by Dia Bondi

for

Prof. C. Benito

Fall 1997

The question asked in this paper is, " What have been the sources of economic stability in Latin America ? "

In many developing countries economic growth is the principle objective in the making of policy and in designing investment projects. However, how can we realize growth without economic stability? It is intuitive that growth without stability can be inefficient and limited. The economic experience of Chile is a prime example of how stability is essential for effective and long term growth.

Not until Chile established economic stability was real growth possible. Bosworth, Dornbush and Laban discuss this in the first chapter of their book The Chilean Economy: Policy Lessons and Challenges. Bosworth states in the conclusion of the chapter on Chilean Stabilization and Recovery: "Once the macroeconomic situation was brought under control, the conditions were created for growth to resume."

In the book, The Principles of Macroeconomics, Joseph Stiglits discusses the differing approaches to economic stabilization. The economic theories he mentions focus on both fiscal and monetary policy as the primary tools of stabilization. These tools are implemented through deficit spending and inflation policy.

The traditional business cycle theorists assert that "Government should design built-in stabilizers to make the economy more stable" while New Keynesians believe that discretionary policy is more effective in reducing economic fluctuations.

These two factors, monetary and fiscal policy, are variables that are included in this study. We will see how these variables affect stability in the countries discussed in this paper.

Other variables contribute to a country’s stability and steady growth. These variables are found in the sources of growth model. This model discusses the relationship between output and variables like capital stock, the size of the labor force, natural resources and others. This model is based on the Harrod-Domar and the Neo-Classical growth models as mentioned in Gillis’ Economics of Development. In this model variables are limited to capital, labor, natural resources, and technology. This model can be and has been adapted to a more contemporary model that allows for other variables to be included as sources if growth. As such, it is referred to as a generic sources of growth model wherein we can add any appropriate variable that lends itself to economic growth. This is an excellent model for this study as it allows the freedom needed to create a model appropriate for the economies included in this sample.

This paper combines two models to explain the sources of stability in these countries. It combines a long run perspective model and a short run perspective model that use fiscal and monetary policies as sources of economic variability or stability. These two models establish a comprehensive model from which to observe the sources of stability for the countries in Central and South America and the Caribbean.

The hypotheses of this paper are:

-First, that there exists a positive relationship between the stability of a country and its economic development.

-Second, that there exists a negative relationship between stability and the business cycle variables: Fiscal deficits and inflation rates.

The sources of the data are the World Bank, World Tables 1995, and the World Bank, World Development Report 1997. The data used dates from 1980 to 1995. This data set is a cross section that is derived from a time series for each country. From the time series for each variable an average value has been found for the fifteen year period. This data is then compiled to create a cross section of data for the countries chosen. This data set is found in Table No. 1.

Using this data relationships between explained and explanatory variables are shown via graphs. The explained variable is represented by variation coefficient. This coefficient is calculated by taking the standard deviation of the percent growth rate of a country and dividing it by the mean of the same variable. This gives a value for the degree of economic variation of a country. I have calculated this for the countries chosen and then graphed them against each explanatory variable to show if a relationship exists. Next, a regression was run for these variables to determine which factors have the greatest effect on the economic variation of a country. The explanatory variables are represented by the mean of each variable chosen. These variables are:

a) Indicators of Economic Development

-GNP per capita. Valued in 1987 dollars.

-Secondary School enrollment as a percent of age group for men.

b) Indicator of Trade Policies

-Trade as a percent of GDP to represent openness.

c) Indicators of Macro-economic Policies

-Average annual inflation using the GDP deflator.

-Central government deficit or surplus as a percent of GDP.

The results of the above calculations are found in the following tables and graphs.

We begin with a spreadsheet that lists each country included in the study. A variation coefficient has been calculated for each country and we see that the values range from 1.27 to 29.48. The countries with a low variation coefficient are economically more stable than those with a higher variation coefficient.

Next, each explanatory variable has been graphed against the variation coefficients. The first two variables, GDP/capita and Education , do not have an impact on the stability of a country. That is to say, stability is indifferent to the state of economic development of Latin America.

Inflation, our next variable, is graphed in the same manner as the previous variables but we see that the trendline shows a relationship between variation and the percent inflation rate. This relationship shows that the greater the inflation, the greater the variation. Although this relationship is visible graphically, our next variables show a greater relationship to variation.

Deficit spending and openness have the greatest impact on the economic stability of a country. We can see that there is a direct relationship between deficit spending and economic variation. That is, the greater the deficit, the greater the variation. In this case, a deficit is represented by a negative value and a surplus is indicated by a positive value.

Openness has a substantial effect on variation as well. The more willing a country is to engage in foreign trade the more economic variation it experiences.

The regression model specifies variation as a function of deficit spending and openness. The intercept value indicates the variation coefficient without openness and with balanced fiscal budgets. The intercept is roughly 6.4%.

The coefficient for Openness is positive showing that for small countries openness is always a source of economic insecurity. The coefficient for deficit is negative, indicating that unstable macroeconomic policies lead to economic variation.

I began this study using a hybrid model to explain economic variations in Latin America. This model included five explanatory variables. After collecting and processing the data, three of the five variables were deemed inconclusive. This is to say that in Latin America, openness and deficit spending are the factors that explain economic variability. In other words, economic variability is explained by external and domestic factors as the Australian model predicts.

Bosworth, Dornbush, and Raul Laban. The Chilean Economy: Policy Lessons and

Challenges. Washington D.C.: The Brookings Institute, 1984.

Gillis, Perkins, Roemer, and Snodgrass. Economics of Development. Ed 4. New York

London: W.W. Norton & Company, 1996.

Stiglitz, Joseph. Principles of Economics. New York London: W.W. Norton &

Company, 1993.