1

Chapter 2Aggregate Accounts,

Production, and Market Structure

© Pierre-Richard Agénor and Peter J. Montiel

2

A General Accounting Framework. Production Structure in an Open Economy. The Structure of Labor Markets. Informal Financial Markets.

A General Accounting Framework

4

The Nonfinancial Private Sector. The Public Sector.

The Nonfinancial Banking Sector. The Central Bank. The Consolidated Public Sector.

The Commercial Banking System. Aggregate Relationships.

5

The Nonfinancial Private Sector

This sector holds both financial and real assets.

Financial assets: currency issued by the central bank CU, deposits issued by the commercial banks Dp, net foreign assets EFp (E is exchange rate and Fp is the

foreign-currency value of these assets), loans extended by households in informal markets, Lh.

Liabilities: credit from banks, Lp, loans received through informal markets.

6

Real assets: Inflation hedges with price pH and quantity H. Nonfinancial private sector's marketable net worth:

p = CU + Dp +EFp +pHH - Lp . (1)

Lh does not affect net worth, because these loans are transacted entirely within the nonfinancial private sector.

Change in p consists of the purchase of financial assets (Sp) plus capital gains:

p = Sp +EFp +pHH . where

Sp = CU + Dp +EFp - Lp .

. ..(3)

(4). . . .

7

Sp is the difference between disposable income and expenditure on consumption and investment:

Sp = Y + idDp + i*EFp - icLp - p - Cp - Ip , (5)

Y: factor income,

idDp + i*EFp - icLp : net interest income (income from deposits and foreign assets minus interest payments on bank credit),

p : net taxes,

Cp: private consumption,

Ip : private investment.

8

The Public Sector

Nonfinancial public sector is a substantial net financial debtor.

Its debt is owed to central bank (Lbg); commercial banks (Lcg); foreigners (-EFg).

Nonfinancial public sector's net worth:

g = EFg - Lbg - Lcg .

The Nonfinancial Public Sector

(6)

9

The change in g is negative of new borrowing by the nonfinancial public sector plus capital gains on net foreign assets:

g = Sg + EFg.where

Sg = EFg - Lbg - Lcg .

Total new borrowing must be equal to the overall fiscal deficit:

-Sg = Cg + Ig + ib Lbg + ic Lcg -i*EFg - p - g ,

g: transfers from central bank to nonfinancial public sector;

ib: interest rate paid on loans received from central bank.

..

. . .

10

Central bank's balance sheet:

b = ER* + (Lbg+Lbc) - M,

R* : net foreign assets of the central bank,

Lbc: credit from the central bank to commercial banks,

M: high-powered money. M is the sum of currency held by the nonfinancial

private sector and reserves of the commercial banking system held in the vaults of the central bank, RR:

M = CU + RR.

The Central Bank

(11)

11

The change in b:

b = Sb + ER*.where

Sb = ER* + (Lbg+Lbc) - M.

Sb is “quasi-fiscal” surplus: difference between the central bank’s earnings and its expenditures.

Earnings: interest earnings on net foreign exchange reserves, credit to commercial banks, net credit to the nonfinancial public sector.

Expenditures: transfers to the government, g.

..

. . . .(15)

12

So Sb:

Sb = i* ER* + ib(Lbg+Lbc) - g .

(15) can be rewritten as:

M = Lbg + ER* - Sb + Lbc .

Sources base money growth: central bank financing of the nonfinancial public sector, balance-of-payments surpluses, quasi-fiscal deficits, credit extended by the central bank to the private

banking system.

. . . .

13

It consists of the nonfinancial public sector and the central bank.

Financial net worth of consolidated public sector:

ps = g + b = E(Fg+R*) + (Lbc-Lcg ) - M.

It changes:

ps = Sps + E (Fg+R*),

where

Sps = Sg + Sb = E(Fg+R*) + (Lbc-Lcg) - M.

The Consolidated Public Sector

. . . . .

..

14

Overall financial surplus of the consolidated public sector:

Sps = Sg + Sb

= (p-Cg-Ig) + ib Lbc + i*E(Fg+R*) - ic Lcg .

Primary surplus: non-interest portion of the overall public sector surplus.

Operational surplus: primary surplus plus real interest payments.

15

The Commercial Banking System

Commercial banks' financial net worth is the difference between bank assets and liabilities:

c = Lp + Lcg + RR - Dp - Lbc .

Changes:

c = Sc = Lp + Lcg + RR - Dp - Lbc

where

Sc = ic(Lp+Lcg) - idDp - ibLbc .

. .... .

16

Aggregate Relationships Aggregate net worth is net international indebtedness

plus stock of inflation hedges:

= p + ps + c = E(Fp+Fg+R*) + pHH

= EF + pHH. Change:

= Sp + Sps + Sc + EF + pHH = S + EF + pHH

where

S = EF.

_

_

__ .....

.

17

National financial saving represents the net accumulation of claims on the rest of the world.

Alternative expression of S:

S = Y + i* EF - (Cp+Cg) - (Ip+Ig).

Gross national product:

GNP = Y + i*EF .

Domestic absorption:

DA = (Cp+Cg) + (Ip+Ig).

Negative national financial saving is referred as foreign saving (current account deficit).

18

National income accounting identity:

GNP = Cp + Ig + G + CA

where

CA = S and G = Cg + Ig. Flow-of-funds version of (32):

CA = ST - (Ip+Ig)where

ST = GNP - Cp - Cg.

This equation links total saving (ST -CA) to total investment (Ip+Ig ).

(32)

19

Balance-of-payments identity expressed in domestic-currency terms:

ER = (GNP-Cp-Ip-G) - E(Fp+Fg).

Left-hand side: reserve accumulation by the central bank (the overall balance of payments).

First term on the right-hand side: current account. Second term: capital account.

. ..

Production Structure in an Open Economy

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The Mundell-Fleming Model. The “Dependent Economy” Model. A Model with Three Goods.

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The Mundell-Fleming ModelAssumptions: Economy specializes in the production of a single

good. It is an imperfect substitute for the single good produced

by the rest of the world. Law of one price holds for each individual good. So the domestic-currency price of the foreign good is

equal to the foreign-currency price (P*) multiplied by the domestic-currency price of the foreign currency, E.

Foreign-currency price of the domestically produced good is its domestic-currency price, P, divided by the domestic-currency price of the foreign currency.

23

Domestic residents demand both the domestic and foreign goods, as do foreign residents.

Foreign good is the home economy's importable good, and the domestic good is its exportable good.

Relative price of the foreign good in terms of the domestic good is referred to as the domestic economy's terms of trade.

Key property of the model: domestic economy's terms of trade are endogenous.

Reason: home country is small in the market for its importable good but large in the market for its exportable good.

Result: changes in domestic demand for the exportable good will affect its relative price or level of production.

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Focus on the production side of the economy (goods and labor markets).

Consider the case of fixed exchange rates. Equilibrium condition of the market for domestic goods:

y = a + b(z, a),

y : output of the domestic good,

a: level of domestic absorption,

b: trade balance.

(36)

25

Because domestic and foreign goods are imperfect substitutes, trade balance is

b = b(z,a), -1< ba < 0,

z = EP*/P : terms of trade. Production function ( diminishing returns to labor):

y = y(n), y’ > 0, y’’< 0

n: employment.

+ -(35)

26

Labor demand:

y’(n) = z nd = nd(z)

z : real wage in terms of exportables. Labor market equilibrium:

nd(z) = n,

n : exogenous supply of labor. Rewrite equilibrium under classical condition:

y(n) = a + b(z,a).

This determines z implicitly as a function of a.

dz/da = -(1+ba) / bz < 0.

-

-

-

27

Reason for negative sign: increase in domestic absorption increases the domestic price level, so terms of trade improve.

In Keynesian mode, labor market-clearing condition does not hold:

y[nd(z)] = a + b(z,a),

dz/da = (1+ba) / (y’nd’-bz) < 0.

Change in domestic absorption has a smaller effect on the terms of trade in the Keynesian case.

Reason: change in z is more effective in eliminating excess demand in the market for domestic goods.

(41)

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Figure 2.1: Simultaneous determination of internal and external

balance.

Classical mode: CC: set of combinations of z and a compatible with

equilibrium in the market for home goods that prevails when the model operates in classical mode.

Slope of CC: dependence of the terms of trade on domestic spending.

BB: set of combinations of z and a compatible with a given trade balance outcome (b0).

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Figure 2.1Internal and External Balance in the Mundell-Fleming Model

E

B

C

z

a

K'

C

FK

B

K

K'

a

A

BD

z0

a0 1a

2 a~

z~

30

Its slope is positive (-ba/bz). Points above BB : improvement in the trade balance

relative to b0.

Points below: deterioration relative to b0. (36) implies that the economy must always lie along

CC. Given a level of absorption a0, CC determines the value

of z required to clear the market for domestic goods (z0).

Trade balance at point B is b0. In the classical case, B represents a point of internal,

but not external, balance. Simultaneous achievement of external and internal

balance, at point E, requires a reduction in a from a0 to a.

~

31

Keynesian mode: Commodity-market equilibrium schedule is derived from

(41). Its position depends on the initial value of the real wage

measured in terms of importables, . Change in causes the commodity-market equilibrium

locus to shift vertically. Downward shift for an increase in and upward for a

reduction. KK: Keynesian commodity-market equilibrium locus that

passes through the initial point B. Since z is more responsive to a in the classical than in

the Keynesian mode, KK is flatter than CC.

32

In the Keynesian case internal balance may not hold at B since labor market equilibrium condition may not hold.

Increasing absorption to a1 would move the economy to F, achieving internal balance.

But this implies further departure from external balance. External balance could be restored at point A, but this

would move the economy away from internal balance. Simultaneous adjustment of a and is required in

Keynesian case. Achieved by an adjustment in nominal exchange rate. Reduction of a from a0 to a, and nominal exchange-rate

depreciation are sufficient to shift KK to K’K’. This would simultaneously achieve external and internal

equilibrium at point E.

~

33

The “Dependent Economy” Model

Endogeneity of the terms of trade in the Mundell-Fleming model is inconsistent for developing countries.

Dependent economy model by Swan (1960) and Salter (1959).

Two domestic production sectors, one producing traded and the other nontraded goods.

Traded goods sector consists of both importables and exportables.

Since terms of trade are exogenous and constant, exportables and importables can be treated as a single Hicksian composite good.

34

What matters for macroeconomic equilibrium is the total value of domestic production and consumption of traded goods.

Domestic residents spend on both traded and nontraded goods.

Real exchange rate is price of traded goods in terms of nontraded goods:

z = PT / PN,

PT: domestic-currency price of traded goods,

PN: price of nontraded goods. Linearly homogeneous sectoral production function in

capital and labor in each sector. In the short run capital stock is fixed.

35

Labor is homogeneous and intersectorally mobile. In the short run, supply of output depends on

employment:

yh = y(nh), y’h > 0, y’’h < 0, h = N, T,

yT and yN: value of domestic production of traded and nontraded goods,

nT and nN: employment in each of the two sectors. Demand for labor from each sector is inversely related

to that sector's product wage:

nT = nT(), nN = nN(z), nT’, nN’ < 0,

= w/PT : real wage in terms of traded goods.

d ddddd (43)

(42)

36

Substituting (43) in (42) yields the sectoral supply functions:

yT = yT(), yN = yN(z), yT’, yN’ < 0 .

= w/PT : real wage in terms of traded goods. Domestic demand for traded and nontraded goods

depends on the relative prices of the two goods (real exchange rate), and on a given by

a = aT + z -1 aN. Thus

aT = aT(z, a), 0 < aT / a < 1,

aN = aN(z, a), 0 < (aN/ a) = (1-aT/ a) < 1.

sssss s

+-

++

37

Trade balance b: value of domestic excess supply of traded goods:

b = yT() - aT(z, a).

Equilibrium in the nontraded goods market:

yN(z) = aN(z, a).

Labor market-clearing condition:

nT(z) + nN (z) = n.

Equilibrium values of and z are simultaneously clear the labor and nontraded goods markets.

s

s

-d d (50)

(49)

(48)

38

Figure 2.2: LL: set of combinations of and z that satisfy (50). NN satisfies (49).

Slope of LL = - (nN ` + nT `) / nN ` < -1.

Slope of NN = -yN ` nN ` / (yN ` nN ` - aN / z) > -1.

CD has a slope of -1. Right (left) of LL: real wage is too high (low), and excess

supply (demand) prevails in the labor market. Below (above) NN: real exchange rate is excessively

appreciated (depreciated), and excess supply (demand) prevails in the market for nontraded goods.

Equilibrium combination of z and is given by (z, ), where LL and NN intersect (point E).

d d d

d dss

~ ~

39

Figure 2.2Classical Equilibrium in the Dependent-Economy Model

E

Lz

N

C

FN'

N'

N

A

D

B

L

45º

1

z1

z~

~ 2

40

Effects of an increase in a: NN shifts down to N’N’. Reason: equilibrium in this market requires a more

appreciated real exchange rate when aggregate spending is higher.

New equilibrium is B: appreciated real exchange rate and an increase in the real wage.

Since B lies below CD, the proportional reduction in z exceeds the proportional increase in .

So product wage in the nontraded goods sector falls, thus, labor is released from the traded goods sector and absorbed by the nontraded goods sector.

41

For this reason, and because the appreciation of the real exchange rate shifts demand towards the traded good, the trade balance deteriorates.

Determination of internal and external balance. Solve (50) for in terms of z. Slope of this relationship is LL in Figure 2.2. Substituting this into (48) and (49). This determines the trade surplus and the nontraded

goods market equilibrium as functions of z and a.

Keynesian form: It takes to be exogenous.

Figure 2.2: if the initial value of is 2, the market for

nontraded goods will clear at point A.

42

There is an excess supply in the labor market, because point A is to the right of LL.

Increase in a: new equilibrium point is F. This reduces the excess supply in the labor market since the

nontraded goods sector would expand by absorbing unemployed workers.

Analysis of internal and external balance: since nominal devaluation would alter , Keynesian version of both (49) and (50) shift in z-a space.

43

A Model with Three Goods Dependent economy model includes exogenous terms

of trade, but not capture variability in the terms of trade as a source of macroeconomic shocks.

Allowing changes in the terms of trade requires three-good model.

It disaggregates traded goods sector into exportables (X) and importables sectors (I).

Assumption: exportable good is not consumed at home. Production takes place in three sectors with sectoral

production functions

yh = yh(nh), yh’ > 0, yh’’ < 0, h = X, I, N. (51)

44

Labor demand:

nX = nX(-1), nI = nI(), nN = nN(z)

: terms of trade, given by PX/PI;

z = PI /PN : real exchange rate measured in terms of

importables;

: real wage in terms of importables;

PX, PI, and PN: domestic-currency prices.

PX and PI are given by the law of one price, so that PX =

EPX* and PI = EPI*.

PN is determined domestically.

(52)d ddd dd

45

Changes in the terms of trade have sectoral resource reallocation effects on supply side, demand-side effects because terms of trade changes

affect a country's real income. To incorporate these effects, assume a is measured in

terms of importables:

a = a(, g).

Equilibrium in the market for nontraded goods

yN(z) = aN(z, a), 0 < aN/a < 1.

(53)

(54)

+ +

++

46

Trade surplus is given by the domestic excess supply of traded goods:

b = yX(-1) + yI() - aI(z,a).

Full employment condition:

nX(-1) + nI() + nN(z) = n.

Effects of terms-of-trade changes on z and .

Classical mode: Figure 2.3: NN and LL depict (54) and (56), and

determines the equilibrium at point E. Assume terms of trade deteriorates by a reduction in PX. and absorption fall.

(56)_

d d d

(55)

47

Figure 2.3Effects of a Negative Terms-of-Trade Shock

in the Three-Good Model

E

Lz

N'

N

N

N'

BE'

LL'

L'

45º

z0

z~

0

~

48

NN shifts to N’N’ since real exchange rate must depreciate to maintain equilibrium in nontraded goods market.

Product wage rises in the exportables sector. To maintain full employment, excess labor must be

absorbed by the nontraded goods sector. This can happen only if z falls, so LL shifts down. New equilibrium E with a depreciated real exchange

rate and reduced real wage.

49

Keynesian mode: Since cannot change, new equilibrium is at point B,

rather than E ’. Unemployed labor since point B lies to the right of L’L’. Real exchange rate depreciation is less than that in the

classical case. Maintaining full employment requires nominal

devaluation (reduce real wage from to ’). New equilibrium point is E ’. Application of the model to the “Dutch disease”:

macroeconomic implications of the existence of a booming sector.

“Boom” is represented by an increase in PX.

50

In this case, z falls, and rises. Result: contraction of output in the importables sector. In developing countries, “Dutch disease” has been

aggravated by expansionary macroeconomic policy responses to favorable terms-of-trade shocks.

In this case, it is difficult to reverse when the shocks are transitory.

Structure of Labor Markets

52

Functioning of Labor Markets. Output and Unemployment. Indexation and Wage Rigidity. Labor Market Segmentation.

53

Functioning of Labor Markets Key differences in labor markets in developing nations

and those in industrial countries: importance of agricultural sector, importance of self-employment, irregular work activities.

So standard labor market concepts used in the industrial world do not necessarily have the same meaning in developing countries.

Three sectors of labor market in developing countries:

Rural sector: large share of self-employed persons and unpaid family workers.

54

Informal urban sector: self-employed individuals or small, privately owned enterprises producing mainly services and other nontradables. In this sector: Activities rely on the provision of labor services by

owners and their families, but occasionally on paid labor without any contract.

Job insecurity is pervasive, wages are highly flexible, and workers get very few benefits from their employers.

Legal minimum wage laws do not apply, and labor unions play a very limited role.

Formal urban sector: medium and large enterprises that hire workers on the basis of formal contracts. In this sector:

55

Workers and employers are subject to labor market regulations.

Employers must provide benefits to their workers. Labor unions play an important role in the

determination of wages, and legal minimum wage laws exist.

Functioning of rural and urban labor markets differs (Rosenzweig, 1988): Heterogeneity and diversity of production in urban

areas requires a wider variety of competence and skills among workers.

Seasonal and climatic effects on production in urban areas are less pronounced.

Urban production activities are more concentrated geographically.

56

Due to informal sectors, proportion of wage earners in total employment is lower than in the industrial world.

Wage employment accounts for 10% of total employment in some sub-Saharan African countries, but 80% in some Latin American countries.

Share of informal sector employment in total urban employment is sizable in many developing countries and may vary between 30 and 60%.

57

Output and UnemploymentProblems: Available data on employment and unemployment in

developing countries are not very reliable. Published measures of unemployment are based on

unemployed workers looking for jobs in the formal sector.

Underemployment is more pervasive than open unemployment.

Figure 2.4: Behavior of output and unemployment rate. Economic slowdown of the early 1980s translated into

increases in the rate of unemployment.

58

Figure 2.4aOutput Growth and Unemployment, 1980-95

Real GDP growth, in percent (right scale)

1980 1985 1990 19950

5

10

15

20

25

0 -20

-15

-10

-5

0

5

10

15

Chile

1980 1985 1990 199510

15

20

25

10 -8

-6

-4

-2

0

2

4

6

Barbados

Sources: ILO Yearbook and International Monetary Fund.

Unemployment rate, in percent (left scale)

59

1980 1985 1990 19957

8

9

10

11

12

13

14

15

7 0

1

2

3

4

5

6

7

Colombia

Figure 2.4bOutput Growth and Unemployment, 1980-95

Real GDP growth, in percent (right scale)

1980 1985 1990 19953

4

5

6

7

8

9

10

3 -10

-5

0

5

10

Costa Rica

Sources: ILO Yearbook and International Monetary Fund.

Unemployment rate, in percent (left scale)

60

Figure 2.4cOutput Growth and Unemployment, 1980-95

Real GDP growth, in percent (right scale)

1980 1985 1990 19951

2

3

4

5

6

1 -5

0

5

10

15

Korea

1980 1985 1990 19952

3

4

5

6

7

8

2 -10

-5

0

5

10

Mexico

Sources: ILO Yearbook and International Monetary Fund.1/ Unemployment data for Mexico for 1994-95 include additional urban areas.

1/

Unemployment rate, in percent (left scale)

61

Figure 2.4dOutput Growth and Unemployment, 1980-95

1980 1985 1990 19951

2

3

4

5

6

7

1 -5

0

5

10

15

Singapore

1980 1985 1990 19954

5

6

7

8

9

10

11

4 -10

-5

0

5

10

Philippines

Sources: ILO Yearbook and International Monetary Fund.

Real GDP growth, in percent (right scale)Unemployment rate, in percent (left scale)

62

1980 1985 1990 19955

6

7

8

9

10

11

12

13

14

5 -10

-5

0

5

10

15

Venezuela

1980 1985 1990 19950

1

2

3

4

5

6

7

0 4

6

8

10

12

14

Thailand

Sources: ILO Yearbook and International Monetary Fund.

Real GDP growth, in percent (right scale)Unemployment rate, in percent (left scale)

Figure 2.4eOutput Growth and Unemployment, 1980-95

63

Relationship between output growth and unemployment rate is weak and varies over time.

This absence of a stable “Okun's law” may be the result of spillover effects across different segments of the labor market.

64

Indexation and Wage Rigidity In high-inflation countries in particular, wage indexation

is an essential feature of the labor market. Indexation allows for adjustment of wages for

productivity changes and past inflation. Procedures differ among countries and over time in

three main respects: interval between wage adjustments, degree of indexation to inflation, nature of adjustments for productivity changes.

Manner in which indexation operates is important for the transmission of policy shocks to output, inflation, and unemployment.

65

Indexation helps to insulate output and employment from monetary (demand) shocks, but not from real (supply) shocks.

High degree of wage indexing at the sectoral level may distort policy-induced price signals and hamper the reallocation of resources.

Indexed contracts are viewed as the root cause of the stickiness of inflationary expectations and inflation persistence in many Latin American countries.

Despite wage indexation, real wages in many countries seem to be more flexible (Horton et al., 1994).

Figure 2.5: some degree of real wage flexibility in Chile. So persistence of unemployment cannot be attributed to

excessive real wage rigidity.

66

1974 1978 1982 1986 1990

-20

-10

0

10

20

30

0

5

10

15

20

25

30

35

0

Figure 2.5Chile: Real Wages and Unemployment

(In percent)

Source: Labán and Larraín (1994, p.118).

Unemployment rate (right scale)

Real Wage growth (left scale)

67

It may result from aggregate demand effects associated with declining

real wages, output market imperfections.

First type of effect: Emphasized by new structuralists economists and is

known as the Keynes-Kalecki effect (Taylor, 1991). Assumption: propensity to save is lower for wage

earners than for profit recipients. If a fall in real wages is accompanied by a fall in the

share of wages in national income, aggregate demand will also fall.

Unemployment may therefore persist.

68

Second type of effect: Result of imperfect competition in product markets,

even if labor markets are competitive and real wages flexible (Layard et al., 1991).

Nominal wage rigidity is a pervasive feature of the labor market in many developing countries.

Reasons for nominal wage inertia: lagged indexation, staggered and overlapping wage contracts, slow adjustment in inflationary expectations, existence of multiperiod labor contracts.

69

Labor Market Segmentation Reasons for labor market dualism in developing

countries: sector of employment or the production structure, geographic location of activities, legal nature of activities (formal and informal), composition of the labor force (skilled and unskilled

workers). Frequent implication of dualism is labor market

segmentation. This is a situation where observationally identical

workers receive different wages depending on their sector of employment.

70

Reasons: Restrictions on occupational mobility between sectors.

This prevents workers in the “low-wage” segment from having full access to a job in the “high-wage'' segment.

Existence of sectoral wage rigidities. This leads to demand-constrained employment.

Migration model of Harris and Todaro (1970): Model of labor market segmentation. Objective: explain the persistence of rural-to-urban

migration, despite widespread urban unemployment in developing countries.

Equality of expected wages is the basic equilibrium condition across the different segments of the labor market.

71

Rural workers, in deciding to migrate, compare the current wage in agriculture wA to the expected urban wage wU.

wU: multiply the prevailing wage wU (fixed) by the urban employment ratio (probability of being hired).

In equilibrium:

a

a

wA = wU = wU

nU

nU + LU

a (57)

nU: urban employment;

LU: absolute number of workers unemployed in urban areas.

72

One set of extensions of the Harris-Todaro model: efficiency wage theories.

Real wage cuts lower productivity because they reduce incentives to provide effort, raise incentives to shirk, increase the quit rate, reduce loyalty to the firm.

Each firm will set its wage so as to minimize labor costs per efficiency unit, rather than labor costs per worker.

Efficiency wage: wage that minimizes labor costs per efficiency unit.

When each firm offers its efficiency wage, aggregate demand for labor falls short of labor supply, so that involuntary unemployment emerges.

73

Efficiency wage theories are useful for explaining why modern-sector firms pay more than the market-clearing wage in models with segmented labor markets.

They predict the existence of noncompetitive wage differentials even in the absence of unions.

Importance of market segmentation and the degree of wage flexibility to understand the effects of macroeconomic shocks on unemployment.

Consider a small open economy producing traded and nontraded goods using only labor.

Figure 2.6: determination of wages and employment under four different assumptions regarding labor market adjustment.

Horizontal axis: total labor available to the economy, OTON.

74

Figure 2.6aLabor Mobility, Sectoral Wage Rigidity, and Adjustment

E

E'

LT

d

LT

d

LN

d

OTONL*

T

'

w* w*

wage wage LT

d

T

LN

d

OTON

Ld'

wN

A

TLc

L 'Tc

EN

w'N

Panel 1. Flexible wages and perfect labor mobility Panel 2. Sectoral wage rigidity and perfect labor mobility

wcT

75

Figure 2.6bLabor Mobility, Sectoral Wage Rigidity, and Adjustment

LT

d

LN

d

OT

ON

'

wN

A

unemployment

TL_

TLcL 'T

c

EN

LT

d

wcT

LT

d

LN

d

OT

ON

'

wN

A

unemployment

TLc

Q

Q

LN

Q'

Q'

w'N

TL 'c

EN

LT

d

wcT

Panel 4. Harris-Todaro migration processPanel 3. Sectoral wage rigidity and no labor mobility

76

Vertical axis: wage rate in the economy, which is either uniform across sectors or sector specific.

LT (LN) : demand for labor in the traded (nontraded) goods sector.

Panel 1: Assumption: wages are perfectly flexible and labor

perfectly mobile across sectors. Initial equilibrium: point E. Wage rate is equal to w*. Labor employed in the traded goods sector is OTLT*,

and labor used in the production of nontraded goods is LT*ON.

In panels 2, 3, and 4 the wage rate in the traded goods sector is fixed at wT whereas wages in the nontraded goods sector remain flexible.

d d

c

77

Panel 2: Perfect labor mobility and wage flexibility in the

nontraded goods sector, prevents the emergence of unemployment.

Initial equilibrium at point A in the traded goods sector employment level of OTLT.

And at point EN in the nontraded goods with wages equal to wN and employment to LTON.

Panel 3: Labor is completely immobile. Labor in the traded goods sector: OTLT .

Labor in the nontraded goods sector: LTON. Unemployment will typically emerge in traded goods

sector.

c

c

78

Panel 4: Equilibrium obtains when the wage rate in the

nontraded goods sector is equal to the expected wage in the traded goods sector.

QQ: hyperbola along which this equality holds (Harris-Todaro curve).

Intersection of the LN curve with QQ determines wage rate and the employment level in the nontraded goods sector.

Intersection of the LT curve with the horizontal line drawn at wT determines employment in the traded goods sector.

Initial equilibrium is characterized by sectoral unemployment (LT LN).

c

d

d

c

79

If demand for labor in the traded goods sector falls, as a result of a macroeconomic shock, LT shifts to left; demand curve for labor in the nontraded goods

sector is unchanged. If wages are perfectly flexible and labor perfectly mobile

across sectors, adjustment of the labor market leads to fall in the overall wage rate in the economy; reallocation of labor across sectors; new equilibrium (E’ in panel 1) with full employment.

When there is sector-specific wage rigidity: If labor is perfectly mobile, the demand shock leads to

reallocation of the labor force; fall in wages in the nontraded goods sector (panel 2).

d

80

If workers cannot move across sectors, the reduction in demand leads to increase in unemployment in the traded goods

sector; no effect on wages and employment in the nontraded

goods sector (panel 3). With a labor allocation mechanism of the Harris-Todaro

type, the demand shock reduces employment in the traded goods sector; has ambiguous effect on unemployment rate.

d

81

Reason: QQ curve shifts to the left following the shift in LT since

the fall in employment reduces likelihood of being hired; expected wage in the traded goods sector.

More workers seek employment in the nontraded goods sector, bidding wages down.

In equilibrium unemployment may increase in the traded goods sector.

d

82

Agénor and Aizenman (1999): Interactions between the formal and informal urban

labor markets may be characterized by substitutability in the short run.

In periods of weak output growth, workers laid off in the formal sector; seek employment in the informal sector where wages

and labor productivity tend to be lower. If skilled workers' reservation wage is not higher than

unskilled workers’ wage in the informal sector, fluctuations in aggregate demand will translate into

changes in average productivity; not a rise in open unemployment.

Informal Financial Markets

84

Informal Loan Markets. Parallel Markets for Foreign Exchange.

85

Informal Loan Markets Transactions can be classified into four categories:

regular money lending by individuals or institutions; occasional lending by individuals, firms, and

institutions with a surplus of funds; tied credit;

lending by those whose main activity lies in markets other than the credit market;

but who tie credit to transactions in markets where their primary activities lie;

Group finance aimed at generating loanable funds for individual credit needs.

86

Informal credit markets are an important feature of developing-country financial markets.

Montiel et al. (1993): share of informal credit in total credit varies from about one-third to three quarters.

Interest rates in informal credit markets are substantially higher than those in official markets.

Figure 2.7: some evidence for Korea. Interest rates in informal credit market may

represent opportunity cost of holding money; so respond to

domestic money market conditions and/or; arbitrage opportunities between domestic lending

and foreign lending.

87

Figure 2.7Korea: Formal and Informal Interest Rates

(Annual rates, in percent)

Source: Bank of Korea.

1979q1 1980q1 1981q1 1982q1 1983q1 1984q1

5

10

15

20

25

30

35

40

45

50

55

Bank lending rate

Informal market rateYield on corporate bonds

Yield on government bonds

88

Distinction between "autonomous" informal sector (relating to indigenous

activities), "reactive“ informal sector (activities that emerge as a

response to regulations, credit constraints, or other deficiencies of the formal sector).

Second component is more directly affected by credit policy and the level of financial repression.

89

Parallel Markets for Foreign Exchange

Parallel currency markets have emerged due to foreign trade restrictions and capital controls.

Under foreign trade restrictions: Imposition of tariffs and quotas creats excess demand

for goods at illegal, pretax prices. Illegal trade creates a demand for illegal currency. This leads to creation and establishment of a parallel

currency market if the central bank is unable to meet all demand for foreign exchange.

90

Under capital controls: Parallel market becomes a major element in financing

capital flight and portfolio transactions. Foreign currency is a hedge against adverse political

change and inflation tax. Other factors to explain the development of a parallel

currency market, private transfers in the context of overvalued exchange rate; illegal activities.

Size of illegal, parallel currency markets depends on range of transactions subject to exchange controls; degree to which restrictions are enforced by the

authorities.

91

When there are large and chronic balance-of-payments deficits, central bank rations foreign exchange allocated to

private sector; so parallel currency markets provides foreign

exchange rate with more depreciated rate. Figure 2.8: evolution of the parallel market premium. Premium reflects asset-price characteristics of parallel

exchange rate. When there is uncertainty over macroeconomic policies,

parallel market rates react rapidly to expected changes in future economic circumstances.

92

Figure 2.8aParallel Market Premia in Developing Countries

(In percent)

Sources: International Monetary Fund and World Currency Yearbook.

1984q1 1987q1 1990q1 1993q1

0

20

40

60

80

100

120 Chile

1984q1 1987q1 1990q1

1993q10

5

10

15

20

25

30

35 India

93

Figure 2.8bParallel Market Premia in Developing Countries

(In percent)

Sources: International Monetary Fund and World Currency Yearbook.

1984q1 1987q1 1990q1

1993q1-20

-10

0

10

20

30

0

Korea

1984q1 1987q1 1990q1 1993q1

0

20

40

60

80

100

120

140 Mexico

94

Figure 2.8cParallel Market Premia in Developing Countries

(In percent)

Sources: International Monetary Fund and World Currency Yearbook.

1984q1 1987q1 1990q1

1993q1-10

-5

0

5

10

15

20

0

Morocco

1984q1 1987q1 1990q1 1993q1

-100

0

100

200

300

400

500

0

Nigeria

95

Illegal supply of foreign currency from five sources: under-invoicing of exports, smuggling of exports, over-invoicing of imports, foreign tourists, and diversion of remittances through nonofficial channels.

Under-invoicing of exports is the major sources of supply.

When there is a tax on exports, under-invoicing allows the exporter to avoid the tax and sell the illegally acquired foreign exchange at premium.

Higher the parallel market premium is, the higher will be the propensity to under-invoice exports.

96

Demand for foreign currency in the parallel market results from four main components: imports (legal and illegal), residents traveling abroad, portfolio diversification, purposes of capital flight.

Macroeconomic implications of parallel currency market:

It entails costs for the government: cost of enforcement in attempting to counteract

parallel market activities and to prosecute and punish offenders;

loss of tariff revenue and revenue from income taxes and domestic indirect taxes;

97

reduced flow of foreign exchange to the central bank; suboptimal allocation of scarce resources.

Parallel market in foreign exchange weakens effectiveness of central bank’s capital controls. It leads to an increase in the degree of substitution

between domestic and foreign currencies. This results in a loss of seigniorage for the

government. Parallel exchange rates may have a large impact on

domestic prices. If domestic prices of tradables are based on the

marginal cost of parallel market rate, aggregate price will reflect the behavior of this exchange rate.

98

Figure 2.9: countries with the highest degree of parallel exchange variability also tend to exhibit a greater degree of price variability.

Because there are two prices for foreign exchange, exports whose proceeds are repatriated at the official exchange rate are taxed relative to other exports.

Parallel market for foreign exchange plays an important role in the transmission mechanism of short-term macroeconomic policies.

99

Figure 2.9Price and Parallel Exchange Rate Variability

(Average over January 1980 - March 1993)

Sources: International Monetary Fund and World Currency Yearbook.Notes: Variables are the consumer price index and the end-of-period U.S. dollar-domestic currency parallel exchange rate. Variability is measured by the coefficient of variation of each variable.

0 0.5 1 1.5 2 2.5

0

0.5

1

1.5

2

2.5

Morocco

Argentina

Chile

Pakistan

Costa Rica

EcuadorDominican Republic

Mexico

India

Malaysia

Korea

Colombia

Philippines

Peru

Uruguay

Nigeria

BoliviaGhana

Venezuela

Bangladesh

Indonesia

Malawi

Parallel exchange rate

Co

nsu

me

r p

rice

ind

ex