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Research Highlights 2006: Macroeconomics and Growth

Themes
Research Highlights
 External shocks explain only a fraction of output volatility in poor countries
  Low saving & productivity at low development levels do not explain poverty traps in Africa  
  
Poverty declines faster with rapid expansion of sectors using unskilled labor
  Better domestic fundamentals are associated with more use of .....
Team
Publications in 2006
Forthcoming in 2007

Growth is essential for poverty reduction, the Bank’s paramount objective. Sustained rapid growth is needed to achieve the other Millennium Development Goals and speed up development. The research program on macroeconomics and growth aims to guide the design of policies and reform strategies conducive to sustained high growth. To do this, the research program seeks to identify factors behind the diversity in aggregate economic performance across the world and understand how it is affected by policy and institutional changes under different country circumstances.

Themes

The research program explores the micro- and macroeconomic foundations of growth and other key dimensions of aggregate economic performance. It has an empirical orientation and draws from a wide range of data sources—from microeconomic surveys to national macroeconomic data, as well as simulation models. Much of the research is designed in consultation and often conducted in close collaboration with the regions, in response to strategic needs identified by operational departments.

One major area of work concerns aggregate instability in developing countries, which—aside from its direct welfare cost—is associated with reduced long-term growth, and can be particularly harmful to the poor. Research examines the contribution of both policy and nonpolicy forces (such as external shocks and other exogenous disturbances) to volatility. It assesses reforms to reduce the frequency and impact of disturbances through suitable fiscal and financial policies, as well as measures to tackle microeconomic inflexibility. Some of this work was presented at a conference cosponsored by the World Bank, Centre for Economic Policy Research, and Centre de Recerca en Economia Internacional on "The Growth and Welfare Effects of Macroeconomic Volatility," March 17-18, 2006. Special issues of two academic journals collecting the conference papers are under preparation. (Agenda and papers available at http://econ.worldbank.org/programs/macroeconomics under events.)

The opportunities and risks posed by international financial integration are also a central research focus. Access to external financing offers firms and countries new investment and risk diversification possibilities, but may also increase macroeconomic vulnerabilities. Research explores the tradeoffs among these effects under different policy and institutional conditions.

The role of governance and institutions for sustained growth continues to be an active research area. The issues under analysis, drawing from both aggregate and firm data, include the effect of governance conditions on the volume and composition of public expenditure with special attention to the growth impact of public investment, as well as the growth cost of corruption.

Research Highlights

External shocks explain only a fraction of output volatility in poor countries

External shocks—world commodity price and financial disturbances, aid instability and so on—are often blamed for the high economic volatility in poor countries. But recent Bank research reveals that external shocks explain only a fraction of output volatility in poor countries. Internal factors—economic mismanagement, political instability, and conflict—are instead the main source of fluctuations [forthcoming 75]. Related to this, many observers have stressed the importance of financial development for the mitigation of shocks; indeed, volatility and financial development are negatively associated across countries. But identifying causal effects of financial development on volatility is difficult due to the multiplicity of factors potentially responsible for countries’ dissimilar volatility performance.

Recent research focuses instead on the heterogeneous response of different industries to financial conditions. Sectors whose operation requires abundant liquid funds are found to be relatively more volatile and prone to deeper crises in financially underdeveloped countries. This indicates that financial market development reduces macroeconomic volatility by enhancing intermediaries’ ability to provide liquidity during periods of distress. Moreover, these sectoral effects of financial development are consistent with quantitatively important cross-country differences in aggregate volatility [154].

Empirical research explores also the influence of structural features of output and factor markets on the impact of terms-of-trade shocks [187]. Larger trade openness magnifies their output impact, while increased labor market flexibility and financial openness facilitate the absorption of shocks and have the opposite effect.

Low saving and low productivity at low development levels do not explain poverty traps in Africa

A variety of mechanisms determine which countries (or individuals) start out poor and are likely to remain poor. Conceptually, poverty itself can be growth deterrent owing to "threshold effects" that require a minimum of physical or human capital to set growth in motion, or institutional constraints preventing the poor from joining the growth process [162]. Recent empirical research explores two canonical mechanisms: low saving and low productivity at low levels of development. Both can theoretically generate poverty traps, or at least very persistent poverty. But the research finds them unable to explain the persistence of low income in African countries.

Poverty declines faster with rapid expansion of sectors using unskilled labor

The other side of the poverty-growth link—the poverty impact of growth—now stands at the center of the development policy debate. There are three potential sources of pro-poor growth: rapid growth of average incomes, high sensitivity of poverty to average income, and poverty-reducing changes in relative incomes. Cross-country evidence shows that over two-thirds of the long-run variation in changes in poverty is due to growth in average incomes, and the rest is mostly due to changes in relative incomes [148]. But the poverty-reducing impact of growth varies greatly across countries and over time—even after initial levels of inequality are taken into account. Recent research suggests that the sector composition of aggregate growth may be responsible for much of this heterogeneity: the international evidence shows that poverty declines more quickly when growth features relatively faster expansion of sectors intensive in unskilled labor [189].


Better domestic fundamentals are associated with more use of international financial markets by domestic firms

International financial integration has reached unprecedented levels and continues to rise. Recent research overturns some widely held views on the links between international integration and developments in domestic financial markets. Better domestic market fundamentals are associated with more, rather than less, use of international financial markets by domestic firms. In fact, as fundamentals improve the importance of domestic financial markets decreases relative to the activity in international markets [143]. Previous research had instead suggested that better fundamentals are related to more domestic financial development and less internationalization.

Furthermore, international financial integration can feed back into domestic financial conditions in potentially perverse ways, and this poses difficult challenges for policy makers. For example, research concludes that the migration of trading abroad can hamper local market liquidity [151]. Firms that succeed in accessing international financial markets grow faster than those that rely exclusively on domestic finance, driving a wedge between firms within countries [forthcoming 76]. Those firms also extend the maturity structure of their debt. But few firms and countries do, in fact, access international financial markets, whereas domestic financial markets fail to provide adequate financing to those that continue to rely on home markets, even after countries have implemented most conventionally recommended financial market reforms [163].

Team

Luis Serven, Research Manager





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