Speed of adjustment and self-fulfilling failure of economic reform
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An economic reform programme where ine¢cient public labour is laid off is considered. The immediate effect is a lowering of wages and increased profitability in the private modern sector. Over time, as capital accumulates in the modern sector, wages and production increases. Big bang reform generates a sharp transitory drop in wages while gradual reform gives a more modest decline. In the presence of a subsistence wage constraint popular resistance can cause the cancellation of big bang reform. Two arguments for gradualism can in that case be made. First, a more gradual reform requires a less abrupt drop in the wage, and will therefore be feasible. Second, the initial wage drop will be stronger if a cancellation of reform is expected and, since cancellation is dependent on the severity of the initial wage drop, multiple equilibria occurs. The existence of multiple equilibria is dependent on the speed of reform. Su¢ciently gradual programmes have a unique successful equilibrium.
Economic reform, Multiple equilibria
Research Council of Norway