Price of Capital, Income, and Demand for Labor in Developing Countries

Abstract

Below equilibrium interest rates typify parts of the capital market in most less developed countries. There has been considerable discussion of whether they have contributed to the low labor absorption in these countries' modern sectors (especially manufacturing), and of the corollary proposition that increasing them would raise the demand for labor. This new conventional wisdom seems usually to be based on the proposition that the representative firm will choose a higher L /K ratio the higher is the price of capital; it contrasts with what we may call the traditional practitioners' view, favoring low rates.1 While the latter view is seldom presented in a theoretically persuasive framework, it is true that a low interest rate could raise the demand for labor if, for example, (a) it leads to greater total capital formation or (b) it leads to a greater share of capital going to firms with above-average labor-capital ratios. This paper analyzes the effect of a below equilibrium rental price of capital on the aggregate demand for labor (and, parenthetically, on income distribution) in a simple static one good model with two sets of firms, one of which has favored access to credit.