a 19

We also notice that capital goods imports have an inelastic response to
sustained changes in net investment although this response is by no means
insignificant. This inelasticity implies that the share of imports of
capital goods in total net investment will decline as net investment
increases. This might be an encouraging result since the alternative
possibilities imply either a long run fixed relation between the domestic
and the foreign capital stock (for an elasticity of one) or an ever
increasing share of capital goods imports in total net investment (for an
elasticity greater than one.) Finally, a sustained increase in the
available amount of foreign exchange resources has two effects on imports:
(1) a small direct effect, and (2) a large indirect effect operating through

the effect of variations in the foreign exchange on investment.

VI. Summary and Conclusions

The main purpose of this paper has been to characterize some of
the most important determinants of long run growth in the non-oil LDCs:
capital accumulation and foreign exchange constraints. There are other
important factors such as labor and education, but the analysis of their
influence has been postponed.

We develop an explanation of investment and import demand behavior
that allows for imperfect substitutability of domestic capital goods for
foreign capital goods and for a non-constant speed of adjustment of capital
formation. In particular, we model the speed of adjustment as a function of
the availability of foreign exchange resources. Our approach is implemented
empirically; the results indicate that aggregate capital accumulation can be
characterized as having a direct, but weak response to long run growth in
income, an inverse and inelastic response to changes in relative prices, and

a rather strong response to the availability


13

get:

& = BR ' f od ' L
AIN(MEe/ Tag) = BOX, IN(A)+OBS (X, 1m(PL4/P yg) )-By(KE IN (Mie a/ Ing) Stuy» (21)

8
where :

2 *  nrpf ypd ya . 2 :
(M mt! rt) 2 ACP / Pee) > a <0; urN(0,0, ), E(u,u,_,)=0-

In the second approach to modeling import demand behavior, we do
not assume that the elasticity of capital goods imports with respect to net
investment is one, and the influences of foreign exchange constraints on
imports and dynamic adjustments are introduced in an ad-hoc way. We

approxiniate equation (18) as:
aoe
Ines m+ D(L)InT y+ E(L) IX, + Ups (22)
; = J = j
with DIL)= djl, E(L)=}je3L”,

where the influence of increases in Pre ut is introduced by reducing the
purchasing power of the given level of foreign exchange resources.

To sum up, the main differences between the two approaches
(equations (21) and (22)) are in (1) the pattern of adjustment of imports to
changes in both prices and availability of foreign exchange resources, and
(2) in the value of the elasticity of imports with respect to net
investment. For the first approach, equation (21), we assume a smooth
pattern for the influence of past prices on investment and that the value of
the import elasticity with respect to changes in net investment is equal to

one. For the second approach, equation (22), the influence of prices is


23

13
Similar results have been obtained by Salas (1982) for Mexico; van

Wijnbergen (1982) obtains a unitary investment elasticity for South Korea,

although no tests are shown for possible misspecifications.

14
Similar results have been obtained by Salas (1982).

1

° For SITC 5-9, ny= 0.277x2.38+0.3448=1.004; for SITC 7,
ny=0.47562x0.238+0.20464=1.3366. Notice that we are assuming that the
elasticity of gross investment with respect to foreign exchange is a good

approximation to the same elasticity but for net investment.


Fig. la

Sil
Sl |
=


34

rt : Export price index of manufactures of developed econonies:

-N,
Trade Statistics. We also use this index as a proxy for Pots which is
then used to construct Py lee using the definition of rental price of

capital (see equation 1};-—


20

of foreign exchange resources. We find that imports of capital goods have a
positive and inelastic relation to investment, an inverse and inelastic
relation to the rental price of foreign capital stock, and an elastic
association with respect to changes in the available amount of foreign
exchange reserves. In summary, we find that foreign exchange constraints
adversely affect growth possibilities for LDCs because of the resulting
reduction in the speed of adjustment of capital formation consistent: with

targeted growth rates.


Bo!

P /oMI
mop)

SSE

26

Table 3

Estimated Elasticities for Share of

Imports of Capital Goods in Investment

X5 X4
0.022967 . 0.023188
-0.6040 0.6201
6.0328 6.7615
0.5902 0.5764
2.419 2.421
0.004367 0.004514

where MI = wt / qs Parameter estimates for equation (21).


22

ir elt) T (-x(t) ii! = 1 - x(t) is substituted in equation
j=0

(6), then we obtain equation (7).

The steady state we have assumed is characterized by having zero
growth rates.

d :
xt) can be derived by

expanding equation (16) around o=1; Kmenta (1971) provides an example for

. . 2 * f
The approximation of (Me Tat) as A(PL/P

the CES production function. The parameter a is negative provided 5 <i,
which seems reasonable for LDCs (see Taylor 1981). In addition, the serial

independence of Ue follows from the statistical properties of Vee

Regression results using both relative prices and foreign exchange
resources in real terms yield non-significant parameter estimates for
relative prices. This empirical evidence suggests that the influence of
higher prices can be captured by using available foreign exchange deflated

by the price of imports.

4U
We use SITC 7 as a proxy for imports since otherwise it would be

possible to have a share of imports greater than one.

t This is because a good deal of the domestic capital stock takes
the form of infrastructure built by the government. The difficulty in
gathering the data arises because the government may use a social criterion,
and not market prices, in evaluating the desirability of a particular
project.

12 We now use SITC 7 and SITC 5-9 as proxies for imports.


17

LDCs. As a corollary, it also indicates that higher prices for exports of
LDCs, es well as greater access to international capital markets have a
significant positive impact on LDCs capital accumulation and output growth.
The available empirical estimates from equations (9) and (13)
suggest that the capital accumulation process in non-oil LDCs has
(1) a weak response to sustained changes in income; (2) a negative (and
inelastic) response to sustained increases in the relative rental price of
capital; and (3) a rather strong response to sustained changes in foreign

exchange resources.

V.b Empirical Results for Capital Goods Imports

Table 3 contains the results for the share of imports of capital
goods imports in total net investment.” Because data on oe are very
difficult to obtain, we have assumed that dq, /dt=aPf, /dt, where =
py, /Pal In contrast to the results for investment, the parameter estimates
for imports of capital goods are sensitive to the definition of foreign
exchange resources; in particular using Xy> Xos and Xg we get implausible
results such as positive price elasticities. For this reason we only
present results for definitions Xy and Xp We find that the estimated long
run price elasticity for equation (21) is -0.6, implying an inelastic
response of the share of capital goods imports in net investment to
sustained price changes.

The results for equation (22) are presented in Table 4 But
again, the parameter estimates are sensitive to the definition of foreign
exchange resources, and therefore we only present the results for X35 Xqe
and X,. We find that a sustained 1% increase in net investment increases

5
imports of capital goods by a magnitude varying from .28% to .57% depending


Tee BoXe lag + ay(PYCLIACLIY,) + a, (PPCLIA(L) (PL/Pa)e )}# (1-BAX)Ty_y + (8)

from which we derive equation (9) as:
= Pp
BIg BoagXy + oyBo(XpPY(LIA(L)Y,) + a8, (X4PP(L)A(L) (PL /P).)

- BX I (9)

otter Ut

2
where up ~ N(0,0, ),

A(L)

1
Lo - (1-8)L ,
7 i
Pr (L)= Yyayl >
Pye j
pr(L) Yyygt >
A Jz -
and L is the lag operator, L 7.5 tj: ,
We obtain the long run expression for investment by setting

Y,=7

tee eer?

I= a) + ay oY oy 8(PL /P. dee (10)
As we can see, our first approach to modeling the speed of
adjustment results in a long run investment demand function unconstrained by
the availability of foreign exchange resources. This implies that the LDCs

will be able, "somehow", to satisfy their investment needs with domestic
production. For this reason we denote this approach as the "Autarkic
approach",

The basic premise in our second approach to modeling the speed of
adjustment is that foreign exchange resources affect investment demand even

in the long run. Implicitly we are assuming that the LDCs will have greater

Participation in world trade and capital markets as their income increases.


32

Purchasing Power Parity, need not bias our parameter estimates for
marginal .propensities and elasticities if there is a fixed relation
between the variables measured under both methods. To determine whether
such a fixed relation exists, we divide our measure of real output for
non-oil LDC's, Y, by the measure of real output for non-oil LDC's
obtained by Summers, Kravis, and Heston, Y*, for the period 1960-1977.
The ratio of Y to Y* has a mean of 0.2232 with a standard deviation of
9.0032, which clearly indicates a fixed relation between Y and Y*. We
also compare the share of investment in real income for the cases of
constant exchange rate conversion and Purchasing Power Parity

conversion. In both instances, this share equals 2

whith implies
that the ratio of investment measured by constant exchange rate to
iavestment measured by Purchasing Power Parity, is the sare as Y/Y*,
Again, this implies a fixed relation between investment obtained using
constant exchange rates and investment obtained using Purchasing Power

Parities. In conclusion, our estimated elasticities and carginal

propensities are not affected by the use of constant ex

age rates to
convert individual countries' GDP expressed in their donestic currency,
into an aggregate measure of real income in USS. Se want to enphasize
that this happens to be an empirical property of our data set, and we do

not mean to generalize these results to other data sets.

Data Sources

Real income is measured in billions of US$ in 1970 prices and 1970


29

Klein, L., 1983, Lectures in Econometrics, (North-Holland, Amsterdam).

Lewis, W., 1984, The State of Development Theory, American Economic Review, 74,

1-10.

Marquez, <'., 1983, International Transmission of Oil Price Effects and the
Derivation of Optimal Oil Prices, Ph.D. dissertation, (University of

Pennsylvania, Philadelphia).

McKinnon, R., 1964, Foreign Exchange Constraints in Economic Development and

Efficient Aid Allocation, Economic Journal, 74, 387-409.

Robinson, S., 1971, Sources of Growth in Less Developed Countries: A Cross

Section Study, Quarterly Journal of Economics, 85, 391-408.

Salas, J., 1982, Estimation of the Structure of and Elasticities of Mexican

Imports in the Period 1961-1979, Journal of Development Economics, 10, 297-312.

Sato, K., 1967, A Two Level Constant-Elasticity-of-Substitution Production

Function, Review of Economic Studies, 33, 201-218.

Summers, R., I. Kravis, and A. Heston, 1980, International Comparisons of Real

Product and Its Composition: 1950-1977, Review of Income and Wealth, March.

Taylor, L., 1979, Macro Models for Developing Countries, (McGraw-Hill, New

York).

Taylor, L., 1981, South-North Trade and Southern Growth. Bleak Prospects from the


III. Investment Demand and Foreign Exchange

In deriving the demand for investment goods, we make use of the
ideas stemming from the two-gap literature, and we incorporate them ina
nested production function as developed by Sato (1967). Here we assune that
the production function is strongly separable, which in turns allows us to
determine optimal input allocations in two stages: in the first stage,
optimal allocations are made with respect to broad categories of inputs such
as capital, labor, or energy; in the second stage, optimal allocations are
made with respect to less aggregated inputs, such as the composition of the
capital stock, taking as given the (optimal) decisions about aggregate
inputs of the first stage.

Following the nested production function approach, we represent
growth opportunities for developing economies by an aggregate production
function whose arguments are the stock of domestic capital, the stock of

foreign capital, and energy:

Y =F (Rats Kegs Ee) (1)

~<
"

where amount of output produced at time t,

na
"

dt = stock of domestic capital at time t,

x
"

ft stock of foreign capital at time t, and

E, = amount of energy used at time t.

In equation (1) we underscore the fact that domestic capital goods
and foreign capital goods are not perfect substitutes for each other, as has
been pointed out by McKinnon (1964) and Taylor (1979). Following the work
of Sato (1967), we might think of Kat as being made up of structures and of
Keg as being made up of equipment. We also introduce raw materials--energy
in this case--in the production function on the basis that production
processes cannot take place unless a minimum level of raw materials ‘is used

4
in production.


The typical LDC, however, does not have enough foreign exchange
resources available to finance all the required imports. Suppose then that
there exists a lower level of foreign exchange resources, x, implying a
maximum level for imports of capital goods equal to a, below M. In this
situation some of the investment projects that would have taken place under
X will not take place under x, shifting the investment demand schedule to
the left, with a corresponding deterioration of growth prospects. This
decline in investment demand implies in turn a decline in the demand for
capital cioods imports (given prices), which shifts the import demand
schedule to the left until these imports are consistent with the (lower)
amount of foreign exchange resources available, X.

As a result, a constraint on foreign exchange resources adversely
affects cutput growth because it dampens investment possibilities, which in
turn causes a decline in the demand for imports. An alternative argument
is to consider constraints in foreign exchange as a limit on the
availability of capital goods imports, which would reduce the supply of
investment goods and therefore the prospects for growth. There are,
however, two drawbacks to this second line of reasoning: (1) it cannot be
refuted empirically, that is, to the extent that investment is partly made
up of capital goods imports, a limit on the latter must impose a limit of
the formers (2) it is implictily assumed that an increase in the amount
available of foreign exchange resources would lead to an automatic increase
in capital goods imports, even if there is no demand for them! For these
reasons we model the effect of foreign exchange constraints on output via

the constraint put on investment opportunities.


18

on the import category used (SITC 5-9 or SITC 7) and on the measure of
foreign exchange reserves. This inelastic response of capital goods imports
to net investment indicates that the assumption of unitary elasticity is not
appropriate for the non-OPEC LNCs considered as an aggregate.

Given a level of investment, a one percent increase in foreign
exchange reserves has a positive and direct, but relatively small effect on
imports of capital goods with a magnitude that ranges from .21% to 38%
However, changes in the available amount of foreign resources affect. the
demand for investment which in turn affects imports. Thus, an increase in
foreign exchange has a positive, and indirect, effect on imports operating
through increases in investment. Taking into account direct and indirect

effects, we derive the "total" elasticity of imports of capital goods with

respect to an increase in foreign exchange reserves as:
0g 2 O%eg Me) CIM 4X 4 EC (Tige Mig) / Tae) IC %e4/ Une) (lng pq) ) +
TN ti mt mee ti nt’ mt mt’ ° ont ti’ ont nt’ ''ti
+((X,,/M~, )(am", /aX,.)) for 1=1,2,3,4,5
ti’ mt mte ti peewauews

Using X3 as the measure of foreign exchange reserves, we “ind
(using the information from tables 2 and 4) that ng equals 1.004 for SITC
5-9, and 1.3366 for SITC 7. These results clearly indicate that changes in
the availability of foreign exchange resources have a significant impact on
capital good imports as soon as we recognize the influence that these
resources have on investment.

In summary, our empirical results point to an inelastic response
of capital goods imports to changes in the rental price of foreign capital,

probably due to substantial excess in productive capacity (Behrman 1971).


economy experiences a reduction of foreign exchange (i.e., the foreign
exchange constraint is binding). Then, rather than abandoning projects
already under way, it may stretch out the completion date of investment
projects by lowering the speed of adjustment of capital formation. 01 the
other hand, if a particular economy has foreign exchange at its disposal,
then it could achieve its target growth rate for output in less time >y
raising the speed of adjustment of capital accumulation.

This clearly suggests the existence of a relation between foreign
exchange resources and the speed of adjustment of capital formation. We
model the speed of adjustment in two different ways, each leading to a
different formulation of investment demand behavior. In the first approach
we make two intuitively appealing assumptions: (1) if there are "severe"
foreign exchange constraints, then the speed of adjustment should be zero;
(2) if foreign exchange constraints are not present at all (e.g., Saudi
Arabia) then the speed of adjustment should converge to a value By
reflecting delivery lags and other constraints such as size and educaion of
the labor force, and appropriate infrastructure, to mention only two
factors. One function satisfying these properties is:

b= B(1-exp(-X,) ), (6)
where x, represents the purchasing power of foreign exchange resources,
measured in several ways as we shall see below. In reality, however, the
foreign exchange resources are neither zero nor infinite and for this reason
we could very well use an approximation to the function be

bee Boxee (7)

Using equations (4), (5), and (7) we obtain an expression for

investment behavior (Coen 1971:167):


24

Table 1

Parameter Estimates for the Long Run Investment Demand Function
Under the Autarkic Approach*

Xl X2 X3 X4 X5
a, 47.4995 51.7502 61.2419 48.6433 128.1963
a,é 0.1092 0.1398 041238 += 041547 0.2040
2,8 -10.4681 -17.4167 15.0396 -14.4759 -22.5135
By 0.0020 0.0017 0.0030 0.0031 0.0014
Yat
sy) 0.4755 0.6088 0.5391 0.6737 0.8883
a -( -( -
23) -0.1018 -0.1694 -0.1463 -0.1408 -0.2190
R2 0.9126 0.8982 0.8994 0.9159 0.9207
D.We 2.318 2.117 2.078 2..233 2.22
SSE 7.0658 8.2308 8.133 6.799 6.408

* Parameter estimates correspond to equation (10), derived from parameter
estimates from equation (9). R“, D.W, and SSE come from equation (9).

PY(L) = 0.85L° + 0.101 + 0.0517. PP(L) = 0.2L + 0.5L) + 0.327,
ACL) = Lv - 0.9671). P= PL/PQ: Reserve expectations are estimated
using a 3 order autoregressive scheme:

2(L) = (1.055L! - 0.8917 + 0.83L>)

The mean values of the x's are: X,=30.7, X,=36, X,=18, X,=14, and X,=16. ,


International Finance Discussion Papers

Number 251

October 1984

FOREIGN EXCHANGE CONSTRAINTS AND GROWTH POSSIBILITIES IN LDCs

by

Jaime Marquez

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished materials)
should te cleared with the author or authors.


11

IV. Imports of Capital Goods and the Optimal Composition of the Aggregate

Capital Stock

As we recall from equation (3) above, the capital stock is an
aggregate of domestic and foreign capital stocks. If we assume a CES
aggregator function for f, and cost minimizing behavior, then the optimal
composition of the aggregate capital stock between domestic and foreign

capital stock is given by:
ra = Orpf sod yo
Kat/Kee= (-w/ 0)" (Pee/Prg)” > (15)

where o = elasticity of substitution between domestic

and foreign capital stocks,

Pee rental price of foreign capital,
a rental price of domestic capital, and

w = value share of Kee in total aggregate capital stock.

Solving for Kat in (15) and using a CES aggregator function for K*, we get
the optimal demand for foreign capital, Kot as:

*

eee {1¢((1-v)/0) (Peg Pe OEE = g PE set yKe (16)

where o = (1-c)/o. Taking time derivatives in equation (16), we get:

tek + ok **
Rete dK, /dt = 9, Kyt O, K . (17)

*

“n * .
But Kee can be approximated by optimal imports of capital goods, We and K

is, by definition, aggregate optimal net investment, re Furthermore, for

low values of o we find that 947 0, which allows us to write the import

demanc equation as:


10

For this reason, we denote this second approach as the "Trade approach".

Following Coen (1971), we assume that the speed of adjustment is linearly
related to the available amount of foreign exchange, Xe relative to the

*
needed expansion in capital, Ke - Ket
*
Dye by + (Uke /(Ky = Key) > (11)

giving an alternative equation to investment equation (8) (Coen 1971:164-

165):
Tpe DG(KE = Keg) + (I-by (1-6) gy + Oy (Xp_g-Cl-8) Rp) (12)

This formulation can be re-expressed in a form suitable for parameter
estimation (Coen 1971:167) as:

= iy p
T= BGS ag bgay(? (LYACL)Y,) + bgap(? (LYACL)(PL/Pa)4) # (1-bg) (1-8) Ty +
+ by - (1-8)X,_») . (13)
The steady state investment demand function is:

I,= (b oa,/9) + (by da,/e)¥,+ (bg Sa5/¢) (PL /Pa)e + (b,/@)X, 5 (14)

with o® 26+ bo- 8b o> which clearly depends on the availability of foreign

exchange resources.


31

Appendix A

Data problems are frequently encountered in empirical anlayses of
LDC's, especially at the level of aggregation used here. We first deal
with the consequences for parameter estimation of using constant
exchange rates to convert individual country's GDP, expressed in
domestic currencies into an aggregate income measure, expressed in
USS. ke then present the data sources.

The nature of the problem of exchange rate conversion is two fold:
(1) exchange rate fluctuations result in income fluctations unrelated to

input changes; (2) even if exchange rates do not fluctuate, their use

may not be meaningful when a sizeable fraction of the domestic output is
not internationally traded. In our data set we use constant exchange
rates to avoid the first problem. In order to solve the second problen,
we'-could have used Purchasing Power Parities to obtain an aggregate
measure of incone taking into account the internal structure of prices

(of traded and non-traded goods) for each of the countries.

is
measure of income can be obtained from Sunmers, Kravis, and Heston
(1980). Consumption, investment, and goveranent expenditures can be

similarly obtained. However, Summers, Xravis, and

ton do not have
data on international trade variables such as imports of manufactures.
For this reason, and in order to have a consistent accounting system, we
have used constant exchange rates to convert variables from domestic

currencies into USS.

Notice that using constant exchange rate conversions, instead of


30

Structuralist Point of View, Journal of International Economics, 11, 589-602.

Taylor, L., 1983, IS/LM in the Tropics: Diagrammatics of the New Structuralist
Macro Critique, in Cline, W., and S. Weintraub, eds., Economic Stabilization in

Developing Countries, (The Brookings Institution, Washington, D.C.).

Tyler, W., 1981, Growth and Export Expansion in Developing Countries: fome

Empirical Evidence, Journal of Development Economics, 9, 121-130.

van Wijnbergen, S., 1982, Stagflationary Effects of Monetary Stabilization
Policies: A Quantitative Analysis of South Korea, Journal of Development

Economics, 10, 133-169.


Using the strong input separability assumption, we express the
production function as:

Y= F(F(Kyps Kee )0E, ) = G(K,,E,), (2)
where

K,= f(K

t K,

= aggregate capital stock. (3)

dt’ ft)

Following the approach developed by Coen (1971), the optimal
amount cf the aggregate capital stock is determined as a function of factor
prices and output:

kos

Ke = (Py Pa) gate)» 8
where Pee = rental price of the aggregate capital stock at time t,

= Pate (Met SP gt /Pg t-y))>

0
"

= price of energy at time t,

et

Ke = optimal aggregate capital stock at time t,
rt = nominal interest rate at time t,

Pat = price of investment goods at time t, and
6 = depreciation rate.

After algebraic manipulations, we obtain (Coen 1971:148,149) an
expression for actual investment:

Ty = b(Ke = (1-8)Ky 4) +(1-b)I, (5)

where b = speed of adjustment.

Actual investment I, might differ from optimal or planned,
investment (Ki (1-8)Ky_) because of obvious lags in the delivery of
capital goods and, more importantly, because of the lack of financial

resources to finance investment projects. Suppose now that a developing


21

Footnotes
*This paper is based on my Ph.D. dissertation at the University of
Pennsylvania. I am grateful to F. Gerard Adams, Jere Behrman, Lawrence
Klein, Akifumi Kuchicki, Peter Pauly, and Mikko Puhakka for their comments
and suggestions. Comments from an anonymous referee proved to be quite
helpful. Any remaining errors are my own. The views presented in this
paper do not represent the views of the Board of Governors or any of its

staff members.

See Salas (1982), and Klein(1983).

This argument implies that domestic capital goods are imperfect
substitutes for capital goods imports, which seems an accurate description

for LDCs (see McKinnon 1964 and Taylor 1981).

As a result of this multistage decision process, it is possible to
have di*ferent elasticities of substitution for different pairs of factors,
which is a relevant consideration in modeling the agricultural sector
(Kaneda 1982) and the price determination process (van Wijnbergen 1982,

Taylor 1979).

In addition, we use energy as this essential raw material because
it introduces one more channel of influence to study the effects of oil

price changes on growth performance of LDCS and their financing requirements

(see Marquez 1983).

Notice that we are assuming zero growth in expected capital

gains.


27

Table 4

Long Run Elasticities for Imports of Capital Goods
(Numbers in parentheses are t-statistics)

X5 X3 X4
SITC #5-9
2
( % 2 Ma 4 0.3754 0.3448 0.2261
wt ay (5.28) (4.432) (4.59)
2
a
( 4 ** ) 0.29057 0.277 0.5674
wat, (7.522) (1.802) (5.317)
R? 0.9878 0.966 0.9879
DW. 2.279 1.575 2.364
SSE 0.0010 0.0023 0.0011
sITc #7.
a ye
2
( a am.) ) 0.2424 0. 2046 0.3828
MX; (3.118) (1.633) (3.412)
oe
aM
4 -—— 0.4529 0.4756 0.4041
My ad, (10.767) (7.501) (7.749)
R2 0.9897 0.9843 0.99
D.We 1.849 1.408 1.96
SSE 0.0013 0.0020 0.0012
* Parameter estimates for equation (22).
D(L) = 0.109 + 0.7L) + 0.2L? . EL) = LO.

2(L) = 2

1.061 - 0.89L” + 0.83L”.

3


I = 1 (0, Y, X),
where 1! = ex-ante investment demand,
Q = rental price of capital relative to the price of energy,
Y = real income, and
X = available amount of foreign exchange resources, in real

terms.

In addition, we model the ex-ante demand for imports of capital
goods as a function of the level of investment and of the price of capital
goods imports relative to the price of domestic goods (again, this
functional relationship is formally derived in section IV):

d

m7

we

a M(P, I

)s

where mt = demand for imports of capital goods,

P = price of capital goods imports relative to domestic prices.

The interdependency between investment and imports is depicted
in Figures la and 1b. Each of these functions is inversely related to their
respective relative prices, and thus the downward sloping nature of their
schedules. Suppose now that a target level of income Y* has been set by the
government or the planning board. Given relative prices, q, and a given
amount of foreign exchange resources, X, we can determine the ex-ante demand
for investment goods as 14, This level of investment demand determines in
turn the ex-ante demand for capital goods assuming a perfectly elastic
supply schedule for capital goods imports, and assuming that X is large
enough to purchase the required capital goods imports. Ex-post, the supply

of investment will be equal to a domestic component plus imports of capital

goods, M.


14

introduced as a reduction of foreign exchange resources; in addition, the
long run elasticity of imports with respect to net investment is freely

estimated.

v. Empirical Results

The purpose of this section is to estimate the parameters of the
investment demand and capital imports equations derived in sections III and
IV using aggregate non-OPEC developing countries data for the period 1960-
1977. Obviously, a more disaggregate level would be preferable, although
our empirical results are supported by particular country studies such as
those reported in Taylor (1979), Salas (1982), Klein (1965), and van
Wijnbergen (1982). In any event, the specifications we have developed here
are of interest since they can be applied to the estimation of investment
and demand equations for particular countries.

Since there is not a unique way of measuring the availability of

foreign exchange resources, we study five alternatives:

eye CPaekae * PreMne)/Pat + (23a)
Xeo= (meat * PreNrt ~ Po Moe)/ Pat» (23)
Xe ge Ep (REG, ZL) (REPEL) = Lyzgh REP he)» (23c)
Xeqe Rea! Pat (234)
Kes® Rea! Pate? (23e)

where

Pat = export price of manufactures of LNCs,


16

propensity to invest suggests in turn a low domestic marginal propensity to
save out of disposable income, which indicates that domestic savings have
played a minor role in financing gross capital accumulation in LNCs (see
Taylor 1983, Lewis 1984). The values for the long run income elasticity
(valued at the mean) range from 0.47 to 0.88. The estimated relative price
elasticity (valued at the means) ranges from -0.1 to -0.22. This price
inelasticity could be due to (1) the absence of a significant amount of
skilled labor, which if available, could have been used as a substitute
factor for capital, and (2) excess capacity in the capital stock (Berman
1971). The inelastic response of investment demand to changes in either
real income or prices is robust to the definitions of foreign exchange
resources used here.

In the second formulation for investment demand, equation (13),
the maintained hypothesis is that foreign exchange resources have a
positive effect on investment in both the short and the long run. The
parameter estimates for this formulation are presented in Table 2. However,
we use the level of foreign exchange resources, instead of its changes. since
in estimating equation (13) we obtained implausible results such as positive
price elasticities. In any event, it is quite reasonable to expect a
positive association between the level of investment and the availability of
foreign exchange reserves, as implied by the two-gap literature. The
results indicate a long run marginal propensity to invest ranging in value
from 0.04 to 0.16 while the estimated Jong run income elasticity ranges from
.21 to .69. The estimated long run (relative) price elasticity ranges from
-0.027 to -0.023, very close to that of equation (9); the estimated long run
foreign exchange elasticity ranges from 1.2 to 4.6, which is indicative of
the potential negative impact of oil price increases on capital accumulation

and income growth of non-oil


of the design and implementation of investment plans (see World Bank 1982),
it is of interest to study investment and import behavior allowing for a
non-constant speed of adjustment and, especially, for imperfect
substitutability between domestic capital and foreign capital as pointed out
by McKinnon (1964) and Taylor (1979).

The intuition behind our approach is developed in section II. In
sections III and IV we present a theoretical framework to explain investment
and import behavior allowing for an endogenous speed of adjustment and for
imperfect substitutability between the domestic and the foreign capital
stocks. In section V we implement empirically our theoretical analysis and

present empirical results; finally section VI contains our conclusions.

II. Investment, Foreign Exchange, and Growth

Several approaches have been used in modeling the effects of
foreign exchange constraints on output growth. One approach relates foreign
exchange resources--measured as either total exports, international
reserves, or deficit in the balance of payments--to investment activities
which are linked to output growth via capital accumulation. A second
approach relates output growth directly to foreign exchange resources via an
aggregate production function on the basis that foreign exchange is a scarce
resource and thus can be treated “as if" it were a factor of production
(Tyler 1981, Robinson 1971).

In this paper we study the influence of foreign exchange
constraints on growth by focusing on investment and import demand behavicr.
We begin by assuming that investment demand depends on the price of capital
relative to energy, real income, and the available amount
of foreign exchange resources (this functional relation is formally derived

below in section III):


25

Table 2

Parameter Estimates for the Long Run Investment Demand Function
Under the (Modified) Trade Approach*

X1 X2 X3
by Oy 3 0.0483 0.0624 0.1597
& .
5 ;
Po Sp ° -2.8081  -8.8842 -24.2046
®
by
= 2.25667 10.3667 9.3455
$
Yat
(33) 0.2103 0.2717 = 0.6954
Pat - -
Eas) 0.0273 0.0864 -0.2354
X(32) 1.2333 4.0433 2.38
R2 0.9927 0.9918 0.9897
D.We 2.635 2.397 2.100
SSE 7.07 7.904 9.95

* Parameter estimates come from equation (14), derived from equation

G3). ‘2, D.W. and SSE come from equation (13).

P, P(L), PPcLy, and A(L) are defined in Table 1.


Foreign Exchange Constraints and Growth Possibilities in LDCs
by
Jaime Marquez*

I, Introduction

One characteristic that many developing countries share is the
substantial government participation in the economic development process
through the setting of targets for output growth and the dates to achieve
them (Chenery and Strout 1966, Lewis 1984). As a result, the government
plays a kay role in determining the speed at which the economy's capital
stock adjusts to the level implied by the growth target. Naturally, the
setting of these growth targets involves taking into account a number of
additional factors such as the distributional effects of growth, the level
of education, natural resources, and national priorities. But, the aspect
that concerns us here is the interaction between the availability of foreign
exchange resources and the speed of adjustment of capital stock.

In particular, if a developing economy is experiencing a lack of
foreign exchange, unable to finance the foreign component of its capital
stock, then it may choose to stretch out the completion date of projects
already under way by lowering the speed of adjustment of capital formation
rather that abandoning these projects altogether. On the other hand, if a
particular economy has foreign exchange at its disposal, then it could
achieve its target growth rate in less time by raising the speed of
adjustment of capital formation. Therefore, it is quite conceivable that
the speed of adjustment of capital formation in a developing country may be
related to the availability of foreign exchange resources.

Although the relationship between the speed of adjustment of
capital formation and foreign exchange resources is intuitively obvious, we
find that this speed is generally treated in the development literature as
one more parameter to be estimated, completely unrelated to the availability

of foreiga exchange resources. Given that these resources are a key aspect


33

exchange rates. The source is Bijou Yeh (1980), “A Global Economic
Model of.a Three Region World,” Ph.D. Dissertation, University of

Pennsylvania. (Main sources: World Bank, U.N., and I.M.F.)

The capital stock is measured in billions of USS in 1970 prices and 1970
exchange rates. We use a capital output ratio of 3.38, which is very
close to the median capital output ratio for developing economies

(Chenery and Strout, 1966), and a depreciation rate of 3%.

Inport data are measured in billions of USS of 1970 prices and are

obzained from U.N. Trade Statistics, various issues

Data on international reserves are in billions of USS and are obtained

from I.M.F., Yearbook, 1980.

Data for prices are measured in indexes with 1970 as the base vear.
They are obtained as follows:
Py: The price of oil is a chained price index of three oil prizes, Ras
Tanura (Saudi Arabia), Es Sidra (Libya), and Tia Juana (Venezuela):
I.M.F. Yearbook, 1980.

2

Poi Export price index of manufactures of non-oil LDC's: U.N. Trade

Statistics.

Py : Import price index of raw materials is a weighted average of the
import price of SITC#0-1 and #2 plus #4. The weights are the trade

value shares: U.N. Trade Statistics.


28

Bibliography

Adams, F.G. and J. Marquez, 1983, A Global Model of Oil Price Impacts, in Adams,
F.G. and Hickman B. eds., Global Econometrics: Essays in Honor of Lawrence Klein,

(MIT Press, Cambridge).

Behrman, J., 1979, Review Article: UNCTAD Secretariat, Trade Prospects and
Capital Needs of Developing Countries, International Economic Review, 12,

519-525.

Chenery, H. and A. Strout, 1966, Foreign Assistance and Economic Development,

American Economic Review, 56, 679-733.

Coen, R., 1971, The Effect of Cash Flow on the Speed of Adjustment, in Fromm,
Gary, ed., Tax Incentives and Capital Spending, (Brookings Institution,

Washington, D.C.).

De Melo, J. and S. Robinson, 1982, Trade Adjustment Policies, Journal of

Development Economics, 10, 67-92.

Kmenta, J., 1971, Elements of Econometrics (MacMillan, New York).

Kaneda, H., 1982, Specification of Production Functions for Analyzing Technical

Change and Factor Inputs in Agricultural Development, Journal of Development

Economics, 11, 97-108.

Klein, L., 1965, What Kind of Macroeconometric Model for Developing Economies?,

The Econometric Annual of The Indian Economic Journal, 13, 313-324.


12

a*_ of sod yr = woof ppd
Mat 90Pe/ Pee Tme= Mae /Pke> Ine) (18)

We use two different approaches to transform equation (18) into an
expression suitable for parameter estimation. In the first approach we
assume that the investment elasticity of imports is one. This assumption
implies that the optimal share of capital goods imports in total net

investment is a function of the real price of foreign capital:

(ME Tne) = 90 Pee/Pee) exP (vy )> (19)

with v4eN(O,0y) and E(V,Vp_y)#(1=A)@,/(J#(1-2)

Changes in relative prices will induce a change in the optimal
share of capital goods' imports in total net investment. However, the
adjustment to relative price changes is unlikely to be instantaneous, and a
powerful reason to have a wedge between optimal and actual values is the
presence of a foreign exchange constraint. As a result there will be a
difference between the actual and the optimal import-investment share. We
postulate the following adjustment process:

Ms 1--' (vy- (1-a)v

) ;
* t t-1
(Me Toe) = (Mme/Ent) Mma Inet) & , (20)

where 4! is the speed of adjustment of the optimal import share. As in the
case of investment demand behavior, we assume that the adjustment rate
varies in direct relation to the availability of foreign exchange

resources, that is, A' = By Xe After taking logs in equation (20), we


lo

Pat = export price of raw materials of LDCs,

Pot = price of oil charged by OPEC,

can = exports of manufactures from LDCs to DCs,

wa = LDCs' exports of raw materials to DCs,

We = imports of oil of LDCs from OPEC,

Cr, = net capital flows to LDCs from DCs and OPEC.
Re = foreign exchange reserves, and

Re = Regt Pent * Pree - PotMoe ~ Pat at + CF.

Xeq represents the value of exports of LDCs in terms of the
capital goods they import from the NCs; Xto is similar to Xep but we deduct
the value of oil imports from total exports since oil is an intermediate
input and it is needed to maintain the current level of output; according to
Xe3 the relevant measure of foreign exchange resources is the expected
value cf the stock of international reserves (in terms of capital goods
imports), and we assume that expectations are formed by a distributed lag of
past values of the level of international reserves in real terms. Xiq and

Xe5 are special cases of Xj.

Va. Empirical Results for Aggregate Investment Demand

In Table 1 we present the long run parameter estimates for the
investment demand equation corresponding to the Autarkic approach (equation
(9)), where the maintained hypothesis is that investment behavior, in the
long run, is independent of the amount of foreign exchange available. With

the exception of X the values for the long run marginal propensity to

5?
invest range from 0.11 to 0.15. This relatively low estimated marginal