High Volatility in Developing Countries

Income growth so much more volatile in poor countries than in rich ones, and this greatly compounds the problems of the poor regions of the world. CEP macro program member Silvana Tenreyro identifies three possible reasons: First, poor countries specialize in fewer and more volatile sectors; second, poor countries experience more frequent and more severe aggregate shocks (e.g. from macroeconomic policy); and third, poor countries' macroeconomic fluctuations are more highly correlated with the shocks affecting the sectors they specialize in. She shows how to decompose volatility into the various sources, quantify their contribution to aggregate volatility, and study how they relate to the stage of development. She finds that, as countries develop, their productive structure moves from more volatile to less volatile sectors. Moreover, the volatility of country-specific macroeconomic shocks falls with development. Finally, there is some evidence that the level of specialization declines with development at early stages, and increases at later stages. In sum, there is no single reason why poor countries are buffeted but such violent volatility: in part it is because they specialize too much in risky sectors, but in part it is also because their overall macroeconomic policies are too erratic.

Fortunately, there are reasons to believe that the high volatility in poor countries will self-correct as these countries develop. To see how this may work, in related research Silvana proposes a theory of technological diversification. Production makes use of different input varieties (e.g., different types of capital, labour, energy, etc.), which are subject to shocks. Technological progress takes the form of an increase in the number of varieties used in economy, raising average productivity. In addition, the expansion in the number of varieties provides diversification benefits against variety-specific shocks and it can hence lower the volatility of output growth. For example, an economy that relies exclusively on oil as a source of energy will tend to be more volatile than an economy that relies on other sources. The decline in volatility arises as a by-product of firms' incentives to increase profits and is hence a likely outcome of the development process. A Quantitative assessment of the predictions of the theory in light of the empirical evidence shows that the theory can generate a decline in volatility with the level of development comparable to that in the data.

To read more about Silvana Tenreyro's research on volatility in developing countries see:

• "Technological Diversification" [Full document in Adobe PDF] (Miklos Koren and Silvana Tenreyro), CEP Discussion Papers 0824, October 2007
  
  
• "Volatility and Development" [Full document in Adobe PDF] (Miklos Koren and Silvana Tenreyro), CEP Discussion Papers 0706, November 2005