Transcript Macro Conference IV

Chapter 2
Aggregate Accounts,
Production,
and Market Structure
© Pierre-Richard Agénor and Peter J. Montiel
1




A General Accounting Framework.
Production Structure in an Open Economy.
The Structure of Labor Markets.
Informal Financial Markets.
2
A General Accounting
Framework




The Nonfinancial Private Sector.
The Public Sector.
 The Nonfinancial Banking Sector.
 The Central Bank.
 The Consolidated Public Sector.
The Commercial Banking System.
Aggregate Relationships.
4
The Nonfinancial Private
Sector
This sector holds both financial and real assets.
Financial assets:
 currency issued by the central bank CU,
p
 deposits issued by the commercial banks D ,
p
p
 net foreign assets EF (E is exchange rate and F is the
foreign-currency value of these assets),
h
 loans extended by households in informal markets, L .
Liabilities:
p
 credit from banks, L ,
 loans received through informal markets.

5


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
.
.
.p
.p .p
 = Sp +EFp +pHH .
where
.
Sp = CU + D +EF - L .
(3)
(4)
6

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.
7
The Public Sector
The Nonfinancial Public Sector



Nonfinancial public sector is a substantial net financial
debtor.
Its debt is owed to
bg
 central bank (L );
cg
 commercial banks (L );
g
 foreigners (-EF ).
Nonfinancial public sector's net worth:
g = EFg - Lbg - Lcg .
(6)
8

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
.g . bg . cg
Sg = EF - L

-L .
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;
9
ib: interest rate paid on loans received from central bank.
The Central Bank

Central bank's balance sheet:
b = ER* + (Lbg+Lbc) - M,

(11)
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.
10

The change in b:
.b
.
 = Sb + ER*.
where
.
.
.
.
Sb = ER* + (Lbg+Lbc) - M.



(15)
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.
11

So Sb:
Sb = i* ER* + ib(Lbg+Lbc) - g .

(15) can be rewritten as:
.
.bg
M=L

.
.bc
+ ER* - Sb + L
.
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.
12
The Consolidated Public Sector


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
.g .
.bc .cg
.
Sps = Sg + Sb = E(F +R*) + (L -L ) - M.
13

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.
14
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
.p
.cg
. . p .bc
 = Sc = L + L + RR - D - L
where
Sc = ic(Lp+Lcg) - idDp - ibLbc .
15
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.
16


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
17
saving (current account deficit).

National income accounting identity:
GNP = Cp + Ig + G + CA
(32)
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 ).
18

Balance-of-payments identity expressed in domesticcurrency terms:
.
.p .g
ER = (GNP-Cp-Ip-G) - E(F +F ).



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.
19
Production Structure
in an Open Economy



The Mundell-Fleming Model.
The “Dependent Economy” Model.
A Model with Three Goods.
21
The Mundell-Fleming Model
Assumptions:
 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.
22






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.
23



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),
(36)
y : output of the domestic good,
a: level of domestic absorption,
b: trade balance.
24

Because domestic and foreign goods are imperfect
substitutes, trade balance is
+ -
b = b(z,a),

-1< ba < 0,
(35)
z = EP*/P : terms of trade.
Production function ( diminishing returns to labor):
y = y(n),
y’ > 0, y’’< 0
n: employment.
25

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.
26


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),
(41)
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.
27
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).
28
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







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.
30
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.
31








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.
32
The “Dependent Economy”
Model





Endogeneity of the terms of trade in the MundellFleming 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.
33



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.
34


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, (42)
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:
nTd = nTd (), nNd = nNd(z), ndT’, nNd ’ < 0, (43)
 = w/PT : real wage in terms of traded goods.
35

Substituting (43) in (42) yields the sectoral supply
functions:
yTs = yTs (), yNs = yNs (z), ysT’, ysN’ < 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) < 361.

Trade balance b: value of domestic excess supply of
traded goods:
b = yTs() - aT(z, a).

Equilibrium in the nontraded goods market:
yNs(z) = aN(z, a).

(49)
Labor market-clearing condition:
ndT(z)

(48)
+
ndN
(z) = n.
(50)
Equilibrium values of  and z are simultaneously clear
the labor and nontraded goods markets.
37
Figure 2.2:

LL: set of combinations of  and z that satisfy (50).

NN satisfies (49).

Slope of LL = - (nNd ` + nTd `) / ndN ` < -1.

Slope of NN = -yNs ` nNd ` / (yNs ` nNd ` - 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).
38
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39

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.
40

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.
41

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.
42
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 threegood 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)
43

Labor demand:
nXd = nXd (-1), nId = nId(), ndN = nNd (z)
(52)
: 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.
44


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).

(53)
Equilibrium in the market for nontraded goods
++
yN(z) = aN(z, a),
0 < aN/a < 1. (54)
45

Trade surplus is given by the domestic excess supply of
traded goods:
b = yX(-1) + yI() - aI(z,a).

(55)
Full employment condition:
_
d
d
-1
nX( ) + nI() + nNd (z) = n.
(56)
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.
46
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47





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.
48
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.
49




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.
50
Structure of Labor Markets




Functioning of Labor Markets.
Output and Unemployment.
Indexation and Wage Rigidity.
Labor Market Segmentation.
52
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.
53


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:
54
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
55
geographically.





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%.
56
Output and Unemployment
Problems:
 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.
57
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58
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59
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60
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61
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62


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.
63
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.
64






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.
65
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66
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.

67
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.
68
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.
69
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.
70



Rural workers, in deciding to migrate, compare the
current wage in agriculture wA to the expected urban
wage wUa.
wUa: multiply the prevailing wage wU (fixed) by the urban
employment ratio (probability of being hired).
In equilibrium:
wA = waU = wU
nU
(57)
nU + LU
nU: urban employment;
LU: absolute number of workers unemployed in urban
areas.
71





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.
72
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.
73

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74
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75
Vertical axis: wage rate in the economy, which is either
uniform across sectors or sector specific.
d
d
 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 wcT whereas wages in the nontraded
goods sector remain flexible.

76
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 OTLTc.
 And at point EN in the nontraded goods with wages
equal to wN and employment to LTcON.
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.
77
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 (HarrisTodaro curve).
d
 Intersection of the LN curve with QQ determines wage
rate and the employment level in the nontraded goods
sector.
 Intersection of the LTd curve with the horizontal line
drawn at wTc determines employment in the traded
goods sector.
 Initial equilibrium is characterized by sectoral
unemployment (LTc LN).
78
If demand for labor in the traded goods sector falls, as a
result of a macroeconomic shock,
d
 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
79 2).



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
80
Reason:
d
 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.
81
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.
82
Informal Financial Markets


Informal Loan Markets.
Parallel Markets for Foreign Exchange.
84
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.
85





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.
86
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87


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.
88
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.

89
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.
90




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.
91
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94




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.
95
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;

96
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.



97
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.



98
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