Labour institutions and vulnerability of developing economies under capital inflows

Abstract

The paper argues that labour institutions, such as efficiency wages or their analogues more typical for the former planned economies, can aggravate a vulnerability of developing economies caused by windfalls, such as additional oil income or foreign aid. The economy is modelled by use of the, so-called, fK endogenous growth model based on microfoundations describing the labour institutions. Despite a rather small formal difference, the model differs much in its properties from traditional growth models. The fK model generalises the well-known AK model but is free of the known shortcomings of the latter. Our analytical results as well as computer simulations show that, despite the presence of temporary acceleration opportunities, the unstable windfalls prohibit long-run sustainable growth. The windfall can be followed by a restructuring leading to a long-run economic decline after ceasing the capital inflow. The effect of the capital inflow depends on the relation between the expected inflow growth rate and the economic growth rate of the benchmark model (without inflow), as well as on the time preferences in the economy. If the capital inflow is expected to grow faster than the proper growth rate of the economy, this can lead to a decline in wages.