Macroeconomics was developed in, and for, the industrialized countries. Theory and policy were both concerned with how monetary and fiscal policies should be used in those economies and what might be expected of such policies in terms of attaining full employment, controlling inflation or stabilizing economic activity. This corpus of knowledge, with its competing schools of thought, is sought to be used in developing countries and without any significant modification. It is by no means clear that such application is either justified or appropriate.
The object of this essay is to analyse the differences between the economies of industrialized countries and developing countries, which have important implications for macroeconomics in terms of theory and policy. Such differences shape not only the descriptive but also the analytical and the prescriptive dimensions of macroeconomics in developing countries. And, even if the foundations of macroeconomics are the same, a recognition of these differences is essential for an understanding of reality in the context of developing countries.
The structure of the essay is as follows. Section 1 suggests that it is the institutional setting, rather than the analytical structure of models, which explains the determinants of causation in macroeconomics. Section 2 explores the differences in the structural characteristics of developing economies as compared with industrialized economies. Section 3 considers the differences in macroeconomic objectives and examines why the range and reach of macroeconomic policies is different in the two sets of countries. Section 4 shows that the relative importance of trade-offs in macroeconomics depends on the institutional context, and analyses why the process of macroeconomic adjustment in developing countries, conditioned by their structural characteristics, might turn out to be very different from that in industrialized countries. Section 5 argues that the distinction between short-run macroeconomic models and long-term growth models is not quite appropriate in the context of developing countries where macroeconomic constraints on growth straddle time horizons. Section 6 concludes.
1. Institutional setting
It is widely recognized that developing economies are significantly different from industrialized economies. Yet, the macroeconomic models used, in terms of analytical constructs, typically follow a similar classification: classical, Keynesian and monetarist. The consensus among economists, much like fashion, has changed over time. The Keynesian consensus vanished, largely because the focus shifted from unemployment to inflation,1 but the shift was attributable, in small part, to the difficulties in reconciling the Keynesian worldview with behavioural hypotheses about households and firms in standard microeconomic analysis. The increasing focus on inflation and growth also shifted focus from aggregate demand to aggregate supply. This led to the emergence of supply-side economics, which argued for reducing public investment in the hope of stimulating private investment through incentives such as tax-cuts. Thereafter, for some time, the monetarist tradition became the ruling orthodoxy in macroeconomics. It stressed the importance of monetary aggregates and justified a natural rate of unemployment. But in most quarters there is now a consensus that monetarism too failed.
Neo-classical and neo-Keynesian models each had their day in the sun. The former constructed macroeconomic theories based on standard neo-classical assumptions of methodological individualism. Hence, neo-classical analysis emphasized the role of rational expectations, using representative agent models. As a result, it ignored the fundamental Keynesian distinction between households as savers and firms as investors. Neo-classical theorizing was premised on the idea that markets always cleared. Thereby it assumed away the problem of unemployment. What is more, it ignored the theory and evidence on market imperfections, asymmetric information and economic irrationalities. Neo-Keynesian analysis attempted to redefine microeconomics so as to make it consistent with macroeconomic observations. These models sought to focus on wage-price rigidities, but such theoretical explanations for rigidities were little better than the ad hoc models that they were intended to replace.