THE WORLD BANK Discussion Paper Public Disclosure Authorized DEVELOPMENT POLICY ISSUES SERIES Report No. JERS5 The Relevance for Developing Counfries Public Disclosure Authorized of Recent Developments in Macroeconomic Theory W. Max Corden Public Disclosure Authorized June 1986 Office of the Vice President Economics and Research Public Disclosure Authorized The views presented here are those of the author, and they should not be interpreted as reflecting those of the World Bank. THE RELEVANCE FOR DEVELOPING COUNTRIES OF RECENT DEVELOPMENTS IN MACROECONOMIC THEORY by W. Max Corden June 1986 The author is Professor of Economics, Australian National University. An earlier version of this paper was prepared, at the suggestion of Carlos Diaz-Alejandro, as background for a proposed World Bank project on macroeconomic policy in developing countries. I am indebted to valuable comments from John Cuddington and Mohsin Khan. for the views expressed herein The World Bank does not accept responsibility be attributed to the World which are those of the author(s) and should not findings, interpretations, and Bank or to its affiliated organizations. The by the Bank; they do not conclusions are the results of research supported Bank. The designations employed, necessarily represent official policy of the in this document are solely the presentation of material, and any maps used imply the expression of any for the convenience of the reader and do not Bank or its affiliates concerning opinion whatsoever on the part of the World city, area, or of its authorities, the legal status of any country, territory, or national affiliation. or concerning the delimitations of its boundaries, Abstract This paper reviews recent developments in macroeconomic theory and considers their relevance for the study of developing countries. Particular emphasis is given to the rational expectations revolution. It is asked whether government policies can be regarded as systematic, and it is suggested that the expectations on which governments' own decisions are based need to be studied. Also discussed are the neo-Ricardian theorem, the implications of real wage rigidity and of supply side models with sectoral income effects, and recent models involving large group interaction. Table of Contents Page No. I. Introduction .......................................... 1 II. Keynesian Economics and Rational Expectations ......... 2 A. Market-Clearing Approach .................. 2 B. Explaining Nominal Rigidities ................... 3 C. Policy Surprises and Rational Expectations ........ 4 III. Are There Keynesian Effects in LDCs?............... 6 IV. The Rational Expectations Revolution .............. 10 V. Systematic and Benign Government Policies? 12 A. Are Government Policies Systematic? ....... 1 2 B. Benign, Optimizing Government and the Political Economy Issue ..... 13 C. The Crucial Macroeconomic Issues for LDCs........ 15 VI. The Rational Expectations of Government ............ 16 VII. The Neo-Ricardian Theorem and LDCs ..................... 17 VIII. Nonmarket Clearing Models.................... 20 IX. Real Wage Rigidity .............................. 21 A. Explaining Real Wage Rigidity ............... 21 B. Raising Employment with Real Wage Rigidity..... 22 C. Real Wage Rigidity and LDCs ................ 23 X. Supply Side Models and Sectoral Income Effects........ 24 XI. Large Group Interaction and Game Theory ...... 26 XII. Conclusion ............ ......... ...... 28 The Relevance for Developing Countries of Recent Developments in Macroeconomic Theory W. Max Corden I. Introduction This paper reviews the recent literature of macroeconomic theory in developed countries (called DCs here). To a great extent this is an American literature, though I shall also refer to some approaches more popular in Europe. The paper considers the relevance of various discussions and models for developing countries (LDCs). Much of the paper is concerned with the "irational expectations revolution" and its possible relevance for studying macroeconomic policies in LDCs. It is impossible to specify some standard DC model, or perhaps some textbook written for DCs, and then relate it to a standard LDC model, or to a particular LDC, hence clearly bringing out differences between the models or bringing out the way in which the DC model (or the textbook) needs adjusting to suit the particular LDC. The reasons for this are (a) that DC macroeconomic theory since the destruction of the Keynesian consensus is not sufficiently consolidated, and (b) the great diversity of the characteristics and experiences of the LDCs. Every idea that can be found in the recent DC literature can be shown to have some relevance for some LDC somewhere, and the DC literature is so extensive that one could never successfully claim that an issue important for any LDC has been completely neglected in the DC literature. For this reason every generalization made below must be thoroughly qualified. -2- II. Keynesian Economics and Rational Expectations The central message of Keynesian economics is that demand management through monetary and fiscal policies can successfully stabilize output and employment, and possibly raise the average level of employment over a longer period. The recent DC theoretical literature seeks to explain to what extent Keynesian nominal demand policies can work when some allowance is made for rational behavior. This literature can really be regarded as having three parts. In the first part it is assumed that market-clearing wages and prices are continuously established, and the question is then asked whether Keynesian effects can still be generated through policy surprises. The second part seeks to explain the existence of nominal rigidities, especially wage rigidities. The third part - which is the most interesting and relevant for the present discussion - is concerned with the role of policy surprises and the scope for policy activism, given some rigidities. A. Market-Clearing Approach Suppose that there were instantaneous market clearing; any increase in nominal demand in a, particular market would thus lead to a rise in the relevant price. Surprise shocks in nominal demand - e.g., an increase in the money supply - would still have real effects if their implications were initially misunderstood. This is an "incomplete information" problem. 1/ For example, if a nominal demand expansion leads to a rise in prices and nominal wages, without necessarily any change in real wages, but it is misunderstood 1/ This market-clearing approach is set out systematically in Barro (1984, Chapter 18), and originated with Lucas, Barro, and Sargent and Wallace (see footnote 3 below). -3- as either a rise in real wages (so as to lead to greater labor supply) or as representing a rise in real profitability (so as to lead to an expansion by firms and thereby greater labor demand), then nominal demand policies would have real effects, This type of story (the Lucas supply function) has been given much prominence in the DC theoretical literature. The argument of the rational expectations theorists is that it is not possible to surprise private agents consistently. If the government is following some kind of policy rule, that rule will be discovered in due course. On average, nominal demand changes will thus come to be expected, and then they will not be misunderstood when they happen. There is an objection to this approach. It seems implausible that firms or workers misunderstand a general expansion or contraction of demand when these actually happen. They may not understand why they happen, and may have failed to anticipate them, but with complete and instantaneous price and wage flexibility it is not really necessary to anticipate events. If one believes that prices and wages are very flexible in response to market conditions one should, therefore, not expect nominal demand policies to generate real output and employment changes, even when the policies are expected. The whole discussion only becomes interesting once some rigidities in prices and wages, or at least significant lags in their adjustment to changing conditions, are introduced. B. Explaining Nominal Rigidities An extensive literature seeks to explain nominal rigidities, especially wage rigidity, as part of an efficient maximizing process. It is -4- notable that nominal wages are (more or less) rigid downwards, and also somewhat sluggish upwards, even in a country like the United States where trade unions are relatively weak. There are explanations both in terms of explicit and implicit contracts. Explicit contracts with unions tend to be longer term in the United States than in-other DCs, so that there has been a particular emphasis on such contracts. One explanation is in terms of negotiation costs, including the costs and delays involved in the process of organizing collectively agreed upon positions (the "logic of collective action"). Another explanation rests on the willingness of employers to accept the risks for their profits of demand fluctuations, employees being risk- averse and unable to insure adequately against income fluctuations. There is an implicit contract literature, which cannot be summarized here (see Azariadis and Stiglitz, 1983). Most explanations for wage rigidities seem to be explanations of real rather than nominal rigidities, and only the difficulties of indexation (which, surely, are not so great) can explain why rigidities that are intended to be real turn out to be nominal. If there is learning, then the experience of inflation