About Nick: i am an economist based in malaysia. I write about development economics, while sneaking in a pop culture reference or two.

Shocking Our Way Out of the Middle-Income Trap

Published in The Edge Malaysia, 13-19 October 2013.

There are 79 people in my program from 34 different countries. Despite the clear differences in backgrounds and nationalities, a common thread permeating through this group is that we all want to work in development. The interests are varied. Some want to do ground work in failed states. Others want to work in microfinance. A handful want to enter into politics one day. And, naturally, there are quite a few who are interested in the fight against poverty, springing countries out of the poverty trap and into the path of sustained economic growth.

This made me reflect further about the nature of the work I seek to do. Unlike my friends who are keen on tackling poverty, I have always been more intrigued by the idea of springing countries (or, more precisely, a particular country) out of the “middle-income trap.” The type of work and thought that addresses the problem of shifting a country middle-income to high-income is very different from the type of work and thought that addresses the problem of shifting a country from low-income to middle-income. My interest in this particular problem is, I think, a natural function of the fact that I am Malaysian and that I have worked in the Malaysian public sector for four years and that a significant amount of what Malaysian policymakers talk about in terms of a long-term economic goal for Malaysia is to escape the middle-income trap and join the ranks of the high-income countries.

Among the papers that I have read for a development class is a super interesting paper by Nathan Nunn, a Harvard economist, entitled, “The Importance of History for Economic Development.” One of the points he makes is that the reason historical events can have permanent effects on development is if they cause a movement from one equilibrium to another. He develops a model which shows that a period of severe extraction in the Acemoglu-Robinson sense (where colonists, for example, simply extract resources from a given area without building institutions and infrastructure for long-term habitation) can cause a permanent movement to an economic equilibrium with significantly lower income levels.

Nunn’s model made me think. What if, regardless of whatever a given country, call it country M, is doing right now, country M cannot escape the middle income trap because it is at its middle-income equilibrium? I thought that since Nunn showed that a large negative shock can lead to a worse equilibrium, then it may follow that the opposite be true. A large positive shock can lead to a better equilibrium. Therefore, to jump from the middle-income equilibrium to the high-income equilibrium, there needs to be a positive shock to the economy.

But what is that shock? Well, for starters, the shock is not to the economy’s output levels, but to the economy’s output growth. The growth trajectory must be changed. It seems reasonable. If country M is growing at 5.0% per annum but the high-income threshold is growing at 3.0% per annum, for example, it will be a long time before country M can catch up. So, it needs a higher growth trajectory.

To consider how the shock can work on the economy, I use a standard aggregate supply and aggregate demand framework, familiar to those who have taken introductory economics. Since country M wants to be high-income by, say, 2020, I do not consider the short run in this note. In the long run, the aggregate supply curve is vertical (since the real economy is not affected by nominal indicators such as prices in the long run). The aggregate demand curve is a standard downward sloping demand curve. If we try to generate a shock by shifting aggregate demand by, say, government spending, we shift the aggregate demand curve to the right, from AD at time 0 to AD at time 1 (see figure 1). However, in the long run, all that happens is just that the government spending is simply reflected in the price level, with no increase in output. No higher incomes, just higher prices.

The key, therefore, is in aggregate supply. Aggregate supply is the capacity of the economy to produce stuff. If the economy is more capable of producing stuff, it makes sense that incomes would rise. Figure 2 shows this. By shifting the LRAS to the right (via some positive external shock), we end up at a higher long run output equilibrium. Thus, what we really need is a shock to the country’s productivity capacity, whether it comes via some technological change, a demographic dividend or the discovery of a renewable cheap energy source. Moreover, a boost in aggregate supply has the added benefit of reducing price levels. If, for example, some technology is discovered that can produce a computer for $50 instead of $250, it follows that price levels would fall in competitive markets. Higher incomes, lower prices; what is not to like?

Therefore, if country M focuses on aggregate demand by boosting consumption, investments, trade, money supply, government spending, and so on, by this framework, it does not shock country M out of its current equilibrium. In fact, in the long run, it just increases the price levels in the economy. This is not to say aggregate demand policies are useless; rather, aggregate demand policies might be better used to smooth out the business cycle (the ups and downs of the economy) on a counter-cyclical basis, rather than be used to generate long-term growth.

Policymakers of country M should, instead, focus their attentions on boosting aggregate supply. This is not the same as the common notion of supply-side economics which, in reality, is actually an aggregate demand measure. This is simply saying that policymakers should strive to boost the productive capacity of the economy. Research, technological diffusions, supporting the demographic dividend; these are the types of things that will work towards shocking country M right out of its middle-income skin into its brand new high-income skin.

Figure 1: A Change in Aggregate Demand

Figure 1: A Change in Aggregate Demand

Figure 2: A Change in Aggregate Supply

Figure 2: A Change in Aggregate Supply

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