The Pace of Economic reform:

Gradualism or Cold Turkey

Transition Economics
lecture 1
 Should reforms be introduced gradually or
rapidly: Stylized Facts on Gradualism

• Gradual Reforms have unintended consequences

– price reform and shortages
– More in general Gradualism creates second best problems

• Gradual Reforms more often fail as the process causes

adjustment problems before points of no return are
reached
• Rapid reformers lost out in elections throughout EE in
spite of apparent succes
 Literature

• Dani Rodrik, “The Dynamics of Political Support for

Reform in Economies in Transition”, CEPR WP no 1115

• S. van Wijnbergen, “Intertemporal Speculation,

Shortages and the Political Economy of Price Reform”,
Economic Journal, 1992
 Rodrik on political support dynamics
• State sector employees
– current: nt
*
– Long term: n
– Adjustment: tn  nt 1   ( n *
 nt 1 )

• Private Sector Employees

– current: mt
*
– Long term: m
– Adjustment: mt  mt 1  k (m  mt 1 );k  1
*
 Subsidies to State Sector

• Subsidies to State Sector

   ( t ), '  0

• Financed through Taxes on Private Sector

–   n / m

• May imply a maximum subsidy rate σmax

Employment Dynamics
nt  n*  (1   )t (n0  n* )
mt  m*  (1  k )t (m0  m* )
ut  1  nt  mt
 Wages and Productivity

• Productivity State Sector 1

• Productivity Private Sector λ>1

w  1 
s

w p   
w 0
u

• Assume wp > ws
 Hiring and Firing Dynamics

• no firings in P sector, hiring from n and u

–
mt  mt 1
Prob(new jobinPsector) 
nt 1  ut 1
• Attrition from S Sector q
nt  nt 1
qt 
nt 1
 (n*  nt 1 )

nt 1

• q > z for small t => u rising initially

 Hiring and firing Dynamics

Hiring back into the state sector:

( zt  qt )nt 1
ft  max( , 0)
(1  zt )ut
 Welfare
• Welfare in P sector (never fired once in)

Wt   vsp s t
P

s t

• Welfare in S sector

Wt   ( pt ( s )vsS  rt ( s )vsP ) s t
s

s t
 Welfare and Subsidies

• σ = σb => no transition

• λ >> 1 => W0S (0)  W0S ( b )

Welfare Dynamics and Subsidies
Welfare and Voting Dynamics

lim Wt (0,  )  W ( )
S S
t 

lim Wt S (0,0)  W S (0)  W S ( )

t 
 Cold Turkey, Gradualism and Speculative
Attacks

• EE started with extensive price controls

• Almost all countries witnessed initial periods of

shortages, speculation and often hyperinflation

• Should prices have been decontrolled Cold Turkey or

gradually?

• What explains periods of sliding back (re-imposition of

controls)?
 Van Wijnbergen (1992) on Gradualism vs
Cold Turkey Price Decontrol
• T-sector cst returns, uses L only
• NT sector uses fixed factor and L
• 2 periods: today (capital letters) and tomorrow (lower
case)
C  C ( w, Y ), Cw , CY , CYY  0
c  c( w, y ), cw , c y , c yy  0
StorageTechnology :
s   ( S ), with
 (0)  0,0   '  1,  ''  0
 Prices and Decontrol Programs
• Market clearing price today, tomorrow: P*, p*

• Controlled price pre-reform: P0

• Reform programs:
– Cold Turkey: jump to immediate market clearing in both periods
– Gradualism:
• market clearing in period 2
• Higher price in period 1, but still rationing: Pg < P*

• Collapse (probability ρ)
– Reform abandoned at beginning period 2
– Gradualism: first period price prevails in second period
– Cold Turkey: re-imposition of controls at level below mkt clearing
price
 Aggregate Supply Schedule for given
collapse probability ρ
• Period 2: state of reform known
– No collapse: cy(y*) = p*
– Collapse: cy(yc) = pg (= Pg)

• Period 1: set output Y and hoarding level S prior to

knowing second period state
max(Y  S ) P
S ,Y
g  C ( w, Y )   ( E{( y   ( S )) p  c( w, y )}

subjectto
S 0
S Y
• Results: CY  Pg  
Pg   ' Ep    
 Market Equilibrium
• Consumers have expenditure function E (  ( P,1),  ( p,1),U )

• Define virtual price PV: E (  ( PV ,.),  ,U )

 ARh
P

• Welfare cost of rationing: dU

EU  ( PV  Pg )
dARh

• Market Equilibrium:
E
Y S 
P
E
y  (S ) 
p
Net Aggregate Supply in period 1 and the
collapse probability
 Equilibrium Collapse Probability
Define Voter Dissatisfaction schedule through impact hoarding
response on perceived collapse probability
dU dARh
EU   AR  ( PV  P0 )
h

dP0 dP0
 ARh  ( PV  P0 )

ARh
Define elasticity at which zero welfare effect: c 
PV  P0

Bayesian updating of everybody’s beliefs after observed net supply

response
What happens to median voter’s beliefs? c

Collapse probability: prob median voter’s belief below αc:   

 m 
f ( m )d m

Yields Voter Dissatisfaction Schedule VDS

Cold Turkey versus Gradualism