Volume 34, Number 4, April 2017

Volume 34, Number 4, April 2017

Answers

Development profile: Country U

Peter Smith

Did you work out the identity of Country U in this issue’s Development profile (back cover)? This resource provides answers to the questions that were posed there, together with some commentary.

Country U is a high-income country on World Bank criteria, and a high human development country according to the United Nations. Indeed, its gross national income per capita (PPP$) is above the regional average. Country U is seen by the World Bank as a relatively egalitarian society, with low inequality and poverty compared with other countries in its region. The average growth rate of 4.8% between 2006 and 2015 has demonstrated resilience in a challenging time for the global economy.

What are the clues to its identity? The statements about the region help, as we know that Country U is located in a region that has been typified by inequality and poverty. Furthermore, Figure 2 in the profile highlights the history of inflation that affected both Country U and its region in the last years of the previous century. This strongly hints at Latin America as being the region. So, Country U is a small country (population 3.4 million) in Latin America. If I were to add that Country U is also the smallest country (in population terms) to have won the football World Cup, you might quickly guess that it is Uruguay. Indeed, Uruguay won the first World Cup in 1930, and the first post-war tournament in 1950.

Inflation and economic growth

Many countries in Latin America experienced high inflation, especially in the latter part of the twentieth century. In the case of Uruguay, inflation peaked at 112% in 1990, but this was by no means uncommon. For example, inflation in Argentina (a close neighbour of Uruguay) reached more than 3,000% in 1989. Bolivia in 1985 saw inflation reach 11,750%. Even in 2015, Uruguay had inflation of 8.75%. In Argentina it was 23.7% (measured by the change in the GDP deflator), having reached 40.7% in 2014.

Why does this matter for economic growth?

Inflation imposes certain costs on a country, which you can read about in your textbooks. These include the so-called ‘shoe-leather’ and ‘menu’ costs, which cut in when inflation gets to be high. In other words, people try to avoid using money, or to keep their money in interest-bearing assets for as much of the time as possible. Firms need to keep changing their menu of prices, thus incurring additional costs. People on fixed incomes tend to lose out in times of high inflation.

Perhaps the key cost of inflation is that it adds to uncertainty, and makes it difficult for firms to form expectations about the future. It also becomes more difficult to draw up contracts if the future level of prices is difficult to predict. For these reasons, firms may be reluctant to invest, thus damaging economic growth.

It may also be the case that people move their assets overseas to find more secure opportunities, thus reducing the amount of finance available for investment in the domestic economy.

There is some evidence to support these views, as growth rates in Latin American countries during the hyperinflation period fell from previous levels, and few countries with high inflation managed to register good rates of growth.

Inequality and economic growth

The relationship between inequality and economic growth is not clear, as there are conflicting arguments. Some commentators argue that inequality in the income distribution could be beneficial for economic growth. If income is concentrated in the hands of people with a relatively high marginal propensity to save, this can generate funds for investment. Indeed, it could be argued that the prospects of benefiting from growth encourage the entrepreneurial class to invest, thus adding to inequality in society.

Simon Kuznets argued that there would be an inverted-U-shape to the relationship between inequality and per-capita incomes, as in Figure 1:

Figure 1 The Kuznets curve

The argument is that when per-capita incomes are low, there tends to be little inequality — because everyone is poor. As economic growth begins to set in, there are some groups in society that benefit more than others, so inequality begins to increase. Then as the country reaches a certain level of development, the benefits of economic growth trickle down through society, reinforced by government’s redistribution policy. Inequality then begins to diminish.

A nice story, but not strongly supported by the evidence. A high level of inequality in a society may reduce incentives for the deprived, and there may be social tension that impedes the development of society, and hence economic growth. This is an area of economics where there is no great agreement, and where debate is likely to continue.