Chapter 22 (11)
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?
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
142 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ 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.
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 extremely variable prices. Finally, economies of developing countries typically
lack developed financial markets and often rely on fixed exchange rates and capital controls.
Chapter 22 (11) Developing Countries: Growth, Crisis, and Reform 143
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.
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-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.
A case study box on international reserves and China addresses two connected issues that are often
controversial politically: the mass accumulation of international reserves (largely in the form of U.S.
Treasury Bills) by developing countries and the attempt by China to limit the appreciation of its currency.
The box points out that much of the reserves accumulation is connected to insuring against shifts in financial
flows (such as sudden stops of external financing) more than trying to insure against excess needs based
on trade flows (as was the case when financial flows were quite small). In addition to self-insurance, though,
some of the reserves accumulation is a by-product of sterilized intervention. The clearest example of this is
144 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
preventative measures to reduce the risk of crises to measures that improve the way crises are handled (such
as reforming the IMF).
◼ 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 (through
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
3. Although Brazil’s inflation rate averaged 147 percent 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
foreign interest rate by 10 percent because expected currency depreciation (equal to 10 percent) must
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
Chapter 22 (11) Developing Countries: Growth, Crisis, and Reform 145
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 addition,
8. Cutting investment today will lead to a loss of output tomorrow, so this may be a very shortsighted
strategy. Political expediency, however, makes it easier to cut investment than consumption.
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 domestic
currency. Because Argentina already operates a currency board holding U.S. bonds as its assets,
dollarization would not be as radical as it would be for a country whose central banks hold domestic
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
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
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
146 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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.
From Table 22(11)-2, we see that yInd = $3,413 and yUS = $41,858. Thus, the ratio of the two countries
out per worker is yInd/yUS = $3,413/$41,858 = 0.08. Output per worker in India is 8 percent as large as
output per worker in the United States.