M.SC.

ECONOMICS FOR DEVELOPMENT

MACROECONOMIC THEORY

Michaelmas Term 2023

Professor Christopher Adam
Email: christopher.adam@qeh.ox.ac.uk

LECTURE 1

AN INTRODUCTION TO DEVELOPMENT MACROECONOMICS

Outline

• Introduction to the Macroeconomics of Developing Countries

• Different horizons: long-run growth and short-term shocks and cycles
• Some motivating facts
• Our workhorse model: the small open economy
• Extensions and methods of macroeconomic analysis: a roadmap

1. Introduction to Macroeconomics of Developing Countries

Macroeconomics is concerned with the study of aggregated general equilibrium systems

(economies), their evolution over time, their response to external shocks and policy actions, and
how these characteristics impact on the welfare of the individuals and groups populating the
economy.

Development Macroeconomics applies these concerns to developing countries and in particular to

low-income, small open economies. This shift in focus does not radically alter the methods of
analysis we bring to bear but does imply important differences in emphasis, particularly in the
characterization of economic structures and the external and political economy environments they
inhabit.

We study both positive and the normative aspects of the macroeconomics of developing countries.
What sort of questions? For example:

• Why are macroeconomic shocks so common and so difficult to manage?

• How best should countries respond to these shocks, in aggregate, and how do different
policy responses affect different groups in society?

• When (and how much) should developing countries borrow?

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 • How do different policy responses to short-term shocks affect long-term growth?

• How should the authorities strike a balance between different instruments (e.g. fiscal, trade
and monetary policy)?

2. Different Horizons

The distinction between ‘evolution over time’ and ‘response to shocks’ in the definition above is one
of the first organizing principles in macroeconomic analysis.

Growth theory is concerned with understanding the ‘low-frequency’ or long-run evolution of

economies. Its central questions are both positive and normative: what factors explain differences
in economic growth (and income levels) between countries over time? What policies should we
adopt to promote growth? What role is played by technology and innovation? By globalization?

In the first part of this course we will recap briefly the neo-classical growth model (the Solow model
and its close relation the Ramsey model) as a way of fixing some ideas about the long-run trajectory
that economies follow and as a means to motivate some of the key ideas that will follow in the
course.

But as we shall see, much of macroeconomics we discuss here has little to say about long-run growth
per se. Conventional wisdom recognizes ‘good’ macroeconomic policy as a necessary, though
certainly not sufficient, condition for sustained growth (and what counts as ‘good’ macroeconomic
policy is highly contested).

Rather, our understanding of economic growth tends to focus primarily on what may be referred to
as ‘supply-side’ issues including an understanding of deep economic structures, politics, the
institutions of economic governance and the interrelationship between these factors.

This is the subject matter of much of political economy and modern quantitative economic history
and of the emerging field of ‘structural transformation’.

The Hilary Term modules on the political economy of economic development and on firms and labour
markets both touch on these issues.

Most of our attention in this lecture sequence, however, will focus on issues of adjustment and
stabilization which are concerned with how economies respond to shocks that perturb economies
from their long-run growth trajectory. The focus is therefore typically on higher frequency events –
months and years as opposed to decades and centuries -- and on the speed with which economies
return to their (dynamic) equilibrium follow some shock, and at what cost and with what
consequences.

Again, this body of theory has both positive and normative aspects. For example, how do economies
respond to specific shocks, such as terms of trade shocks or, indeed, the dislocation caused by the

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Covid-19 pandemic? How does this depend on endowments and policies? What policies constitute
the ‘best’ response to shocks?

Economies are always in disequilibrium and hence macroeconomics is the study of the interaction
between of underlying dynamic processes, the nature of shocks and responses to them. In doing so,
we often distinguish between the use of policy to adjust the level of aggregate nominal demand
relative to equilibrium supply (this is what we mean by ‘stabilization’) as well as to influence the
structure of consumption, production and trade (‘structural adjustment’).

3. The facts of the case: growth and shocks

Most of this term’s course will be concerned with shocks, stabilization and adjustment but before we
get into the theory, it is appropriate to set the scene with some observations on broader patterns of
growth and development.

Tables 1 to 4 and figure 1 provide some basic statistics on GDP, per capita income growth and terms
of trade shocks.

Some points to note:

• PPP Adjustment. Comparing economic outcomes across countries require us to express our
data in a common currency, most usually the US dollars. It is natural to do this using market
exchange rates. This is generally fine if we are examining one country over time, but it can
create problems comparing across countries.

This arises for the following reason. Suppose the ‘Law of One Price’ held for all goods so
that the cost of acquiring them would be the same in all locations, we could indeed compare
incomes by converting incomes and expenditures in local currencies into a common
currency (i.e. convert them at market exchange rates).

But the costs of some goods and (especially) services, in particular those we refer to as non-
tradables, can differ markedly across countries, not just in the short-run but in the long run,
principally because there is no cross-border trade to arbitrage away international price
differentials. Think about the cost of labour-intensive services such as construction or
domestic services – a gardener, for example, the real cost of whom is very different
between, say, India and Germany. The manifestation of this is that a dollar of income can
buy different quantities of the same good or service in different countries.
To address this, cross-country comparisons are often made on a purchasing-power-parity
(PPP) basis. Unlike market exchange rates, PPP exchange rates are constructed to account
for the differential cost of non-tradables and are thus used to measure real incomes in a
cross-country setting.

As we will see later in the course, there are good reasons why these price differences exist
across countries. One such idea – the so-called Harrod-Balassa-Samuelson effect – suggests

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 that in general the price of non-tradables will rise relative to tradable prices (i.e. those that
are arbitraged by international trade) will tend to rise as economies get wealthier.

This has an important implication: market exchange rates will tend to overstate the real
price of non-tradables, and therefore understate real incomes, in poor countries relative to
rich ones. PPP exchange rates adjust for this. Cross-country GDP differentials are therefore
typically smaller in PPP terms than when GDP is measured at market exchange rates.

• The law of compound interest rules! Small differences in growth rates sustained over time
lead to huge differences in incomes. Recall, a country growing at 7% per annum doubles in
size in a decade; one growing at 2% will take 35 years to double.

• Country rankings change dramatically owing to big differences in average growth rates over
time, but overall incomes are still very unequally distributed – the average income of the
global top 10 percent is about 90 times that of the global bottom 10 percent.

• Aggregate growth rates in low income countries are often thwarted by high population
growth rates (table 1). ‘Too much capital widening and not enough capital deepening’ as
Robert Solow would say…we’ll come to him shortly.

• Growth in many developing countries, especially in Latin America and Sub Saharan Africa
over recent decades has been episodic (Table 4). Many countries enjoy periods of very fast
growth but too often these growth spurts or accelerations are not sustained.

• Countries with volatile growth rates often face volatile terms of trade (‘shocks’). See Table 4
and Figure 1. Volatility in terms of trade is particularly difficult to manage for small open
economies.

• As is increasingly being understood, although there has been some reduction in cross-
country inequality over recent decades, within-country inequality has tended to increase.

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Table 1: GDP, composition and growth

Average annual growth

Current Prices 2017 PPP US dollars

1990 2022 Population GDP per capita

1990-2019 1990-2019 2019-22

$22.8 $100.5
World GDP[1] 1.61% 2.54% 1.23%
trillion trillion

Regions Share[2]
OECD 82.5% 59.3% 0.80% 1.80% 0.99%

Middle East and North

3.5% 4.4% 2.97% 1.87% 0.77%
Africa

Latin America and

4.9% 6.2% 1.59% 1.79% 0.54%
Caribbean

South Asia 1.8% 4.3% 2.22% 7.54% 2.24%

East Asia and Pacific 20.8% 30.5% 1.01% 8.41% 2.78%
Sub-Saharan Africa 1.6% 2.0% 4. 4% 1.00% -0.59%

Source: World Bank WDI (GDP PPP(constant US$2017)

Note: [1] 1 trillion = 1012 [2] sums to more that 100% because some OECD members are counted more than
once.

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Table 2: Shares of world GDP (PPP) of top 12 countries

1990 (PPP) 2022 (PPP) 2022 (Current US$)

1
United States 20.7% China 18.8% United States 25.7%
2
Japan 8.3% United States 15.8% China 18.1%
3
Russia 6.5% India 7.4% Japan 4.3%
4
Germany 6.0% Japan 3.8% Germany 4.1%
5
Italy 4.2% Germany 3.3% India 3.4%
6
France 4.0% Russia 2.9% UK 3.1%
7
UK 3.7% Indonesia 2.5% France 2.8%
8
China 3.3% Brazil 2.4% Russia 2.3%
9
India 3.2% UK 2.3% Canada 2.2%
10
Brazil 3.2% France 2.3% Italy 2.0%
11
Mexico 2.6% Turkey 1.9% Brazil 1.9%
12
Spain 2.2% Italy 1.9% Australia 1.7%

Share top 15 72.7% 70.4% 76.1%

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Table 3: Per capita incomes (2020 PPP Constant US$)

Note: Data truncated because of missing data for: Syria, Yemen, South Sudan,
North Korea, Eritrea, Cuba, European principalities (e.g. Monaco, San Marino, Liechtenstein),
British Overseas Territories (e.g. British Virgin Islands).

Table 4: Volatility in GDP and Terms of Trade (1990 – 2021)

Coefficient of Proportion of years in which growth was…

variation relative to
OECD < 0% < 1% < 2% > 2%
GDP
growth ToT

OECD 1.00 1.00 10% 29% 58% 42%

MENA 1.72 2.19 26% 45% 52% 48%
LAC 2.20 1.79 29% 39% 58% 42%
SA 0.70 1.19 6% 7% 16% 84%
EAP 0.59 0.48 6% 6% 7% 93%
SSA 1.59 2.55 29% 52% 68% 32%
Coefficient of variation = standard deviation / mean.

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Figure 1.1: Net Barter Terms of Trade

Net Barter Terms of Trade 1980-2020

(1980=100)
180

160

140

120

100

80

60

40

20
Chile Malaysia United States Zambia
0

Percentage ratio of the export unit value indexes to the import unit value indexes, measured relative to the
base year 2000, using the current year's trade values as weights.

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 4. The Small Open Economy

These big ideas in growth and volatility serve as a background for much of the analysis we will
undertake this term.

Throughout much of this course – although with some very obvious exceptions such as China and
India -- we make extensive use of the small open economy (SOE) model, sometimes referred to as
the Dependent Economy model. Formally, we mean that the economy is small enough that its
consumption and production decisions do not influence prevailing world prices for goods, labour and
capital. The SOE is therefore a price taker in world (goods and factor) markets.

The notion is often stretched further however to ensure our ‘calibration’ of models reflects key
characteristics of developing countries. Thus, for example:

• Developing countries tend to be more open to trade in general, and more reliant on primary
commodity exports in particular, than industrialized economies. Hence current account
shocks (terms of trade shocks) are more prevalent and the evolution of the current account
arguably more important.

• Similarly, in developing economies, especially in low-income ones, production is often less

diversified so that climatic and technological shocks can have consequences which are large
relative to total GDP.

• In contrast, developing countries, especially low-income developing countries, are less

integrated into global capital markets and therefore may be less vulnerable to global
portfolio shocks (although this is rapidly changing, so that the risk of ‘sudden stops’ or
reversals of capital flows plays an increasing role in policymaking – as is being played out
during the current pandemic.

An aside: It will often be the case that while low income countries are insulated from ‘first-
round’ asset market shock, because they are less financially integrated, they are affected
through the current account by the indirect effect of these shocks on global demand and
hence the terms of trade, and on the cost of trade finance.

• Thin goods and factor markets means monopoly/imperfect competition is endemic. Lots of
implications flow from this, in terms of the distributional impact of shocks and policy
interventions, and a range of political economy considerations. [Very often, our economic
models tend to side-step this issue…and I can’t promise we will not do the same in this
course].

• Labour markets. Many macroeconomic models of the small open economy tend to assume
full employment of resources with aggregate output determined on the supply side. We
initially follow this tradition, but this may often be a very poor reflection of economic
realities. Economies may be better described by open and/or disguised unemployment and

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 output may determined on the demand side with key prices (e.g. for labour) being sticky,
certainly in the short-run and possibly also in the medium term.

• Finally, and related, domestic markets for financial assets (money, public debt, equity and
corporate bonds) tend to be thin or non-existent and key institutional capacities are weak.
This means, amongst other things, that transmission mechanisms from instruments of
macroeconomic policy to the real economy are likely to differ from those found in
industrialized economies, if not in terms of the channels of influence certainly in terms of
the relative strength of different effects [These issues will be explored in detail in my HT
Development Module on Macroeconomic stabilization].

5. Methods of macroeconomic analysis and a roadmap for the lectures to follow.

Economies are general equilibrium systems characterized by pervasive feedback effects, where
many variables of interest are determined endogenously. Hence the ceteris paribus assumption on
which we heavily rely in partial (micro)economic analysis cannot be so readily invoked.

In principle we could study macroeconomic systems from a purely microeconomic perspective (by
modelling the behaviour of individual agents) but this is analytically intractable.1 To render
macroeconomic analysis tractable we must therefore aggregate: over individuals, over goods and
sectors and even over time. Here we consider the different dimensions of aggregation used in
macroeconomics; they will shape the structure of the remainder of this course.

5.1 Aggregation over individuals

Much of modern macroeconomics is based on the concept of the representative (private) agent –
who is assumed to act in a manner that is consistent with the micro-foundations of consumer
behaviour and the theory of the firm. This allows us to examine aggregate outcomes and choices as
if they were the outcome of individuals’ optimizing behaviour. One area where this is particularly
valuable is in the analysis of international trade where the focus is on differences between different
countries’ preferences, in which case being able to suppress within-country differences through
aggregation is analytically valuable.

However, this is a rather heroic assumption. To see how potentially serious the issue of aggregation
can be let’s look at a very simple example.

Suppose we are interest in describing consumption and we adopt a very simple linear Keynesian
consumption function of the form:

𝑐𝑖 = 𝑎𝑖 + 𝑏𝑖 𝑦𝑖 .

1
Having said this, powerful computing techniques make it possible for this microeconomic approach to
general equilibrium modelling to be adopted numerically, in the form of computable general equilibrium (CGE)
models.

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If we adopt the natural aggregation over all i individuals in the economy so that 𝐶 = ∑𝑖 𝑐𝑖 and 𝑌 =
∑𝑖 𝑦𝑖 then we would write down the aggregate consumption function as

𝐶 = ∑ 𝑎𝑖 + ∑ 𝑏𝑖 𝑦𝑖 = 𝐴 + 𝐵𝑌
𝑖 𝑖

∑𝑖 𝑏𝑖 𝑦𝑖 ∑𝑖 𝑏𝑖 𝑦𝑖
where 𝐵 = = ∑𝑖 𝑦𝑖
is what we typically refer to as ‘the’ aggregate marginal propensity to
𝑌
consume.

Looking at this for 30 seconds reveal the problem with naïve aggregation! Suppose the income of
person i rises by one unit, other things equal. Then aggregate income Y also rises by one unit and
consumption rises by 𝑏𝑖 . So if the b’s vary across individuals then the effect on consumption depends
on who gets the extra income. The aggregate B is constant only if all individuals have the same
marginal propensity to consume, i.e. 𝑏𝑖 = 𝑏 = 𝐵, and hence the aggregate propensity will be
directly related to the individual propensity. In all other circumstances, the aggregate propensity
will depend on the distribution of marginal income, i.e. who gets how much.2

In other words, the representative agent is only representative if she or he represents a

completely homogenous group, or if we make strong assumptions about preferences.

When there is heterogeneity in preferences across agents, the representative agent structure may
be extremely problematic. A classic example might be where some households are credit rationed
and others are not. In such circumstances, for example, the aggregate response to changes in
interest rates will depend crucially on this heterogeneity, it will depend on who precisely gets the
income. For example, an increase in income at the margin will induce very different consumption
responses if the individual is credit rationed or not.

Heterogenous agent (HA) models in macroeconomic constitute an emerging field in computational

macroeconomics. It is beyond the scope of this course to examine this field but if you are interested,
this topic is taught in the 2nd year ‘Advanced Macro II’ course in the M.Phil. Economics programme.

One approach to the question of aggregation over individuals stretches back to classical and Marxist
traditions in economics where emphasis is placed on identifiable class-based groups: landlords,
workers and capitalists being the most obvious. These distinctions underpin structuralism or
heterodox traditions in development macroeconomics, much in favour in Latin America until the
1990s. Structuralism, which rejects the (neoclassical) focus on methodological individualism in
favour of an approach which emphasises class- or group-based conflicts and sees macroeconomics in
terms of the dynamic resolution of these class-based tensions (see for example Taylor, 2004).

2
The conditions under which aggregation over preferences is and is not possible is discussed extensively in the
classic text by Angus Deaton and John Muellbauer Economics and Consumer Behaviour (CUP: 1980) chapters 5
and 6.

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5.2 Aggregation over sectors

There are two important dimensions here. The first concerns the structure of production in an
economy. Historically, macroeconomic analysis has tended to restrict itself to a one-sector model
with one representative firm producing a homogeneous good (output). This is a useful in a wide
range of settings, but less so in others. Consider, for example, issues of growth where the
economics of development is as much about the structural transformation of economies – from
(labour-intensive) agriculture to (capital or skill-intensive) manufacturing and services – as it is about
aggregate growth. In our study of growth, for example, we will want to maintain a multi-sector
distinction. We do not tackle multi-sectoral growth models in this part of the course.

When we adopt a short- or medium-term focus, questions of economic adjustment (around a long-
run growth path) we will often need to distinguish between sectors. We discuss how this might be
done in the context of ‘aggregation over goods’ (see below).

The second fundamental distinction is between the public sector and the private sector and it is on
this distinction that the analysis of economic policy is based. Analysis of fiscal, monetary and
exchange rate policies proceeds from the perspective that the public sector has monopoly powers in
key respects: the setting and collection of taxes; the issuing of (base) money; the enforcement of
contracts etc. At the same time, much of modern political economy is located in the analysis of the
competition for, and disposition of, these monopoly rights. Fiscal and monetary topics are discussed
towards the end of this term. Political economy considerations are discussed in Hilary Term
modules.

5.3 Aggregation over goods

The simplest macroeconomic model, such as the basic IS-LM model you will have encountered as
undergraduates, has only one good which is used indifferently for both investment and consumption
and involves only one period (implying that investment has only a demand effect since we do not
hang around long enough to get the future payoff; it has no supply side effects).

But if we want to study open economies in which goods are exchanged, where trade is not
necessarily always balanced, and where investment expenditure today does have future
consequences, we need to permit some distinction over time and between goods. There are a
number of schemes we could adopt:

• between ‘home’ and ‘foreign’ goods

• between tradable and non-tradable (a ‘two-good’ disaggregation)
• between exportable, importable and non-tradable goods (a ‘three-good’ disaggregation).

5.4 Aggregation over time and inter-temporal macroeconomics

Even when the physical characteristics of a type of good are identical, two units are not the same
good if they are available at different dates. Hence net trade may take place between countries

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even if their production is essentially indistinguishable, because of differences in time preference or
in expectations about their respective futures.

Study of trade flows and especially of the current account balance can therefore be carried out
without reference to difference in goods, but rather in an inter-temporal perspective.

Relatively few questions of macroeconomic interest can be addressed satisfactorily within a one-
period framework. Savings, investment, business cycles, debt accumulation, growth, all take place
over time, while the analysis of the effects of shocks and policy choices often requires an ‘impulse-
response’ rather than a simple ‘comparative static’ perspective.

Models of inter-temporal optimization must take a position on:

The life of the economy (i.e. the horizon for analysis):

• Finite horizon models (e.g. two periods or more). Note that the two periods simply could be
‘the present’ and ‘the future’;

• Infinite horizon models.

The lives of individuals

• Infinite (possibly appropriate if we focus on representative agents or social-planners);

• Finite lives, non-overlapping generations (one generation is born just as the previous one
dies);

• Finite lives, overlapping generations (so that at any point in time ‘old’ and ‘young’ co-exist
and interact). These are known as overlapping generations (OLG) models.

Our first look at inter-temporal behaviour will assume that the life spans of individuals are coincident
with that of the economy. We shall return to the question of finite, and overlapping lives.

5.5 The Roadmap

The themes of growth, shocks and what to do about them are cross-cutting issues and we shall
return to them repeatedly through the term as we explore the different dimensions of aggregation
and different classes of policy problem. In doing so, I need to stress two points:

First, to keep our macroeconomics manageable, we will frequently ‘close down’ one disaggregation
to understand the importance of another. So, for example, when we first look at inter-temporal
resource allocation we will suppress issues of inter-sectoral resource allocation and vice versa.
Similarly we will exploit a representative agent structure as much as possible.

However, these different aggregation strategies may be relevant for different aspects of the same
policy question. For example, while ‘one good’ inter-temporal models will be relevant to

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understanding issues of debt sustainability and adjustment in the face of a terms of trade shock, a
‘two-good’ or ‘three-good’ model will be necessary for understanding implications for inter-sectoral
resource allocation issues in response to the same shock. In reality the appropriate model is likely to
disaggregate over time and between sectors. Such models are conceptually simple but cumbersome
and while they are frequently used in practice we shall tend to keep matters simple and allude to
them only in passing.

Second, the analysis in the first five weeks of the course will be grounded overwhelmingly in models
of the real economy in which the public sector has a shadowy existence and, in particular, where the
‘classical dichotomy’ between money and goods holds. In other words, money is neutral: all goods
prices are relative prices in terms of some numeraire; the real interest rate is the relative price of
current and future consumption; and factor prices are determined by their marginal products.

Only when we move on to considering issues in the areas of fiscal, monetary and (nominal) exchange
rate policy do we bring the public sector out of the shadows and, in doing so, relax our assumptions
about the neutrality of money.

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