods,ser
vices,gi
ft
s,andasset
sbet
weent
her
esi
dent
sofa
nat
ionandt
her
esi
dent
sofot
hernat
ionsdur
ingapar
ti
cul
arper
iodoft
ime,
usual
l
ya
cal
endary
ear
.Thet
echni
quesofr
ecor
dingt
ransact
ionsunderDebi
tandCr
edi
tin
t
hebal
anceofpay
ment
.

Anyt
ransact
iont
hatsuppl
i
est
hecount
ry’
scur
rencyi
nthef
orei
gnexchangemar
ket
(
themar
keti
nwhi
chcur
renci
esofdi
ff
erentcount
ri
esar
eexchanged)i
srecor
dedas
adebi
t.Forexampl
e,aU.
S.r
etai
l
erwant
stobuyJapaneset
elev
isi
onset
ssot
hathe
cansel
lthem i
nhi
sst
oresi
ntheUni
tedSt
ates.Heneedt
osuppl
ydol
l
art
oFX.Any
t
ransact
iont
hatcr
eat
esademandf
ort
hecount
ry’
scur
rencyi
nthef
orei
gnexchange
mar
keti
srecor
dedasacr
edi
t.

I
nter
nat
ionalt
ransact
ionsar
ecl
assi
fi
edascr
edi
tsordebi
ts.Cr
edi
ttr
ansact
ionsar
e
t
hoset
hati
nvol
vet
her
ecei
ptofpay
ment
sfr
om f
orei
gner
s.Debi
ttr
ansact
ionsar
e
t
hoset
hati
nvol
vet
hemaki
ngofpay
ment
stof
orei
gner
s.

TheBoPhast
hreemaj
oraccount
sunderwhi
chdi
ff
erentt
ransact
ionsar
erecor
ded:
1)Cur
rentAccount(
CA)
:hasmanycomponent
s,suchast
radei
ngoods,t
radei
n
ser
vices,debtser
vicepay
ment
s,i
ncome&netuni
l
ater
alt
ransf
ers.Thebal
anceof
cur
rentaccountt
ell
susi
facount
ryhasadef
ici
torasur
plus.I
fther
eisdef
ici
tor
sur
plus,
doest
hatmeant
heeconomyi
sweakorst
rong?Notnecessar
il
y.

At
radedef
ici
toccur
swhenacount
ryi
mpor
tsmor
ethanexpor
ts.Thi
scoul
dbe
i
ndi
cat
ionofl
essr
evenuebei
nggener
atedandhencer
esul
ti
ngi
nlow st
andar
dof
l
i
vingi
nagi
veneconomy
.Itcoul
dal
sobeasi
gnofeconomi
cexpansi
on.At
rade
sur
plusoccur
swhenacount
rysel
l
smor
ethani
tbuy
sfr
om f
orei
gnmar
ket
s.

2)Capi
talAccount
:incl
udesal
lpay
ment
srel
atedt
othepur
chaseandsal
eofasset
s
and t
o bor
rowi
ng and l
endi
ng act
ivi
ti
es.I
tsmaj
orcomponent
sar
e out
fl
ow of
domest
iccapi
talandi
nfl
ow off
orei
gncapi
tal
.Capi
talaccountcl
assi
fi
edi
ntot
wo
capi
talout
fl
ow (
domest
icpur
chasesoff
orei
gnasset
s)andcapi
tali
nfl
ow (
for
eign
pur
chaseofdomest
iccur
rency
).

142
 END

143
144