Topic 1: What's different about applied development

macroeconomics?
Kasper Brandt
4. september 2015
08:39

4. september
Rise of New Classical Macroeconomics:
Philips curve: relationship between inflation and unemployment. In 1970's we
experienced rising inflation with the same high unemployment rate (Stagflation).
Lucas critique. Models need to have a microfoundation. Optimizing behaviour of
individuals.
What emerged: Macro based on micro.
New Keynesian Revival (1980s):
Incorporated rigidities (example: only a share of firms can update their prices)
Example (Slide 13):
Main goal of policy: Reduce macroeconomic volatility.
Assumptions: Perfectly competitive firms. Only one good. No capital is flowing in or out.
The market for capital, labor and commercial bank loans are competititve.
This is a typical paper from 2007. Kinda outragous assumptions.
Crisis in macroeconomics and critique of the 'New' Neoclassical Synthesis:
Krugman: Let's stop deriving models from 1. principles of economics, and start deriving
models from empirical facts.
Representative agent implies homogenous beliefs which rules out coordination
problems. However, in the real world different views on the economy leads to
coordination failures.
Robert Solow and Sidney Winter are strong opponents to the DSGE models and the
assumptions of representative agent and rationality.
DSGE models will not be found anywhere but in Academia and Central Banks. The
private sector uses much simpler methods. If DSGE models are so good, why don't the
private sector use them and make better prediction and more money?
How do developing countries differ from developed countries (structural differences)?
Statistics more difficult to obtain.
Politics and corruption.
More exposed to severe exogenous shocks.
Market failures.
Self-sustaining households.

9. September
Applied Economics = applying an established core of theory to specific applications using
empirical methods.
What theory? --> new neoclassical synthesis. However, increased theoretical critique of
these models and empirical failure (lack of use in "real world").
Definition of developing countries.
Classifications: World Bank income groups (ADP, Atlas method), UNDP HDI (Education,
income, health).
Operational classifications: Much more about vulnerability. A country may ask for
assistance from IMF if it cannot meet its international net payments on affordable
terms. Developing countries are in general more vulnerable (volatile income, trade
balance, etc) than developed countries.
Solow residual is for developing countries dominated by a stochastic trend process
(unit root process).
Adv. Dev. Econ. Applied Macro Page 1

(unit root process).

Stylized facts. Developing countries are much more volatile and vulnerable to shocks.
Structure. Long tradition of seeing developing countries as being 'dualistic'. Does not
have to be a two sector or two market economy. It can also be three or more. Ex.:
traditional rural, informal urban, and formal urban.
Styles of economic reasoning
Deductive: Theory --> Hypothesis --> test (Theoretical method). Very academic and
not popular in policy analysis. Therefore not used a lot by for example IMF.
Inductive: Data --> Infer patterns --> models (Statistical method). Ex: RCTs and natural
experiments. RCTs are not possible in macroeconomics, but natural experiments are
possible. Drawbacks: i) hard to find evidence of something if you don't know what to
look for or ask the right questions, ii) different statistical models give rise to different
results, iii) External validity.
Abductive (iterative): given evidence E and candidata explanations H()1, ... , H(n) of E, if
H(i) explains E better than any of the other hypotheses, infer that H(i) is closer to the
truth than any of the other hypotheses. The "Ten Commandments for Economists" by
Danny Rodrik.
Compulsory assignment:
Starts with a question or statement
Elaboration drawing on evidence or literature
Questions:
The applicability of new neo-classical synthesis macroeconomic models to developing
countries is limited.
When working with policy challenges in developing countries, an abductive approach
to research is appropriate.
Reasons why this is true or proof of contradiction.
de Long, B. (2011). Economics in crisis. "We need fewer efficient-markets
theorists and more people who work on microstructure, limits to arbitrage, and
cognitive biases." That is, we need practitioners. This statement is in favour of the
inductive or abductive reasoning. Remember to say that this blog focuses on the
crisis of economics after the financial crisis, though he does say that various
economists have emphasized the possibility of a new major crisis. The crisis arises
in the fact that economics departments are not (according to the author)
reorienting themselves. They continue to appreciate theorists too much.
Use the three circles from the slides.
Colander (2013). "Koen carefully points out that, while there is a connection
between engineering and science, engineering is not applied science; rather,
science should be seen as applied engineering. By that he means that science is the
application of the engineering methodology Use the best available engineering
heuristics to solve problems to a particular problem". Thereby, Koen argues that
the abductive approach relates to engineering methodology. Since Koen argues in
favour of the engineering approach, then he must appreciate the abductive
approach the most.
Important insights can be gained from the use of dualistic macroeconomics models in
developing countries.
Use new new-classical synthesis models to show that dualistic models give rise to
important insights not gained in the new neo-classical synthesis.
Should applied macroeconomists in developing countries orient themselves as
engineers rather than detached scientists?
De Long, B. (2011). May also we relevant for this question. Economics in crisis
leads to economists having to reorient themselves as practitioners rather than
theorists that have structural solutions. In contrast to Colander (2013).
De Long, B. (2015). Science is good if it is detached. However, "some economists
have a tendency to claim that what is true about certain types of theories is true
Adv. Dev. Econ. Applied Macro Page 2

have a tendency to claim that what is true about certain types of theories is true
for all theories and thus applicable to the real world". These are for example price
taking behaviour, homogenous agents, and rational expectations.
IMF (2004). "The main conclusions are as follows. First, no single model or
framework is universally applicablepolicy formulation relies on a variety of
models, techniques, and economic judgment." This is in agreement with what de
Long is saying about what is true for one theory may not be true for another. And
it is in agreement with what Colander says about non-scientific knowledge also
being important (economic judgment).
Colander (2013).
Scholars should see themselves as engineers who solve real-world problems
instead of detached theorists whose goal is to provide better understanding
of the economy for the sake of the understanding. If the primary goal of
macroeconomists were to provide policy advice then the methodology used
is very problematic. Macroeconomists forgot to point this out and that the
primary goal usually just is to understand the theory for the sake of model
building. It wouldn't be a problem if objective for macroeconomists was to
understand theories for the sake of understanding. However, society expect
macroeconomists to help with real-world problems, and then it is
problematic to apply theories that have been developed for the sake of
understanding.
"The difference between thinking about applied economics as applied
science and as engineering can be seen by considering what is at the core of
the model used. Applied science sees scientific knowledge at its core. It
excludes all non-scientific knowledge. The engineering core includes all
applied science but can include non-scientific knowledge in the core as well
as established scientific knowledge. Historical knowledge, intuitive
knowledge and guestimates are all allowed as foundations for engineering
models. This larger core opens up the analysis to a wider range of acceptable
models than does applied science."
If a situation is perfectly understood then the engineering and scienrific
approach is asymptotically the same. "But Koen emphasizes that engineers
deal with poorly understood and uncertain situations, and the less
understood, and more uncertain, the situation, the more likely the methods
will differ."
No economics crisis. "Implementing an engineering methodology instead of
a scientific methodology would lead to five changes in how applied
economics is done. See the paper for these changes. Contrary to what some
heterodox economists claim, the economics profession is not in crisis far
from it, it is highly successful in recruiting students and in being respected by
the public."
Implementation could be through university funding. Some of the funding is
for applied research while another share of the funding is for purely
scientific purposes. Thereby, research incentives would change to a more
engineering/problem-solving approach.

Adv. Dev. Econ. Applied Macro Page 3

Topic 2: How has macroeconomic policy evolved in developing

countries?
Kasper Brandt
14. september 2015
21:54

Rethinking macroeconomic policy: Introduction

Macroprudential policies. Dynamically adjusted financial regulation. Macroprudential tools
more used after the Crisis.
Other macroeconomic instruments are monetary policy and fiscal policy (e.g. debt-to-GDP
aim)

Easterly (2005): What did structural adjustment adjust?

Position: Loans from the World Bank and IMF conditioned on structural adjustment have not
worked (no positive effects on policies or growth) properly.
Rationale from the structural adjustment loans (SALs) was to maintain growth and to
facilitate balance of payments adjustment. More specific the objective was to "reduce
their current account deficit to more manageable proportions by supporting programs
of adjustment . . . to strengthen their balance of payments, while maintaining their
growth and developmental momentum."
SALs are e.g. fiscal adjustment, getting the prices right (inflation stabilization), trade
liberalization, and in general a movement towards free markets.
Selection bias problem. Addressed by using Heckman-type selection techniques and IV
estimation.
Objective: Measure the performance of SALs. The effect from the number of loans to
macroeconomic distortions. If we believe that loans are like a pill or drug, then we would
expect a negative relationship between the number of loans and macroeconomic
distortions. But due to country-specific heterogeneity it might be the case that some
countries need more loans than other countries or that the loans do not work in every
country.

16. September
What do we mean by macroeconomic policy:
Policy domain

Elements / tools

Institution

Monetary policy

Money supply, deposit interest rate

Central bank

Macro-prudential
policy

Financial sector regulation (like liquidity rules), Financial Risk

Capital controls
Council in
Developed
Countries.

Fiscal policy

Annual budget --> Allocation of spending and

taxation, MTEF

Central government

Exchange rate policy

(can't be used
seperately from
monetary policy)

International reserves/Debt obligations

Central bank or
government if
central bank is not
independent

Monetary policy is the most important/used macroeconomic policy since our main objective is
to stabilize inflation.
Capital controls have been used extensively in the past, but it has not been used in a dynamic
way. Financial sector regulation is rather new and we have not seen the long-term implications
of this tool.
Oil shocks
Adv. Dev. Econ. Applied Macro Page 4

 Oil shocks
Oil shock of 1973 led to huge current account deficits which led to a slowdown of
investments and growth.
Between 1973 and 1977 developing countries struggled a lot with repayments of debt.
When the second oil crisis hit many developing countries couldn't pay off their debt and
in order to stabilize balance of payment (BoP) they asked IMF and World Bank for help.
This led to the Washington Consensus of SALs.
Stabilization (mainly IMF). Short-term macroeconomics:
Control inflation
Guarentee essential imports
Balance of payments correction
Structural adjustment (mainly World Bank). Long-term macroeconomics:
Sustainable public finances
BoP sustainability
Static efficiency (factor reallocation)
Dynamic efficiency (institutions)
Washington Consensus (1980s/1990s):
Pursue macroeconomic stability by controlling inflation and reducing fiscal deficits.
Open-up to the rest of the world through trade and capital account liberalization.
Liberalize domestic product and factor markets through privatization and deregulation.
Basically: Market works.
Crisis following the Washington Consensus --> questioning the consensus:
Mexico Crisis. Mexico adopted all the recommendations by IMF and World Bank. Led to
reinforcing optimism and essentially they had to devalue the peso remarkably.
East Asian financial crisis of 1997.
Lost decades of growth in Africa (1980s and 1990s)
Success in India and China show that there are other paths to growth than the
Washington Consensus.
Post-Washington Consensus
The Washington Consensus + focus on institutions + country-specificity + more.
See table by Rodrik on slide 27.
Why is it so difficult to evaluate whether IMF/WB programmes have been successful?
No counterfactual
Selection bias
Country heterogeneity is difficult to deal with. Maybe some countries benefit less from
these programmes than other countries.
Confounding factors (national and global)
Sample size (usually a maximum of 70 developing countries)
Dynamics. Being in a macroeconomic crisis today might influence the probability of still
being in a macroeconomic crisis tomorrow.
Multiple outcomes (what should be measure when we want to evaluate the
performance of the programmes.

23. September
Pre-Washington Consensus view was primarely neoclassical synthesis (new neoclassical
synthesis emerging). Role for government was very limited.
Washington Consensus was markets works and sound money (fiscal and monetary policy).
Post-Washington Consensus had the same view as the Washington Consensus, but also
focused on institutions. That is, market works, but we need to wrap inside a nice framework of
good institutions. Due to the focus on institutions a larger role for government emerged.

Superficial evidence on stabilization and structural adjustment loans.

Adv. Dev. Econ. Applied Macro Page 5

 Superficial evidence on stabilization and structural adjustment loans.

Selection problems. The countries engaging in these loans are not randomly chosen. It is
countries with fundamental macroeconomic problems. In addtion, the countries that
gets better form the loans will stop receiving loans, while countries not recovering will
continue receiving loans. Therefore, we might even find a negative effect from the loans
due to this selection problem.
At imf.org we can observe all imf loans to a specific countries.
Easterly (2005) conclusion: "No relationship between cummulative adjustment loans and
macro distortions".
But, "Absence of Evidence" is not the same as "Evidence of Absence".
Probably wouldn't get published today. Dynamic effects ignored (being distorted today
is correlated with being distorted yesterday). Failure to account for country
heterogeneity. Difficult to replicate the paper, because he does not make clear
definitions of his data (e.g. where do the 30 IMF loans to Argentina come from?).
Sum up:
Absence of Evidence (Not evidence of absence).
Selection problem.
Usually the relationship between programmes and outcomes (e.g. growth) is in focus.
But, it might be better to focus on the relationship between programmes and policies
(e.g. the effect on implemening good policies).
Over-simplification. Common fallacy is that underdevelopment is due to one constraint,
X. Loosen X and development will follow. The believe of what X is has changed during
time.
Rodrik (2005)
Universal principles which in general works, but different ways of implementing these
principles.
Institutional arrangements need not be universal. They can vary depending on the
specific context. As long as these institutional arrangements pursue the universal
principles we should be fine. That is, liberalizing trade and other objectives might be
good, but if a country does not have an institutional framework for doing so, then
nothing will happen. The important thing is to have an institutional framework which
pursue these universal principles.
Government budget rules (fiscal rules): e.g. current account dificit should not be more than 3%
of GDP.
How do we identify good institutional designs (not comprehensive list):
Clear and distinct institutional mandates over different domains of macroeconomic
policy.
Institutional independence.
Rule-based behaviour (e.g. fiscal laws, budget reporting). E.g. the budget needs to be
availavle by a certain date.
Transparent and timely reporting of data/decisions.
Multi-year horizon over policy and plans. Not only "how much am I gonna spend this
year", but also a draft plan for future years. E.g. how to achieve growth, how many
schools to build, where to build roads, etc.
Mechanisms for policy monitoring and coordination. Difficult and not many countries
have solved this issue.
Data sources at slide 49.

Questions:
Adv. Dev. Econ. Applied Macro Page 6

 Questions:
Easterly (2005):
There is little evidence to suggest that WB/IMF programmes (SALs) have contributed to
growth and macroeconomic stability (like public debt, inflation and balance of
payments) in developing countries.
What does research tell us (e.g. Easterly)? Overall they find little evidence of any
macroeconomic effects from WB/IMF programmes. (This would be a minimum for
an answer).
Go further and ask why this is the case.
Econometric problems like selection bias, heterogeneity, reverse causality,
measurement error, etc.
Absence of evidence, not evidence of absence.
Bad advice. Look at Rodrik (2005) for more flexible considerations on the
WC. Not one golden path as has been suggested by WB/IMF.
Rodrik (2005):
Policy recommendations of Washington Consensus (WC) are not necessary to achieve
sustained economic growth.
First of all, what are the policy recommendations of WC - both underlying
principles (sound money, non distortionary policies) and specific policy content
(widespread deregulation, privatization, financial liberalization). Important
distinction between underlying principles and specific policy content.
You could argue that China followed the underlying principles, but differed in their
specific policy content.
Question from Sam (V1 and V2 are the same):
V1: Good macroeconomic governance (policy-making institutions) is critical for the
achievement of macroeconomic stability.
Distinction between institutions and policy-making institutions (institutions with
capacity or/and legally bounded to follow underlying principles. E.g. independent
central bank or fiscal rules).
V2: Fiscal rules and Central Bank independence can be critical for achievement of
macroeconomic policy.
There is a paper on the reading list relating to this question.
Evidence.
Opposite cases. There can be cases where these fiscal rules and central bank
independence are limiting flexibility and disimprove stability because they limit
policy.
Examples of improving macro governance. Not necessary for macroeconomic
stability.

Adv. Dev. Econ. Applied Macro Page 7

Topic 3: What priorities should macroeconomic policymakers focus

on?
Kasper Brandt
27. september 2015
21:52

30. September
Exam relevant: Start by taking a standpoint, and then argue for your case. Like the position notes.
But, it is ok also to be critical saying that under certain circumstances the standpoint taken is not true
or less true.
At least four potential sub-goals:
Stabilization. Could argue that the focus has been on stabilization.
Allocation
Distribution
Accumulation

Monetary policy and macro-prudential policy is closely linked to stabilization, while fiscal
policy is closer linked to distribution.
Welfare costs of consumption volatility.
c(t)_bar = certain income
c(t) = c(t)_bar * e(-(sigma^2)/2) * epsilon(t)
We want to find a situation where utility of certain income is equal to utility of actual
income times a risk premium (lambda).
The utility function can be either CRRA (constant risk aversion) or logarithmic.
Using the ln-function we get that:
ln(1 + lambda) = variance / 2
, variance = variance of consumption.
==> lambda is approximately the same as variance / 2.
Lucas' point = Too much emphasis have been put on fighting volatility in the business
cycle.
A problematic assumption is that expected shocks are stochastic. In real life they are
definetely not stochastic - they have persistance and will not necessarily return to the
trend or at least not very fast.
Gains at margin from stabilization vs. Avoiding crisis. When you get to a reasonbly
stabilized business cycle then the gains from stabilization are low. But, if you avoid crisis
by stabilizing more then more stabilization might still have severe positive effects. So the
effect from stabilizing more mainly comes from the lower probability of crisis.

2. October
Zimbabwe. Around 2000 Mugabe made a reform redistributing land from the white to the
African. But, the Africans receiving the land (political allies) had no experience in farming and
no interest in farming.
The interesting part is not only how much GDP declines, but the integrated income between
the counterfactual GDP and reality (volume between actual GDP curve and counterfactual GDP
curve).
It might be that the counterfactual should not start at the peak, but several years before the
peak, because the years before the shock experienced higher growth than the counterfactual
stabilizing outcomes.
Real money (M/P) is equal to GDP times the money demand function of the interest rate.
==> Real money as a share of GDP (M/(P*Y)) is equal to the f(i).
==> interest rate is equal to the inverse of the money demand function ( i =
Adv. Dev. Econ. Applied Macro Page 8

 ==> interest rate is equal to the inverse of the money demand function ( i =
f^-1(M/(P*Y)) = g(M/(P*Y)) )
South Africa paper on measuring welfare costs from inflation (Gupta & Uwilingiye (2008).
They find that their time series are not stationary, so they check for cointegration.
When you're in a situation with moderate levels of inflation the gains from reducing
inflation is rather small in a welfare context. Inflation of 10% leads to a deadweight loss
of approximately 1% of GDP.
Vollrath (2009).
Gains from moving people to specific sectors (e.g. moving people from agriculture to
manufacture).
According to his results, the gains from reallocation of resources are large.
Jones & Tarp (2015).
Differences in productivity between sectors have widened.
We would expect convergence so that the productivity of sectors became more and
more alike. However, the opposite has occured. A failed structural transformation story.
Priorities in practice:
Stability as the primary mandate of monetary and fiscal policy (macroeconomic policies).
Stabilization as a precondition for growth. There are large gains from being intermediate
stable compared to unstable. But, there are not large gains from being stable compared
to intermediate stable. This is in accordance with the key point from the lecture - that
inflation reductions do not lead to large gains when being in a moderate/reasonable
inflation situation.

9. October
Four main critiques of price stability focus:
Economic vs. Social trade-offs between employment and inflation. Economically, we
have the usual Phillips curve saying there is a trade-off between inflation and
unemployment. So how much economic activity should we sacrifice to keep inflation
down. There might be a technical trade-off, but does this trade-off transfer into social
preferences. What we see is that people usually value employment more than low
inflation.
Blog by Michael Power: "Devaluation and inflation".
Concern in the population is that devaluation will lead to inflation and increase the
prices of oil and other necesssities.
The author argues against this concern.
South Africa has a surplus labour force. Devaluation shifts relative prices in the economy
(relative price of import versus domestically produced goods). Argument: Cost of
increases in inflation is a fair price for the change in relative prices which will lead to
lower unemployment.
Different forms of inflation:
Cost push inflation. If a lot of imports are intermediates in domestic production
and therefore prices will rise. E.g. oil.
Wage inflation. If you have a market with low level of unemployment then wage
inflation will rise. Less severe wage inflation if the labour force is unemployed.
Inflation targetting might be ineffective when there are foreign (external) price shocks
and a country needs to restructure its factors of production. Inflation targetting is
probably more effective when inflation is due to internal shocks. The reason is that if the
external shocks are permanent then you need to restructure factors, while internal
shocks are within your reach of something you can change.
Inflation targetting less effective: External shock --> higher intermediate prices -->
higher domestic prices --> inflation
Inflation targetting more effective: Internal shock --> wage increases --> inflation
Adv. Dev. Econ. Applied Macro Page 9

 Inflation targetting more effective: Internal shock --> wage increases --> inflation
Pham & Riedel (2013):
Inflation Growth Scenario
Rising

Rising

"Phillips Curve"

Rising

Falling

Incredible policy environment

Falling

Rising

Credible policy reform

According to the authors we should be in the third row, but we probably are in the
second row.
It's not the central bank's mandate to restructure the labour market or SOEs, so the
government should put some emphasis on these distortions. In that sense, we could
experience falling inflation and increases in growth. At least temporarily.
Wong, C. (2013). The Fiscal Stimulus Programme and Public Governance Issues in China.
The primary objective for the Chinese government is to maintain a high growth rate in
order to maintain high employment rate.
The paper gives a good overview on what the Chinese government did in response to
the financial crisis.
Monetary policy easing (standard response).
Stimulus package of around 20% of GDP.
Administrative measures.
Explicit and implicit interventions in financial markets.
Local investment companies (quasi public, because they are allowed to earn
profits). Financed through central government and bank financing. A lot of
public investment is through these local investment companies.
More than 60% investment rate in 2009. In most developing countries we would
be lucky to see investment rates of 20%.
However, not all developing countries should follow this strategy. There are trade-offs.
One trade-off is the housing bubble they experience in China. Another is debt followed
by these huge investment rates. Currently, we don't know the magnitude of the debt.

Questions:
Lucas (2003):
Do long-run structural policies have a larger impact on consumption possibilities than
short-run stabilization policies?
Can cyclical output variability be completely offset by stabilization policies?
Should macroeconomics policymakers in developing countries focus only on price stability?
Answer should distinguish between what kind of price stability (remember there is also
wage inflation, and not only price inflation) and the objective from price stability. Price
stability as avoiding crisis versus price stability as maintaining inflation below some X%
of GDP.
Draw on the case of China as an example where they do not only focus on inflation
targetting, and the case of South Africa where the author argues that structural changes
are also necessary.
What structural features of developing countries should be taken into account in the design of
growth and stabilization policies?
Vollrath paper.
Vietnam paper.
Lucas paper which points to the need of structural change.
South African blog which points to reallocation of factors.
Do have a stable Pihillips Curve? If yes, then we can fine tune. If not (Vietname case)
Adv. Dev. Econ. Applied Macro Page 10

 Do have a stable Pihillips Curve? If yes, then we can fine tune. If not (Vietname case)
then we need structural changes.

Adv. Dev. Econ. Applied Macro Page 11

Topic 4: What are we measuring?

Kasper Brandt
21. oktober 2015
08:16

21. October
Morgenstern (1963): Argue that economic statistics should only be published together with an
estimate of their error.
We need practical definitions for:
GDP: value of total domestic production.
Price and volume indexes.
Exchange rates: nominal, effective, real.
Interest rates: nominal, real.
But it is difficult to calculate these. E.g. "which nominal interest rate?", "which prices to use?",
"what should be considered part of production (how about the grey economy)?".
GDP. Three approaches:
Value-added (output - inputs). Total values of sales in the economy minus intermediates.
Final expenditures. Y = C + I + G + (X - M)
Incomes (labour, capital). Y = r*K + w*L. What do we need? 1) wage incomes, 2) capital
income (financial interest, rental income), 3) Corporation profits, 4) Own income (grey
economy). Surveys/censuses (household budget survey, informal business survey,
agricultural survey) are the only way in which we can measure incomes when
administrative data are missing.
All approaches should be similar and publishing GDP statistics should preferably use all three
methods as a robustness check.
The most applied index number is probably the Laspeyres index. It is simply just a weighted
mean of price ratios. "s(0)" is the weighting factor. In the Paasche index "s(t)" is the weighting
factor.
If we have a Laspeyres prices index and expenditure shares then we can obtain a Paasche
quantity index.
L(p) * P(q) = V
==> P(q) = V / L(p)
Each contry has many bilateral exchange rates. Denmark has bilateral exchange rate with the
euro, dollar, svenske kroner, etc. In order to have a composite measure we calculate the
effective exchange rate. Typically, we calculate a trade-weighted average. It can be
Arithmethic average and Geometric average.
The real exchange rate tries to capture the differences in purchase power.
W(i) / P(i) = what can be bought in country i.
W(i) / ( E(ij) * P(j) ) = what can be bought in country j. E(ij) = nominal exchange rate.
Q = E(ij) * P(j) / P(i) = real exchange rate.
Pick one of the following macroeconomic aggregates:
Real GDP index.
Laspeyres consumer price index.
Real effective exchange rate.
Real interest rates.
These are complicated measures to calculate, because there are various interest rates,
different ways to measure exchange rates and prices. Especially difficult in developing
countries. Main questions when we want to calculate these measures: 1) What do you need
(which statistics)? 2) Where do you get it from (surveys, or maybe central databases in
advanced countries)?
Adv. Dev. Econ. Applied Macro Page 12

advanced countries)?

28. October
Sources of uncertainty
Temporary uncertainty. Usually preliminary (e.g. quarterly) statistics are measured, and
these have high uncertainty. Later, revisions take place and the statistics get more
accurate. It may take many years for the statistics to be correct or "very accurate".
Persistent uncertainty. National accounts base year.
Base year --> prices (fixed)
Benchmark year --> comprehensice set of national accounts estimates for ONE
benchmark year, and then use growth rate within two benchmark years based on
surveys. The older the benchmark year is the higher is the probability that you will
miss new products and services, which is problematic.
Permanent uncertainty. Informal sector is higher in Sub-Saharan Africa and Latin
America. We can get an estimate of this uncertainty in different ways.
Data from extension agents. Simply ask an agent in a region: "How has your crops
been doing this year - good, bad, how much?".
Agricultural censuses.
Surveys.
Rainfall.
Even regular data is usually poor in LDcs. E.g. in Mozambique CPI is calculated with data
from a few large cities, and NOT data from a representative sample.
Spatial uncertainty. You cannot get the same for dollar in Denmark as in Mozambique.
Therefore, we use PPP.
Relevance. How significant are these sources of uncertaincy.
Base years are pretty bad for LDC. For developed countries base years are usually within
the last fice years. Also, public statistics (government accounts, balance of payments,
cpi) are delayed and not reported as fast as in developed countries.
Especially in Africa we see huge impacts of revisions. Nigeria and Ghana were adjusting
GDP upwards by around 89% and 60% respectively.

Often GDP estimates are downward biased due to old base years. These old base years leads
to new products, services and technologies being overseen. In the old base year you naturally
didn't measure products invented after the base year. But later years will not measure these
(now invented) products, because you are only measuring what was measured in the old base
year.

30. October
When calculating the real effective exchange rate we need to choose a deflator. But which one
should we choose? - CPI is heavily weighted towards non-tradables. On the slides we compare
real effective exchange rate for US and South Africa using various deflators.
In measuring real interest rate we have the same problem with deflators, but also which
nominal interest rate to use.
Case studies (Argentina):
What is the research question?
Can online inflation data match offline inflation measures? (since 2007 there has
been discussion on wether the offical inflation statistic is correct).
Is official inflation "wrong"?
How do the authors answer?
Web-scraped prices for various countries (other Latin American countries). Use
supermarket websites and their prices on food, beverages, household appliances.
Construct an online price index. They have the prices, but now the challenge is to
put weight on the products. They take a product and put it into a group (e.g. "beer
group", "milk group", "bread group", etc.). Geometric mean of each group.
Adv. Dev. Econ. Applied Macro Page 13

group", "milk group", "bread group", etc.). Geometric mean of each group.
Arithmetic weighted of each group price.
What are the main findings?
Online and offline measures match in other Latin American countries. In Argentina
there is systematic differences in LEVEL of prices.
Online measure ==> inflation higher than officially estimated.
Robustness check says the same. Higher inflation than officially estimated.
What do we learn about measurement challenges?
Knock-one effects. If you miscalculate inflation then it will have an immediate
effect on real wages, real interest rate, etc.
Real wages has a political dimension. This leads to the relevance of an
independent statistical agency. Or, transparency. If they DO fabricate the statistics
then other people can go in an to the same calculations and find different results.
Thereby, the political incentives will be diminished.

Case studies (China):

What is the research question?
Is revision on Chinas GDP reliable? Level of nominal GDP increased for 2004 (which
was the most recent year the considered).
What happened in 1998?
How do the author answers?
He applies standard retropolation methods (trend-deviation interpolation
approach). He keeps the original deviations around the trend, but the trend
changes. He compares his results from the standard technique to what the
revision reports.
What are the main findings?
GDP growth is higher for every year except for 1998.
Most "extra" growth from service.
Decline in construction growth.
He is able to replicate the results for the primary production, secondary
production and construction, but fails to replicate the revision of the service
sector using the standard approach.
Price deflator in service sector is moving around a lot. Conclusion is that they
manipulated the price deflator to generate political acceptable or "desirable" real
growth rates.
What do we learn about measurement challenges?
There are political incentives to manipulate with official statistics. Might move
both ways. In China the incentive was to live up to the target of 8 percentage real
growth rate. In other countries they may overvalue the growth rate in order to
say: "Look, aid is working here. Give us more". Or countries may undervalue
growth rate in order to say: "We are very poor and we need more aid".
Penn World Table (PWT) paper by Johnson et al.:
What is the research question?
Are PWT versions different?
What is driving the differences? If they are random and not systematic then it
might not be that big of a problem.
Are key research papers robust to use of different versions of PWT? They take key
papers that use a specific version of the PWT, and they do the same calculations
with a new version of PWT. (growth of GDP as dependent variable).
How do the author answers?
To answer the first research question they simply look at descriptive statistics. Do
the average growth rate for countries change when looking at different versions of
PWT.
For the second research question they regress the differences between version 6.2
and 6.1 on some variables and see if they can explain the differences. To see if
there is systematic differences explained by certain factors.
What are the main findings?
Adv. Dev. Econ. Applied Macro Page 14

 What are the main findings?

They find large differences in growth rates between versions.
Systematic relationship with the distance to the base year (larger distance leads to
higher differences).
They find that some papers are robust while others are not. Papers on developing
countries and countries with bad data seem to be much less robust than papers on
developed countries. Also, papers looking at annual changes in growth rates will
suffer more from using different versions of PWT than papers using changes over a
long run. That is, frequency matters a lot.
What do we learn about measurement challenges?

Questions:
What drives large differences in estimates of GDP at international prices, and should we
care?
International prices = PPP. PWT report GDP in PPP. There are challenges of
collecting international prices.
Changes in underlying national accounts. Why do these national accounts change?
e.g. rebasing.
Johnson et al. (2013) is the key study. It looks at how key articles change results
when using different versions of PWT. This relates to the "should we care" part.
Statistical agencies should focus on creating statistical capacity via independence and
transparancy.
We can bring in the China and Argentina studies as examples of why
independence and transparency is important.
Do countries neglect statistical capacity because they have other priorities?
Production of good quality statistics costs money. E.g. rebasing, household budget
surveys, labour force surveys.
The IMF should promote quality and quantity of statistics.
Pretty much the same as the above question (question 2).
What can be done to reduce the scope for bias/manipulation of key statistics such as
poverty estimator?
Look at the four different sources of uncertainty and explain their impact on
potential bias on key macroeconomic variables (diagnosis).
Discuss what can be done to bring these uncertainty sources down. We want our
statistics to be timely and precise.
What are the priorities for improving the quality of macroeconomic statistics in
developing countries?
Pretty much the same as the above question (question 4).

Is there only one optimal way in which real GDP can be constructed?
Is uncertainty important, and if so, are some sources more important than others?
Can we directly observe key macroeconomic variables?
Does revisions (i.e. decreasing uncertainty) alter macroeconomic research?

Adv. Dev. Econ. Applied Macro Page 15

Topic 5: What kind of a process is GDP?

Kasper Brandt
30. oktober 2015
08:14

3. November
What kind of process?
Stationary?
Trend-stationary?
Difference stationary? (stochastic trend/unit root process/random walk).
To what extent are shocks permanent or temporary?
Policy implications.
If the shock is only temporary then we do not need to do anything, because the process
is mean-reverting (returns to the trend).
If the shock is permanent then we will do a lot to avoid these negative shocks.
Very important when forecasting to know whether we have a deterministic trend or a
stochastic trend.
If we assume presence of stochastic trend then the economy will be less able to recover
from a negative shock. This is because the past matters more when the stochastic trend
is strong.
Examples of stationarity and non-stationarity processes:
Basicly we do not know exactly what kind of process, but we can test and get an idea of
the process.
(1) = Stationary with break.
(2) = Random walk.
(3) = Random walk with drift.
(4) = Non-stationary with deterministic trend (trend-stationary).
We distinguish between unit root and non-unit root processes by using the Dickey-Fuller type
tests.

11. November
DF test has null hypothesis of a unit root, while KPSS test has no unit root at the null
hypothesis. The examples from class with simulated data show that we can easily reject both
the DF test and the KPSS test when the real process is nonlinear and we only do linear unit
root tests. The same goes with level shifts.
Level shift may be caused by war or conflict (negative level shock) or by opening up for trade
and ressource finding (positive level shock).
Cuestas & Garratt (2011):
What is the main research question?
Is there a unit root in real GDP?
What methods do the authors use?
They use multiple tests for various countries.
Non-linearity in two ways
ESTAR process. Exponential smooth transition autoregressive process
Polynomial de-trending.
Main findings.
Evidence that GDP may be stationary around some non-linear deterministic trend
(of unknown form).
Ying et al. (2014):
Adv. Dev. Econ. Applied Macro Page 16

 Ying et al. (2014):

What is the main research question?
Is real GDP stationary in Africa?
What methods do the authors use?
They are worried about weak DF tests and structural breaks (e.g. reforms)
To "take care" of the structural breaks they use Fourier transforms.
They take sinus and cosinus to smooth out the structural breaks (see equation (1)
in the paper). "Sophisticated non-linear approximation". "The decomposition can
pick out the structural breaks)".
Unit root test which takes into account the Fourier transform with sinus and
cosinus terms.
Main findings.
Null hypothesis: There is a unit root. In the majority of cases we accept the null
hypothesis (in 7 cases we reject the null hypothesis).
Conclusion is in contrast with the Cuestas & Garratt paper which found that for
most countries we could reject the null hypothesis.
Where are the data from? The figures on the GDP processes seem totally
unrealistic.

13. November
What determine e.g. GDP:
Deterministic trend ---> predictable, often a function of time. E.g. linear trend.
Stochastic trend ---> unpredictable (random), but it has a permanent level effect on
GDP.
Transitory effects ---> possibly with short-term memory. It could be price spikes or short
term recessions.
Noise.
It is always possible to include a polynomial of a specific order to make a time series be trend
stationary. But, the question is if this polynomial is a meaningful trend. Does not make much
sense to have a deterministic trend following a polynomial of order 5.
Moving average is the most normal detrending tool. However, there exist much more
sophisticated tools. A popular one is the Hodrick-Prescott filter (HP filter). Higher values of the
smoothing parameter (in HP) will take us closer to the linear trend and lower values of the
smoothing parameter will take us closer to the raw data. Usually 1600 is chosen. Drawback
with HP filter: If we have a linear deterministic trend with a lot of noise then the HP filter
moves with the noise although we have a linear trend. It will not give us the linear trend that is
actually going on.
Why is it important to retrospectively identify growth cycles (periods of elevated/depressed
growth)? It is important because we don't want to make the same mistakes over again.
Retrospectively identifying business cycles is important because fiscal policy is dependent on
which state we are in, and we can see how e.g. inflation react to fiscal policy in certain states.
But to find out how inflation reacts in certain states we first need to identify the states
(business cycles).
Characterizing the data generating process behind GDP (deterministic or stochastic or both) is
important because it has different policy implications whether we have a deterministic trend
or a stochastic trend.
African countries have faced many more structural breaks than other regions (e.g. Europe).
This indicates that the GDP processes in Africa are more stochastic.

18. November
Questions
How convincing is the claim that GDP is stationary around a deterministic trend?
Important to show the empirics. That is why we changed the question from "how
Adv. Dev. Econ. Applied Macro Page 17

 Important to show the empirics. That is why we changed the question from "how
can we determine whether GDP contains a stochastic versus deterministic trend".
Relates a lot to our papers where they test for unit roots in the GDP processes.
Satisfy the first bullit in learning objectives ("To understand the theoretical and
empiral differences between stochastic and deterministic trends in
macroeconomic time series.
To do: 1) meaning/definition of stationarity, deterministic trend, unit root,
stochastic trend. 2) evidence from the papers we have looked at. 3) how
convincing? Linear trend is not convincing. Non-linear is more convincing, but the
function is arbitrary and a high degree polynomial is nonsense for a true process.
Look at the power of the methods (depends on the null. Often we cannot reject
because of low power).
Can we separate structural breaks in growth from volatility?
The same procedure as the first question: meaning/definition of structural breaks,
evidence from the paper related to structural breaks, and how convincing are the
results from that paper.
This question will be put into the first question. If Sam does not merge the two
questions together then you can still use structural breaks as a subject or a
paragraph in the first question.
What are the challenges of forecasting GDP levels over the long-run and what does this
mean for policy?
If there is some component of GDP where there is a deterministic trend then we
have a chance of doing a reasonable approximation of future GDP (good forecast).
If there is no trend then we have no chance of doing a good forecast.
Again we have to look at the distinction between deterministic versus stochastic
trend.
Severe volatility makes it more difficult to do a good forecast.
Important to find a reasonable non-linear trend. Maybe structural breaks should
be included.
Also relates to Frankel (2011).
Of course it has large policy implications, since public investments are dependent
on how many resources that are available.

Adv. Dev. Econ. Applied Macro Page 18

Topic 6: Monitoring economic structure and stability

Kasper Brandt
18. november 2015
09:09

18. November
The "Table 1: Generic macroeconomic (Social) Accounting Matrix [SAM]" handed out in class.
This is a small example of a SAM containing households and enterprises. It could
potentially contain hundreds of rows and columns, where each column represent a
sector. Many of the cells will be empty because there is no linkage between two specific
sectors.
Every column is expenses (outflows from a sector), and every row is revenues (inflows to
a sector)
Indonesia's balance of payments
Current Account + Capital Account + Financial Account should equal zero. It does not
equal to zero here, because they have separated "Reserves".

2. December
National accounting identities page 24 out of 72
A = aggregate absorption
GNDI can be understood as total income available in the economy.
Old-style crisis
Main symptom: persistent weakening of current account balance. That is, we need
foreign savings to finance our own consumption or investments.
Often these crisis are associated with less developed countries, because they do not
have access to short-term financing. Instead, they need to apply for long-term financing,
which takes longer time to obtain. E.g. getting a loan from IMF. Then IMF will demand
structural changes which takes time to negotiate upon.
Current account deficit is equal to changes in assets minus changes in reserves.

4. December
New-style crisis
Faster-paced financial or balance sheet mismatch.
What to look for: 1) mismatch in currency denomination of assets and liabilities. 2)
mismatch in maturity of assets and liabilities
We need to think about if macroeconomic policies generate these mismatches.
"Stylized balance sheet". Commercial banking sector has a maturity mismatch in assets
and liabilities in this hypothetical example. They borrow short-term and invest longterm. In this example we would be worried about a potential depreciation.

Contagion
Transmission of economic and/or financial crisis across border. There are a broad and
narrow type of contagion (don't know what the difference is).
Real contagion. Transmission through trade linkages. When Thai baht depreciated they
ceteris paribus become more competitive than Indonesia (that is when there is a crisis in
a net exporter country). If Thailand buys a lot from Indonesia and Thailand is hit by a
crisis, then they will buy less from Indonesia (that is when there is a crisis in a nat
importer country). So real contagion can happen if your trading partners (both importers
and exporters) experience a crisis.
Financial contagion. Crisis via external financing channels - especially access to (or cost
of) capital inflows. Distinguish between direct and indirect financial linkages.
Informational contagion. A crisis in one country may signal that other countries similar
to the crisis country face the same problems. At least focus is directed towards the
similar countries and analysis of the similar countries is carried out. These analysis may
reveal that these similar countries face the same or larger problems.
Adv. Dev. Econ. Applied Macro Page 19

reveal that these similar countries face the same or larger problems.
Early warning methods
Signals (leading indicators)
First, we need to define what constitutes a crisis. Maybe there is different degrees
of crisis.
Second, choose a set pf ptential crisis indicators and associated thresholds.
Third, evaluate which indicators are the best at predicting a crisis.
Regression-based prediction
Market-based sentiment (not discussed here).

9. December
Questions
What are the most robust early warning indicators of economic crises, and how practical
are they for use in real time in developing countries.
Empirical results (describing the results in the literature).
Comment/reflect on robustness. 1) Difficulty of defining a crisis. 2) Changing
nature of crises (balance sheet mismatches?) What might have been good
indicators in the beginning is not necessarily good indicators anymore.
Practical? 1) reliable. 2) availability (how easy to get the data and what is the most
reason data).
A sustainable current account position is not sufficient to avoid an economic crisis.
Talk about other triggers of economic crisis (balance sheet mismatch crisis,
contaigion). In general, the new-style crisis.

Adv. Dev. Econ. Applied Macro Page 20

Topic 7: Choosing the MERP regime

Kasper Brandt
9. december 2015
08:53

9. December
Gold Standard and interwar years: Exchange rate system was backed by gold.
Bretton Woords System: Only the US dollar was backed by gold. But all other currencies were
fixed to the dollar. That is, partially backed by gold.
Floating Exchanges Rates: Not backed by anything.
What is it that maintain the value of the currency? Which nominal anchor?
Nominal anchors are intermediate targets - nominal policy variables that serve to anchor
monetary policy. Examples: Inflation target, fixed exchange rate (anchor your currency
to another currency. Case of Zimbabwe: "Borrow others credibility"), commodities (gold,
but noone does this anymore), rule for rate of growth of money aggregates (used in
many developing countries. M1), more examples on slides. IMF document that explains
the different anchors: "Annual report on exchange arrangements and exchange
restrictions 2015".
Distinguish between "hard pegs" and "short pegs".
Hard Peg: Very strong commitment to the fixed exchange rate. Not even the central
bank has the authority to change the exchange rate.
Soft Peg: Many different kinds of soft pegs. See slide for an overview of IMF
classifications.
In addition, we have "floating" and "free floating" exchange rates.
The IMF classification is de facto, but subjective. Sam is generally unsure how they distinguish
between "floating" and "free floating". In Sam's view the difference is that for "floating" they
will sometimes intervene, but for "free floating" the central bank will never intervene in
international monetary markets.
Potential empirical indicators of FX (foreign exchange rate) regime
Nominal FX volatility.
More on slides
IMF classify Canada as floating since 1970. Another paper says it has never been
"floating", while a third paper says it has been shifting between being "floating" and
"fixed".
Most small developing countries prefer to fix their exchange rate.

11. December
A currency board = every note and penny (M1) has to be backed by foreign currency. Think of
it like a dollar standard (like the gold standard).
Exam practice. What determines the choice of exchange rate regime?
Practical efficacy.
How does this affect choice of regime? Evidence (data or empirical results).
The financial markets need to be very deep. If the CB is not the largest player, then
they will have difficulty in influencing the price. Therefore, very big markets
decreases the likelihood of having a fixed exchange rate. Relates to "interest rate
pass through" (IRPT).
Examples: 1) Breakdown of M1: interest rates in advanced countries. 2) Jamaica
paper. 3) China.
Institutional credibility.
Fixed exchange rate. Denmark. Other countries do not have the same credibility
Adv. Dev. Econ. Applied Macro Page 21

 Fixed exchange rate. Denmark. Other countries do not have the same credibility
as Denmark.
A currency board is seen as more credible than a peg. However, in some cases
(Argentina) the currency board will not work either.
Dollarization (currency board). "Borrw other countries' credibility". Zimbabwe
stopped hyper inflation with dollarization.
Shocks.
If you have large domestic shocks then it is more profitable to peg the exchange
rate to another currency. However, fixing the exchange rate exposes you to
international shocks (or just the shocks in the country you have pegged your
exchange rate to). Therefore, it is preferable when you have larger shocks than the
country where the currency has been pegged.
Example: Brazil is a good example at the moment.
Benefits/motives of foreign exchange stabilization.
Trade/investment (higher nominal and real exchange rates volatility tends to
dampen trade investments).
Original Sin (inability to issue external debt in own currency). Especially difficult for
small countries to obtain loans from other countries, since the other countries
have no interest in the small country's currency. In addition, if you have previously
obtained external loan of 50 million in foreign currency and devalue your own
currency by 40%, then you have to repay 70 million. ==> incentive for stabilization
of currency.
"Exchange rate pass through" (ERPT). Refers to the magnitude and speed by which
changes in the exchange rate are reflected in domestic prices. High rate ==> less
incentive to devalue, because the new exchange rate will very fast lead to higher
prices.
Questions
What might lead a country to adopt another currency (e.g. US dollar or Euro) and are
there costs in doing so?
Relates to the above four considerations. Argument 1, evidence. Argument 2,
evidence. Four arguments and evidence for each argument.
Explain, using examples, what are the principal trade-offs between alternative MERP
frameworks in developing countries?
Are there genuine trade-offs? Describe main trade-offs. Evidence.
Again, we can use the four above-mentioned considerations.

Adv. Dev. Econ. Applied Macro Page 22

Exam
Kasper Brandt
9. december 2015
08:35

Don't write less than or more than demanded. Approximately 3 pages per question.
Quality, not quantity.
Include list of references.
Do not copy the exam question or statement.
Structure is essential - use headings!
E.g. 1) Empirital results. 2) Reflection on robustness. 3) Practicality.
First argument, then evidence. Reason 1, Evidence. Reason 2, Evidence. Etc.
Conclusion. Repeat main argument/viewpoint. Maybe add some reflections if not done so
before.
Don't ignore important arguments or relevant counter-arguments. Ask yourself: is there
something missing?
Remember to refer back to the desired learning objectives.
Demonstrate understanding of curriculum. Show all the abilities below.
Ability to explain fundamental concepts/ideas.
Knowledge of relevant empirical results. Case studies, and studies from the curriculum.
Bring in ideas from relevant empirical studies (from different papers).
Evaluate the quality or strength of existing arguments/evidence. Critically assess the
evidence.
Where it is relevant, reflect on policy recommendations/issues/challenges. E.g.
challenges with data availability or reliability of data.

Adv. Dev. Econ. Applied Macro Page 23