The Structuralist Macroeconomic

Models

Module One

ECN 422 Lecture Slides

1.1 Introduction
• We have seen in chapter 1 the various economic crises on the global
scene and particularly in the LDCs and how it made the intervention
of the IMF inevitable.

• The IMF, in providing assistance to redress balance of payments

difficulties in LDCs, imposed some conditionalities on its loans which
took the form of short-term stabilization measures.
1.1 Introduction

• The IMF approach was seen as being harsh but there was no distinct
methodological approach to serve as bases for alternative policy
analysis. It was this perception that led to the development of the
structuralist school of thought.

• The building blocks of the structuralist model are the same as those
of the main stream macro models: aggregate supply and aggregate
demand. The main differences are in the specifications of the demand
and supply functions.
1.2 Aggregate Supply Function

• Aggregate supply in an economy depends on the behaviour of

economic agents on one hand and the product and labour markets
supply and demand functions. In all these cases, LDCs are perceived
to be different from developed economies.

• The main differences are as follows:

(1) Product markets are non competitive in LDCs. Product markets in
LDCs are characterized by oligopoly with markup pricing.
1.2 Aggregate Supply Function

(2) There is persistent excess supply in the labour market due to high
wages. This resulted from
• Emergence of labour unions;
• Salaries in civil services are inflated; and
• Multinational corporations mimic salary structure in the advances
countries.

(3) Economic production activities in the manufacturing sector are

influenced by imported intermediate inputs
1.2 Aggregate Supply Function

(4) Financing production activities

• Cash borrowing to finance working capital;
• Equity investment relatively low;
• High interest rate; and
• Exchange rate.
1.2 Aggregate Supply Function

• Based on these, the aggregate supply function is specified as follows:

Ys= Ys(P,i,w,e)
Ys: real output

P: price level
i: interest rate
w: nominal wage rate
e: exchange rate
1.2 Aggregate Supply Function

• In the P, Y plane the aggregate supply curve AS is upward sloping and

an increase in i, w or e would shift the aggregate supply schedule left.
It is also expected that the AS schedule will be relatively flat and not
steep.
1.3 Aggregate Demand Function

Aggregate demand in developing countries is affected by their institutional

characteristics.
• Financial intermediation is not widespread;
• Number of banks is low and unduely concentrated in the urban areas;
• Bank interest rate are often controlled by the government (financial
repression); and
• Large part of investment is self-financed.

• There are four different types of economic agents considered in a typical

developing economy namely: (i) the Central Bank, (ii) Commercial Banks (iii)
Firms and (iv) Households.
 1.3 Aggregate Demand Function

Given the following definitions:

  : sum of past government budget deficits
  : Sum of past balance of payment surpluses
R: Commercial Bank reserves
Lb: short-term working capital loan to firms
Df : Deposits of firms
Dh: Deposits of Household
Pk: Nominal value of current capital stock
Lh: Loans from household
Nf: Net worth of firms
Nh: Net worth of Household
1.3 Aggregate Demand Function

• Then, we can describe the financial balance sheets of the four

economic agents which correspond to the equality between assets
and liability i.e.
Assets Liabilities
CB:    = R …………..…..(2)
ComB: R + L = Df + Dh ……………………………….(3)
F: Df + Pk = Lb +Lh + Nf ……………………………(4)
H: Dh + Lh + Nf = Nh ……………………………(5)
 Monetary base
This is determined completely by the sum of past government budget deficit and
the sum of past balance of payments surplus. This will cause a direct and
cumulating increase in the monetary base. At any time period,
 = wNg + PIg - T ………………………………………………………………(6a)
 = e(X - M) …………………………………………………………………(6b)
Ng
where: : Size of labour force employed by government
Ig : Amount of investment undertaken by government
T: Tax revenue
X: Exports
M: Imports
e: exchange rate
 Monetary base

The Central Bank imposes a reserve requirement ratio on the

commercial banks such that
R = r(Df + Dh) ………………………………………………………………(7)
Using equations 1, 2 and 7, the supply of bank loans is determined as
1 r
Lb        ……………………………………………………..(8)
r
Monetary base

Consequently, any increase in the monetary base or decrease in the

reserve requirement ratio increase Lb.
How do we obtain equation (8)?
  
=R
R + Lb = Df + Dh
Eliminate R from (2) using (7)
R = r(Df + Dh)
R (Df + Dh) + Lb = Df + Dh
Lb = (1-r) (Df + Dh) ……(i)
 Monetary base

From (1) and (7)

     = R = r (Df + Dh)
     = (Df + Dh) ……. (ii)
r
Combine (i) and (ii)
Lb =       1 r r …… …………………………………………………………………….(8)
 
 Demand for Balances

This is modelled as a function of real income Y and the interest rate, i. Thus demand for real
balances
Dh by households is given as:
 h Y , i  ………………………………………………………………………………………(9)
P
Firms demand for money in order to finance their variable costs during the period of
production is given as:
Df  wN  emY 
f  , i………………………………………………………………………….(10)

P  P 

where:
w: nominal wage rate
N: level of employment
m: marginal propensity to import
 The LM curve

To obtain the LM curve we need to substitute appropriately and

eliminate the financial variable to get a single equation that describes
the financial equilibrium of the economy:
 wN  emY 
P f  , i   P h Y , i  
 
 0 …………………………………………..(11)
 P  r

i.e. money demand by firms and household must equal money supply
 
   
 r
The LM curve

The endogenous variables are P, Y and I the two obvious policy

variables are e, r i.e exchange rate and reserve requirement ratio.
Holding all other ingredients constant, the slope of the LM schedule is

di  ( f /  ( wN  emY )em  (h / Y 

  0
dY LM  1  (h / i ) 
The LM curve

Hence LM is upward sloping in the (i, Y) plane. This is the same result
obtained for a Keynesian LM model. However, in LDCs the LM curve is
steeper because
• Ratio of money to GNP is smaller in LDCs
• Increase in price level will lower real supply of money and shift the LM
curve upward and to the right
• Increase in e, r row will have the same effect
• Increase in and implies an increase in the monetary base and the
LM curve shift to the right.
IS curve
In order to obtain expression for the IS curve, we must describe the
equilibrium conditions in all the goods markets. Goods market
equilibrium occurs when aggregate goods demand equals aggregate
supply. We shall thus describe four markets: consumption,
investment, government and external trade.
IS curve
(a) consumption function
Real consumption expenditure depends on real disposable income. In addition
functional distribution of income is important in LDCs. It is often argued that
the marginal propensity to consume of wage is lower than that out of capital
income. With the inclusion of tax rate into consumption function, we have:

C  C Y , S ,  
+ - -
Where: SL : Share of labour in total income
‫ ﺡ‬: proportional income tax rate
IS curve
With the a priori as indicated by the signs below the variables on the
night hand side consumption rises when real income rises and falls
when share of labour in total income or income tax rate rises.

(b)Investment Function:
Investment is assumed to depend positively on the desired capital
stock, which in turn, depends on output. Two interest rates are
available in the market: ib which is fixed and i , which is flexible.
Investment function can simply be expressed as:
 IS curve
I  I (Y , i , ib , ,  , w , e )
     p ……………………………………………………………………..(13)
p
 

where Y: income/output
i : Interest rate (flexible)
ib : Official bank rate (fixed)

: Government budget deficit

  
: Balance of payments surplus
: Total reserve
w/p : Real wage
e/p : Real exchange rate
: Government budget deficit
• Exercise: Interpret the signs below the variables.
IS curve

(c)Government Expenditure
Government spending in LDCs is composed largely of wage payments.
The wage paid to government employees is kept in line with those in
private sectors or vice versa. Another determinant of government
expenditure is public investment. The latter is fixed in short run in real
terms. We thus have
 
G=G  wNg
, Ig  ……………………………………………………………….(14)
 P  
  
IS curve
(d) Net Exports
The assumption of small open Economy (SOE) is generally adopted in
LDCs. Hence, domestic price of tradeable depends on world prices,
subsidies, tariffs and exchange rate.
IS curve
• In most LDCs, import and domestic goods are very poor substitute.
Even in cases where countries embarked on import substitution
industrialization strategy, imports end up being non-competitive
imported inputs.

• Government also derives substantial income from ad valorem taxes

on imports (‫ﺡ‬m). There is also a tax on export, ‫ﺡ‬x which are often
subsidies such that ‫ﺡ‬x<0 this external sector constitute an important
part of macroeconomic problems of LDCs since they often end up in
current accounts deficit.
IS curve
We can write net exports, NX, as:
e  e(1   x )  
NX  (1   N ) X    (1   m )mY  ……………………………………………………(15)
p  P  

(d)Goods Market
We can now write the goods market equilibrium condition a
wGn e e(1 -  X )
Y = C(Y, SL, ) + I(Y, i, ib,     , , w , e ) + G( , Ig ) + [(1 -  X )X( ) - (1 +  m )mY]
p p p p P

• The IS schedule is the equilibrium relation between i and Y in equation (16).

The schedule has a negative slope in the ( i, Y) plane for fixed value of other
variables.
IS curve
Experiments
• An increase in government expenditure will shift the IS curve
outward.
• ‫ ﺡ‬or ‫ﺡ‬m will reduce the value of net exports in domestic currency
thus shifting the curve inwards. This is achieved if export supply or
import demands are price elastic.
• When there is a devaluation of the real exchange rate (e/p) the terms
of trade, TOT, are adversely affected and investment declines because
the cost of intermediate inputs rises. Under Marshall-Lerner
condition, we know that
IS curve
B
 X xs  Z zD  0 …………………………………………………………………(17)
e
where
B: initial trade balance in domestic currency
 XS : export supply elasticity
 zD : absolute value of import demand elasticity
Z: imports in foreign currency
X: exports in foreign currency
IS curve
 XS and  ZDare small in LDCs and B may be large negative value in time
of BoP difficulties. Hence, under condition (17) devaluation will
reduce aggregate demand and shift the IS curve inwards.

A reduction in real wage (w/p) has two opposing effects on the IS

curve:
• It will lead to IS curve being shifted downward and to the left through
its effect on wage share, SL
IS curve
• It will lead to IS curve being shifted upward and to the right through the
effect on retained earnings and hence fixed private investment.
• In LDCS, we expect the former to dominate.
• The price level is the 3rd endogenous variable in the goods market
equilibrium equation. An increase in P implies both a revaluation of the real
exchange rate (a decrease in e/p) and a fall in the real wage (a decrease in
w/p).the net effect would therefore be ambiguous. Thus, zero is assumed
for this effect.

• We now turn to the determination of Aggregate demand, AD, and

aggregate supply, AS, schedules.
1.4 Discussion on Aggregate Demand and
Aggregate Supply
1.4.1The Aggregate Demand (AD)
• The AD is obtained by removing one of the three endogenous variables i.e.
from the system. We now have a relation between P and Y and we write as
follows:
• AD=Yd
• With all other factors held constant, the AD schedule is downwards sloping in
the (P,Y) plane. This AD curve is much steeper due to
• (a) if price rises, the IS schedule shifts to he left in the standard model but
does not do so in developing countries.
• (b) IS curve is relatively steep due to high marginal propensity to import and
a low interest elasticity of investment demand.
The Aggregate Demand (AD)

• In the developed economics, devaluation increase aggregate demand

whereas in LDCs, devaluation decreases aggregate demand.

• In addition, the nominal wage enters aggregate demand with an

uncertain sign.
1.4.2 The Aggregate Supply (AS)

The AS function can be written as:

Y S  Y S ( p, c, e, w) …………………………………………………………………….. (19)
   

In addition, the AD can be rewritten as:

Y d  Y d ( p, r , I g , e, w,  ,   ) …………………………………………………………………(20)
    ?  
The Aggregate Supply (AS)

• Explanation of the sign of the partial derivatives below the Yd and Ys

should be tried by students.
• We need to eliminate i from Ys. In doing that we write down the curb
market interest rate as a function of the price level and the exogenous
variable:
i  i ( p,  , I g , e, w,  ,   )
   ?   
……………………………………………………….. (21)
• These signs of the partial derivation in equation (21) are those
appropriate to the LDC model. With equation 21 we can eliminate i
from AD and AS framework and write them as function of two
endogenous variables, P and Y. thus equation 19 becomes
 The Aggregate Supply (AS)

 
Y  Y i , ( p, r , I g , e, w,  ,   ), p, e, w
s s

 


? 
_ _     ………………………………………… (22)

• The signs of the partial derivatives can be explained i.e. equation 22

1.5 Some Experiments

• Examine the effects of the following policy shocks:

• (a) Monetary Contraction
• (b) Restrictive fiscal policy
• (c) Devaluation
• (d) Wage restraint