Chapter 22
Developing Countries:
Growth, Crisis, and Reform
■ Chapter Organization
Income, Wealth, and Growth in the World Economy.
The Gap between Rich and Poor.
Has the World Income Gap Narrowed Over Time?
The Importance of Developing Countries for Global Growth.
Structural Features of Developing Countries.
Box: The Commodity Supercycle.
Developing-Country Borrowing and Debt.
The Economics of Financial Inflows to Developing Countries.
The Problem of Default.
Alternative Forms of Financial Inflow.
The Problem of “Original Sin.”
The Debt Crisis of the 1980s.
Reforms, Capital Inflows, and the Return of Crisis.
East Asia: Success and Crisis.
The East Asian Economic Miracle.
Box: Why Have Developing Countries Accumulated Such High Levels of International Reserves?
Asian Weaknesses.
Box: What Did East Asia Do Right?
The Asian Financial Crisis.
Lessons of Developing-Country Crises.
Reforming the World’s Financial “Architecture.”
Capital Mobility and the Trilemma of the Exchange Rate Regime.
“Prophylactic” Measures.
172 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
Coping with Crisis.
Understanding Global Capital Flows and the Global Distribution of Income: Is Geography Destiny?
Box: Capital Paradoxes.
Summary
■ Chapter Overview
This chapter provides the theoretical and historical background students need to understand the
macroeconomic characteristics of developing countries, the problems these countries face, and some
proposed solutions to these problems. Students should be aware of the general events of the East Asian
financial crisis. The chapter covers the East Asian growth miracle and subsequent financial crisis in depth.
First, though, it introduces general characteristics of developing countries and the economics of their
extensive borrowing on world markets, as well as the inflation experiences, debt crisis, and subsequent
reform in Latin America.
The chapter begins by discussing how the economies of developing countries differ from industrial
economies. The wide differences in per capita income and life expectancy across different classes of all
countries are striking. Some economic theories predict growth convergence, and there is evidence of such
a pattern among industrialized nations, but no clear pattern emerges among developing countries. Some
have grown rapidly, while others have struggled. Overall however, developing countries have accounted
for an increasingly large portion of both global GDP and global economic growth.
There are important structural differences between developing economies and industrial economies.
Governments in developing countries have a pervasive role in the economy, setting many prices and
limiting transactions in a wide variety of markets; this can contribute to higher levels of corruption. These
governments often finance their budget deficits through seigniorage, leading to high and persistent
inflation. The economies of developing countries are typically not well diversified, with a small number of
commodities providing the bulk of exports. These commodities, which may be natural resources or
agricultural products have exhibited a volatile boom and bust cycle over the past two decades. Finally,
economies of developing countries typically lack developed financial markets and often rely on fixed
exchange rates and capital controls.
There is a discussion of the use of seigniorage in developing countries in the text. You may want to use the
discussion of seigniorage in the text as a springboard for a more in-depth discussion of this topic. In
particular, you could present a model of where seigniorage revenue is a function of the inflation rate
chosen. The function is concave, at first increasing but eventually decreasing as high inflation leads people
Chapter 22 Developing Countries: Growth, Crisis, and Reform 173
to hold less money (see Figure 22-1 below). It is much like the Laffer curve for taxation. This helps
explain how similar seigniorage revenues may come from widely different inflation levels.
Figure 22-1
In principle, developing countries (and the banks lending to them) should enjoy large gains from
intertemporal trade. Developing countries, with their rich investment opportunities relative to domestic
saving, can build up their capital stocks through borrowing. They can then repay interest and principal out
of the future output the capital generates. Developing-country borrowing can take the form of equity
finance, direct foreign investment, or debt finance, including bond finance, bank loans, and official
lending. These gains from intertemporal trade are threatened by the possibility of default by developing
countries. Developing countries have defaulted in many situations over time, from 19th century American
states to most developing countries in the Depression to the debt crisis in the 1980s. If lenders lose
confidence, they may refuse further lending, forcing developing countries to bring their current account
into balance. These crises are driven by similar self-fulfilling mechanisms as exchange rate crises or bank
runs (and are often referred to as “sudden stops” when financial flows stop running to developing
countries seemingly without warning), and the discussion of debt default provides an opportunity to revisit
the ideas of currency crises and bank runs before a full-fledged discussion of the East Asian crisis.
It is important to recognize the different types of financing available to countries. Bond funding, bank
borrowing, or official lending can all provide debt-oriented funding, while foreign direct investment or
portfolio investment in firms can provide equity financing. In addition, countries can borrow in their own
currency or in another currency. The chapter discusses the problem of “original sin” where many countries
are unable to borrow in their own currency due to both problems in global capital markets and countries’
own histories of poor economic policies.
The next section of the chapter focuses on the experiences of Latin America. In the 1970s, inflation
became a widespread problem in Latin America, and many countries tried using a tablita, or crawling peg.
The strategy, though, did not stop inflation, and large real appreciations were the result. Government-
174 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
guaranteed loans were widespread, leading to moral hazard. By the early 1980s, collapsing commodity
prices, a rising dollar, and high U.S. interest rates precipitated default in Mexico followed by other
developing countries. After the debt crisis stretched through most of the decade and slowed developing
country growth in many regions, debt renegotiations finally loosened burdens on many countries by the
early 1990s.
After the debt crisis appeared to be ending, capital began to flow back into many developing countries.
These countries were finally undertaking serious economic reform to stabilize their economy. The chapter
details these efforts in Argentina, Brazil, Chile, and Mexico and also discusses how crisis unfortunately
returned to some of these countries.
Next, the chapter covers the success and subsequent crisis in Asia. The causes of success, such as high
savings, strong education, stable macroeconomics, and high levels of trade are considered. Some aspects
of the economies that remained weak, such as low productivity growth and weak financial regulation are
also discussed. The crisis, beginning in August 1997, is explained in detail along with its spread to other
developing countries. The lessons of these years of growth and crisis are summarized as: choosing the
right exchange rate regime, the importance of banking, proper sequencing of reforms, and the importance
of contagion. A box then considers whether currency boards can make fixed exchange rates more
sustainable.
Finally, the chapter concludes with a section on current debates in the growth literature, chiefly a
discussion of the relative importance of geography and institutions in driving income growth and levels.
These factors are crucial to understanding the “Lucas puzzle” of why capital does not appear to be flowing
to developing countries despite their low levels of capital, suggesting a high return in these countries.
Rather, it appears that capital is flowing from the developing world to rich countries! Possible
explanations for this puzzle include lower levels of human capital in developing countries as well as
weaker institutions.
■ Answers to Textbook Problems
1. The amount of seigniorage governments collect does not grow monotonically with the rate of
monetary expansion. The real revenue from seigniorage equals the money growth rate times the real
balances held by the public. But higher monetary growth leads to higher expected future inflation and
Chapter 22 Developing Countries: Growth, Crisis, and Reform 175
2. As discussed in the answer to Problem 1, the real revenue from seigniorage equals the money growth
rate times the real balances held by the public. Higher monetary growth leads to higher expected
future inflation, higher nominal interest rates, and a reduction in the real balances people are willing
3. Although Brazil’s inflation rate averaged 147% between 1980 and 1985, its seigniorage revenues, as
a percentage of output, were less than half the seigniorage revenues of Sierra Leone, which had an
4. Under interest parity, the nominal interest rate of the country with the crawling peg will exceed the
5. Capital flight exacerbates debt problems because the government is left holding a greater external
debt itself but may be unable to identify and tax the people who bought the central bank reserves that
6. There may have been less lending available to private firms than to state-owned firms if lenders felt
that state guarantees ensured repayment by state-owned firms. (In some cases, such as that of Chile,
7. By making the economy more open to trade and to trade disruption, liberalization is likely to enhance
a developing country’s ability to borrow abroad. In effect, the penalty for default is increased. In
8. Cutting investment today will lead to a loss of output tomorrow, so this may be a very shortsighted
9. If Argentina dollarizes its economy, it will buy dollars from the United States with goods, services,
and assets. This is, in essence, giving the U.S. Federal Reserve assets for green paper to use as
Still, though, through dollarization, Argentina loses interest by holding non-interest-bearing dollar
bills instead of interest-bearing U.S. Treasury bonds. Thus, the size of the seigniorage given to the
lose is the interest they should be getting every year they hold the dollars.
10. No. Looking simply at countries that are currently industrialized and finding convergence is not a
valid way to test convergence. Countries that are currently well off may have started from a variety of
11. The moral hazard comes from the fact that borrowers may borrow in a foreign currency, assuming the
government will keep its promise to hold the exchange rate constant. Rather than hedging against the
Chapter 22 Developing Countries: Growth, Crisis, and Reform 177
12. Liability dollarization means that not only do participants in global financial markets face exchange
rate risk, but many citizens simply participating in local markets face these risks. This means that a
13. The production function in both countries is given by Y = AKαL1-α. We can convert this into a per
worker production function by dividing both sides by L. Y/L = AKαL–α = A(K/L)α. For ease of notation,
let lowercase letters denote per worker values so that y = Akα.
We can show that k = (y/A)1/α. Plugging into the expression above gives
yInd/yUS = [(yInd/AInd)/(yUS/AUS)]1/α. Solving for AInd/AUS yields:
178 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition