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Leverage Cycle Theory of Economic Crises and Booms  

John Geanakoplos

Traditionally, booms and busts have been attributed to investors’ excessive or insufficient demand, irrational exuberance and panics, or fraud. The leverage cycle begins with the observation that much of demand is facilitated by borrowing and that crashes often occur simultaneously with the withdrawal of lending. Uncertainty scares lenders before investors. Lenders are worried about default and therefore attach credit terms like collateral or minimum credit ratings to their contracts. The credit surface, depicting interest rates as a function of the credit terms, emerges in leverage cycle equilibrium. The leverage cycle is about booms when credit terms, especially collateral, are chosen to be loose, and busts when they suddenly become tight, in contrast to the traditional fixation on the (riskless) interest rate. Leverage cycle crashes are triggered at the top of the cycle by scary bad news, which has three effects. The bad news reduces every agent’s valuation of the asset. The increased uncertainty steepens the credit surface, causing leverage to plummet on new loans, explaining the withdrawal of credit. The high valuation leveraged investors holding the asset lose wealth when the price falls; if their debts are due, they lose liquid wealth and face margin calls. Each effect feeds back and exacerbates the others and increases the uncertainty. The credit surface is steeper for long loans than short loans because uncertainty is higher. Investors respond by borrowing short, creating a maturity mismatch and voluntarily exposing themselves to margin calls. When uncertainty rises, the credit surface steepens more for low credit rating agents than for high rated agents, leading to more inequality.. The leverage cycle also applies to banks, leading to a theory of insolvency runs rather than panic runs. The leverage cycle policy implication for banks is that there should be transparency, which will induce depositors or regulators to hold down bank leverage before insolvency is reached. This is contrary to the view that opaqueness is a virtue of banks because it lessens panic.

Article

Earnings Inequality in Latin America: A Three-Decade Retrospective  

Manuel Fernández and Gabriela Serrano

Latin American countries have some of the highest levels of income inequality in the world. However, earnings inequality have significantly changed over time, increasing during the 1980s and 1990s, declining sharply in the 2000s, and stagnating or even increasing in some countries since 2015. Macroeconomic instability in the region in the 1980s and early 1990s, as well as the introduction of structural reforms like trade, capital, and financial liberalization, affected the patterns of relative demand and relative earnings across skill-demographic groups in the 1990s, increasing inequality. Significant gains in educational attainment, the demographic transition, and rising female labor force participation changed the skill-demographic composition of labor supply, pushing the education and experience premiums downward, but this was not enough to counteract demand-side trends. At the turn of the 21st century, improved external conditions, driven by China’s massive increase in demand for commodities, boosted economies across Latin America, which began to grow rapidly. Growth was accompanied by a positive shift in the relative demand for less-educated workers, stronger labor institutions, rising minimum wages, and declining labor informality, a confluence of factors that reduced earnings inequality. In the aftermath of the global financial crisis, particularly after the end of the commodities price boom in 2014, economic growth decelerated, and the pace of inequality decline stagnated. There is extensive literature documenting and trying to explain the causes of recent earnings inequality dynamics in Latin America. This literature is examined in terms of themes, methodological approaches, and key findings. The focus is on earnings inequality and how developments in labor markets have shaped it.

Article

Economic History of the Middle East, 622–1914  

Timur Kuran

In the Middle Ages, the Middle East was an economically advanced region. Driving its successes were an essentially uniform legal system that supported intra- and interregional commerce, partnership rules that supported commerce among nonrelatives, and a form of trust known as waqf, which served as both a wealth shelter and a vehicle for endowing social services with protections against state predation. These same institutions disincentivized the institutional advances needed to generate the modern economy’s infrastructure indigenously. Home-grown innovations, such as the tradable equity known as gedik and a form of waqf used for moneylending (cash waqf), were ill-suited to large-scale and perpetual enterprises. Partnerships used to form small and ephemeral enterprises did not spawn organizational forms conducive to pooling resources on a large scale and perpetually. The waqf’s rigidities led to increasingly serious capital misallocation and misuse with changes in relative prices and the emergence of new technologies. Thus, the Middle East reached the Industrial Era institutionally unprepared. Sensing an existential threat from the West, its ruling elites launched massive economic reforms in the 1800s. These reforms involved transplanting Western economic institutions to the West in a hurry. Although the Middle East’s economic performance improved greatly in absolute terms, it remained underdeveloped in 1914, and the catch-up process has continued. Until the 1700s, the economic fortunes of the Middle East’s religious minorities generally tracked those of its Muslims. Thereafter, non-Muslims pulled ahead. As the global economy modernized, they benefited from a right that, from the early years of Islam, was denied to Muslims: choice of law. With the development of modern economic institutions by Europeans, choice of law enabled non-Muslims to increase the efficiency of their business operations. In the century preceding the Industrial Revolution, non-Muslims benefited also from international treaties that strengthened their property rights vis-à-vis those of Muslims.

Article

Trade Liberalization and Informal Labor Markets  

Lourenço S. Paz and Jennifer P. Poole

In recent decades, economic reforms and technological advances have profoundly altered the way employers do business—for instance, the nature of employment relationships, the skills firms demand, and the goods and services they produce and export. In many developing economies, these changes took place concurrently with a substantive rise in work outside of the formal economy. According to International Labour Organization estimates, informal employment can be as high as 88% of total employment in India, almost 50% in Brazil, and around 35% of employment in South Africa. Such informal employment is typically associated with lower wages, lower productivity, poorer working conditions, weaker employment protections, and fewer job benefits and amenities, and these informal workers are often poorer and more vulnerable than their counterparts in the formalized economy. Informal jobs are a consequence of labor market policies—like severance payments or social security contributions—that make the noncompliant informal job cheaper for the employer than a compliant formal job. Each model has a different benefit (or lack of punishment) for employing formal workers, and a distinct mechanism through which international trade shocks alter the benefit-cost of these types of jobs, which in turn results in a change in the informality share. The empirical literature concerning international trade and formality largely points to an unambiguous increase in informal employment in the aftermath of increased import competition. Interestingly, increased access to foreign markets, via liberalization of major trading partners, offers strongly positive implications for formal employment opportunities, decreasing informality. Such effects are moderated by the de facto enforcement of labor regulations. Expansions toward the formal economy and away from informal wage employment in the aftermath of increased access to foreign markets are smaller in strictly enforced areas of the country.

Article

Economics and Family Structures  

Thomas Baudin, Bram De Rock, and Paula Gobbi

Household decisions are one of the key elements impacting many dimensions of any economy. For instance at the macro level, decisions regarding how much to save affect the economy’s investment possibilities or decisions regarding children’s education affect the overall level of human capital. Economists who study household behavior have almost solely focused on the understanding of nuclear families, i.e., parents living with their own children, childless couples, or singles. However, it is well documented that family types are heterogeneous across and within countries, both in the past and in present times. Among the different types, a classical distinction can be made between nuclear, stem, and complex households. Stem families are those allowing for three generations to live in a same household. Complex families allow for several married siblings to live together in a household. It is important to note that this is not a marginal phenomenon. For instance in China or India, the two most populous countries in the world, the majority of the population lives in either stem or complex families types. However, there is still a lot to understand about them. What are the driving factors leading individuals to form one type of family over another? Are these drivers economic or cultural? What are the intra-household dynamics of these families and how do they function? What are the implications of these differences for implementing effective family policies? The focus on nuclear families limits our capacity to answer these questions and to analyze the impact of institutional phenomena or public policies. More research to understand the determinants and functioning of other types of families hence matters both from an academic and a policy perspective.

Article

Behavioral Development Economics  

Karla Hoff and Allison Demeritt

Economics, like all behavioral sciences, incorporates premises about how people think. Behavioral economics emerged in reaction to the extreme assumption in neoclassical economics that agents have unbounded cognitive capacity and exogenous, fixed preferences. There have been two waves of behavioral economics, and both have enriched development economics. The first wave takes into account that cognitive capacity is bounded and that individuals in many situations act predictably irrationally: there are universal human biases. Behavioral development economics in this first wave has shown that low-cost interventions can be “small miracles” that increase productivity and well-being by making it easier for people to make the rational choice. The second wave of behavioral economics explicitly takes into account that humans are products of culture as well as nature. From their experience and exposure to communities, humans adopt beliefs that shape their perception, construals, and behavior. This second wave helps explain why long-run paths of economic development may diverge across countries with different histories. The second wave also suggests a new kind of intervention: Policies that give individuals new experiences or new role models may change their perceptions and preferences. New perceptions and preferences change behavior. This is a very different perspective than that of neoclassical economics, in which changing behavior requires ongoing interventions.

Article

Missing Women: A Review of Underlying Causes and Policy Responses  

Aparajita Dasgupta and Anisha Sharma

One of the most egregious manifestations of gender bias is the phenomenon of “missing women.” The number of missing women is projected to increase to 150 million by 2035, as a result of prenatal sex selection and excess female mortality relative to men, and is reflected in male-biased sex ratios at all ages. The economics literature identifies several proximate causes of the deficit of females, including the widespread use of prenatal sex selection in many Asian countries, which has been fueled by the diffusion of ultrasound and other fetal sex-detection technology. The use of prenatal sex selection has become even more expansive with a decline in fertility, as parents with a preference for sons are less likely to achieve their desired sex composition of children at lower levels of fertility. Gender discrimination in investments in health and nutrition also leads to excess female mortality among children through multiple channels. The deeper causes of son preference lie in the socioeconomic and cultural norms embedded in patriarchal societies, and recent literature in economics seeks to quantify the impact of these norms and customs on the sex ratio. Particularly important are the norms of patrilineality, in which property and assets are passed through the male line, and patrilocality, in which elderly parents coreside with their sons, whereas their daughters move to live with their husbands’ families after marriage. Another strand of the literature explores the hypothesis that the devaluing of women has roots in historical agricultural systems: Societies that have made little use of women’s labor are today the ones with the largest female deficits. Finally, economic development is often associated with a decline in son preference, but, in practice, many correlates of development, such as women’s education, income, and work status, have little impact on the sex ratio unless accompanied by more extensive social transformations. A number of policies have been implemented by governments throughout the world to tackle this issue, including legislative bans on different forms of gender discrimination, financial incentives for families to compensate them for the perceived additional costs of having a daughter, and media and advocacy campaigns that seek to increase the inherent demand for daughters by shifting the norm of son preference. Quantitative evaluations of some of these policies find mixed results. Where policies are unable to address the root causes of son preference, they often simply deflect discrimination from the targeted margin to another margin, and in some cases, they even fail in their core objectives. On the other hand, the expansion of social safety nets has had a considerable impact in reducing the reliance of parents on their sons. Similarly, media and advocacy campaigns that aim to increase the perceived value of women have also shown promise, even if their progress appears slow. Analysis of the welfare consequences of such interventions suggests that governments must pay close attention to underlying sociocultural norms when designing policy.

Article

Urbanization and Emerging Cities: Infrastructure and Housing  

Gilles Duranton and Anthony J. Venables

Urbanization is a central challenge of our times. At its core, it is an urban development challenge that requires addressing transportation and housing in cities. Transport improvements can reduce travel times and improve the spatial reach of urban dwellers. But these improvements may be crowded out by latent demand for travel and may lead to worse congestion, pollution, and other negative externalities associated with urban traffic. To evaluate the effects of transport improvements, direct travel effects must be measured. Then, an improvement in traffic conditions somewhere may spill over to other areas. Firms and residents may also relocate, so economic growth close to a transport improvement may just result from a displacement of economic activity from other areas. Conversely, better accessibility is expected to foster agglomeration effects and increase productivity. Valuing these changes is difficult, as it requires being able to quantify many externalities such as congestion delays, scheduling gains, and greater job accessibility. Housing policies present different challenges. More fundamental policies seek to enable housing construction by offering more secure property rights, up-to-date land registries, and competent land-use planning—all complex endeavors and all necessary. Other housing policies rely on heavy government interventions to provide housing directly to large segments of the urban population. These policies often flop because governments fail to link housing provision with job accessibility and appropriate land-use planning. Housing is also an expensive asset that requires significant initial funding, while credit constraints abound in the urbanizing world. Policymakers also need to choose between small improvements to extremely low-quality informal housing, retrofitting modern housing in already-built urban areas, or urban expansion. All these options involve sharp trade-offs, subtle induced effects, and complex interactions with transport. All these effects are difficult to measure and challenging to value.

Article

Knowledge Spillovers, Trade, and Foreign Direct Investment  

Wolfgang Keller

This article explores knowledge spillovers, positive externalities that augment the information set of an economic agent, and reviews the evidence on such spillovers in the context of international economic transactions. The entry discusses trade channels of knowledge transfer associated with purchases from abroad (imports) and sales to abroad (exports). Another focus is on the foreign direct investment (FDI) channel through purchases from abroad (inward FDI) and sales to abroad (outward FDI). The entry also distinguishes knowledge flows from foreign to domestic agents and from domestic to foreign agents. The entry underlines the importance of empirical methodology and data characteristics that determine the quality of econometric identification. Even though spillovers are by their very nature—as externalities—difficult to identify, over recent decades a number of advances have produced robust evidence that both trade and foreign direct investment lead to sizable knowledge spillovers. These advances have been both conceptual as well as in the areas of empirical methodology and new data.

Article

Making Institutions Work From the Bottom Up in Africa  

Moussa P. Blimpo, Admasu Asfaw Maruta, and Josephine Ofori Adofo

Well-functioning institutions are essential for stable and prosperous societies. Despite significant improvement during the past three decades, the consolidation of coherent and stable institutions remains a challenge in many African countries. There is a persistent wedge between the de jure rules, the observance of the rules, and practices at many levels. The wedge largely stems from the fact that the analysis and design of institutions have focused mainly on a top-down approach, which gives more prominence to written laws. During the past two decades, however, a new strand of literature has emerged, focusing on accountability from the bottom up and making institutions more responsive to citizens’ needs. It designs and evaluates a mix of interventions, including information provision to local communities, training, or outright decentralization of decision-making at the local level. In theory, accountability from the bottom up may pave the way in shaping the institutions’ nature at the top—driven by superior localized knowledge. The empirical findings, however, have yielded a limited positive impact or remained mixed at best. Some of the early emerging regularities showed that information and transparency alone are not enough to generate accountability. The reasons include the lack of local ownership and the power asymmetry between the local elites and the people. Some of the studies have addressed many of these constraints at varying degrees without much improvement in the outcomes. A simple theoretical framework with multiple equilibria helps better understand this literature. In this framework, the literature consists of attempts to mobilize, gradually or at once, a critical mass to shift from existing norms and practices (inferior equilibrium) into another set of norms and practices (superior equilibrium). Shifting an equilibrium requires large and/or sustained shocks, whereas most interventions tend to be smaller in scope and short-lived. In addition, accountability at the bottom is often neglected relative to rights. If norms and practices within families and communities carry similar features as those observed at the top (e.g., abuse of one’s power), then the core of the problem is beyond just a wedge between the ruling elite and the citizens.