The Pace of Economic Reform

8/6/2019 The Pace of Economic Reform

1/21

The Pace of Economic reform:Gradualism or Cold Turkey

Transition Economics

lecture 1


2/21

Should reforms be introduced gradually or

rapidly: Stylized Facts on Gradualism

Gradual Reforms have unintended consequences

price reform and shortages

More in general Gradualism creates second best problems

Gradual Reforms more often fail as the process causes

adjustment problems before points of no return are

reached

Rapid reformers lost out in elections throughout EE in

spite of apparent succes


3/21

Literature

Dani Rodrik, The Dynamics of Political Support for

Reform in Economies in Transition, CEPR WP no 1115

S. van Wijnbergen, Intertemporal Speculation,Shortages and the Political Economy of Price Reform,

Economic Journal, 1992


4/21

Rodrik on political support dynamics

State sector employees current:

Long term:

Adjustment:

Private Sector Employees

current:

Long term:

Adjustment:

tn*n

*

1 1( )t t tn n n nU !

tm*m

*

1 1( ); 1t t tm m k m m k U !


5/21

Subsidies to State Sector

Subsidies to State Sector

Financed through Taxes on Private Sector

May imply a maximum subsidy rate max

( ), ' 0tU U W U!

/n mX W!


6/21

Employment Dynamics* *

0

* *

0

(1 ) ( )

(1 ) ( )

1

t

t

t

t

t t t

n n n n

m m k m m

u n m

U

U

!

!

!


7/21

Wages and Productivity

Productivity State Sector 1

Productivity Private Sector >1

Assume wp > ws

1

0

s

p

u

w

w

w

W

P X

!

!

!


8/21

Hiring and Firing Dynamics

no firings in P sector, hiring from n and u

Attrition from SSector q

q > z for small t => u rising initially

1

1 1

Prob(new job in P sector) t t

t t

m m

n u

!

1

1*

1

1

( )

t tt

t

t

t

n nq

n

n n

n

U

!

!


9/21

Hiring and firing Dynamics

Hiring back into the state sector:

1( )max( , 0)(1 )

t t tt

t t

z q nf

z u

!


10/21

Welfare

Welfare in P sector (never fired once in)

Welfare in S sector

P p s t

t s

s t

W v Hg

!

!

( ( ) ( ) )s S P s tt t s t ss t

W p s v r s v Hg

!

!


11/21

Welfare and Subsidies

= b => no transition

>> 1 =>0 0(0) ( )

S S b

W W W"


12/21

Welfare Dynamics and Subsidies


13/21

Welfare and Voting Dynamics

lim (0, ) ( )

lim (0, 0) (0) ( )

S St

t

S S S

tt

W W

W W W

W W

W

pg

pg

!

!


14/21

Cold Turkey, Gradualism and Speculative

Attacks

EE started with extensive price controls

Almost all countries witnessed initial periods ofshortages, speculation and often hyperinflation

Should prices have been decontrolled Cold Turkey or

gradually?

What explains periods of sliding back (re-imposition of

controls)?


15/21

Van Wijnbergen (1992) on Gradualism vs

Cold Turkey Price Decontrol

T-sector cst returns, uses L only

NT sector uses fixed factor and L

2 periods: today (capital letters) and tomorrow (lower

case)

( , ), , , 0

( , ), , , 0

Storage Technology :

( ),

(0) 0, 0 ' 1, '' 0

w Y YY

w y yy

C C w Y C C C

c c w y c c c

s S with

J

J

J J J

! "

! "

!

!


16/21

Prices and Decontrol Programs

Market clearing price today, tomorrow: P*, p*

Controlled price pre-reform: P0

Reform programs: Cold Turkey: jump to immediate market clearing in both periods

Gradualism:

market clearing in period 2

Higher price in period 1, but still rationing: Pg < P*

Collapse (probability ) Reform abandoned at beginning period 2

Gradualism: first period price prevails in second period

Cold Turkey: re-imposition of controls at level below mkt clearingprice


17/21

Aggregate Supply Schedule for given

collapse probability

Period 2: state of reform known No collapse: cy(y

*) = p*

Collapse: cy(yc) = pg (= Pg)

Period 1: set output Y and hoarding level S prior toknowing second period state

Results:

,

( ) ( , ) ( {( ( )) ( , )}

0

max gS Y

Y S P C w Y E y S p c w y

subject to

SS Y

H J

ue

'

Y g

g

C P

P Ep

Q

HJ P Q

!

!


18/21

Market Equilibrium

Consumers have expenditure function

Define virtual price PV:

Welfare cost of rationing:

Market Equilibrium:

( ( ,.), , ) hVR

E P UA

P

Tx 4!

x

( )U V ghR

dUE P PdA

!

( ( ,1), ( ,1), )E P

p UHT4

( )

EY S

P

Ey S

pJ

x !

x

x !

x


19/21

Net Aggregate Supply in period 1 and the

collapse probability


20/21

Equilibrium Collapse Probability

Define Voter Dissatisfaction schedule through impact hoarding

response on perceived collapse probability

Define elasticity at which zero welfare effect:

Bayesian updating of everybodys beliefs after observed net supply

response

What happens to median voters beliefs?Collapse probability: prob median voters belief below c:

Yields Voter Dissatisfaction Schedule VDS

0

0 0

0

( )

( )

hh R

U R V

h

R V

dU dAE A P P

dP dP

A P P E

!

!

0

h

Rc

V

AP P

E !

( )c

m

m mf d

E

E

V E E

!g

!


21/21

Cold Turkey versus Gradualism

Documents

The Pace of Economic Reform