Business Cycles Along the Development Path
In developing countries, compared to advanced economies, recessions are characterised by a larger drop in output, relatively sharper drops in consumption, and much less increase in unemployment. While the existing literature associates the relatively sharper drops in consumption with the reversals in current account deficits (and sudden stops), I document cases of recessions in developing countries with little to no reversal in the current account deficit. I show that relatively sharper consumption drop in such cases is explained by a muted response of domestic savings: households do not tap much into their savings to smooth consumption. Then I offer a unified theory of business cycles along the development path to explain these facts: an incomplete-market heterogeneous agent model with non-homothetic preferences and multiple sectors with different sectoral TFP risk. Development leads to an increase in income, and through the non-homothetic preferences, structural transformation away from more volatile sectors. Households become wealthier and (endogenously) less hand-to-mouth, implying stronger consumption smoothing. I characterise the conditions under which non-homotheticiy amplifies (or dampens) the marginal propensity to consume of the poor; and argue that amplifying conditions are credibly held in recessions under study. Finally, non-homotheticity amplifies the income effects of a wage drop in the less developed economy, which explains why there is less increase in unemployment during recessions.
